January 18, 2022

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What are the legal challenges imposed by smart contracts

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This article is written by Swesh Saurabh, pursuing a Diploma in Cyber Law, Fintech Regulations, and Technology Contracts from LawSikho.com.

This article has been published by Shoronya Banerjee.

Table of Contents

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The term “smart contract” was first introduced by computer scientist and cryptographer Nick Szabo some 20 years ago as a graduate student at the University of Washington. 

Whenever we talk about any legal work or documents, the first thing which comes into our mind is “a lot of paperwork”. The smart contract could be the game-changer here as it can reduce or say can help us get rid of paperwork completely. 

A smart contract is an agreement that gets executed automatically. This automatic execution is made possible through computer code which translates the terms of the contract into an executable program. To perform such execution it is required to have control over the necessary physical or digital objects and this program helps in getting that control.

The smart contract is used to automatically execute any agreement when predetermined conditions are met. This helps participants in receiving the outcome immediately without the involvement of any third party or any intermediaries.

The smart contracts work on a simple format of  “if/when….then..” statements that are written into code on the blockchain. Let’s understand this with a very common example i.e. A rents his apartment to B. They both agreed that if B fails to pay the rent then A will be entitled to lock the door of the apartment. Further, they agreed to enforce this agreement through a smart contract that will automatically lock the door if B fails to pay the rent. Now, when we have the basic idea of what a smart contract is, let’s see what the legal issues that smart contracts cause are.

As the smart contract is nothing but an agreement that runs on a code, it does not have the means to determine whether the agreement in which the parties are entering creates any legal obligation or not.  Neither it has any means to check and verify that the parties who decide to make use of a smart contract have validly given their consent to do so. There are chances that the parties may have not understood the terms of the contract and how it works. Smart contracts do only those things which it has been told to do. However, it does not mean that if a smart contract has the power to do something then it is legal or right too. Code is not a law. If we take the above example in which A and B enter into a smart contract and the terms of the contract are that if B fails to pay rent then the door of the apartment will get locked till the payment is made. In this case, if B fails to pay the rent he will be immediately evicted from the apartment. Indian laws regarding this matter state that the owner must inform the tenant before a particular time period which is mentioned in the law before evicting the tenant. The example thus shows that there is a need for a legal system for smart contracts to determine whether they are valid or invalid, legal or illegal. 

The ability of smart contracts to automatically execute transactions is the key feature of it. However, because of this the parties entering into the contract could face some difficulties. We know that in traditional contracts if any breach occurs then it can be simply excused by the parties by not enforcing the penalties.

 If a payment is delayed by any valued customer then in that case the vendor can make a real-time decision and preserve the long-term commercial relationship as for a vendor it is more important than imposing any late fee or terminating the contract. But if this relationship is reduced to a smart contract then in that case this option of not enforcing the contract in case of any delay is not available to the vendor. So if any late payment is made then the late fee will be deducted from the customer’s account automatically. This feature of smart contracts is not the way the business works in real life.

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A contract that includes provisions that are expressed in different languages is not generally effective under local laws. Because of that, a contract in which provisions are expressed in code can be seen as a contract that is expressed in different languages. And hence there is a possibility that contracts which are partly in code and partly in natural language may not be effective either. 

For an agreement to be legally valid, it is very important that the parties to the agreement mutually understand the terms of the contract. But the problem which parties face in a smart contract is that the provisions are written in code and that becomes difficult for the parties to understand. It becomes a matter of contract law such as whether there was sufficient mutual understanding between the parties regarding the terms of the contract to form a contract at all. 

Presently there is no such way to amend a smart contract which creates challenges for the parties contracting. For example, in a traditional contract if the parties of the contract mutually agree to change any provision of the contract or if there is any change in law then they can draft an amendment to address that change. 

But when we talk about smart contracts, it doesn’t offer such flexibility. Once a smart contract is made then it becomes so complicated to modify it as it resides on blockchains that are immutable. Even if somehow the parties managed to amend then it will cost much more than amending a traditional contract. 

Similar challenges can be faced by the parties while terminating a contract. Projects are currently underway to create smart contracts that are terminable at any time and more easily amended.

Smart contracts are accepted legally by very few numbers of countries currently. 

For example- 

1. Japan

There isn’t any governmental definition of ‘ blockchain’ and smart contracts in Japan. However, the Japan Blockchain Association provides a working definition of  ‘blockchain’ in Japanese but smart contracts are yet to be defined. The definitions are also absent from the main text and legal summary and analysis of the Virtual Currency Act. The reason behind this is that there is not yet a consensus on a legal definition for a ‘smart contract’ in Japan. 

