Legal issues with Blockchain in Corporate Governance System of Indian Banks

Posted on by Tech Law Forum NALSAR

[This post has been authored by Harinie. S, a fourth-year law student at Symbiosis Law School, Hyderabad]

The recent onset of economic recession highlights the need to overhaul the governance system of the largest player of the economy- the banks. The failure of Lakshmi Vilas Bank and Yes Bank, and the downfall of Dhanalakxmi bank’s management are a result of a bad corporate governance system. The same has been acknowledged by the Reserve Bank of India (‘RBI’).

Given the number of problems that come up every day in the banking system, it is very difficult to achieve transparency only with manual force. Many suggestions have come up in this regard and the most interesting one is the blockchain. Implementing a blockchain application in the banking system will prove to have various advantages. However, given the number of problems that have come up with it, it is necessary to look into the legal aspects of the same. This article will analyze the legal issues pertinent to introducing a blockchain system in corporate governance for banks in India and will also discuss some approaches to tackle the same.

 

Commonly proposed Suggestions

The hype around blockchain is based on its immutability. Any information stored in a block cannot be changed. It is especially suited for the banking industry because it can bring in trust and accountability, two of which are highly needed in the industry.

There are various problems associated with the corporate governance structure of banks in India based on which suggestions have been made. The biggest one of all is the board and composition of the board. Blockchain applications have been recommended for solving the transparency problems. Following this comes the data integrity and Management Information System (‘MIS’). Various banks, internationally, have resorted to banking consortiums on a blockchain application for solving similar problems. The same has been considered by few Indian banks for purposes other than governance. Blockchain applications have also been recommended for financial reporting. It has also been used for developing a voting system for Annual General Meetings. Apart from these, Decentralized Autonomous Organizations (‘DAOs’) have also been a common suggestion to eliminate hierarchies in an organization.

The reaction to the feasibility of these methods seems to be positive in India. To explore these possibilities, the RBI, through its Institute for Development and Research in Banking Technology had come out with a whitepaper. In this paper, the Institute had discussed the feasibility of using Blockchain for increasing transparency in banks through financial reporting, management of documents, fund management, etc. Apart from that, banks have considered the overall feasibility of blockchain and have incorporated the Indian Bank’s Blockchain Infrastructure to implement blockchain-based projects.

While all of them seem viable, there are some legal issues specific to India in this case. It is very important to deliberate on these issues before incorporating any of these methods in the traditional banking system.

 

Legal issues and Possible Solutions

Implementing a Blockchain-based system has a host of general problems. The following are problems that have been noticed by banks experimenting with the technology in a governance setup: –

  • Issues with imposing liability

With the increasing application of technology comes legal issues. Liability issues will be the first to arise before the implementation of blockchain. With the present laws in India, it is difficult to impose liability on an individual in this system. It is also equally difficult to impose any liability when ‘blockchain’ has not been defined under the law. Though blockchain sounds like a fool-proof solution, there have been times where the applications have been hacked into. A vulnerability, which is commonly pointed out as a strength of the system, called the 51% rule is sufficient for authorizing a transaction. In a case where an individual gets the majority control, transactions can be altered. An attack of a similar nature happened on the exchange platform of a popular crypto exchange leading to a huge monetary loss. Different attacks seem to have happened on private blockchains too. If this happens in a traditional banking system with a substantial amount of confidential information in it, the whole economy will be put at risk. One possible solution starts with defining blockchain. Various states in the US have adopted blockchain law whereby important terms are defined. Though most of them do not specifically deal with imposing liability, there is some clarity as to the legality of such systems and their usage. Imposing liability on a decentralized system has been discussed by various scholars and an approach that is commonly taken is to draw a ledger hierarchy to identify the parties involved. Identifying a hierarchy might help the legislators in drafting a suitable law.

 

  • Enforceability of Smart Contracts

The banking consortiums for managing MIS run on smart contracts where a set of conditions are already agreed upon. The same applies to financial reporting where mutually agreed goals are set as conditions. However, the enforceability of smart contracts is a big question in India. While the closest it can be compared to is with electronic contracts, there are some stark dissimilarities between both. The generation of hash for verifying transactions on the blockchain is in direct contravention with the method of obtaining electronic signature under Section 35 of the Information Technology Act, 2000 (‘IT Act’). This further leads to hash being inadmissible under the Indian Evidence Act, 1872 (‘IEA’). For the corporate governance of a bank to rely on, the contract has to be enforceable under law. Accordingly, the IT Act and IEA have to amended to consider hash as an exception to the process of obtaining an electronic signature.

 

  • Jurisdictional Challenges

Normal jurisdictional theories will not apply to cross-border technology. Though the nodes, in this case, can be restricted within India, it will stop further expansion of the technology for achieving greater efficiency. In 2013-14, financial institutions had experimented with private blockchain systems. However, the private blockchain did not help in satisfying all the financial needs. Countries have taken different and conflicting approaches to jurisdiction on the internet. Till a consensus is arrived at, the blockchain platforms can, by means of a contract, make their users agree to jurisdiction and a dispute resolution method.

 

  • Issues with data localization

Adding to this, important issues under data protection will arise. The Personal Data Protection Bill, 2019, seems to be leaning towards data localization which will lie in sharp contrast to implementing a blockchain system with nodes across a few if not many countries. While this concern has been pointed out, the possible solution to this is when the bill is amended and passed accordingly.

 

  • Problems with DAO

Though DAOs are highly discussed, the closest form of a DAO in India is the MahaDAO which is working on developing a non-depreciating currency. The idea of a DAO is to eliminate hierarchies in a company thereby decentralizing the corporate governance structure. Slock.it in Germany created the first DAO based on a smart contract. This was however attacked thereby exposing vulnerabilities in the system. The wider implication of the same was that banks in the US became more cautious of blockchain as they were potentially exploring DAOs. The Indian laws are not sufficient to handle the functioning of a DAO, the problems discussed above have to be addressed before establishing a DAO as this is prone to more vulnerabilities.

 

Additionally, the legal environment regarding cryptocurrencies in India is less likely suitable for blockchain innovation and could bring it to a halt. This could also discourage potential investors from exploring this platform. A positive environment with regard to cryptocurrency can help investors.

 

Conclusion

Though the legal concerns seem to top the list, there are general concerns that have been cited by users for employing blockchain. It is a very complex technology, hence employing it in a traditional bank system would require the training of directors and regulators. Connecting MIS with blockchain would also require some level of understanding of the technology. It would also need an implementation of a strong data protection policy to prevent any breach. When the technology is combined with voting in AGM, shareholders have to understand the basics of the system. All these factors have to be considered before implementing a blockchain system.

Blockchain in the corporate governance of a traditional bank setting could bring a lot of changes to the Indian economy. Implementing the technology in problem areas can help in increasing accountability and transparency. However, the associated legal risks have to be weighed in carefully. Starting with a trial private blockchain set-up should help the regulators in identifying any vulnerabilities and working on them accordingly. Amending necessary laws will help with much-needed clarity on the blockchain.

 

Recommended Readings: