Buenviaje, Manolo III

Fordan, Daniel John

Smart Contracts and Contract Law

I. Contract Law
Brief History of Philippine Civil Law

Philippine contract law is primarily governed by Title II, Book IV of the New Civil Code.

The primary basis of the Philippine Civil Code Civil Code was the Spanish Civil Code which took

effect in the country on 1889 until the introduction of the New Civil Code. Said Spanish Civil code

was in turn an adaptation of the Napoleonic Civil Code, otherwise known as the French Civil Code

of 1804.1 The development of the French Civil Code was inspired by the codification of ancient

Roman Civil Law in the 6th century.2 Our civil law, including principles of contract law, has

retained some of its most basic ideas as it developed through the centuries. The question to be

examined in this paper is whether the same concepts that have endured centuries of legal scrutiny

and evolution may still be applicable to the so-called "smart contracts".

Philippine Contract Law

One of the sources of obligations are contracts.3 A contract is defined under the law as a

meeting of minds between two persons whereby one binds himself, with respect to the other, to

give something or to render some service.4 Unlike obligations arising from law, where the

performance by the obligor is mandated by legal provisions of law, the acts or omissions that

1
Edgardo L. Paras, Civil Code of the Philippines Annotated Volume I 7-8 (Sixteenth Ed. 2008)
2
Iain Stewart . "Mors Codicis: End of the Age of Codification?". Tulane European & Civil Law Forum. 27: 17 at
2324 (2012)
3
An Act to Ordain and Institute the Civil Code of the Philippines [CIVIL CODE], Republic Act No. 386, art. 1157
(1950).
4
CIVIL CODE, art. 1305.
contracting parties are obligated to comply with derive its compulsory nature from the terms and

stipulations as agreed upon by the parties themselves. In fact, contractual obligations have the

force of law as between the contracting parties and the law requires that said parties should comply

with their respective undertakings with good faith.5

Generally, parties are free stipulate the terms and agreements that shall be binding upon

them. This is part of the principle of autonomy of contracts. However, such terms and stipulations

that the parties may introduce in their agreement cannot be contrary to law, morals, good customs,

public order, and public policy.6

A contract goes through different stages from its initial conception until it is extinguished.

It ordinarily starts in the so-called negotiation stage where prospective parties intimate their desire,

usually with offers and counter offers, to enter into a contractual relation with one another.

Thereafter, once all the essential elements of a contract are in place and agreed upon, it enters the

perfection stage where the contract is said to be born. Lastly, the contract begins the consummation

or performance stage in which the parties perform their respective undertakings until the contract

is extinguished.7 It should be noted that instead of faithful compliance, a party may altogether

avoid or err in the performance of his obligations under the contract. Such circumstance is

ordinarily referred to as a breach.

To have a valid and existing contract under the law, the following requisites must concur:

(1) consent of the contracting parties; (2) object certain which is the subject matter of the contract;

5
CIVIL CODE, art. 1159
6
CIVIL CODE, art. 1306.
7
Asuncion v. Court of Appeals, G.R. No. 109125 (1994).
and (3) cause of the obligation which is established.8 If any of the above requisites is wanting,

neither of the contracting parties may be obliged to comply since there is no contract to begin with.

Generally, the contract is perfected by mere consent as to the object and the cause. 9 However,

some contracts require additional elements prior to its perfection. For instance, real contracts such

as deposits are not perfected unless delivery of the object is performed.10 On the other hand, formal

or solemn contracts starts to exist only upon its execution in a particular form as required by law.11

A perfected contract, under the principle of mutuality and obligatory force, binds both parties and

its validity or compliance may not be left to the caprice of one party.12

II. Smart Contracts

Nowadays, everything seems to be becoming smart thanks to technological advances. We

now have smartphones, smart appliances, smart homes, and even smart cars. At their very core,

the basic idea behind smart objects is automation through the assistance of software and hardware.

One of the things benefitting from these technological advances and getting a smart label are

contracts.

The Concept of Smart Contracts

8
Sps. Lequin v. Sps. Vizconde, 603 SCRA 407, 417 (2009).
9
CIVIL CODE, art. 1315.
10
CIVIL CODE, art. 1316.
11
Asuncion, G.R. No. 109125.
12
CIVIL CODE, art. 1308.
 The concept of smart contracts is not new. It has been around for around 20 years now.13

It was conceptualized by Nick Szabo in the 1990s.14 Szabo defined smart contracts as a set of

promises, defined in digital form, including protocols within which the parties perform on these

promises.15 Werbach and Cornell find this definition a little vague and lacking as it does not

encapsulate the attributes and essence of smart contracts.16 As such, they defined a smart contract

as an agreement in digital form that is self-executing and self-enforcing.17 Raskin, on the other

hand, defines a smart contract as an agreement whose execution is automated.18 Evidently, there

exists a varying definition of smart contracts. However, the numerous definitions are in agreement

that smart contracts automate contract execution and enforcement through digital means. Szabo

explained the concept of smart contracts by using an example which he considers to be the

primitive ancestor of smart contracts the vending machine:

