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COMPLIANCE ELLIANCE JOURNAL | VOLUME 4 NUMBER 1 2018
PAGE 11
PRIVATE LAW COMPLIANCE THROUGH SMART CON-
TRACTS?
Martin Fries
AUTHOR
Martin Fries is a private lecturer (Privatdozent) at the University of Munich (LMU). His
research focuses on various topics around civil law, civil procedure, conflict of laws, legal
ethics, and legal technology. Much of his teaching is available online at
https://www.youtube.com/jurapodcast/. Martin regularly serves as a mediator in commer-
cial and inheritance disputes.
ABSTRACT
Smart contracts allow for automated compliance with contractual rules. They derive their
“smartness” from an execution software that catches the most typical defaults and responds
by mechanically triggering a compensation payment or another prearranged consequence.
Through this self-enforcement mode, smart contracts are able to save time and effort that
is associated with more customary rights enforcement mechanisms. Now, whereas compli-
ance with in-house rules or corporate governance standards is common today, compliance
with contract law only occurs on a voluntary basis. This might, however, change if businesses
should be obliged to automatically meet customer claims through smart contracts. On the
basis of a sample case, this article examines the pros and cons of smart consumer contracts
and carves out the most suitable applications of smart contracts as a means to ensure private
law compliance.
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MARTIN FRIES | PRI VATE LAW CO MPLIANCE THROUGH SMART CONTRACTS?
PAGE 12
COMPLIANCE ELLIANCE JOURNAL | VOLUME 4 NUMBER 1 2018
TABLE OF CONTENTS
I.!BACKGROUND: TRADITIONALLY LIMITED COMPLIANCE WITH PRIVATE
LAWS 13!
II.!SMART CONTRACTS AS A COMPLIANCE INSTRUMENT 14!
III.!SAMPLE CASE: A SMART RAILWAY TRANSPORT CONTRACT 15!
IV.!A CONTRIBUTION TO MARKET EFFICIENCY 16!
V.!PRECONDITIONS TO AN EFFECTIVE SMART COMPENSATION SCHEME
17!
VI.!CONCLUSION 17!
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MARTIN FRIES | PRIVATE LAW COMPLIA NCE THROUGH SMART CONTRACTS?
PAGE 13
COMPLIANCE ELLIANCE JOURNAL | VOLUME 4 NUMBER 1 2018
I. BACKGROUND: TRADITIONALLY LIMITED COMPLIANCE WITH PRIVATE
LAWS
Compliance typically refers to the duty of companies to act in accordance with public law.
Failure to comply is sanctioned by a civil penalty or by means of criminal law. During the
last several decades, the importance and influence of compliance departments has signifi-
cantly grown. At the same time, whether or not businesses choose to comply with the
growing body of private law is still regarded a strategic decision rather than a straightfor-
ward legal duty. Private law is designed to be available as a state-provided system of rules
for cases where conflicts of private interests cannot be otherwise resolved. Traditionally,
however, the enforcement of private claims is relegated to the resolve of the very persons
involved. In principle, the state does not care whether market participants eventually avail
themselves of their rights. If they back off from making a claim, their opponent goes free,
and the state is fine with that.
This regulatory approach gives remarkable leeway to the strategic decisions of repeat play-
ers.
1
They might voluntarily meet private law obligations as an aspect of a service strategy,
but they can just as easily wait out any customer requests and count on a common aver-
sion to bring legal action. In spite of these options, there is a strong incentive to choose
the latter alternative. As market dynamics focus more on low prices rather than customer
service, it becomes more difficult to stand one’s ground in the market without cutting
back on private law compliance.
2
This calculus notably applies in the field of consumer
law, because the vast majority of consumers are extremely risk-averse and have little
knowledge of their rights and no experience in enforcing them. Hence, there is a consid-
erable threshold for consumers to take legal action.
3
Sure enough, most consumer rights
are mandatory and, thus, cannot be contractually waived. However, the mandatory na-
ture of consumer rights makes little difference in this decision paradigm, as mandatory
rights are just as likely to remain unclaimed.
