DISCLAIMER: The contents of this blog article reflect the personal views of the author alone and do not constitute the views of any of the author’s affiliated organizations. The contents of the blog article cannot be treated as legal advice under any circumstances.
The use of smart contracts as opposed to paper based traditional contracts continues to increase in commercial activity and practice. With the advent of Web 3.0 technologies, smart contracts may become a standard form of contract since the characteristics of automated self- execution, operability on a decentralized blockchain and speedy execution of contractual obligations are more suitable to the needs of commercial transactions, and as well as for eliminating breaches in day- to day commercial transactions. However, the possibility of disputes exist in every contractual transaction and smart contracts are no exception to it. Considering that the regulation of smart contracts is at a nascent stage across jurisdictions, with India, having no legal framework at place, the idea of resolving smart contract disputes in a Civil Court is still implausible. But, at the same time, the possibility of solving smart contract disputes through arbitration is feasible due to the possibility of party autonomy in several crucial aspects such as choice in law, choice of forum, choice of procedure and the like, to be applied in the arbitration proceedings. Therefore, this blog attempts to examine the arbitrability of smart contract disputes in India with an aim to expose challenges and provide solutions in the current legal framework that may pave a path to better arbitrability of smart contract disputes in India.
Understanding Smart Contracts
A smart contract is an agreement between two or more parties in the form of computer codes which automatically executes either a portion or the entire contract between parties on the fulfilment of pre- determined parameters that have been added to the code. The execution of smart contracts happen on a blockchain network for which transaction fees referred to as “gas fees” are paid by the executing party. Since the idea of having smart contracts was to alleviate breach of contract, smart contracts are irreversible. In order to illustrate in a better way, a diagram with an example is being provided below:
The diagram above showcases an example of a transaction of sale of goods by the manufacturer to the wholesaler using a smart contract. However, smart contracts in the practical sense tend to be more complex involving pre- determined parameters for aspects such as non- acceptance of delivery, delay in transportation, termination of contract and the like.
Nature of Smart Contract Disputes
Now that a basic idea of smart contract transactions along with an example has been discussed, it is important to discuss the nature and manner in which smart contract disputes may arise. Contrary to the general perception, although smart contracts self- execute on pre- determined parameters, the scope of breach of contract is quite high. Disputes may arise on account of error in the code leading to non- execution, change in law resulting in illegality of contract, defect in goods or deficiency in service and many more similar reasons. Due to this, it is necessary for an adequate dispute resolution mechanism to be used for resolving smart contract disputes. Arbitration is the most-suited dispute resolution method for smart contract disputes since blockchain arbitration as well as standard arbitration methods already exist and are being used in few jurisdictions to solve disputes arising out of smart contracts.
On perusal of Diagram 2 above, it is easily inferable that blockchain arbitrations are conducted on the blockchain itself where adjudicators referred to as “jurors” arrive at a decision on the basis of majority voting and where the enforcement of the award takes place on the blockchain itself. The enforcement of the award on the blockchain itself is achieved by ensuring that the parties deposit an escrow amount on- chain. Blockchain arbitrations may not be legally recognized in several jurisdictions and are often viewed as reducing party autonomy and snatching the expert element away from arbitrations since majority voting by jurors is the criteria for reaching at a decision. Standard off- chain arbitration is the traditional arbitration process where the dispute is resolved before an Arbitration Tribunal (which can either be a physical or a virtual Arbitral Tribunal) by Arbitrator(s) appointed by the parties and the enforcement of the Arbitral Award is made by a Civil Court having jurisdiction. However, when it comes to smart contract disputes, even standard arbitration has its own set of issues such as the non- recognition of smart contracts as a valid contract in many jurisdictions and problems related to enforceability of an Arbitral Award solving a smart contract dispute.
Identifying Legal Challenges from the Indian Perspective
Essentials of Contract and the Consideration Conundrum
In the Indian context, to determine the arbitrability of smart contract disputes, it is primarily necessary to examine if smart contracts can be treated as valid contracts. Section 10 of the Indian Contract Act, 1872 stipulates the essentials of a valid contract.
