Digital Contracts And Smart Contracts: Legal Validity And Enforceability
Shreyas Ranjit
University Of Mumbai Law Academy
This Article is written by Shreyas Ranjit, a Fourth-Year law student of University Of Mumbai Law Academy
Introduction:
Everything regarding legal agreements appears to form a reformative change with the turn of technology and legislation. The development of digital contracts and smart contracts is a significant paradigm shift in how contracts are formed, executed, and enforced. A digital contract is simply the electronic version of the traditional paper contract, but a smart contract works on an advanced level using blockchain technology to automatically enforce contractual terms without human intervention. In today's increasingly digitalized world, the enforceability of these contracts, particularly smart contracts, is becoming an increasingly crucial legal issue.
Digital contracts are relatively easy to understand; they consist of signatures (usually electronic) to authenticate and bind the parties involved much like a paper contract. Smart contracts are much more complex. These contracts automatically execute the transactions when the conditions, which are encoded in the blockchain, get satisfied; hence intermediaries such as banks, lawyers, or even courts are dispensed with. For all these promises of efficiency and transparency, the legality and enforceability of smart contracts remain contentious at least for jurisdictions like India, where the law remains to be amended because of fast technological progress made here.
In this respect, the article throws light on the comparative legal status of both digital and smart contracts with a special focus on their enforceability under Indian law in the wake of comparisons with global trends. Also, we shall analyze how blockchain technology transforms standards of contract law and what challenges smart contracts throw up at traditional legal structures.[1]
Understanding Smart Contracts and Digital Contracts:
Smart contracts are a type of software program developed to facilitate, authenticate, and execute the execution of an agreement through the use of blockchain technology. The conditions for the agreement are encoded and placed on a blockchain and, therefore, are self-enforcing when the specified conditions are met. This kind of contract is therefore termed self-executing, meaning that once it is created, it performs independently without requiring further action on the part of the parties involved. For example, if a smart contract governs a real estate transaction, the contract could automatically transfer ownership of a property once payment is made by the buyer, without the need for any third-party involvement.
On the other hand, digital contracts include electronic versions of conventional contracts. Generally executed with digital signatures, these contracts are subject to the same legal requirements applicable to paper contracts. While in the context of India, electronic contracts are recognized under the Information Technology (IT) Act, 2000, which gives legal validity to both the electronic contract and signature. This legislation ensures that digital contracts can be enforced within Indian judiciary systems, provided they satisfy certain criteria, including having a valid digital signature.
Even though both digital and smart contracts provide the possibility of conducting transactions in the virtual world, the main difference is between the degree of automatization and dependence on such middlemen being involved. A digital contract demands human intervention to execute and enforce it, often demanding the participation of legal practitioners, middlemen, or judicial systems in case of disputes. Smart contracts try to do away with such middlemen as their process is fully automated by blockchain technology while executing and enforcing the contract.
The Legal Framework for Digital Contracts in India:
Digital contracts are widely recognized and accepted in the present legal system of India. The Indian Contract Act of 1872 forms the primary basis of all agreements through contracts in India; this also includes those carried out digitally. According to Section 10 of the same Act, a valid contract must meet the following important elements:
1. Competency of Parties: The parties entering into the contract must be competent to contract, meaning they must be of legal age, sound mind, and not disqualified by any law.
2. Free Consent: The agreement must be based on the free consent of the parties. If consent is obtained through coercion, undue influence, fraud, or misrepresentation, the contract may be declared void.[2]
3. Lawful Consideration and Object: The consideration (something of value exchanged between the parties) and the object of the contract must be lawful. Contracts based on illegal activities are void.
4. Not Explicitly Declared Void: The contract should not be explicitly declared void by the law. For instance, contracts entered based on wagering or gambling are considered void under Indian law.
Interestingly, even though the Indian Contract Act, 1872 does not have express mandates to the effect that contracts be in writing or signed with penned signatures, except where the statutes require a written contract, such liberality allows the acceptance of smart contracts as binding in law, provided they fulfill the basic conditions of capacity, mutual consent, lawful consideration and legality.
The Information Technology (IT) Act, 2000, henceforth provides greater teeth to electronic agreements in that it recognizes digital signatures and electronic processes as valid means for executing agreements. Section 5 of the IT Act presumes an agreement to be genuine, wherein the same is made through a digital signature and Section 10A categorically states that contracts created through electronic means shall not be void merely because they are created electronically.
Therefore, the regulatory structure regarding digital contracts in India is well-defined, providing clear guidelines for implementation and legal underpinnings. However, the same cannot be said for smart contracts due to their specific challenges like they are decentralized and automated.
Enforceability of Smart Contracts Under Indian Law:
The law of smart contracts remains a grey area in Indian jurisdiction, where dedicated statutes are absent, solely governing smart contracts. However, such contracts may still be held to be valid and enforceable under the Indian Contract Act, 1872 when it meets the basic contracting prerequisites outlined above. In a traditional smart contract, the offer and acceptance are embedded in the blockchain. These would automatically be triggered based on specific conditions being met. For instance, in a smart contract governing a financial transaction, a stipulation may be made that Party A is to transfer cryptocurrency to Party B as long as goods are delivered. If the goods are successfully delivered and verified in the blockchain, the contract automatically triggers a fund transfer and requires no more communication between parties.
