From Blueprints to Blockchain: Innovating Construction Contracts

Introduction

Blockchain technology is poised to transform the construction industry by introducing smart contracts. Construction projects often face delays due to financial constraints, supply chain disruptions, and coordination challenges among subcontractors. These delays not only increase costs but also erode trust among stakeholders, leading to a more adversarial environment. This essay will first analyze the intricate structure of the construction industry and its current use of technology. We will then explore the potential of blockchain and smart contracts to significantly improve efficiency and transparency, followed by a detailed discussion on the practical steps required for the implementation of smart contracts in construction.

Current Challenges in the Construction Industry

The construction industry is composed of various specialized sectors involving clients, contractors, suppliers, and regulatory bodies. Projects typically progress through several stages, such as planning, pre-construction, construction, and post-construction, each requiring meticulous coordination and strict regulatory compliance. This complexity often results in fragmented workflows and inefficiencies that can delay project timelines and inflate costs.

Despite the significant role of the construction industry in any nation’s economy, it is widely recognized that the sector has long been troubled by issues such as late or non-payments. Payment delays and disputes among parties in construction projects are severe problems, leading to cost and time overruns, cash flow difficulties, and even business bankruptcies. Major factors contributing to these contractual disputes include missed payment deadlines, lack of payment assurance, and refusals to pay. Additionally, the construction industry has traditionally been slow to adopt innovations and digital improvements. Limited knowledge and understanding of various technologies among stakeholders further exacerbate these issues. Furthermore, many studies indicate that the construction industry lags in implementing modernization-related technologies compared to other sectors like logistics, automotive, hospitality, and mechanical engineering.

Another one of the primary issues in the construction industry is the mismanagement of records and inadequate documentation. This often leads to disputes over transactions and fund disbursement. In traditional construction projects, paper-based records are still prevalent, which are prone to errors and manipulations. Furthermore, the lack of a centralized system for record-keeping means that stakeholders often rely on disparate systems that do not communicate effectively with each other.

Application Of Smart Contracts: A Potential Solution

To begin with, a smart contract (SC) is an agreement between two parties that uses code to leverage blockchain’s numerous benefits, including enhanced efficiency, transparency, and security. Smart contracts, a critical application of blockchain technology, can automate various aspects of construction projects. These digital contracts are self-executing agreements where the terms are directly written into code. This means that when the pre-defined conditions are met, the contract automatically enforces the agreed-upon actions, such as releasing payments. This automation eliminates the need for intermediaries, reduces administrative overhead, and ensures timely execution of contractual obligations.

A simple illustration to understand the concept of smart contracts is to observe the functioning of Vending machines. When a payment is made for the purchase of a product displayed in the vending machine, a predefined sequence of actions is triggered, and the machine executes the transaction by calculating and dispensing the selected product along with any change due. This vending machine model closely resembles the concept of a smart contract. However, more sophisticated transactions necessitate intricate programming. For instance, obligations such as payment and delivery can be automated to execute based on algorithmic calculations. These contracts demonstrate a decrease in the resources required for contract management.

As discussed above, SCs can address the challenges looming in the construction sector by providing a decentralized and immutable ledger that records all transactions, contracts, and project milestones. This transparency fosters trust among stakeholders and significantly reduces disputes. For example, once a transaction is recorded on the blockchain, it cannot be altered, ensuring that all parties have a single source of truth. Moreover, the blockchain’s encrypted and immutable nature helps prevent fraud and unauthorized activity. Potential privacy issues on the blockchain can be addressed by anonymizing personal data and using permissions to restrict access. Information stored on a distributed network of computers enhances security against hacking.

Efficiency Gains as a Consequence of Use of Smart Contracts

Blockchain technology and smart contracts offer several benefits for the construction industry and result in efficiency gains. These include:

• • 1. Enhanced Transparency: All transactions and changes to contracts are recorded on the blockchain, creating a transparent and tamper-proof record. This transparency helps build trust among stakeholders and reduces the likelihood of disputes.