On perusal of the Diagram above, it is easily understandable that the essentials of a valid contract under the Indian Contract Act, 1872 is that there must be parties competent to contract, a legitimate offer and acceptance, free consent of parties entering into the contract, lawful consideration, lawful object and the contract must not expressly be declared as void. In the Indian context, smart contracts can certainly have competent parties to contract, legitimate offer and acceptance, free consent of parties, lawful object and the contract would also not expressly be declared as void, but the challenge arises in the portion of meeting the requirement of lawful consideration.
The colossal reason for the consideration involved in smart contract transactions not being treated as lawful is because of the use of cryptocurrency as consideration in smart contract transactions. Initially, the Reserve Bank of India had banned banks and financial institutions from dealing in cryptocurrencies, but this was subsequently reversed by the Supreme Court of India. Vide the Finance Act, 2022 direct tax on transfer of cryptocurrencies were introduced. However, this is more or less a temporary arrangement up till the introduction of the Central Bank Digital Currency which will impose a blanket ban on all other forms of cryptocurrencies and only legalize the Central Bank Digital Currency introduced by the Reserve Bank of India. For the present moment lack of express legalization of cryptocurrency in India exists but once the Central Bank Digital Currency is introduced, its use as consideration in smart contract transactions will be treated as “lawful consideration”. Until then, the consideration conundrum may continue because of manifold interpretations and lack of clarity.
Impossibility of Stamping of Smart Contracts
Under Indian law, there is an express requirement of every contract to be stamped as per the provisions of the Indian Stamp Act, 1899 read with the provisions of the State law for stamping enacted. Even though the Supreme Court of India has emphasized that although unstamped contracts are curable, but in the occasion of Arbitral Tribunals and Civil Courts coming across unstamped contracts, they have to impound such unstamped contracts and require parties to pay Stamp Duty. This may entirely be impossible in terms of smart contracts since smart contracts are executed on the blockchain itself and are intrinsically irreplicable, making them impossible for stamping as per the Indian Stamp Act, 1899 or as per the State stamping laws.
Non-Recognition of Blockchain Arbitration
Indian law does not recognize blockchain arbitrations because of the entire legal system having been created for accommodating dispute resolution of paper- based and written contracts. Furthermore, blockchain arbitrations may not involve oral hearings and may also not permit additional pleadings to be made, resulting in the violation of principles of natural justice. This is why, for the moment, the possibility of blockchain arbitration in the Indian context may be a far- fetched idea.
Governing Law, Choice of Procedural Rules, Venue, Seat of Arbitration, Appointment and Qualifications of Arbitrators
Traditional paper-based contracts and electronic contracts commonly have governing law, choice of procedural rules, venue of arbitration, legal seat of arbitration, appointment and qualification of arbitrators incorporated as a part of the contract itself. However, this may not be the case when it comes to smart contracts since parties may often opt for blockchain arbitration wherein the dispute is solved as well as enforced on the blockchain itself with the help of escrow deposit made at the time of initiation of the dispute and a voting “jury” system. In the Indian context, this may prove to be challenging since the entire mechanism of blockchain arbitration is not legally recognized.
Power of Judicial Authority to Refer Parties to Arbitration Defeated on Procedural Ground
Section 8 of the Arbitration and Conciliation Act, 1996 confers a judicial authority (including a Civil Court) to refer parties to arbitration where an application is made. However, a mandatory procedural condition imposed is that an original or duly certified copy of the arbitration agreement has to be furnished along with such application. This can prove to be an impediment when it comes to smart contracts since smart contracts are executed on the blockchain and intrinsically irreplicable and therefore, to be able to provide an original or duly certified copy of the arbitration agreement may not be possible unless and until an arbitration agreement was signed off-chain.
Issues in Enforcement of Arbitration Award
The above Diagram explicates the issues which currently exist in the enforcement of arbitration awards solving smart contract disputes in India. The first extant issue is that Article II of the New York Convention requires that a valid arbitration agreement needs to be in writing. Smart contracts can be in code as well as natural language form, but in case the smart contract is entirely in code, then it may not be treated as a valid arbitration agreement under the New York Convention.
The second extant issue is that similarly, Section 7 of the Arbitration and Conciliation Act, 1996 also requires that an arbitration agreement needs to be in writing which may lead to non- recognition of smart contracts entirely in code.