The basic idea behind smart contracts is that many kinds of contractual clauses (such as collateral,
bonding, delineation of property rights, etc.) can be embedded in the hardware and software we deal
with, in such a way as to make breach of contract expensive (if desired, sometimes prohibitively so)
for the breacher. A canonical real-life example, which we might consider to be the primitive ancestor
of smart contracts, is the humble vending machine. Within a limited amount of potential loss (the
amount in the till should be less than the cost of breaching the mechanism), the machine takes in
coins, and via a simple mechanism, which makes a freshman computer science problem in design
with finite automata, dispense change and product according to the displayed price. The vending
machine is a contract with bearer: anybody with coins can participate in an exchange with the
vendor. The lockbox and other security mechanisms protect the stored coins and contents from

13
Werbach, Kevin D. & Cornell, Nicolas, Contracts Ex Machina, 67 DUKE LAW JOURNAL, FORTHCOMING (2017),
available at https://ssrn.com/abstract=2936294 (last accessed 10 June 2017). See Szabo, Nick, Formalizing and
Securing Relationships on Public Networks, 2 FIRST MONDAY 9 (1997), available at
http://ojphi.org/ojs/index.php/fm/article/view/548.
14
Id.
15
Id. (citing Szabo, Nick, Smart Contracts: Building Blocks for Digital Markets (1996), available at
http://szabo.best.vwh.net/smart_contracts_2.html).
16
Id.
17
Id.
18
Id. (citing Raskin, Max, The Law of Smart Contracts, Georgetown Tech. Rev. (forthcoming) available at
https://papers.ssrn.com/sol3/papers2.cfm?abstract_id=2842258).
 attackers, sufficiently to allow profitable deployment of vending machines in a wide variety of
areas.19

Evolution of Smart Contracts

There have been different forms and implementations of smart contracts in the past

which attempted to automate some parts of contracting through electronic or digital means. These

can be grouped in three broad categories: electronic contracts, data-oriented contracts, and

computable contracts.20 Electronic contracts are simply written agreement in digital form like

click-wrap agreements such as a license agreement for use of software21 or browse-wrap

agreements such as terms of use in a website.22 They are only a change in the form of the contract,

not in its substance nor the manner of its execution.23 Thus, the parties may still view and read the

agreement in its entirety. Only the manner of giving consent is abstracted from the parties.

An evolution of these electronic contracts is a data-oriented contract which is a contract

in which the parties have expressed one or more terms or conditions of their agreement in a

manner designed to be processable by a computer system.24 In this kind of contract, the parties

leave the determination of terms or conditions of their agreement to computer systems by writing

such part in a machine-readable form. This kind of contract differs from simple electronic contracts

since, in this case, some parts of the agreement are not meant for the human parties to understand

19
Szabo, Nick, Formalizing and Securing Relationships on Public Networks, 2 FIRST MONDAY 9 (1997), available
at http://ojphi.org/ojs/index.php/fm/article/view/548 (last accessed 11 June 2017).
20
Werbach & Cornell, supra note 13.
21
See Specht v. Netscape, No. 01-07860 (L) (2nd Cir., 1 October 2002).
22
See Ticketmaster, Corp. v. Tickets.com, Inc., 2003 US Dist. Lexis 6483 (C.D. CA., 7 March 2003).
23
Werbach & Cornell, supra note 13.
24
Id. (citing Surden, Harry, Computable Contracts, 46 U.C. DAVIS L. REV. 629 (2012)).
and determine but for a machine.25 In this kind of contract, the determination of a term or condition

in a contract is abstracted from the parties.

Computable contracts add another layer of automation to data-oriented contracts by

allowing the computer systems to make automated, prima facie assessments about compliance or

performance.26 This kind of contract now pervades the consummation or performance stage of a

contract. Computer systems are now given the power to determine or assess the propriety of

performance, albeit only prima facie thus leaving the power to assess to the human parties and

ultimately, to the courts.27

The latest incarnation of smart contracts are computer programs utilizing the blockchain28

technology.29 Essentially, current smart contracts are like digital vending machines using

cryptocurrencies as cash, and the blockchain as the vending mechanism. The blockchain

technology was primarily used to create a digital currency called Bitcoin through the use of

decentralized networks and cryptography.30 However, the effect of the blockchain technology was

not limited to digital currencies. The creation of the blockchain technology has propelled a trend

of innovation on decentralization, finding application, among others in cloud storage, ridesharing,

domain name registration, crowdfunding, online voting, and contracts.31 The current

implementation of smart contracts is only one of the applications of the blockchain technology.

25
Id.
26
Id.
27
Id.
28
A blockchain is essentially a distributed database of records or public ledger of all transactions or digital events
that have been executed and shared among participating parties. Michael Crosby, Nachiappan, Pradhan Pattanayak,
Sanjeev Verma, & Vignesh Kalyanaraman, Blockchain Technology: Beyond Bitcoin, SUTARJA CENTER FOR
ENTREPRENEURSHIP & TECHNOLOGY TECHNICAL REPORT (2015), available at http://scet.berkeley.edu/wp-
content/uploads/BlockchainPaper.pdf (last accessed 11 June 2017).
29
Werbach & Cornell, supra note 13.
30
Id.
31
Id.
Implications of Smart Contracts

The effect of the blockchain on contracts is that even performance and enforcement is

automated and abstracted from the parties.32 This automation of enforcement is what makes current

smart contracts very radical even compared to its predecessors.33 Such level of automation is

possible only because of the blockchain and the concept of cryptocurrency that came with it.34

In effect, however, enforcement and performance is taken away from the parties, and

ultimately, from the legal system. The aim of smart contracts, like other applications of the

blockchain technology, is to remove intermediaries and create a decentralized system.35 This

means that the purpose of smart contracts is so that there is no more need for contracting parties

to go to courts to ensure enforcement.36 In such case, smart contracts seem more of an enforcing

agent rather than an agreement where parties bind themselves to an obligation. Thus, while

contracts embody an agreement, smart contracts serve as the agreement itself and the enforcing

mechanism thereof. Seemingly, smart contracts may supplant not only contracts themselves but

the entire contract law system.

III. Is a Smart Contract a Contract?

Consequently, a question arises on whether a smart contract may be categorized the same

as the traditional contracts we normally encounter today. Is a smart contract a contract as

contemplated under civil law? At first glance, there can be an obstacle for such a classification.

The basic understanding of a contract is that, as a source of an obligation, it creates a compulsion

to one or both of the parties to perform an act or give something to the other. Since the terms and

32
Id.
33
Id.
34
Crosby, et al., supra note 28.
35
Werbach & Cornell, supra note 13.
36
Id.
conditions integrated in an agreement has the force of law as to the contracting parties, compliance

thereof may be effected with the intervention of the courts of law. This basic premise, however, is

problematic when it comes to smart contracts since as discussed previously, enforcement of smart

contracts is effected automatically through the mechanisms in the contract itself. However, a study

suggests otherwise and states:

Nevertheless, we believe that smart contracts are, at the conceptual level, still contracts. Though
they might not constitute promises per sedepending on how we understand that ideasmart
contracts are agreements that purport to alter the rights and duties of the parties. Not all contracts
are executory. An agreement may still count as a contract even though it leaves nothing open to be
done or performed. A conveyance, for example, is a contract that alters rights presently, and does
not involve any further, open promises. Smart contracts similarly constitute present agreements
without further promises to perform. The simple bitcoin smart contract just imagined is more like a
present but contingent conveyance than it is like an executory promise to pay.37

To have a better grasp on the similarities and differences between traditional contracts and

smart contracts, it is instructive to examine its details in each of the different stages of a contract

as discussed previously. Specifically, it is helpful to study the details of both concepts during its

perfection, consummation and in circumstances of breach by one or both of the contracting parties.

Perfection

As regards the formation or perfection of contracts, one study suggests that there is no

substantial difference between traditional contracts and smart contracts because there must first be

an agreement as to the terms that initiates the contract before a contractware can be operated.

However, unlike in the usual course of traditional contracts, acceptance, which normally triggers

the perfection of contracts, is done by performance when it comes to smart contracts. 38 The same

37
Id.
38
Raskin, Max, The Law and Legality of Smart Contracts, 1 GEO. L. TECH. REV. 304 (2017), available at
https://www.georgetownlawtechreview.org/the-law-and-legality-of-smart-contracts/GLTR-04-2017/ (last accessed
11 June 2017). 1
study suggests that the main difference between traditional and smart contracts as to formation is

in the precision in which the terms and condition is incorporated. Any ambiguities in the codes in

a smart contract is to be handled by computer operation. Although the final resolution of a smart

contract may vary from the original intention of the parties, it provides for a more optimal first

approximation.39

Consummation

As discussed previously, the performance stage in the existence of a contract is simplified

in smart contract. However, a smart contract may encounter issues in instances of imperfect

performance.40 Philippine laws recognize the concept of substantial compliance in obligations.

