SMART CONTRACT ENFORCEABILITY

By Clark

INTRODUCTION TO SMART CONTRACTS-

In the year 1996, Nick Szabo in his article Formalizing and Securing Relationships on Public Networks1 came up with the concept of smart contracts he stated that

“a smart contract is a computerized transaction protocol that executes the terms of a contract. The general objectives of smart contract design are to satisfy common contractual conditions (such as payment terms, liens, confidentiality, and even enforcement), minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries. Related economic goals include lowering fraud loss, arbitration and enforcement costs, and other transaction costs.”

He predicted the application of smart contract in the fields of Arbitration and secured transactional processes using a public network interface. A smart contract is a self-executing contract which has certain specific terms pertaining to a normal contract between a buyer and a seller inculcated within the code lines, which enables it to function independent of human intervention.

The only platform which enables the functioning of a smart contract currently is Ethereum, if a person wants to develop and customize his own contract, he can do so by using this platform. The virtual currency which is used in this case is the ether. Compared to a Bit coins, ether has no limitations as to the customization.2 Developers generally use this platform to develop various smart contract based applications and other distributed ledger technology applications. A smart contract, when using this platform generally requires a virtual currency to be functional, the virtual currency and the smart contract have an interdependent relationship. Virtual currency is generally used to authenticate the smart contract. Whenever a transaction pertaining to a smart contract takes place, the value which’s generated is in the form of a hash value which can be indicated as fbb9995bab9b1e15d69d2c3cc206654, a hash value is the result of the completion of the transaction which involves the exchange between the parties. To put it simply a general application of smart contract can be explained with the help of a vending machine as explained by szabo in his paper, he stated that “

Anyone with the accepted means of payment can tender the beverage” the machine has been encoded with a specific tender value for specific beverage meaning that when a specific sum of money is inserted in the dispenser as a pre-programmed output the beverage amounting that is dispensed. This simply explain the front end of a smart contract in order to initiate a contract, a party has to give a specific value in the form of virtual currency for it to work. ”The vending machine is a contract with bearer: anybody with coins can participate in an exchange with the vendor. The lockbox and other security mechanisms protect the stored coins and contents from attackers, sufficiently to allow profitable deployment of vending machines in a wide variety of areas.”

The backend of the smart contract can be explained using the machinery of the vending machine by saying that a customer trying to break the vending machine will have to go through a lot of hassle which will result in detection of the breach.3

SMART CONTRACT FRIENDLY REGIMES AND THEIR LAWS

  1. ANGUILLA UTILITY TOKEN ACT, 2018

The Anguilla Utility Token Offering Act (AUTO Act) provides that only qualified companies registered with the Anguilla Financial Services Commission may issue utility tokens. In order to register, a significant amount of disclosure must be made, and once registered; the companies must follow the anti-money laundering legislation of Anguilla to ensure that utility tokens are not used in an unlawful manner.

Under Section 1(1) (20) of the act defines what a smart contract is. It states that “a smart contract means a Block chain based computer protocol intended to facilitate, verify, or enforce the negotiation or performance of digit set of agreed upon terms, or contract.” It mentions about the functionality of terms mentioned in the smart contract:

  • Facilitation for the execution of the contract- since smart contract consists of two factors which are currently underlying codes and virtual currency; they execute the terms and conditions of the contract automatically when a virtual currency having the amount mentioned in the terms of contract is added in the chain. It is a very hassle free process which provides a safe gate way for the execution of smart contract. The underlying interpretation can be said as the platform on which a smart contract is created with the sole intent to facilitate the functioning of the smart contract as it is a standard block chain based computer protocol. It provides a room for including the platforms under the ambit of this definition.
  • Verification process- Since smart contracts are block chain based so once the contract is entered upon and executed the verification for the same is represented in the form of Hash function at the end of the procedure which acts as an indicator of the completion of the contract from both the parties.
  • Negotiation process- Terms pertaining to negotiations can be entered into and enforced using these protocols. If a party wants to change the quantity of the goods and there is a negotiation term in the smart contract, it can be enforced and the terms can be acted upon accordingly.

