by Varda Saxena
The release of Ethereum Blockchain in 2015 created a plethora of opportunities for Bitcoin investments and access to services or commodities. The previous bitcoin transactions which were once merely additions or deductions in money became complex by the codification of business norms and clauses. Using Ethereum smart contracts a person could buy a car without visiting either a bank, the transport office or even a showroom. These dealings were done via Smart Contracts and promised impenetrable systems with automated transfer protocol, and were idealised as the greatest invention of the era. However, there is only so much which can be handled by e-contracts alone. The discussion below illuminates the expanse of the usage of smart contracts and the applicability of legal principles to such modern-day technologies. The analysis proceeds in six parts and comprises of the working of a blockchain, usage and genesis of Bitcoin, working of smart contracts, the applicability of Raz’s theory on such contracts, the applicability of the theory of reliance and the possible shortcomings of these contracts with respect to Indian Laws.
Before dissecting the various concepts in blockchain technology and smart contract, let us take a brief look at the recent legal developments within India. In the case of Internet Mobile Association, the Supreme Court of India struck down a circular published by the Reserve Bank of India (“RBI”), which delimited the usage of cryptocurrencies like Bitcoin. This move was heavily opposed by many innovators and entrepreneurs within India who were already wildly dealing with cryptocurrencies and making their own. Banning of such cryptocurrencies would legitimise certain contracts or transactions. It was argued by RBI that such cryptocurrencies render government control nugatory as they involve stateless, decentralised encryption techniques. However, the Supreme Court opined that this measure was disproportional to the harm caused. Relying on State of Maharashtra v. Indian Hotel and Restaurants Association, the court ruled that there was a lack of empirical data corroborating to the intensity of harm suffered by the state’s regulatory entities.
Terminologies like ‘Bitcoin’ and ‘Blockchain’ associated with this judgment have been considered the modern-day technological regalia. By giving rise to immutable transactions which occur on a peer to peer basis, this innovation abets various financial, political and managerial process such as the creation of supply- chain, maintenance of tamper-proof records, encrypted voting and deletion of intermediaries who usually mediated these activities. With the development of blockchain and ledger technology, a new means of transaction called ‘Smart Contracts’ was promulgated by a cryptocurrency platform called Ethereum. Even though, Smart Contracts increase market accessibility, the question arises as to how such contracts would fit into the traditional legal system. This article aims at analysing the applicability of the Indian Contract Act on Smart Contracts and elucidating the shortcomings of contract creation via codes due to lack of qualitative measures, moral attributes and applicability of theories of contract in a Bitcoin blockchain.
Blockchain: What is it and how does it work?
The beginning of the era of encrypted documents began when a cryptographer and physicist, respectively, Stuart Haber and Scott W. Stornetta published their academic paper titled, ‘How to Time-Stamp a Digital Document’. They discussed the creation of an immutable ledger which tamper-proofed the time-stamps of a document. This model was further enhanced by Stornetta, Haber and Dave Bayer, in 1993 by induction of Merkle trees which facilitated the compilation of several documents into one block, resolving the impediments around storage, verification and distribution. It was in 2008, when a radical idea arose, proposed by some person/persons under the pseudonym of Satoshi Nakamoto, who published a white paper regarding the application of blockchain for cashless transfers involving bitcoins. These cashless transfers occurred without any central regulatory body. This proposal was a paradigm shift from currency and transactions as we knew them.
The transactions were supposedly trustworthy as they involved software programs for verification, validation and consensus in a novel networking system called a blockchain. By shifting the functions of intermediaries to the peer participants in the blockchain a distributed and de-centralised system was created. Since the peers within the network may not be known to each other, trust became paramount for the success of the blockchain. The trust established in this system arises from the processes of validation, verification and confirmation of transactions recorded in a distributed ledger, similar to the traditional ledger and bookkeeping humans have practiced for centuries. Further the system had a consensus-building protocol involving puzzle-solving activities which decides who gets the right to create a block. Creating blocks is beneficial to people on the network because they get rewarded in bitcoins when the block is accepted by the next person on the network. This reward also reinforces self-interest and encourages peers to create blocks with valid transactions. This consensus-building activity and validation is undertaken by special peer nodes called Miners. They are powerful computers working as per the software-defined by the blockchain protocol.A group of transactions form a block, and many blocks form a chain via digital data linking, and the next block is developed via a consensus after which the chosen block is verified and added to the current blockchain. A block comprises a header of information regarding the block, and a set of valid transaction.