 

• • 2. Improved Efficiency: By automating tasks such as payment processing, contract enforcement, and document management, smart contracts can significantly reduce the administrative burden on project managers and other stakeholders. This leads to faster project completion times and lower costs.

 

• • 3. Increased Security: Blockchain’s decentralized nature and cryptographic security features make it highly resistant to hacking and fraud. This ensures that sensitive project data and transactions are protected from unauthorized access and manipulation.

 

• • 4. Reduced Costs: By eliminating the need for intermediaries and reducing administrative overhead, blockchain and smart contracts can lower the overall costs of construction projects. This is particularly beneficial for large-scale projects where even small cost savings can add up to significant amounts.

 

• • 5. Better Compliance: Smart contracts can be programmed to automatically enforce compliance with regulatory requirements and industry standards. This ensures that projects adhere to all necessary regulations, reducing the risk of legal issues and fines.

 

Practical Applications of Smart Contracts in Construction

Smart contracts can be tailored to specific project requirements and structured to execute automated actions based on predefined terms. Some practical applications of smart contracts in the construction industry include:

• • 1. Payment Processing: One of the most common applications of smart contracts is in payment processing. For example, a smart contract can be programmed to release payments to contractors and suppliers only when specific milestones are met. This ensures that payments are made on time and only for completed work, reducing the risk of disputes. In SCs, the clauses and instructions required for contract operation can be encoded into a computer program and automatically executed when the specified contractual conditions are met. As a result, SCs are considered a self-enforcing type of contract. They enable digital transactions, such as payment amounts, to be embedded in the system and automatically transferred to the contract parties. Additionally, payment security is ensured by blocking the amount to be paid, preventing any single person from accessing the blocked funds. The blocked amount is released to the relevant parties only when the coded terms and conditions are fulfilled. Therefore, SCs are effective due to their binary logic, which ensures that the input and output are consistent, and the contract conditions operate based on the coded parameters.

 

• • 2. Supply Chain Management: Smart contracts can streamline the procurement process by automating the ordering and payment of materials. When a supplier delivers materials to a construction site, the smart contract can automatically verify the delivery and release payment. This reduces the administrative burden on project managers and ensures that suppliers are paid promptly.

 

• • 3. Contract Administration: Smart contracts can automate various administrative tasks, such as contract distribution, modification monitoring, and approval management. This reduces the time and effort required to manage contracts and ensures that all stakeholders are working with the most up-to-date information.

 

• • 4. Dispute Resolution: Smart contracts can also be used to automate the dispute resolution process. For example, if a dispute arises between a contractor and a client, the smart contract can automatically trigger an arbitration or mediation process. This ensures that disputes are resolved quickly and fairly, without the need for lengthy and costly legal proceedings.

 

• • 5. Addressing Corruption in the Real Estate Sector: The integration of smart contracts into the real estate sector offers substantial advantages, particularly in addressing the inefficiencies and corruption prevalent under the traditional contract regime. The existing state-maintained Record of Rights (RoR) often reflects inaccurate property titles due to manipulation by government officials. This manipulation, enabled by the exclusive control and lack of oversight over the RoR, results in widespread corruption and a high volume of land-related disputes in district courts. Furthermore, the registration process is hindered by procedural inconsistencies across states, leading to significant delays in property transactions.

 

Legal Validity of Smart Contracts

In 2018, the Telecom Regulatory Authority of India (TRAI) defined smart contracts as programmable code capable of executing predefined tasks or rules to ensure regulatory compliance without human intervention. TRAI highlighted their compatibility with Distributed Ledger Technology (DLT) for creating digital contracts. Integrating blockchain and smart contracts in the construction sector can streamline operations, enhance transparency, and boost efficiency, benefiting all parties involved. However, certain challenges, such as regulatory compliance, technological infrastructure, and stakeholder acceptance, must be addressed for successful implementation.

