[Rishi A is legal analyst at spotdraft.com]
Introduction
Earlier this year, the State Bank of India (‘SBI’) launched BankChain, a blockchain platform formed by a consortium of 27 banks, which was proposed to be used to share e-KYC information about customers within the consortium. This would help with the transmission of information directly to the banks without any leakages or delays.
Last week, the SBI announced that it was going to beta test smart contracts on this blockchain platform to minimize the effort involved in executing contracts of a generic nature, like non-disclosure agreements. Articles in leading newspapers were soon to follow, arguing in favour of the huge benefits that come along with adopting a revolutionary technological service like smart contracts.
I do not dispute the benefits of the adoption of either the blockchain technology or smart contracts, but it is my argument that our current regulatory framework does not support the introduction or adoption of smart contracts on a large scale.
What are Smart Contracts?
Before moving to the legality of smart contracts, it is important to understand how they work. Smart contracts are contracts whose terms and conditions are converted into a software code. The contract is then floated on a blockchain such that each transaction executed by the contract is logged as a block on the blockchain platform thus creating a clear audit trail, which is extremely difficult to erase or wipe-out.
Since the terms and conditions have to be encoded, smart contracts are easily formed around contracts which are based on an ‘if-then’ situation – ‘if’ x condition is fulfilled, ‘then’ y obligation must be enforced. Because of this feature, smart contracts are best suited for industries which use such ‘if-then’ contracts, like the insurance sector or the financial services sector. Moreover, smart contracts are easier to create when there are no (or minimum) non-operational clauses involved – clauses which are ambiguous and open to interpretation, like good faith obligations, uncertain governing/ jurisdiction clauses.
The computer coded obligations of the contract self-execute when certain conditions are met. This gives the contracts a feature of being self-executory. Further, once the contracts are executed, the completion of the obligations, encoded, cannot be stopped mid-way; thus, it becomes self-enforcing. However, unlike a traditional contract, modification of smart contracts is extremely difficult. Since the obligations are computer coded, any modification or amendment would require parties to code the contract from scratch.
How have smart contracts been regulated around the world?
Smart contracts have to fulfill the basic ingredients of a traditional contract, i.e., there must be a valid offer, a valid acceptance, lawful subject matter and consideration, valid consent and competent parties. Having fulfilled these conditions, the questions that arise are: (i) whether an electronic signature obtained using the blockchain technology is considered as a valid form of authenticating an electronic agreement; and (ii) whether a smart contract would carry evidentiary value so that it may be submitted in court as evidence if a dispute arises.
In 1999, around 47 states in the United States (‘US’) adopted the Uniform Electronic Transactions Act (‘UETA’). The UETA placed regulations with regards to electronic contracts, records and signatures and stated that electronic contracts would be valid, and the use of an electronic signature was a valid method of providing consent for contracts.
However, in 2017, various states in the US saw the need to make special regulations for the adoption of smart contracts on a large scale. Thus, states like Arizona passed laws recognizing the signatures provided for smart contracts using the blockchain technology.[1] Furthermore, states like Vermont and Nevada passed laws recognizing contracts executed on the blockchain, thereby giving specific recognition to smart contracts.[2] Laws were also passed to allow smart contracts to be used as a form of evidence if a dispute ever arose.
What are the regulations in India that could regulate smart contracts?
India has enacted the Information Technology Act, 2000 (‘IT Act’) which is very similar to the US’s UETA. While the IT Act allows contracts or records to be validated or authenticated by using electronic signatures,[3] it has placed regulations or conditions on how one can obtain a digital signature. Under section 35 of the IT Act, a digital signature can be obtained only from a government designated certifying authority. This would be the first point of concern for a smart contract, since to validate a smart contract it is the blockchain technology that generates the hash-key to be used as an individual identifier and authenticator.
Numerous amendments were also made to the Indian Evidence Act, 1872 to include provisions for the admissibility of electronic records, signatures and agreements. Section 85B states that an electronic agreement would be considered as a valid agreement only if it is authenticated using an electronic signature, one obtained in accordance with the provisions of the IT Act. Section 88A of the Indian Evidence Act states that the court shall presume the authenticity of an electronic record produced in court, but shall make no presumptions about the sender of the record. Thus, if a signature is used that is obtained via the blockchain technology, it will only make the admissibility of the smart contract more difficult, since the signature has not been obtained under the IT Act. This not just vitiates the authentication process present for smart contracts within the blockchain technology, but also disallows such contracts to be submitted as evidence in front of the court.
Conclusion
Having said the above, there is no doubt that the adoption of smart contracts can be revolutionary and can directly result in the reductions of over-head costs in the billions while at the same time making the entire process more secure. For example, a Capgemini study reports that, through the adoption of smart contracts, retail banking and insurance companies alone can save close to USD 3-11 billion in reduced overhead costs, which could in-turn result in a USD 980 savings for each individual customer.
However, regulatory concerns exist, especially in India where there are no regulations with respect to the finer details relating to smart contracts. A wide scale adoption of the technology will require the government to make amendments to the Indian Evidence Act, 1872 and the IT Act, if specific regulations are not made. Also, with respect to the capability to code certain kinds of clauses, industries must try and affix a specific interpretation on clauses which could be considered ambiguous.
Thus, to conclude, it would be too early to celebrate the introduction of smart contracts into our markets, especially when they operate in such a regulatory grey area.
– Rishi A
[1] Article 5, HB 2417, State of Arizona, 53rd Legislature, 2017, available at: http://www.azleg.gov/legtext/53leg/1r/bills/hb2417p.pdf
[2] Senate Bill No. 398, State of Nevada, March 20, 2017, available at: https://www.leg.state.nv.us/Session/79th2017/Bills/SB/SB398_R1.pdf; See also, Act No. 157 (H. 868), House Committee on Commerce and Economic Development, State of Vermont, 2017, available at: http://legislature.vermont.gov/assets/Documents/2016/Docs/ACTS/ACT157/ACT157%20Act%20Summary.pdf
[3] Section 5 of the Information Technology Act, 2000.