This automated procedure satisfies the conditions for offer and acceptance under Indian contract law. Still, the decentralized feature of smart contracts raises concerns regarding their enforceability since such contracts do not require digital signatures authenticated by a governmental authority, a provision under the IT Act, 2000, for electronic agreements. Instead, smart contracts rely upon cryptographic keys for verification purposes and may not be recognized by Indian courts as a valid form of signature. A scenario like this may lead to a challenging process to prove the genuineness of a smart contract during litigation, considering that Section 65B of the Indian Evidence Act, 1872 provides that an electronic record shall be considered as a document only if it carries a valid digital signature.[3]
Another challenge is manifested in the immovability of smart contracts. While on the blockchain, the terms of a smart contract become unchangeable, which makes it difficult to update for some instances that may require modification in light of unforeseen incidences or legal amendments. Traditional contracts can be modified based on the mutual agreement of the affected parties or through judicial decisions to allow adjustment in the event of a conflict case.
Smart contracts have an in-built inflexibility in their design, executing precisely as they are articulated, allowing little scope for judicial intervention. Despite these challenges, smart contracts may be enforceable in India if only they comply with the basic elements of offer, acceptance, and consideration. However, the lack of a profound legal framework that explicitly governs smart contracts does not guarantee the same extent of protection that ordinary contracts normally enjoy for the parties to it. [4]
To understand the enforceability of smart contracts in India, it is essential to look at Section 10 of the Indian Contract Act, 1872, which specifies the following conditions to form a valid contract:
1. The parties to the contract must be competent to contract.
2. The agreement must be based on the free consent of the parties.
3. The consideration and object should be lawfully sound. 4. The agreement must not be expressly declared void.
It is noteworthy that the Indian Contract Act has clarified the point that a contract need not always be in writing unless so directed by statute, and a contract need not necessarily be in paper or computer medium to be valid. This means smart contracts might well be legally enforced in India if they are by the criteria mentioned above.
Smart contracts, like traditional contracts, involve an offer, acceptance, and lawful consideration, all of which are essential elements for contract validity under Indian law.
Nevertheless, certain restrictions still apply, particularly to consideration for each other. Under Indian law, a contract requires consideration that must be provided by both parties in mutual consideration. A unilateral contract, where the contractual consideration is provided by one party only, can even be rendered invalid. Under the smart contract framework, the execution of a contract on the blockchain does not guarantee enforceability in an Indian court if mutual consideration is absent. For example, should a smart contract permit the transfer of cryptocurrency without corresponding obligation, it may be held invalid due to the lack of mutual consideration.[5]
International Perspectives on Smart Contract Enforcement:
At a global level, many legal jurisdictions are establishing the recognition of the legal validity of smart contracts and then consequently adapting their respective legal frameworks. In the United States, the Uniform Electronic Transactions Act (UETA) combined with the Electronic Signatures in Global and National Commerce Act (E-SIGN) provides legal effect to electronic contracts and signatures. However, the enforceability of smart contracts is still an emerging area of law. Some states in the United States, such as Arizona and Nevada, are at the forefront, enacting laws that affirmatively ratify smart contracts and blockchains as valid methods of contract enforcement.
Its law in Arizona holds that data on a blockchain, even smart contracts, cannot be rendered without legal effect solely based on its presence on a blockchain. This forward-thinking legal position establishes a significant precedent for the future application of smart contracts within the United States and may encourage other jurisdictions to implement comparable legislation.[6]
Within the EU, the GDPR represents a new dimension of challenges posed to smart contracts, particularly in aspects like the right to forget and blockchain immutability. However, several other countries in the EU are starting pilot applications of smart contracts in domains as varied as financial sectors, property registrations, and supply chains in Estonia and the Netherlands, embracing their role in streamlining and automating complex transactions.
In both Singapore and the United Kingdom, the use of smart contracts continues to increase, with judicial authorities displaying receptiveness to discuss smart contracts in the context of traditional contract law provisions, assuming that these contracts meet the basic requirements of offer, acceptance, and consideration.
Blockchain Technology and Contract Execution:
The foundation of smart contracts lies in blockchain technology, a decentralized and distributed ledger that records transactions across multiple nodes in a network. This technology ensures that once a smart contract is deployed, its terms are immutable and transparent, providing a high level of security and trust. Each transaction on the blockchain is cryptographically verified by the network, ensuring that the contract cannot be tampered with or altered by any party.
Blockchain technology eliminates the need for intermediaries in contract execution, allowing parties to engage in peer-to-peer transactions without relying on banks, lawyers, or courts to oversee the process. For instance, in a smart contract governing the sale of goods, the contract can be programmed to automatically transfer payment from the buyer to the seller once the goods are delivered and verified. This automation reduces transaction costs and increases efficiency, making smart contracts particularly attractive in industries such as finance, supply chain management, and real estate.