The third extant issue is that Section 47 of the Arbitration and Conciliation Act, 1996 requires that during enforcement of a foreign award, the original arbitration agreement or a duly certified copy of the original arbitration agreement has to be presented before the Civil Court. As pointed out, this is not possible in relation to smart contracts unless and until an arbitration agreement is entered into between the parties separately off- chain.
The fourth extant issue is that in case an Arbitral Tribunal passes an Award directing certain remedial action to be taken on the blockchain itself, it is unclear if the Civil Court enforcing the Award has the power to order such remedial action to be undertaken on the blockchain to the blockchain network provider since the blockchain network provider is neither obligated by Indian law to do so, nor is the blockchain network provider a party to the smart contract. It is indeed true that the parties have to accept the terms and conditions (in the form of an electronic contract) of the blockchain network provider while availing their services, but that in itself would constitute a separate contract. Furthermore, Section 36 of the Arbitration and Conciliation Act, 1996 also stipulates that enforcement of Award has to be done as per the Code of Civil Procedure, 1908 as if it was a Decree passed by a Civil Court. For foreign awards, similar provisions exist under Sections 48 and 49 of the Arbitration and Conciliation Act, 1996. Due to these provisions, immense difficulty may arise for the portion of the Arbitration Award to be executed on- chain (on the blockchain) since there exists no mechanism permitting the enforcement of Award on the blockchain itself.
Solving Legal Challenges in the Arbitrability of Smart Contract Disputes in India
Now that several extant issues in the arbitrability of smart contract disputes have been discussed, it is necessary to solve such legal challenges under Indian law which are hampering the arbitrability of smart contract disputes in India. Due to the inherent nature and development of Indian jurisprudence, it may not be possible to legalize blockchain arbitration for the moment. However, this does not mean that parties in smart contract disputes should be left remediless. Therefore, this part of the article is dedicated towards explicating solutions and suggestions that can permit smart contract disputes to be solved under the current law of arbitration in India.
Dealing with the Consideration Conundrum
Section 23 of the Indian Contract Act, 1872 stipulates what considerations are lawful. In case a form of consideration is forbidden by law, by its nature defeats the provisions of any law, is fraudulent in nature, involves or implies injury to property or person of another or if it is deemed as immoral or opposed to public policy by a Court, then such form of consideration would be treated as unlawful. Cryptocurrency does not defeat the provisions of any existent Indian law, is not fraudulent in nature, does not imply injury to property or person of another and has not been deemed as immoral or opposed to public policy by a Court. Furthermore, for the moment, cryptocurrency is not expressly forbidden by law either, but it seems that Indian law is certainly heading towards that direction with the idea of the Central Bank Digital Currency. This would mean that in case parties enter into smart contracts with a choice of governing law as India, and the change in law forbidding cryptocurrencies except the Central Bank Digital Currency occurs, then parties would not be able to initiate arbitration since such contract would become void on account of illegal consideration under Section 23 read with Section 24 of the Indian Contract Act, 1872. Even if an arbitration is initiated and the change in law occurs after that, parties would still face tremendous difficulties in enforcing such arbitral awards since it would be challenged and may even be set- aside by Indian Courts for being in contravention to fundamental public policy of India under the Arbitration and Conciliation Act, 1996. Therefore, up till the introduction of the Central Bank Digital Currency (since the legalization of other forms of cryptocurrency seems to be highly unlikely) it would be on the more commercially viable side, for two Indian parties or even foreign parties with disputes in India arising out of smart contracts to choose a foreign seat of arbitration and a foreign governing law with a venue of arbitration as India in order to avoid any form of difficulties to initiating arbitrations or enforcing awards made for smart contract disputes.