Section 1(1)(23) of the Act gives the definition of “Tokens” it states that it is a “cryptographically secured digital representation of rights which includes smart contracts within its ambit which can be provided on a digital platform which is issued or to be issued by an issuer.” This part of the legislation talks about the platform on which the smart contract can be developed and enforced upon the term ,“token” in this reference also speaks about the encoded rights within the smart contracts, which can be issued by the issuer, defined under Section 1(1)(10) meaning a person who has the power to issue utility tokens.

Under Section 1(1) (25) defines Utility Token Feature which addresses the contractual right of the holder to utilize certain facilities like to became a member or become a member of the platform facilitating smart contracts, usage of token for purchase of products, for leasing or any other facilities which is supposed to be developed on the platform, this section determines the usage of tokens in the services like purchase, lending, renting and any other facilities. This facilitates the enforceability of contractual obligation pertaining to the smart contracts in commercial spheres. It entails various use cases with in itself.

  1. MALTA, VIRTUAL FINANCIAL ASSETS ACT, 2018-

The Virtual Financial Assets Act, 2018 (“VFA Act”) was passed by the Maltese Parliament on July 4, 2018 and it came into effect from November 1, 2018. This Act intends to regulate three service providers — a) VFA issuers b) VFA agents and c) VFA exchanges.

Article 2 of the act defines the smart contracts in two segments, it states that first is as a computer protocol and second is as an agreement concluded wholly or partly in the electronic form, which is automatable and enforceable by computer code, although some part may require human input and control or which can be enforceable by both conventional legal method or a mixture of both. The interpretation for the aforesaid clause can be liberally interpreted for the means including contractual obligations like escrow arbitration, registration, negotiation etc. this provides a basic understanding about the implications in the aforesaid fields, the scope is not limited by the definition. The last line of the article a smart contract can be enforced using a conventional legal method of enforcing a contract and a mixture of both technological aspect and the conventional legal method.

Article 3 initial vfa offerings and admission to trading on vfa exchange to be made with a registered white paper.of the act provides for a an Issuer must draw up and register a whitepaper with the Authority where a virtual financial asset is offered to the public in or from within Malta.” But where there is a smart contract there is no need to register a white paper in an authority because whenever a virtual financial asset is issued there is an alternative procedure to that when the smart contract contains the code particulars of the white paper it is not necessary for a company to register a white paper for the VFA since all the records can be entered and stored in the distributed ledger associated with the smart contract. Smart contract saves time in the registry process here.

Article39 “powerof competent authority to require information.” The act provides for the monitoring of the activities relating to virtual financial assets, under this article any competent authority has the power to ask for information, they can ask for the intermediary providing platform of exchange and the person who is responsible for the advertisement of such an agency. This is a very viable step for the government as it facilitates a monitoring environment for them. But the best part about this clause is that the authority cannot ask for the information pertaining to the source code of the smart contracts involved in the whole transaction, which also gives a hint that in spite of the monitoring aspect involved it aims at respecting user’s privacy.

Article 2 of the act also provides us with the specifics of the white paper, it gives us an idea what is supposed to be included in the white paper and the method of payment mentioned in the point 7(z) of the act and sub points (ae, af, ag, and ai) speaks about the due diligence which is to be followed by the person who is issuing the virtual financial assets should keep in mind while drafting of a white paper for registry:

Ae- if a smart contract is deployed then the person issuing them should mention about the auditor of that contract in a detailed manner in the white paper.

Af- description of any limitation of the deployed smart contract should be mentioned in the smart contracts including limitations pertaining to investments or geographical location.

Ag- description of the program which was used for the collection of data through smart contracts along with their functionality and characteristics in the white paper.

Ai- it should also mention the voluntary period in which the smart contract can be withdrawn.

The VFA, 2018 kept a balance between the transparency and monitoring of a decentralized system.

  1. UNIFORM ELECTRONIC TRANSACTION ACT, 2018this act was introduced in United States of America which aimed at providing a uniform transaction mechanism for the states who enact it. The act was rectified by the 47 states in the United States few notable ones are mentioned below along with their interpretation-
  • State of Tennesseethe senate introduced the bill which specifically mentions about the smart contract in Section 1( title 47 chapter 10 ) of the act as amended in 2018point 2 of the chapter states that “Smart contract” means an event-driven computer program, that executeson an electronic, distributed, decentralized, shared, and replicated ledger that is usedto automate transactions, including, but not limited to, transactions that:

(A) Take custody over and instruct transfer of assets on that ledger;

(B) Create and distribute electronic assets;

(C) Synchronize information; or

(D) Manage identity and user access to software applications.