The legal framework for smart contracts in India is still evolving. Currently, smart contracts lack regulation, providing them with a binding effect. Disputes over contractual terms in projects using smart contracts present dilemmas regarding the appropriate actions. The responsibility for mistakes remains uncertain, including legal and operational constraints such as sensor problems triggering smart contracts. Furthermore, the absence of clear legal guidelines on the enforceability and recognition of smart contracts adds another layer of complexity to their implementation.

The legality of an e-contract in India is principally regulated by two key statutes: the Indian Contract Act, 1872, and the Information Technology Act, 2000. Together, these laws establish the validity and enforceability of electronic contracts in India unless specified otherwise.

In India, according to Section 2(h) of the Indian Contract Act, 1872 (ICA), a contract is defined as “an agreement enforceable by law.” Section 10 of the ICA outlines the essential conditions for an agreement to constitute a contract: it must be made by parties who are competent to contract, based on their free consent, for a lawful consideration and object, and not expressly declared void. Additionally, Section 11 specifies that a person must be a major, of sound mind, and not prohibited by state laws to be competent to contract. Therefore, any agreement meeting these criteria is presumed valid. However, the question arises whether electronically entered agreements hold legal validity, which hinges on understanding the concept of an electronic contract.

The Information Technology Act, 2000 (hereafter referred to as the IT Act), aims to confer legal recognition on transactions conducted through electronic media, commonly known as “electronic commerce.” Section 10A of the Act, introduced by the IT Amendment Act of 2008, specifically grants legal validity to electronic contracts. Additionally, Section 35 of the IT Act regulates the issuance of digital signatures, specifying that such signatures can only be obtained from certifying authorities designated by the government. These digital signatures serve as crucial identifiers in the digital realm, essential for authenticating electronic documents and protecting against online misrepresentation and identity fraud. Consequently, the legality of electronic contractual obligations in India hinges on the interplay of these Acts.

Therefore, Electronic contracts, or e-contracts, are agreements established through electronic means during e-commerce transactions. This can occur through interactions between individuals using electronic platforms like email or through communication between a person and an electronic agent, such as a computer program. Another scenario involves interactions between at least two electronic agents programmed to acknowledge the formation of a contract. An example of this is seen in end-user license agreements, where users typically accept contractual terms by using, downloading, or installing software or services.

Such e-contracts are wholly different fro a smart contract as a smart contract, in contrast to an e-contract, operates within a blockchain-based electronic ledger network. It functions as a dynamic entity by automatically executing logical transactions required to meet the contract’s terms instead of remaining static within an archived document. Therefore, a holistic reading of the two legislations seems to suggest that there exists significant legal uncertainty on the issue of legality of smart contracts. Since, for a smart contract to be initiated, a hash key generated by blockchain technology is required as an identifier to authenticate the contract, which deviates from the authorized digital signatures under the IT Act, it becomes difficult to meet the requirement of obtaining digital signatures as contemplated by section 35 of the IT Act.

Furthermore, Section 86 of the Bharatiya Sakshya Adhiniyam, 2023 specifies that an electronic document is only valid if authenticated with a digital signature. Section 91 of the Bharatiya Sakshya Adhiniyam, 2023 asserts that while the Court presumes an electronic record to be genuine, it does not make any presumptions about the originator’s identity. Therefore, if a blockchain-generated signature is used to authenticate a smart contract, the document’s admissibility becomes problematic since the signature is not obtained under the IT Act.

This adds another layer of complexity, as a smart contract could be deemed inadmissible in a court of law due to its digital signature not conforming to the Information Technology Act. Consequently, if the terms of a smart contract related to a non-fungible token (NFT) are violated, the legal enforceability of such a contract becomes uncertain. This issue is compounded by the absence of legally binding precedents on blockchain-based contracts, as such matters have not yet been addressed by Indian courts.