Solving the Issue of Stamping of Smart Contracts
Since the provisions of the Indian Stamp Act, 1899 are based completely for traditional paper- based contracts, they are redundant when applied in the context of smart contracts. The need for solving the issue of stamping of smart contracts arises out of the fact that stamping entails the collection of Stamp Duty for the Government and would lead to Revenue loss in case robust provisions for stamping of smart contracts are not introduced. Furthermore, as pointed out above, the Supreme Court of India has laid down that Arbitral Tribunals and Civil Courts (during enforcement) are required to ensure that parties cure any defects of unstamped agreements by the payment of Stamp Duty and therefore, in spirit has affirmed the mandatory nature of stamping of contracts. Although the long-term goal should be to introduce a blockchain based stamping system, looking at the current ground realities, the Indian Government may be few years away from developing such a system. In order to ensure that stamping does not become an incurable defect for smart contracts, the e- stamping facility could come to the rescue. The buyer in the smart contract transaction or the seller (only if expressly agreed upon in the smart contract) can pay the necessary Stamp Duty using the e- stamping facility. However, in order for this to happen, the Indian Stamp Act, 1899 and its corresponding State stamping laws will have to specifically confer recognition of “instrument chargeable with duty” to smart contracts and also include them in the Schedule prescribing the Stamp Duty payable. Once this is done, the buyer or the seller (if specifically agreed upon in the contract) can pay the applicable Stamp Duty prescribed through the e- stamping facility. This way, even if it is found during arbitration proceedings or enforcement of award proceedings that Stamp Duty has not been paid, it will remain as a curable defect which can be rectified by the concerned parties.
Solving Issues Pertaining to Governing Law, Choice of Procedural Rules, Venue, Seat of Arbitration, Appointment, Qualification of Arbitrators and Enforcement of Arbitration Awards
As opposed to traditional paper- based contracts or even electronic contracts for that matter, aspects such as governing law, choice of procedural rules, venue, seat of arbitration, appointment of arbitrators and qualification of arbitrators may not be included in smart contracts as a matter of standard practice due to its reliance on blockchain arbitration that is not legally recognized in India. Considering that these aspects play a vital role in standard off- chain arbitrations, there are two ways in which parties to smart contracts can deal with the issue.
The parties could opt to implement only the transactional portion through a smart contract code and have a natural language electronic contract or a natural language paper contract as an arbitration contract that will contain governing law, choice of procedural rules, venue of arbitration, seat of arbitration, appointment and qualification of arbitrators. This will enable parties to initiate arbitrations and enforce the arbitration award without any difficulty and parties can even freely choose between ad- hoc arbitrations or institutional arbitrations as per their requirements. Alternatively, the parties could include governing law, choice of procedural rules, venue of arbitration, seat of arbitration, appointment and qualification of arbitrators in the smart contract itself and permit the intervention of an Arbitral Tribunal acting as a blockchain oracle when a dispute arises. A blockchain oracle is an entity that connects the blockchain with external data sources allowing inputs and outputs from external sources to the blockchain as well as vice versa. In other words, it is the mechanism through which a blockchain can interact with external data sources. In order to explicate as to how an off- chain Arbitral Tribunal can act as a blockchain oracle, a diagram has been provided below:
On perusal of the diagram above, the first step in the process of Arbitral Tribunal as a blockchain oracle is that the smart contract needs to be coded with predetermined parameters that would constitute a breach of contract. Without this, the possibility of automated initiation of arbitration would not be possible. This means the parties would have to agree in advance in respect of the factors that would constitute as a breach of contract. In case the breach of contract arises out of a technical issue in the blockchain itself or the smart contract, then the respective contracts of the parties with the blockchain network provider will have relevance and separate legal action will have to be taken by the aggrieved party against the blockchain network provider. The second step is that the notice for commencement of arbitration will have to be sent manually by the party initiating arbitration and this is extremely crucial since Section 21 of the Arbitration and Conciliation Act, 1996 stipulates that the commencement of arbitration would be deemed to be the date on which a Notice or request for arbitration is received by the responding party. However, since the provision begins with “unless otherwise agreed by the parties”, the parties can specifically agree that the date of commencement of arbitration should be the date on which the smart contract sends an automated email communication to the Arbitral institution or Arbitrators, as the case may be for appointment of an Arbitral Tribunal.