If claimants shy away from enforcing their rights, other market participants will some-
times step in and take on the job. The law of unfair commercial practices allows businesses
to sue their rivals for injunction in cases of grossly unfair market behavior. However, com-
petition rules are usually limited to correct the way customers are approached, whereas
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1
A profound analysis of the advantages of repeat players c ompared to one-shotters i s provided by Marc G a-
lanter, Why the “Haves” Come Out Ahead: Speculations on the Limits of Legal Change, 9 L. SO C. REV. 95,
97-114 (1974).
2
The economic concept for this kind of market dynamic is the famous market for lemons as described in George
A. Akerlof, The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, 84 QUART. J.
ECON. 488 (1970).
3
See, e.g., Franziska Weber & Michael Fauré, The Interplay Between Public and Private Enforcement in Euro-
pean Private Law: Law and Economics Perspective, EUROP. REV. PRIV. L 525, 533 (2015).
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COMPLIANCE ELLIANCE JOURNAL | VOLUME 4 NUMBER 1 2018
MARTIN FRIES | PRIVATE LAW COMPLIA NCE THROUGH SMART CONTRACTS?
PAGE 14
competitors can typically neither request proper contract performance nor demand com-
pliance with other contractual rights of their customers.
4
In some jurisdictions, consumer
organizations and trade commissions dispose over special procedural rights to bundle cus-
tomer claims and enforce them collectively.
5
However, these mechanisms are actually em-
ployed in only a small fraction of possible cases, which makes them hardly more effective
than the existing alternatives, namely easy-to-use court or conciliation procedures.
6
Thus,
compliance with private law and with consumer rights in particular remains unalluring
for most market participants. From a traditional viewpoint, this is an almost natural con-
sequence of private law being private law. However, the more companies ignore claims
out of sheer calculus, the more pressing becomes the question how private law can be
rendered more meaningful for legal practice.
II. SMART CONTRACTS AS A COMPLIANCE INSTRUMENT
Only recently, a potential solution for this problem has presented itself, the development
of smart contracts. Smart contracts attempt to facilitate rights enforcement by automating
contract execution, as well as the handling of typical impairments of performance. For
this purpose, contracts are translated into computer code and digitally connected to some
assets of the parties. Hence, the “contract machine” automatically detects changing cir-
cumstances or events of default and takes the predetermined action.
7
Of course, this con-
cept requires contract lawyers to design a contract that anticipates as many problematic
situations as possible. Moreover, programmers are demanded to link detection mecha-
nisms (the so-called oracles) to the appropriate legal consequence without creating fric-
tions with the word and spirit of the contract.
With the growing extent of data tracks, the scope of application for smart contracts is
rapidly expanding. For example, a car sharing contract could be made smart by charging
the renter a contractual penalty for speeding, or by automatically locking the car if she
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4
In Europe, the law of unfair competition is governed by the Unfair Commercial Practices Directive
2005/29/EC; see Hans-Wolfgang Micklitz, Unfair Commercial Practices and Misleading Advertising, in Un-
derstanding Consumer Law 61-117 (Hans-Wolfgang Micklitz, Norbert Reich & Peter Rott ed s., 2009).
5
A good overview on the legal situation in Europe is provided by the contributions to WILLEM VAN BOOM
& MARCO LOOS, COLLECTIVE ENFORCEMENT OF CONSUMER LAW: SECURING COMPLI-
ANCE IN EUROPE THROUGH PRIVATE GROUP ACTION AND PUBLIC AUTHORITY INTER-
VENTION (2007).
6
The European Union has issued a small claims procedure through its Regulation (EC) No 861/2007, recently
amended by Regulation (EU) 2015/2421. With its Directive 2013/11/EU on consumer dispute resolution, the
EU switched to an out-of-court approach, obliging its Member States to provide access to free-of-cost concili-
ation for consumer disputes; critical assessment by Horst Eidenmüller and Martin Engel, Against False Settle-
ment: Designing Efficient Consumer Rights Enforcement Systems in Europe, 29 OHIO ST. J. DISP. RESOL.
261-297 (2014).
