We’ve got a trillion dollar trust problem to solve. We are trying to make tomorrow’s deals with yesterday’s dispute resolution systems.
Everyone works together with others to create value. Our success depends, in part, on cooperation. We can cooperate efficiently by making agreements and abiding by them. When disagreements arise, if we can resolve them quickly and efficiently, we can avoid wasting productive resources. Unfortunately, currently available dispute resolution alternatives for enforcing agreements are often neither quick nor efficient.
The growth of the internet and other emerging technologies like the blockchain, the breaking down of trade barriers, and the progress of developing economies around the world is creating a wealth of potential opportunities for new cooperation. But our legal systems of contract enforcement remain localized and byzantine, largely ineffective for small players, slow and costly for large ones, and ill-suited for international deal making.
Every day, in a truly global marketplace, millions of decision makers must decide whether or not to enter into agreements knowing that they will be costly to enforce if they are broken. Some will decline to act, knowing they cannot depend on an agreement. Others will enter into agreements that will ultimately be broken, leaving them to choose between pursuing costly and slow enforcement, perhaps in a foreign jurisdiction, or surrendering to injustice. Particularly for small business, or larger businesses that have many agreements for small sums, the cost of enforcing a broken agreement can exceed the amount in dispute.
Whether in the form of wasted effort or in the form of opportunity missed due to lack of a context that allows trust, the cost of inefficient dispute resolution is enormous. Authorities such as The World Bank, The Organization for Economic Cooperation and Development, and The World Economic Forum agree: efficient dispute resolution is essential for economic success.
World Bank: Efficient Contract Enforcement Is Essential To Economic Development
The World Bank asserts “Efficient contract enforcement is essential to economic development and sustained growth” citing a handful of studies published by IMF, University of Chicago, and other prestigious institutions. Furthermore: “Overall, enhancing the efficiency of the judicial system can improve the business climate, foster innovation, attract foreign direct investment and secure tax revenues.”
World Bank reports that the cost of resolving disputes amounts to over 20% of the amount of the claim in the high income subset of OECD countries. It could be worse. In Cambodia, World Bank reports the average cost of contract enforcement is over 100% of the claim, indicating on average litigants walk away with less than they started with, even when they win.
In East Asia and the Pacific, cost of enforcement is 47% of the claim value. In comparison, 20% seems low. But when you add an average resolution time of 577 days even in high-income OECD countries, you can see the dispute resolution system is introducing a lot of “friction” in business relationships, even in the areas of the world where it works best.
OECD — Lack of Timely And Cost Effective Dispute Resolution Stifles Growth
The OECD recognizes the importance of efficient dispute resolution in their investment guidance for member countries. “The ability to make and enforce contracts and resolve disputes is fundamental if markets are to function properly. Good enforcement procedures enhance predictability in commercial relationships and reduce uncertainty by assuring investors that their contractual rights will be upheld promptly by local courts. When procedures for enforcing commercial transactions are bureaucratic and cumbersome or when contractual disputes cannot be resolved in a timely and cost effective manner, economies rely on less efficient commercial practices. Traders depend more heavily on personal and family contacts; banks reduce the amount of lending because they cannot be assured of the ability to collect on debts or obtain control of property pledged as collateral to secure loans; and transactions tend to be conducted on a cash-only basis.”
Direct and Indirect Costs of Ineffective Dispute Resolution
We can divide the economic cost of dispute resolution into two categories, direct and indirect costs.
While we could consider a narrow definition of direct costs in the sense of the cost of legal services and court fees paid by the parties to a dispute, we can also define “direct” more broadly and say that the direct costs include all the public and private costs of maintaining the government’s dispute resolution system and the costs of education required to create the human capital on which the system relies. The 20% of claim value in OECD countries estimated by World Bank is thus only a small component of the total direct cost.
In addition to those broadly defined “direct” costs, inefficient dispute resolution imposes even larger indirect costs. As the OECD has noted, unreliable, slow, and costly dispute resolution stifles economic activity. Partners who cannot trust each other cannot plan and operate as efficiently as partners who are confident that agreements will be followed.
World Economic Forum — Indirect Costs May Be Trillions
As the World Economic Forum Agenda notes: “More importantly, litigation imposes significant indirect costs. It causes higher borrowing costs, wasted management time, the deterioration of business relationships and organizational stress.”
Researchers believe the indirect costs are much larger than the direct costs. In a study published in the International Journal of Management, and highlighted in the WEF Agenda on Dispute Resolution, coauthors Wenxue Lu, Lihan Zhang, and Jing Pan estimate the total burden of disputes amounts to trillions of dollars a year globally. While in our opinion, the project of estimating these costs is too complex to result in a confident answer, we believe we can be sure that they are immense.
So we can see that in the large view, the cost of inefficient dispute resolution is enormous. Scaling down to the small view, we will see that inefficient dispute resolution is maddeningly unjust for the individual or small business
Contracts For Small Sums Are Effectively Unenforceable
When a business or individual is a victim of a breach of contract and the value in dispute is small, surrendering to injustice is often the most rational response. The cost of pursuing a resolution can exceed the sum being contested. And then even if the cost of a ruling is less than the amount awarded, U.S. small claims courts (for example) will not enforce judgements; you will have to handle collection yourself.
Taking the U.S. as an example, cost of small claims court begin with filing fees of $15 to $200 and $30 to $100 for a process server to provide formal notice to the other party. That’s only $45 to $300 so far, but you might want to get a consultation from an attorney to avoid being tripped up in technicalities and possibly stuck paying for your opponent’s lawyer, in which case you’ll be paying at least another $500 for a two hour minimum. In addition to these costs, you’ll be sacrificing your time. The process of preparing and filing a claim, submitting evidence, showing up for trial, and possibly consulting an attorney can take over 20 hours.
With minimal legal consultation and valuing your own time at a modest $25 an hour, your cost for a small claims suit will surely exceed $1,000. If you want your lawyer to actually appear in court on your behalf, your costs will be much higher. Even if you forgo all legal advice, if you value your time, a small claims suit will cost you over $500.
We can see that as far as the civil justice system is concerned, anyone who suffers a loss of $500 or less from breach of contract has little choice but to consider it an expensive lesson about who to trust and give up on recovering the money. And remember, winning the suit is only half the battle. You still have to collect! So it is no wonder so many people give up and so many people get away with breach of contract.
While such losses are small regarded individually, considering the vast number of small agreements, the total value of sums that go unrecovered because the cost of justice is too high along is surely substantial.
An Enormous Problem Equals An Enormous Opportunity
The market for dispute resolution is enormous. Government courts and formal arbitration systems currently serve most of the market, along with several other solutions serving niche markets. Government and arbitration are costly and slow; alternatives have their own limitations.
For many small contracts, no viable enforcement mechanism exists. Disputes for some small contracts can be resolved with niche solutions, but these are limited in applicability and have shortcomings even when they can be used.
Between the completely unserved segment of the potential market in small contracts and the rest of the underserved 70 trillion dollar world economy, there is a large total market that could benefit from faster, cheaper dispute resolution and contract enforcement.
In our next article, we will consider currently available approaches to dispute resolution and their strengths and weaknesses. Then we will turn to some nascent potential solutions and their limitations before finally introducing a unique new decentralized approach to dispute resolution based on the blockchain that represents a watershed event in legal and economic history.
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