A Critical Review of the Kleros “Dispute Revolution”

By Prof. Dr. Frank Emmert, LL.M., FCIArb

Several years after their launch and the development of a multitude of potential uses, Smart Contracts face an uphill battle for mass adoption. This is most likely due to the fact that the Smart Contracts themselves are only one part of a larger puzzle, like changing one wheel of a car, one element of a larger and more complex legal mechanism that evolved over hundreds of years. Smart Contracts hold great promise in improving the speed and efficiency of the legal process, but only when the right constellation of necessary elements is updated simultaneously. Fair and efficient dispute settlement is another necessary element of the puzzle. Kleros claims to have solved this problem.

As a lawyer with 25 years of experience in international commercial transactions and arbitration, and a penchant for innovative solutions, including Smart Contracts on the Blockchain, I was naturally curious to see what exactly Kleros is developing. In a nutshell, Kleros is offering “decentralized justice” for disputes arising from (international) online transactions.

International transactions in general have the problem that different parties to a contract have different understandings of its terms, and claims may have to be pursued abroad, where we are unfamiliar with the legal system, do not speak the language, let alone the legalese we will find in contracts and laws, don’t know any good attorneys, and may not find courts that work as efficiently and fairly as at home. Some problems can be avoided by resorting to international (commercial) arbitration, instead of transnational litigation. In arbitration, we can choose the language, the applicable law, and the “judges” to suit our business needs. However, this private justice system tends to be quite expensive. As a rule of thumb, it is, therefore, rarely worth our while to pursue a claim in a foreign country unless it is quite large, say 50,000$ or more.

In online transactions, we have the additional problem that the identity of our business partners is not always clear and we may have no idea where their business is domiciled and their assets are located. Furthermore, transaction speeds are vastly increased and a traditional dispute settlement system that takes years (before the courts) or at least months (in arbitration) may feel out of sync with a system where business transactions are conducted in minutes or even seconds.

The Kleros Handbook of Decentralized Justice estimates that “disputes arise in 3 to 5% of online transactions, totaling over seven hundred million in 2015 alone”. I was not surprised by the percentage estimate and, obviously, by the second half of 2019, the overall number of online transactions and potential disputes has already grown exponentially. More importantly, this growth is set to continue for years to come. As a result, there is a real need for a dispute settlement system that can handle a very large number of claims, in particular if it can also be made accessible for smaller claims, potentially as small as 50 or 100$.

Instead of tinkering with existing dispute settlement systems, Kleros wants to do to dispute settlement what Wikipedia did to knowledge databases, AirBnB did to hospitality, or Uber did to transportation: Not evolution but revolution, via reliance on crowdsourcing! Kleros is inviting anybody — regardless of professional background or legal expertise — to become a “juror” in its system and participate in decentralized dispute settlement. If a dispute arises between two parties, they can submit it to a random selection of these jurors who will then vote whether a claim should be satisfied or not. The idea is that the wisdom of the crowd will yield fair outcomes at least as often as reliance on a single judge or a small panel of judges or arbitrators does. More importantly, the jury can be compiled and render its vote within hours of a dispute being brought to the system.

What is the relevance of such a vote by a random number of anonymous jurors, none of which are lawyers, let alone judges, one may ask. After all, the losing party in the dispute may choose not to adhere to the decision of the jurors — and the question of enforcement arises.

Virtually all countries in the world more or less automatically enforce the decisions of their own courts — provided of course that the losing party is subject to their territorial or personal jurisdiction and/or has assets in the country that can be seized. When it comes to enforcement of decisions adopted by the courts of other countries, however, the large majority of countries are not so forthcoming. Complicated and time-consuming procedures for the recognition and enforcement of foreign judicial acts are the bread and butter of entire armies of attorneys and law firms and much will depend on reciprocity: if country A generally recognizes and enforces judgments from country B, country B will probably return the favor. However, if the record of country A is a bit patchy, for example when it comes to decisions against powerful or politically connected individuals or companies, country B will also exercise discretion on a case-by-case basis, whether a decision from country A should be enforced or not.