Block Formation and the Role of Miners
Bitcoins are one of the five thousand plus cryptocurrencies existing in the market. They are used to incentivise the miners working on block creation. These independent miners validate transactions for more than twenty criteria like size, syntax, Referenced Input Unspent Transaction Output (UTXOs), correct usage of reference output UTXOs etc. They check whether the reference input amount and output amount match, and invalid transactions, or transactions which don’t fulfil the criteria, are rejected and will not be broadcast. This creates a dispute amongst various miners because if every miner adds a block to the chain, it’ll result in various branches and will generate an inconsistency. Since blockchain is a single linked chain of flux, and thus it needs verified blocks without any branches. Therefore, these miners compete to solve complex mathematical puzzles (the ‘Hash Puzzles’ mentioned earlier), and the winner gets the right to create the relevant block. This block is then broadcast amongst other miners for verification and is added to the blockchain. The algorithm used for reaching a consensus is called Proof of Work Protocol as it revolves around solving a puzzle and claiming the right to block formation.
The block created by the miner lists the zero transaction which has a special UTXO and is called a Coinbase Transaction. It generates a minor’s fees for the block creation (the ‘Block Reward’). Bitcoin facilitates an optional and distinct element known as Scripts for Conditional Transfer of Values. The new Ethereum Blockchain extends this scripting feature into a proper code execution framework called Smart Contract.
What is a Smart Contract?
A smart contract incorporates a series of codes positioned in the blockchain node. Ethereum currently uses a proof-of-work algorithm called ETHash, which is designed to prohibit the mining done by pools based on Application Specific Integrated Chips (ASIC). Such a prohibition is necessary cause it works against the decentralised nature of a blockchain and concentrates it in the hands of a few. The technique allows the Graphics Processing Units to be utilised for mining. Currently, the latency in the block creation is 12 seconds as against 10 minutes in the case of bitcoin. These contracts are executed by the initiation of a message embedded in the transaction which was initially done by mere addition and subtraction requests transferred by digital currencies.
Ethereum has enabled transactions which could perform sophisticated operations like the incorporation of contingencies, promisee qualification criteria and conditional transfers. For example, the setting of a specific time and date for the transfer of assets, the signature of more than one parties, age limit, fixing of maximum and minimum bids in an auction etc. The code for these Smart Contracts is written in specific languages like Solidity and are compiled into byte code. This code is then executed on a unique framework known as Ethereum Virtual Machine. These contracts help in embedding business logic on a blockchain and subtract the need for intermediaries like agents, solicitors, service providing agencies etc. Smart Contracts can be executed by the preservation of currency in an escrow account which is then transferred to the promisor automatically, once the ownership of a commodity is received. These automatic processes are governed by codified legal principles and contractual liabilities embedded in the transaction. These functions are carried out by the deployment of three significant categories of blockchains found in the Bitcoin Foundation.
1. The first category comprises of coins in a virtual cryptocurrency chain, like Bitcoin;
2. The second category supports the cryptocurrency and codification of business logic in a blockchain like Ethereum; and
3. The last class doesn’t involve coins but executes the embedded business logic alongside the laws of contract formation, validating the acceptance of offers and contract formation. An example of this category can be the Linux Foundation’s Hyperledger.
Types of Blockchains
With the smooth transaction and distributed ledger comes the question of public access and privacy. Therefore, the chains are classified into private, public and permission based blockchains based on access limits. People are free to join or leave these blockchains as per there will and the transaction blocks are visible to everyone even though the participants are anonymous, therefore creating a system of accessible information which preserves the identity even though the system is open-source. A private blockchain can also be designed to limit access to a select group like an organisation. Apart from these two types, a third one called Permissioned/Consortium blockchain exists which allows consortiums like healthcare agencies, mobile companies to transact, providing ease of governance and creating effortless business models. New digital coin currencies can also be created by modifying the Bitcoin code, and wallet applications provide an interface to transfer the money via a blockchain. However, conversion into physical currency incurs costs.
Smart Contracts & their legality
Joseph Raz’s ‘Theory of Contract’ justifies whether a particular legal force can be applied against a defaulting individual legitimately. However, contract law theories institute the interpersonal commitments which should be enforced by law. In this section, we aim to discuss the applicability of some of these theories on smart contracts.