The aforesaid section defines smart contract as an event driven protocol which can be used for transferring the assets on the ledger, create and distribute electronic assets this particular clause opens up the avenue for the distribution of crypto assets pertaining to the entry into the distributed ledger because every time a person enters a transactional information in the ledger this clause will promote the distribution of crypto assets which are formed in the course of such entry, synchronization of information points towards the corroboration of the records with the transactional entries in the ledger. Clause d provides the user with the decentralized data storage which can be used for verification purposes. This section provides us with variable options which are outside the scope of the sub clauses. When liberally interpreted they open a whole new avenue for the application of smart contracts.

Title 47 chapter 202 under clause c of the Bill provides for the enforceability of the smart contract in the commercial spheres without any backlashes from any other law in force. The verbatim of the same has been produced asSmart contracts may exist in commerce. No contract relating to a transaction shall be denied legal effect, validity, or enforceability solely because that contract is executed through a smart contract. This section provides a very broad sphere in the commercial application of the smart contract, the smart contract according to this clause will have a similar enforceability as any written contract and it won’t be denied to any other legal effect.

Title 47 chapter 202 under clause b provides one of the quintessential point for the enforceability of smart contracts, it provides an evidentiary value to it. The verbatim of which is mentioned as “A record or contract that is secured through distributed ledger technology is considered to be in an electronic form and to be an electronic record.”It enables smart contract to be produced as an electronic record in the court of law which provides them with a legal sustainability in the court of law.

  • State of IllinoisThe representative of the state introduced the bill on amending the state technology law in the year 2019. The bill specifically defines the use case of smart contract under it.

Section 5 (4) of the bill dictates the definition of electronic records as “Electronic record” means a record created, generated, sent, communicated, received, or stored by electronic means, including a block chain or a smart contract” this gives the evidentiary value to the smart contract as they can be produced in the court of law as a documentary evidence. Before defining the smart contracts they gave value to the evidentiary perspective in this case. This further eliminates any question for the legal enforceability.

Section 5(6) of the bill define smart contracts which states “Smart contract means a contract stored as an electronic record which is verified by the use of a block chain.” This definition complements the electronic record’s definition which again strong arm the clauses against the non-enforceability in the court of law. The clause 6 is very clear for the authenticity as it admits any smart contract which can be verified by their entries in the ledger. This adds up to a viable enforceability model for the smart contracts.

Section 10(a) and (b) of the bill – permitted usage of Block chain- again recognizes the use cases in terms of evidentiary value of the smart contracts the it says that “ A smart contract, record, or signature may not be denied legal effect or enforceability solely because a block chain was used to create, store, or verify the smart contract, record, or signature.” When we read it in the light of section 10 (b) which states that in a proceeding, evidence of a smart contract, record, or signature must not be excluded solely because a block chain was used to create, store, or verify the smart contract, record, or signature. It again broadens the evidentiary horizon for the enforceability of smart contract in the court of law it gives a very strong position to the smart contracts in terms of evidentiary value. This clause also pronounces the legality of any electronic signatures which is produced using Block chain which is generally used to authenticate the smart contracts. It covers a broad category of block chain applications by giving it a viable evidentiary perspective.

Section 15 of the bill- limited usage of block chain- clause (d) – this section introduces some essential limitations to the smart contracts with respect to written notice acknowledging the completion of the contract parties whether they have a relationship formed through the smart contract or not they have to submit a written notice acknowledging the receipt of the goods , it states that “Regardless of whether a smart contract was used to establish the relationship between the parties to an agreement, a requirement that a notice or an acknowledgment or other response to a notice be in writing is not satisfied by providing or delivering the notice or recording an acknowledgment or other response to the notice by the use of a block chain if the notice is a notice of:

A person receiving the goods out of the smart contract obligation has to acknowledge the notice of certain things which are simply not allowed to be presented as the records of block chain transactions they are namely:

1. The cancellation or termination of service by a public utility

2. Default, acceleration, repossession, foreclosure, or eviction, or the right to cure, under a credit agreement secured by or a rental agreement for, a primary residence of a natural person;

3. The cancellation or termination of a policy of health insurance, benefits received under a policy of health insurance, or benefits received under a policy of life insurance, excluding annuities; or

4. the recall of a product, or material failure of a product, that risks endangering the health or safety of a person.’