Article 1234 of the New Civil Code states that if the obligation has been substantially performed

in good faith, the obligor may recover as though there has been strict and complete fulfillment,

less damages suffered by the obligee.41 Substantial compliance in good faith was explained by

the Philippine Supreme Court, citing Tolentino, as follows:

In order that there may be substantial performance of an obligation, there must have been an attempt
in good faith to perform, without any willful or intentional departure therefrom. The deviation from
the obligation must be slight, and the omission or defect must be technical and unimportant, and
must not pervade the whole or be so material that the object which the parties intended to accomplish
in a particular manner is not attained. The non-performance of a material part of a contract will
prevent the performance from amounting to a substantial compliance.42

39
Id.
40
Raskin, supra note 38.
41
CIVIL CODE, art. 1234.
42
International Hotel Corporation v. Joaquin, Jr., G.R. No. 158361 (2013).
 As one study posits, the mechanisms in a smart contract may not recognized instances of

substantial compliance because such outcome may not be contemplated by the parties at the

beginning of their relations.43

Another issue highlighted by the same study concerns modifications. The New Civil code

recognize impossibility and impracticability of obligation as one of the modes of extinguishing an

obligation. Article 1266 states that "the debtor in obligations to do shall also be released when the

prestation becomes legally or physically impossible without the fault of the obligor."44 On the

other hand, Art 1267 states that "when the service has become so difficult as to be manifestly

beyond the contemplation of the parties, the obligor may also be released therefrom, in whole or

in part."45 The cited study proposes that methods must be developed in order that smart contract

may be updated to take into considerations changes in legal landscapes that may result to

impossibility or impracticability of performance.46

Breach

A study suggests that in breach of smart contracts, the government are likely to resort to

regulation/policing and criminal/civil actions.47 However, since smart contracts are self-executing

and self-enforcing, a legal breach in a smart contract would arise only when the computational

breach as determined by the computer systems vary from the determination of the parties of what

constitutes a breach. In such case, it seems that there would be a breach only in cases where the

agreement of the parties is not truly reflected in the smart contract.

43
Raskin, supra note 38.
44
CIVIL CODE, art. 1266.
45
CIVIL CODE, art. 1267.
46
Raskin, supra note 38.
47
Id.
 IV. Going Forward
Difficulty of Translating Traditional Contracts to Smart Contracts

Communicating with a machine requires the utmost precision. After all, computer

programs are basically just sets of instructions to a machine written in a language, called a

programming language, translatable to machine-readable format.48 Therefore, there is no room for

vagueness in giving instructions to computer systems. This can pose a problem for smart contracts

when it comes to grey areas in agreements which are actually meant to be broad or vague.49

Schuringa cites some examples of this problem such as commonly used terms credit

documentation such as best endeavors, material adverse effects, and reasonable notice which

are currently very complex to translate to smart contracts.50 Further, he states that an attempt to

do so might create a contract wherein unforeseen situations will not be covered.51

This problem may be solved by utilizing the advances in natural-language processing52 in

creating a system that may be able to parse and understand such complex terms.

Clarifying the Purpose of Contract Law

As discussed above, smart contracts exist between contracts and contract laws such that

the line between the agreement and the enforcement mechanism is blurred. There is thus a need to

clarify the real purpose of Contract Law in order to come up with a policy that effectively

48
An Act Prescribing the Intellectual Property Code and Establishing the Intellectual Property Office, Providing for
its Powers and Functions, and for Other Purposes [INTELLECTUAL PROPERTY CODE], Republic Act No. 8293,
171.4 (1998).
49
Gilmore, Lauren, 7 Interesting Laws Blockchain Will Force to Change (15 May 2017) available at
https://thenextweb.com/worldofbanking/2017/05/15/7-interesting-laws-blockchain-apps-will-force-to-change/ (last
accessed 11 June 2017).
50
Id.
51
Id.
52
Knight, Will, An Algorithm Summarizes Lengthy Text Surprisingly Well (12 May 2017) available at
https://www.technologyreview.com/s/607828/an-algorithm-summarizes-lengthy-text-surprisingly-well/ (last
accessed 11 June 2017).
delineates the scope and purpose of smart contracts in the legal realm vis--vis traditional contracts

and their enforcement mechanisms.

Regulating Smart Contracts

Due to the decentralized nature of smart contracts, it may be necessary for the State to

create a regulatory policy which would govern smart contracts. As discussed, smart contracts are

enforced even without the intervention of the State. Thus, there might be instances where a legally

void contract, such as one with an illegal purpose, may be enforced even though the State does not

sanction such.53 To do so, the State might have to exercise its police power in order to check the

legality of the contracts or mandate certain digital provisions to be included in the contracts which

may serve as a self-regulating mechanism.

53
See CIVIL CODE, art. 1409. The article enumerates void or inexistent contracts. It further states that the enumerated
contracts cannot be ratified nor the right to set up the defense of illegality be waived, showing the strong policy
against enforcement of such contracts.