Arbitrability of Smart Contract Disputes in India: Part 1
Analysing how Smart Contract Disputes can be arbitrable
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.
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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.
Read the Second Part of this article here.