2. USA

Unlike Japan, the USA masters a nice example of both application and definition. In the USA, smart contracts are not regulated by any federal law but there are new laws on a state level. Tennessee was one of the states to adopt the legal concept of smart contracts. State law identifies smart contracts as an event-driven computer program, that executes on an electronic, distributed, decentralized, shared, and replicated ledger that is used to automate transactions, including, but not limited to, transactions that:

  1. Take custody over and instruct transfer of assets on that ledger;
  2. Create and distribute electronic assets;
  3. Synchronize information; or
  4. Manage identity and user access to software applications.

Law also states that smart 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.

In India, for the regulation of any contract, we have The Indian Contract Act 1872.  It lays down the basic elements which are essentials for any contract to be valid.

 According to Section 10 of the Act, “all agreements are contracts if they hold the free consent of parties willing to contract, for a lawfully accepted consideration and with an object.”

We can infer from the definition that Smart contracts are allowed under the Indian contract Act, 1872 as smart contracts consist of the offer, acceptance, and consideration. 

However, if we are talking about contracts that are coming into existence through electronic means, we must refer to Section 10A of the Information Technology Act. It talks about the validity of a contract formed through electronic means. It says that while forming a contract, for example, communication of proposals, acceptance of proposals or the revocation of proposals and acceptances are being done through electronic mode, then such contract is valid and it shall not be deemed to be unenforceable just because of the reason that its formation was done through electronic means.

Even under the Indian Evidence Act, an e-contract has the same legal effect as a paper-based agreement. Section 65B(1) talks about it. It says that if any information is contained in electronic form is also deemed to be a document and shall be admissible in any proceedings.

Regulatory issues, however, exist, especially in India where there are no regulations regarding the finer details of a smart contract. If specific regulations are not made, a wide-ranging adoption of the technology will require the government to make amendments to the Indian Evidence Act, 1872, and the IT Act.

Smart contracts are called smart but it doesn’t mean that they do not contain risks. Smart contracts are tasked especially to manage the User’s fund and it will be very irresponsible if we ignore the risks or threats which come with these autonomous programs. The adaptability and strength of the smart contract mainly depend on the coding skill of the developer. It requires a level of experience and knowledge that many blockchain developers do not possess in this era of copy-paste. 

Ethereum has been praised by many as having a superior code to that of Bitcoin. But still, that same “bullet proof” smart contract code was attacked by a hacker who stole around $60 million in just the first 12 hours of the attack. There is no doubt that smart contracts are of great use but still, there are risks because of which the users can suffer a huge loss if they are not resolved. Since smart contracts and blockchain technology are still in the maturing state, we should wait and see how the legal systems across the world will handle these agreements in terms of taxation and other laws.

There is no doubt that smart contracts have caught the attention of the global legal industry. To understand how smart contracts and blockchain works, many of the largest firms are partnering with initiatives such as the Ethereum Enterprise Alliance and the R3 consortium’s Legal Centre of Excellence. Only by understanding the working of smart contracts, we can solve many issues which arise out of it. The rest of the problems regarding the legality of the smart contract can be solved only by making separate regulatory rules. 

Problems regarding the termination and amendment of smart contracts are the major issue and changes should be made to overcome this issue. There is no question that the implementation and growth of smart contracts is the next step of innovation and can lead directly to billions of overhead costs being minimized while making the whole system more efficient. Finally, we found a revolutionary solution, but we are still just at the beginning of its implementation!

1. The Enforceability Of Smart Contracts In India – Corporate/Commercial Law – India (mondaq.com)

2. Smart contracts: a boon or bane for the legal profession? – Taylor Vinters

3. An Introduction to Smart Contracts and Their Potential and Inherent Limitations (harvard.edu)

4. Smart Contracts: Key Legal Issues | by Smartz | Smartz Platform Blog | Medium

5. https://searchcompliance.techtarget.com/definition/smart-contract

6. https://www.coindesk.com/people/nick-szabo/

7. https://thelawreviews.co.uk/title/the-virtual-currency-regulation-review/japan

8.https://neo-project.github.io/global-blockchain-compliance-hub//japan/japan-smart-contracts.html

9.https://www.wallerlaw.com/news-insights/3189/Tennessee-becomes-one-of-first-states-to-approve-blockchain-smart-contractstennessee-becomes-one-of-first-states-to-approve-blockchain-smart-contracts/

10. https://legislative.gov.in/sites/default/files/A1872-09.pdf

11. https://www.indiacode.nic.in/show-data?actid=AC_CEN_3_20_00035_187209_1523268996428&sectionId=38613&sectionno=10&orderno=10


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