Once the smart contract sends an automated email communication for constitution of the Arbitral Tribunal as per the number and qualifications of Arbitrators as agreed upon by the parties, the third step would be to conduct the arbitration proceedings off- chain as per the governing law, procedural rules at the seat and venue of arbitration agreed upon by the parties. Now, the pertinent question which would arise is what would be the ideal governing law, procedural rules, legal seat and venue of arbitration. Although there are no issues for parties to agree for the venue of arbitration in India, since Indian law is not completely equipped for arbitrating smart contract disputes, issues may arise for parties if they decide to choose Indian law as the governing law and India as the legal seat. More suitable governing laws and legal seats would be jurisdictions, who have at least some forms of legal recognition conferred to smart contracts. The United States of America, United Kingdom and Italy are jurisdictions which have laws in place for smart contracts and blockchain whereas jurisdictions such as Estonia and the United Arab Emirates seem to be moving towards such legal recognition. Parties could opt for the respective governing laws and legal seat based on their requirements and the intricacies of the impugned transactions. As far as procedural rules are concerned, the JAMS Rules Governing Disputes Arising Out of Smart Contracts and the United Kingdom Jurisdiction Taskforce Digital Dispute Resolution Rules are two of the most commonly known procedural rules for smart contract arbitrations.
However, since the idea is to make Indian law a preferred legal seat and choice of law for parties to smart contract disputes, it is necessary that primarily, insertions in clause (3) of Section 7 of the Arbitration and Conciliation Act, 1996 have to be made. Under Section 7(3), a proviso could be added to state that natural language or even fully coded smart contracts should be treated as “agreements in writing” for better clarity. Furthermore, it is of utmost necessity that specific principal legislation on smart contracts is also legislated. A specific enactment for smart contracts is mainly necessary to ensure that Government authorities, Courts, Arbitral Tribunals and statutory auditors are able to seamlessly interact with the smart contracts on the blockchain network as oracles in order to carry out the verification of existence of smart contracts, to reduce the insurmountable difficulties to furnish smart contracts as evidence and also, to ensure that outcomes of disputes expressed in the form of Judgments, Decrees or Awards are reflected in the smart contract. Such principal legislation would also be necessary to assign legal definitions to terms such as “smart contract”, “blockchain” and the like. Introducing specific legislation for smart contracts would also help in solving the dilemma under Section 8 of the Arbitration and Conciliation Act, 1996 which mandatorily requires parties to furnish an original arbitration agreement or a duly certified copy of the arbitration agreement since then, a mechanism for Civil Courts to verify the existence of the smart contract would be made possible. Principal legislation on smart contracts would also have legislative competency since Entry 7 of the Concurrent List (List III) of Schedule VII of the Constitution of India stipulates concurrent powers of the Union of India as well as the States to legislate on matters pertaining to contracts including special form of contracts.
Coming back to Diagram 5, the last part is where the Arbitration Award is passed by the Arbitral Tribunal and the portion of the outcome which cannot be enforced on the blockchain is enforced by a Civil Court as per Section 36 of the Arbitration and Conciliation Act, 1996 read with the provisions of the Code of Civil Procedure, 1908 and Sections 48 and 49 of the Arbitration and Conciliation Act, 1996 for foreign Awards. However, when a certain portion or the entire Award has to be executed on the blockchain itself through an inbound oracle, then the same Sections 36, 48 and 49 would create impediments since the express requirement is for enforcement to be done by a Civil Court. Therefore, in order to make Indian arbitration law compatible for smart contract disputes, it is necessary that provisions are introduced in the Arbitration and Conciliation Act, 1996 explicating enforcement of Awards on the blockchain alongside the standard route of enforcement through Civil Courts. Additionally, the requirements of furnishing the original arbitration agreement under Section 47 of the Arbitration and Conciliation Act, 1996 for enforcing a foreign award can also be solved by the principal legislation on smart contracts discussed earlier, coupled with necessary amendments to Sections 47 which will permit the Civil Court (in case of off- chain enforcement) to verify the existence of smart contract.
Conclusion
From the discussions made in the preceding paragraphs, it is manifestly clear that several qualms do exist in the arbitrability of smart contract disputes in India which can be eliminated by way of necessary insertions and amendments and as well as through introduction of specific principal legislation on smart contracts. However, till that time, in order for parties in smart contract disputes to not be rendered remediless, parties may choose to solve their disputes through arbitration choosing a legal seat and governing law of a jurisdiction with a recognized legal framework for smart contracts as discussed above, up till the time relevant changes are brought under Indian law to make smart contract disputes arbitrable in India.