Making Contracts Smarter in the Blockchain
Bridging the Trust Deficit
If you use the internet in any way for your day-to-day transactions, whether at your workplace, for business or personal purposes, you cannot have missed the buzz around blockchain technology in India, particularly since the advent of demonetization last year. Some analysts cite demonetization as the primary trigger for the increased interest and investments in blockchain technology, especially in the banking and financial services sector. While that’s partially true, it misses the point that at any rate the government and regulators across sectors could not have ignored the elephant in the room called blockchain – a disruptive technology that’s closest to bridging the trust deficit in online and physical transactions.
The blockchain is a distributed, digital, decentralized public ledger that allows multiple users (each of whom can make encrypted entries) to operate or manage it. Most importantly, it eliminates the requirement of ‘trusted’ third parties such as banks, governments, notaries, accountants, paper money etc. All transactions, including information on the time, date, participants and amount, are logged chronologically and irreversibly. Each node on the network owns a complete record of the blockchain. Every block is linked to the subsequent block (which contains the hash of the previous block) with a cryptographic signature, thereby achieving a robust, immutable and tamper-proof standard of security. Participants can add and authenticate new transactions through a process called ‘mining’ on each block of data which allows a consensus amongst those who do not know or trust each other. Such consensus becomes a pre-requisite for the next transaction. Blockchain technology can considerably simplify processes and cut costs for certain complex transactions (such as peer-to-peer payment services, trans-border remittances, supply chain tracking, stocks trading etc.), across industries (banking, retail, healthcare & life sciences, insurance, capital markets, logistics, telecommunications, real estate etc.).
This is where the concept of smart contracts comes into play. A smart contract is a certain computer code (and not exactly another kind of a contract in the traditional legal sense) built into the blockchain network that automatically processes pre-defined business logic and executes a transaction without the auspices of a third-party. To explain with a case from the IT industry, an IT supplier provides application, development and maintenance services for a Software-as-a-Service on a fixed price model to a client, where the work is performed over multiple milestones. Upon completion of each milestone within a stipulated date, and acceptance of services by the client in accordance with the acceptance criteria, the supplier invoices the client. The acceptance criteria are mutually accepted specifications captured in writing against which the services are tested. Here, invoicing is conditional on client’s acceptance within a particular time period and supplier’s completion of the concerned milestone. The supplier uploads the invoices onto the client’s AscentERP application that’s hosted on the Salesforce platform. The client has to pay the invoiced amounts within thirty days of receipt. The client pays the amounts through internet banking where the sender’s and beneficiary’s banks verify the alphanumeric code and the account number respectively. In today’s world, lawyers representing both parties will draft, negotiate and finalize the framework contract and service-level agreements that enunciate in legalese, each step in this lifecycle, right from the effective date of commencement of services, scope of services, milestones, acceptance period, acceptance criteria, payment period and mode of payment. Enforcement of and compliance with the contract is typically successive to contract execution.
If this was to play out in the blockchain ecosystem, the smart contract would hold back the client’s payment to the supplier until service milestones are met and client accepts the services within the acceptance period. The services of managing the design, coding, testing, ongoing upgrades and debugging can be recorded real-time in the blockchain. A sensor that embeds information into the blockchain can monitor delivery of hardware or equipment, if any, by the supplier. The smart contract would define the acceptance criteria, and proceed for client to issue certificate of acceptance only on services meeting such criteria. The smart contract would then invoice the client, eliminating the need to upload it in the client’s application hosted in a third-party cloud. Payment will be made only if the invoice is released. The client can make payments in bitcoins or any other cryptocurrency, which disintermediates the sender’s and beneficiary’s banks. The certificate of acceptance from the client and the invoices from the supplier can be released as digital assets in the blockchain. All these functions can execute automatically when supplier’s and client’s specific conditions are met.
In what seems to be a first-of-its-kind globally, IBM reported signing a contract with Bank of Tokyo-Mitsubishi UFJ (BTMU), Japan’s premier bank, in 2016 to apply blockchain technology to the design, management and execution of contracts, and to automate business transactions among multiple partners. The venture is built on an open-source blockchain platform that allows, among others, for a smart contract system prototype to “improve the efficiency and accountability of service level agreements in multi-party business interactions”.
What’s Changing in the Traditional Contracts
The traditional natural language contract serves as proof of parties’ intent as to their rights and responsibilities, and is binding and enforceable under law, if it has all elements of a valid contract. Smart contracts are a step ahead and effectively enforce parties’ intent by conditionally controlling transfer of assets and currency. In the event of a dispute between parties, the entire process of litigation or alternate dispute resolution can be prolonged, expensive and damaging. Millions of contracts with complex legalese come under the scrutiny and interpretation of courts globally every day because enforcement in a dispute scenario becomes the need of at least one party. Technically, smart contracts are not capable of being breached because they are coded with mathematical logic and will not perform unless a condition is met. Breach by any one party is impossible in a consensual and transparent ecosystem. This automatically makes the potential for dispute and litigation weak.
All this begs the obvious question: how will the law of contracts apply to smart contracts? Smart contracts will not completely dislodge the traditional legal contracts because they are not capable of judgment or independent thinking. But the structure and templates of the latter will have to be revamped to accommodate a code-written contract within its framework. The question whether smart contracts satisfy the elements of a valid contract such as offer, acceptance, legal purpose, consideration, consent etc. (and this could vary with each country or body of law), though clichéd, is eternally relevant. While smart contracts are technologically enforceable, their legal enforceability in courts will depend on whether they are valid in the eyes of the law and regulators in the first place. In addition, lawyers have to grapple with hitherto unfamiliar risks that are not typical of financial transactions. Take the example of QuadrigaCX, a Canadian digital currency exchange that recently reported a coding error in a smart contract that led to a multi-million loss of the cryptocurrency Ether. The error held back the inflowing amounts of Ether in the smart contract which was valued at USD 14 million. The parties can possibly correct such an error by entering into another suitably coded smart contract, but the loss arising from the error can be significantly huge (as seen here), and can be worse if it leads to a security breach or loss of data. Lawyers, especially those negotiating contracts with entities that provide smart contract based-services, would do well to draft appropriate indemnification remedies into the natural language contracts that address such risks, including for product liability and cybersecurity.
Intellectual property assignment and licensing has a greater potential to be written into a smart contract than clauses such as non-competes, non-solicitation, limitation of liability, statutory compliances, representations, covenants and warranties, indemnities for third-party claims, governing law etc., which cannot be easily automated. Liability, in particular, may be difficult to determine. Lawyers love to labour over standards of fault involved in simple and gross negligence. Miswriting a code could throw open novel interpretations of negligence under contract laws. Secondly, in an open-source blockchain where multiple anonymous users modify the code, fixing liability on any one user can be a dilemma for the courts.
Sairam Sanath Kumar is a technology lawyer and a Legal Counsel with Cognizant Technology Solutions, based in Chennai.
Views expressed are personal of the author. The Indian Jurist does not take responsibility for the views expressed or facts stated.