  • State of Florida-The Bill brought an amendment to the Section 668.50 of Uniform Electronic Transaction Act, 1999, the federal government aimed at defining smart contracts and provide with certain limitations at the same time. Section 2(p) of the bill defines smart contract it says “Smart contract” means an event-driven program thatruns on a distributed, decentralized, shared, and replicated ledger and can take custody over and instruct the transfer of assets on that ledger.This has a similar technical definition to Tennessee’s enactmentwith the only difference that the legislation has opened it up to various interpretations, the intention of the legislature was to give full freedom to the judiciary to include various aspect of ever evolving Block chain technology. Same can be said about the intention of the Tennessee legislature but they have given some of the use cases to the definition.

Section 2(h) of the bill gives smart contract an evidentiary value for the enforceability in the court of law. It states”Electronic record” means a record created, generated, sent, communicated, received, or stored by electronic means. A record or contract that is secured through block chain technology is in an electronic form and is an electronic record. The aforesaid section recognizes the transactions, made in relation to the smart contracts can be recorded and produced in the form of electronic record in the court of law.

State of New Yorkthe bill was introduced in year 2017 and was passed in 2018; the bill contains a technical explanation of smart contracts. The amendment was made in state to include the definition and to provide evidentiary sanctity to transactions made under the smart contracts. Section 302 of the State technology under subdivision 7 it has been defined as Smart contracts shall mean an event-driven program that runs on adistributed, decentralized, shared and replicated ledger and that cantake custody over and instruct transfer of assets on that ledger. The definition of smart contracts basically covers only the technical perspective of the smart contracts which doesn’t add a legal edge to it. But still it defines the functionality of the contract and how it works. It can be said that intention of the legislature here seems that it has opened up doors for interpretation of the judiciary because of the evolutionary aspect of the smart contracts. To elaborate more on the definition the aforesaid definition should be read in the light of Section 310(3) of the bill which states that the Smart contracts may exist in commerce. A contract relating to a transaction may not be denied legal effect, validity or enforceability solely because that contract contains a smart contract term. The aforesaid definition can be said to be expanded through the said Section 310 (3) of the bill since it give enforceability to the smart contract in the commercial domain. This can be termed as a use case definition of the smart contracts.

Section 310(2) of the bill this section provides for the evidentiary enforceability in the court of law the section states that “a record or contract that is secured through block chain technology is considered to be in an electronic form and to be an electronic record.” This section allows the passage of smart contract based transaction under it as an electronic record which ensures its enforceability as a proper documentary evidence.

  • State of Nebraska– the legislation defines the similar definition of smart contracts in this state as defined in the New York state legislation under section 302 sub division 7 and section 310(3) – the section for the definition in Nebraska’s is Section 2(1) and Section 2(2)

The United States of America provides focus on evidentiary value in the court of law.

Legality of Smart Contracts in India-

India doesn’t have a proper legislation pertaining to the enforceability of Smart Contracts. However, if we look at the definition of section 10 of the Indian Contract Act, 1872 which states that “all agreements are contract if they hold the free consent of the parties willing to for a lawfully accepted consideration and with an object.” Let us dissect the section into its fundamentals which are

1. Free consent

2. Lawful consideration

3. Lawful object

This can provide us the outline for the enforceability of smart contract in India as it provides us with a use case. If we also look at Section 5 and 10A of the Information Technology Act, 2000 provides for the legal backing of the technology in India, Section 5 of the aforesaid act states about the electronic signature affixation on the documents and section 10A gives a way for the enforceability of electronic contracts which means that a contract entered by the parties electronically will have full enforceability in the court of law.

This paves a way for the Smart Contracts to be enforceable in India, Since the blanket ban on crypto currency has been lifted.


1 Nick Szabo, Smart Contracts: Building Blocks for Digital Markets (1996), Source Link.
2 Coin desk, Ethereum- 101, coin desk, 4/06/2020, 4:00pm Source Link.
3 JONATHAN G. ROHR, SMART CONTRACTS AND TRADITIONAL CONTRACT LAW, OR: THE LAW OF THE VENDING MACHINE, CLEVE LAND LAW REVIEW, UNIVERSITY OF TENNESSEE.

Clark

Head of the technology.

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