By contrast to the rather heterogeneous world of recognition and enforcement of foreign judgments, almost all major trading nations are normally willing to recognize and enforce foreign arbitral awards. Indeed, on the basis of the 1958 New York Convention, some 160 countries around the world have committed themselves to the recognition and enforcement of these kind of private judgments, while there is no comparable convention committing countries around the world to recognize and enforce judgments from foreign courts.

Against this background it is possible for Kleros to build a system where parties agree in advance, when they enter into an online transaction, or later, when a dispute has already arisen, to forgo their right to call upon the public courts and exclusively pursue a particular form of online dispute resolution instead. At least when it comes to business-to-business (B2B) transactions, such a choice will be respected by most countries around the world, although this is less obvious for business-to-consumer (B2C) transactions, where many countries seek to protect consumers from being drawn into situations they may not have fully understood and that may be disadvantageous to them, by securing their right to call upon the public courts regardless of what they may have signed or agreed to.

Kleros wants developers to insert clauses in Smart Contracts — they give the example of a website design freelance contract — which provide that any disputes arising from the contract, for example if the buyer is not satisfied with the work of the designer, will be “arbitrated in the Kleros network”. Obviously, the buyer from one country would normally have to write off any funds already sent to the designer in another country because it would simply not be efficient to throw thousands of $$ at lawyers to try to recover a few hundred $$ in foreign courts from a person halfway around the world. Kleros, by contrast, sends the dispute to a handful of its jurors and promises to get a decision rapidly and efficiently.

Private arbitrators could theoretically pick up such a case as well. However, the fees of qualified arbitrators would be disproportionate to the value of the dispute, even if the contracts can provide that all fees have to be borne by the losing party.

How is Kleros suggesting to get jurors interested in working for its system, when real arbitrators would charge thousands of $$ for their time and expertise? This is where crowdsourcing comes in. A little bit like Uber drivers competing for rides, the jurors are supposed to compete for the opportunity of deciding cases. Different from Uber drivers, the jurors are not expected to click quickly on an opportunity when it comes up. They are actually expected to bid crypto money for that opportunity. The Handbook gives the example of a software developer in Kenya who works freelance “in the Website Quality subcourt, which requires skills in html, javascript and web design” and has deposited 2 PNK, the token issued by Kleros, to get dispute settlement business. In the example, Kleros claims that our Kenyan developer “makes a couple of thousand dollars a year on the side” with their system, while also acknowledging that he will only be picked as a juror if he has deposited enough crypto funds because “[t]he more tokens he deposits, the more likely it is that he will be drawn as a juror.”

After a dispute has been triggered by the simple click of the button “Send to Arbitration”, several jurors who have all deposited crypto funds for the opportunity of participating will be randomly selected. Each one is supposed to independently analyze the evidence and vote “who is right”. Those who vote with the minority will lose their crypto bids and those who vote with the majority will pick up those additional funds.

This idea is actually cute. If it would work, Kleros would be offering a service that is basically free for the users. The jurors would themselves be paying — a bit like in a casino — for the privilege of spending their time and expertise on the chance of winning more money than they put in. Of course, it is at the very least unclear whether enough potential jurors would be willing to wager their crypto funds to provide at least somewhat qualified neutrals for each case. This would be all the more questionable when cases are to be decided with small juries — Kleros is talking about juries of three — and all jurors might agree on the outcome, which does not leave money for re- distribution.

Therefore, Kleros is requiring one or both of the parties to the original contract to submit funds to pay for the dispute settlement procedure. Like in real arbitration, the claimant could advance

the funds for the procedure, hoping to get her money plus the cost of the proceedings, after winning the case. Kleros also cites a model where both parties to the dispute have contractually agreed to share the cost of the proceedings. What remains unclear is why jurors should spend their time and expertise to read contracts, evaluate evidence, and think about fair solutions, if their rewards are very small — 13$ in the example of the Kenyan website developer. Aren’t they much more likely just to give a quick thumbs up or down, hoping to vote with the majority more often than not? Supposedly, a lazy juror would be punished because he would be too often out of sync with the majority and lose his deposit too many times. But what if all or most jurors become lazy because the cases are just not worth any real effort? It seems at least possible that the system would become one of “first impression” voting…

The next big challenge lies in the collection of funds from the losing parties. Any kind of claims, whether for a refund of payments for goods or services found inadequate, or for procedural expenses, will only be enforceable by Kleros to the extent that funds have been locked and are still locked in the original Smart Contract. In other words, if the funds for the website development or for any goods purchased have already been distributed to the vendor, there is no easy way of getting them back. The same is true for any procedural expenses. Why should the website designer send funds to defend himself in a procedure about the fulfillment of the original contract, if he has already been paid, in particular if he believes that the customer may actually have a valid claim because the work was potentially not done in the best possible way? Why should he return his original payment just because a handful of jurors think he should?