Smart contracts have distorted the boundaries of what can be called the formal and informal realm of business; however, the mechanical aspect of codifying the terms of the contract have eased the determination of consent to contract. In his work titled “Promises in Morality and Law”, which was a review of Patrick S. Atiyah’s “Promises, Morals and Law”, Raz stated that “The purpose of contract law should be not to enforce promises, but to protect both the practice of undertaking voluntary obligations and the individuals who rely on that practice.”
The smart contracts whose divinity lies in the hands of a coder have their basis in the enforcement of promises. Where contract completion becomes ‘a one-tap process’ as the ownership of commodity gets transferred the moment consideration is received. Raz’s theory emphasises reliance and responsibility to undertake obligations, and in cases of anonymous buyers who transact in the absence of accountability, they have the freedom to forgo the contract as and when they desire. This kind of setting, according to Raz, is optimal for parties; however, it reduces social welfare. The ease of access to commodities and the decentralised system absorbs reliable firms, reducing the quality of exchanges when the market is anonymous. Therefore, cases governing smart contracts, which are in the nature of Couturier v Hastie , where a contract stands frustrated due to destruction of subject matter, the ownership would have been transferred to the buyer as soon as bitcoins were released from the payment wallet. However, if the contracting parties are anonymous, receiving compensation for unstipulated damages becomes difficult. In cases of breach or mistake, the most common remedy in a blockchain would be to get the consideration back if the liabilities are codified properly into a transaction. This scenario decreases accountability of the parties as all the transfers happen involuntarily when the transaction begins. Additionally, this network does not encompass much of a state’s economy, thus reducing its efficiency in society.
The above-mentioned hypothetical elucidated an instance which could become extremely common due to lack of a quality checking mechanism in the software. If such a practice goes unchecked due to technical bounds, it’ll distort the existing moral practices governing contractual agreements. Therefore, doctrines like the formation of contract, frustration, mistake, fraud, and others which have their roots in public policy will not be able to mirror standard moral views in cases of anonymous smart contracts. This argument is not only based on limits of a coding language to determine subjective contingencies and qualitative aspects but also on the abstractness of a legal system. ‘Reasonableness’ is one of the factors which cannot be determined by a series of codes. It is something which is realised via statutory interpretation and precedents on a case- to case basis. For example, in the doctrine of frustration of a contract wherein the frustration of the foundation of the contract discharges the parties of their liability. These issues cannot be detected via a code and will require a judicial mechanism like traditional contracts. However, the maintenance of anonymity in the chain can increase the possibility of fraud, making smart contracts a not so viable option to transact.
Theory of Reliance
Raz’s contractual theory revolves around “protecting the practice of undertaking voluntary obligations” and seems to overlap with the Reliance Theory of Contracts. It states that “When a person suffers loss by relying on the specific promise that another person made, any failure therefore on the accomplishment of that promise may be intervened by the law by setting contractual obligations particularly by the person who made such a promise” . The essence of this theory lies in creating contractual obligations by conserving the right of the individual who relies on the promise. Smart contracts tend to negate the concept of reliance by creating a trust-less system which may contend to uphold contractual relations but merely facilitates fund transfers. It is a system which purports money laundering and acquiring assets via fraud and misrepresentation as in the case of AA v Persons Unknown, wherein hackers encrypted the systems via malware, taking USD 950,000 as a ransom (via Bitcoin). Such cases question the credibility and trustworthiness of smart contracts and immutability of ledgers.
The discourse on reliance theory resonates with the ‘harm principle’ which elucidates that, “The state only interferes with individual liberty (by imposing obligations) to prevent harm to others”. Fuller and Purdue in their work titled ‘The Reliance Interest in Contract Damages’ argue that amongst a contracting party’s restitution, reliance, and expectation interests, the restitution interest has the most substantial claim to protection. They explain this argument by expounding that where A causes detriment to B, B loses one unit (-1), which gets transferred to A (+1). This results in the creation of there are two units of injustice which need to be remedied. On observing the principles of the Aristotelian ideal of corrective justice, which aims to maintain an equilibrium among the elements of society, B’s restitution interest stands twice as strong as compared to his reliance interest. However, B’s reliance can also result in a loss (where B’s -1 results in A’s +1).