Moreover, the principle of privity of contract, which confers rights and imposes duties only on the contracting parties, is difficult to satisfy on blockchain platforms. This complicates the enforceability of smart contracts under traditional contract law principles. Furthermore, the absence of a regulatory framework limits the legal assistance available to parties involved in smart contracts, raising concerns about their enforceability and potential for legal recourse in case of disputes.

Lastly, the aspect of ‘consideration’ presents a significant challenge, particularly when it involves cryptocurrency. This raises the question of whether cryptocurrency is recognized as a valid consideration under Indian law. The legal ambiguity surrounding cryptocurrency represents one of the numerous obstacles to the implementation of smart contracts in India. In March 2020, the Supreme Court of India struck down the Reserve Bank of India’s ban on cryptocurrency, which had prohibited banks from providing services to entities engaged in cryptocurrency transactions.

Prior to this decision, trading was restricted to crypto-to-crypto transactions, excluding crypto-to-INR exchanges. Nevertheless, the Indian Government maintains a cautious stance on cryptocurrency due to concerns regarding consumer safety, market integrity, and white-collar crimes such as money laundering. Recent reports indicate that the Government may enact legislation to heavily regulate cryptocurrency trading, which could significantly impede the functionality and adoption of smart contracts.

While Indian Courts have accepted e-contracts, there is no governing authority to assess the legality of a smart contract’s object. These factors collectively contribute to the uncertainties surrounding the legal validity of such contracts. Several critical questions regarding their enforceability arise, including:

• • 1. Will an electronic signature generated through blockchain technology be deemed valid for authenticating a smart contract agreement?

 

• • 2. Can a smart contract be admitted as evidence in a court of law if a dispute arises?

 

Judicial View on Smart Contract Implementation

In the case of Rosmerta Technologies Ltd v. State of Maharashtra [(2023) 1 Bom CR 166], the Bombay High Court scrutinized stringent pre-eligibility conditions in smart contracts. The court criticized the exclusivity of allowing only two technical bidders while rejecting entities experienced in implementing specific smart contract applications like DL/RC certificates. This raises concerns about the feasibility of replacing traditional written contracts with smart contracts under the current legal framework.

Challenges in Widespread Adoption of Smart Contracts

Firstly, implementing smart contracts in the construction industry requires technical expertise in both blockchain technology and contract law. Smart contract programmers, who may be third parties not directly involved in the transactions, raise concerns about possible variations between contractual conditions and the smart contract’s code. In case of errors, technical experts are needed to verify the alignment between computer code and contractual terms. Additionally, smart contracts’ security is a concern due to the complexity of existing programming languages, which limits effective contract execution and requires highly skilled programmers.

Secondly, smart contracts, despite their name, do not inherently possess intelligence or qualify as traditional contracts. The permanence of recorded code increases the risk of errors, which raises concerns about achieving seamless execution. Alternative methods may offer faster and more efficient task performance. Therefore, smart contract technology should be viewed as a valuable tool for automating and documenting specific contractual aspects rather than replacing traditional written contracts.

To address security concerns, it is crucial to employ robust security measures when developing and deploying smart contracts. This includes conducting thorough code reviews, testing for vulnerabilities, and implementing security best practices. Additionally, compliance with relevant regulations and industry standards is essential to ensure the legal enforceability of smart contracts.

Thirdly, in the context of intellectual property rights, smart contracts are pertinent to NFTs as they can facilitate the transfer of copyright by modifying the smart contract linked to the NFT. Creators can permit NFT buyers to use their digital assets for commercial purposes by altering the smart contract terms, as demonstrated by the Bored Ape Yacht Club, a collection of NFTs on the Ethereum blockchain. While this offers numerous opportunities, it is constrained by the risky nature of smart contracts, particularly within the current legal framework. A solution gaining traction is the inclusion of an arbitration clause in the smart contract. To best serve the interests of the contracting parties, it would be prudent to appoint an arbitrator knowledgeable in NFTs and blockchain technology. However, in India, it is crucial to recognize that not all IPR issues are subject to arbitration.