Traditionally, this is where the recognition and enforcement of foreign judgments, respectively the recognition and enforcement of foreign arbitral awards comes in. We don’t even have to pursue the question whether the randomly selected jurors and their votes would be acceptable as “arbitral awards” under the New York Convention — as a Fellow of the Chartered Institute of Arbitrators and on the basis of 25 years of experience, I have at least some doubts. The problem is more immediate: Even if the Kleros votes would be accepted as arbitral awards, since the parties have agreed to use the system and the jurors are genuinely neutral, we still have to pursue the recognition and enforcement of “the awards”, which is where all the problems of hiring attorneys in foreign countries, finding assets, and presenting claims for enforcement to the foreign authorities have to be addressed. If anyone would pursue this avenue for a claim of just a few hundred $$, the entire profession would be laughing.

This would seem to leave only one avenue for Kleros to enforce claims that are not or no longer secured via funds locked in a Smart Contract: reputation and feedback. Like Uber drivers and AirBnB hosts, who get ratings for their services, online vendors of goods and services may choose to participate voluntarily in the Kleros system and/or refund moneys received and/or pay dispute settlement fees, to protect their ratings and their reputation. Or they may not. I am sure that most of my readers have already met the eBay sellers or buyers or the Yelp or Amazon reviewers who create short-lived accounts that can and will be discarded at any time and replaced with new and equally short lived online avatars. Why care about negative ratings if you can just become a new you? The problem is even more pronounced in countries like China, where the number and variety of names is distinctly limited and tens of thousands of companies or individuals are called “Chen” or “Ying” or “Xing”. Trust me, you will never know for sure which one is the good and which one is the bad one.

Digital identity models for the crypto world are currently being developed in a multitude of forms. And herein lies the true great challenge of the entire crypto world, not only Kleros’: Without verified identities, reputation models make little sense. Yet, with verified identities, the crypto model betrays its original quest of anonymous transactions needed to achieve full decentralization, and countries like the US would continue to force their international policies on other countries via granting or denying access to the financial system. At the present time, it is unclear when and how – or even whether – the problem can find a lasting and economically efficient solution. However, without a proper working model, the entire industry is unlikely to make great advances. Finally, even if a vendor actually cares about his or her reputation, that care may induce a refund of a few hundred $$ but will hardly suffice, once a claim goes into several thousands of $$.

When reading the Kleros Handbook, I came to conclude that the founders know a lot more about computing and cryptography than they know about dispute settlement and transnational law. In particular, they seem to underestimate the difficulty and cost or pursuing claims in foreign jurisdictions, including the recognition and enforcement of arbitral awards. They are citing the example of Henry Ford who claimed that people would have asked for “faster horses” because they would not even have been able to imagine cars. Obviously, Kleros is suggesting that it has discovered a completely new and different solution to an age old problem, and that all the old school methods are ready to join the dinosaurs and the horse buggies. I am not so sure about that. I do believe that there are constellations where the Kleros model can work: If the funds are still locked in the Smart Contract, if the case and the evidence are rather straightforward, and/or if the parties care enough about their reputation and their ratings. However, parties to an online transactions have to be somewhat lucky to find one or more of these conditions in their particular case. And we don’t need to resurrect Henry Ford to tell us that counting on luck is not a very good business strategy.

Don’t agree? Get in touch! www.FrankEmmert.com

(Full disclosure: The author and his team are working on their own model for settlement of international disputes, including Smart Contract and Blockchain related problems. They are following a more traditional approach, however, that should work for disputes over a few thousand $$ but would not work for disputes over just a few hundred $$, see www.SmartArb.com)