Even though smart contracts work on the principle of remedying the damage caused by automatic work protocol system, which transfers the consideration only when the promise is fulfilled, the non-fulfilment of an obligation does not award damages automatically. This creates a legal conundrum as identification of the guilty seems tedious.
Blockchain in the Indian Context
Even before considering the acceptance of cryptocurrency as a valid means of exchange, there have been very few precedents in India substantiating the effectiveness of the blockchain technology itself. Cases like Maninder Singh Pasricha v State of Punjab and Amit Bhardwaj v State of ANR have presented scenarios where money was laundered in the garb of Bitcoin investments, illuminating the lack of awareness or ‘illiteracy’ regarding the Blockchain technology. Furthermore, smart contracts fail to align with the Indian laws due to a lack of interpretative skills and ambiguity imported from English Laws.
In the mid-nineteenth century, when the Indian Contract Act was being drafted, the influence of will theory had travelled far and wide in England, leading to frantic academic and judicial attempts to revise all of the English laws of contract. The drafters of the Indian Contract Act were also influenced by the same ; however, the act was not a forthright codification of the English contract laws and digressed from it on various points. These digressions are being explored academically and involve precedential interpretations which could change the usual perceptions surrounding multiple aspects of the Indian contract act, for example, the discourse regarding the invention of privity and its roots in Section 2c of the Indian Contract Act. The reading of the doctrine of privity, into the Indian Contract Act, was done by Pollock and Mulla as can be observed by case laws preceding their invention. For example, the case of Debnarayan Dutt v Chunnilal Ghose where Lord Jenkins obliterated the existence of privity in India. Such instances of demystification of Indian laws put up a question on the plausibility of valid legal codification in a blockchain.
When we talk about legal interpretation, we cannot subdue the exegesis of the terms of contract done by the contracting parties. In cases like Raffles v Wichelhaus parties end up at “cross purposes” due to latent ambiguities in terms of the contract. In this case, two parties contracted to sell cotton, to be transported via a ship called ‘Peerless’. The other party misunderstood which ‘Peerless’ the contract was talking about as there existed more than one ship by the same name. Therefore, the claimant shipped it via the Peerless arriving in December instead of the one intended by the defendant, which arrived in October. The defendant tried to repudiate the contract due to late arrival. If this transaction were to happen via a smart contract, the codification of terms would have still been ambiguous, rendering these smart contracts not-so-smart.
Smart contracts help in processing transactions over a decentralised system where contracting across the world becomes more relaxed. This may result in illegal sales as specified in illustration (d) of Section 56 of the Indian Contract Act which states,
—“A contract to do an act which, after the contract is made, becomes impossible, or, by reason of some event which the promisor could not prevent, unlawful, becomes void when the act becomes impossible or unlawful.
Illustration d— A contracts to take in cargo for B at a foreign port. A’s Government afterwards declares war against the country in which the port is situated. The contract becomes void when war is declared”.
Contracting at the time of war with enemy aliens may prove to be against national security, making the object of the contract illegal. The anonymity of the buyer may also play a role in acquiring consent. The contracts entered into by a party may not conclude if the identity of the buyer was exposed. In many cases like Maninder Singh Pasricha where the petitioners allured innocent people into investing in a fake ‘Bitcoin’ related scheme would increase, resulting in dissemination of partial consent.
Apart from the legal discrepancies mentioned above, more would arise as we go on to discuss common instances of breach of contract which could quickly occur on an anonymous dealing platform. Smart contracts may reduce the number of intermediaries, management/legal costs and time required to process a contract. However, they cannot substitute the subjectivity of legal theory and the importance of statutory interpretation as there are limits to codification and no limits to ambiguity.
The way forward may appear to be vested in the mechanisation of contracts but, lack of precedents, moral attributes of artificial intelligence and boundaries of codification of laws in a language like Solidity, diminish the applicability of this technology in India. The actions of a machine are generally attributed to the person who instructed or programmed it to perform a specific function. Therefore, as the ownership of the blockchain doesn’t lie under an identifiable entity, the duty of care imposed on the coders will be maximum. This will result in a more tedious process of transaction involving coders and lawyers, making the traditional contracting methods the most viable option.
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About the Author
Varda is a Second Year Law student at Jindal Global Law School. Her interest in smart contracts led her to join The Digital Future as an Editor as well as a Research Associate in the ‘Blockchain & Cryptocurrency’ research team.