Fourthly, the global distribution of blockchain nodes can lead to jurisdictional conflicts. In long-term contracts with multiple payments, encumbering funds far in advance undermines the self-enforcing nature of smart contracts. Ownership changes through mergers and acquisitions add complexity due to unclear government rules on ownership and jurisdiction, making the legal landscape for smart contracts even more complicated.

Moreover, smart contracts operate through blockchain technology, utilizing nodes, which can be any device such as computers, laptops, or larger servers. These nodes form the infrastructure of the blockchain, constantly updating each other with the latest blockchain data to ensure synchronization. Because these nodes are globally distributed, jurisdictional conflicts may arise concerning smart contracts.

In long-term contracts involving multiple payments over extended periods, the paying party is unlikely to encumber funds far in advance of future payments, undermining the self-enforcing nature of smart contracts. For instance, if the contracting parties are large conglomerates based in different cities, ownership changes through mergers and acquisitions could create hurdles in using smart contracts due to the absence of clear rules established by the government. This lack of clarity on ownership and jurisdiction adds another layer of complexity to the adoption and implementation of smart contracts.

Lastly, despite their potential, integrating smart contracts into real-world applications faces significant challenges. As argued in the foregoing section, their legal recognition remains ambiguous, and the immutable nature of smart contracts makes it difficult to rectify coding errors or address unforeseen circumstances. Smart contracts depend heavily on external data sources (oracles) to validate real-world events, and their accuracy and reliability are crucial. Adoption necessitates robust technological infrastructure and shifts in mindset and legal frameworks, making the process complex and time-consuming. Additionally, educating stakeholders about the benefits and limitations of smart contracts is essential for their widespread adoption.

Moving Forward: Strategies for Implementation

For the construction industry to fully leverage the benefits of blockchain and smart contracts, a multi-faceted approach is required. This involves collaboration between industry stakeholders, regulatory bodies, and technology providers. The following strategies can help facilitate the successful implementation of smart contracts in the construction sector:

• • 1. Stakeholder Education and Training: Educating stakeholders about the benefits and limitations of blockchain and smart contracts is crucial. This includes training sessions for project managers, contractors, and suppliers to ensure they understand how to use these technologies effectively.

 

• • 2. Regulatory Framework Development: Governments and regulatory bodies need to develop clear guidelines and standards for the use of blockchain and smart contracts in the construction industry. This includes addressing issues related to legal recognition, enforceability, and data privacy.

 

• • 3. Collaboration and Standardization: Industry stakeholders should collaborate to develop standardized protocols and best practices for the implementation of smart contracts. This will help ensure interoperability between different systems and reduce the risk of errors.

 

• • 4. Technological Infrastructure: Investing in the necessary technological infrastructure, such as secure blockchain platforms and reliable oracles, is essential for the successful implementation of smart contracts. This includes ensuring that all parties have access to the required hardware and software.

 

• • 5. Pilot Projects and Case Studies: Conducting pilot projects and documenting case studies can help demonstrate the practical benefits of smart contracts in the construction industry. These examples can serve as a reference for other projects and help build confidence among stakeholders.

 

Conclusion

Blockchain technology and smart contracts hold significant potential to transform the construction industry by improving transparency, efficiency, and security. However, their successful implementation requires addressing various technical, legal, and regulatory challenges. By adopting a collaborative approach and investing in the necessary infrastructure and education, the construction industry can harness the power of blockchain and smart contracts to drive innovation and improve project outcomes. As the technology continues to evolve and mature, it is likely that we will see increased adoption and integration of smart contracts in construction projects around the world, leading to a more efficient, transparent, and resilient industry.

Authors:

Aayushi Singh, Associate, Khaitan and Co, New Delhi

Editorial Team:

Managing Editor: Naman Anand
Editor in Chief: Abeer Tiwari and Harshita Tyagi
Senior Editor: Adhya Sarna
Associate Editor: Akash Kumar Surya
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