However, the rigidity of smart contracts also presents challenges, particularly in situations where contract terms need to be modified or where disputes arise. Traditional contracts allow for flexibility and judicial interpretation, enabling courts to intervene when unforeseen circumstances affect contract performance. Smart contracts, by contrast, are designed to execute exactly as written, leaving little room for discretion or interpretation. This can create difficulties in cases where the contract does not account for all possible outcomes, such as delays, force majeure events, or changes in the law.[7]
Challenges and Future Developments:
Despite holding within them such great potential, the legal hurdles are numerous and would have to be transcended before such contracts can be widely adopted in the Indian jurisdictions. Specifically, the lack of well-defined laws applicable to smart contracts, especially in countries like India, is one key issue. While the Indian Contract Act of 1872 will form a good basis for a contract law, it lacks the special requirements for contracts such as smart contracts, mainly because it relies on blockchain technology and cryptographic verification.
A further obstacle is the lack of mechanisms for dispute resolution within smart contracts. Conventional contracts typically incorporate clauses that provide for arbitration or litigation should a dispute arise, enabling the parties involved to pursue legal remedies in cases of contract breach by one party. In contrast, smart contracts are structured to execute automatically upon the fulfillment of specific conditions, lacking any process for addressing disputes post-execution. This leaves parties vulnerable in cases where the contract is executed poorly or where unforeseen circumstances arise. However, smart contracts also have a place in which they may not be well-suited for complex agreements, which still rely on discretion or human judgment. A good example would be a contract that includes some form of subjective criteria-like whether one party used "reasonable efforts" to fulfill obligations.
Although smart contracts show great ability in automation of simple, objective transactions, such as a transfer of funds or checking the delivery of goods, they are less effective in matters that require complex legal interpretation or implementation of equitable principles. Despite these challenges, the prospects seem favorable for smart contracts. Since blockchain technology is undergoing a rapid transformation process, lawmakers will naturally adapt to changes to use the innovative features of smart contracts. The States of Arizona, Nevada, and Estonia have already initiated the process of amending statutes under which smart contracts would be recognized as valid, and more jurisdictions are likely to follow suit sooner rather than later.
Conclusion:
The advent of smart contracts and digital contracts shows a revolutionary change in the way legal agreements are being executed and enforced. Growth in digital contracts is well accepted and enforceable under the Indian law system, whereas smart contracts raise complex issues due to their decentralized and automated nature. Under the Indian Contract Act, 1872, smart contracts can be deemed valid if they satisfy the barest minimum of competency, free consent, and lawful consideration. However, the Information Technology Act, 2000, and the Indian Evidence Act, 1872, do throw up a roadblock or two, at least so far as the requirement of government-certified digital signatures is concerned.
Many jurisdictions around the world are at the forefront of clarifying the legal efficacy of smart contracts, with states such as Arizona and Nevada giving clear legal frameworks for the enforcement of smart contracts. As blockchain technology assumes a greater share of importance, most jurisdictions, including India, are more likely to update their frameworks to accommodate unique features associated with a smart contract, which would add greater clarity and protection for parties entering into blockchain-based transactions.
Only when the legislators modernize existing laws to respond to the challenges of such decentralized and automated contracts can their implementation be wide-scale. Until then, parties who offer smart contracts must exercise caution, have agreements in place that can weather the storm of any possible legal challenge, and be alive to the limits of the current legal frameworks.
References
2. https://blog.ipleaders.in/smart-contracts-and-their-enforceability-in-india/
3. https://www.bitlaw.com/blockchain/smart-contracts.html
5. https://www.lexology.com/library/detail.aspx?g=260896e4-d780-4c6b-be1e-c16c8ae4bf52
6. https://lawschoolpolicyreview.com/2024/01/13/are-smart-contracts-really-smart/
[1] Sannidhi Agrawal Smart Contracts: Functioning and Legal Enforceability In India August 2023 https://www.researchgate.net/publication/373280600_Smart_Contracts_Functioning_and_Legal_Enforceability_In_India Sept 9 2024
[2] Aanchal Trivedi and Shilpi, Smart Contract: A New Paradigm of Contracts in the Digital Era March 27, 2024 https://sandalawoffices.com/smart-contract-a-new-paradigm-of-contracts-in-the-digital-era/ Sept 9 2024
[3] Max Raskin - THE LAW AND LEGALITY OF SMART CONTRACTS Georgetown Law Technology https://www.ilsa.org/ accessed September 9 2024
[4] Aanchal Trivedi and Shilpi, Smart Contract: A New Paradigm of Contracts in the Digital Era March 27, 2024 https://sandalawoffices.com/smart-contract-a-new-paradigm-of-contracts-in-the-digital-era/ September 9 2024
[5] Smart contracts: legal issues and validity, Sept 25 2023 https://www.arifa.com/articles-and-publications/ Sept 9 2024
[6] Max Raskin - THE LAW AND LEGALITY OF SMART CONTRACTS Georgetown Law Technology https://www.ilsa.org/ accessed September 9 2024
[7] Smart contracts: legal issues and validity, Sept 25 2023 https://www.arifa.com/articles-and-publications/ Sept 9 2024