7
See, e.g., Alexander Savelyev, Contract law 2.0: „Smart“ contracts as the beginning of the end of classic contract
law, 20 INF. & COMM. TECHNOL. L. 116, 120-12 1 (2017); Max Raskin, The Law and Legality of Smart
Contracts, 1 GEO. L. TECH. REV. 305, 306, 309 (2017); Mark Giancaspro, Is a „smart contract“ really a smart
idea? Insights from a legal perspective, 33 COMP. L. & SEC. REV. 825, 826 (2017); Kevin Werbach & Nicolas
Cornell, Contracts ex machina, 67 DUKE L. REV. 313, 330-352 (2017).
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COMPLIANCE ELLIANCE JOURNAL | VOLUME 4 NUMBER 1 2018
MARTIN FRIES | PRIVATE LAW COMPLIA NCE THROUGH SMART CONTRACTS?
PAGE 15
illegally drives abroad. Likewise, a mobile phone contract could be complemented by soft-
ware that observes network availability and issues some sort of a lump-sum compensation
if the network becomes unavailable for more than ten minutes. Another scenario could
involve a lawyer working on her client’s documents in a cloud who receives remuneration
only for the time she is actively working in the cloud database. The key advantage of a
smart contract in these cases is that the parties to a contract are automatically forced to
comply with their contractual duties. To put it in legal Latin: Pacta non modo sunt
servanda sed etiam sunt servata.
The sixty-four dollar question, however, is: What incentive is there for any contracting
party to attach a self-enforcement mechanism to a contract? Here, two cases have to be
distinguished. On the one hand, where two contractors meet at eye level and could both
be subject to automatic enforcement, there might be a common interest in contract relia-
bility that leads both parties to agree to a smart contract. On the other hand, where there
is a considerable power imbalance between both parties, like in consumer contracts, there
is little reason for the mightier part to agree to a self-enforcing compliance system. This is
exactly the very reason why many companies hesitate to meet civil claims today. Thus, the
only way to change their calculus would be a law requiring companies to make use of
smart contracts when doing business with consumers. This seems to be inconsistent with
the nature of private law, to wit, a law that is not enforced by the state. However, at least
in Germany, the government currently considers to do just that: encourage or even com-
pel companies to use smart contracts in an effort to make the enforcement of consumer
rights more effective.
8
III. SAMPLE CASE: A SMART RAILWAY TRANSPORT CONTRACT
How could such a private law compliance mechanism be applied in practice? The parlia-
mentary group of one of the political parties that formed the current German government
offers two concrete examples. In their view, smart contracts could be used to facilitate
compensation claims for flight or railway transport contracts.
9
Thus, imagine a train carrying 100 passengers from Munich to Berlin for 100 € per ticket,
the regular travel time being 4 hours. If this train is one hour late, Art. 17(1) (a) of the
European Regulation No 1371/2007 on rail passengers’ rights and obligations grants pas-
sengers a refund of 25% of the ticket price. If usually 10% of all trains are delayed for one
hour or more
10
and 10% of all passengers take the trouble to claim their refund, the railway
operator will set aside 0.25% of his turnover for satisfying these claims. Now, as soon as
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8
For further details see Martin Fries, Smart consumer contracts: The end of civil procedure?, Oxford Business
Law Blog (Mar. 29, 2018, 11:18 AM), https://www.law.ox.ac.uk/business-law-blog/blog/2018/03/smart-con-
sumer-contracts-end-civil-procedure.
9
See the explanation at (Mar. 05, 2018, 09:40 AM), https://www.spdfraktion.de/themen/verbraucherinnen-
verbraucher.
10
Delays of two hours or more result in a refund of 50% of the ticket price. To simplify matters, this is not taken
into calculation here.
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COMPLIANCE ELLIANCE JOURNAL | VOLUME 4 NUMBER 1 2018
MARTIN FRIES | PRIVATE LAW COMPLIA NCE THROUGH SMART CONTRACTS?
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the respective transport contract is connected to smart enforcement software, the enforce-
ment ratio will bounce up to almost 100%. This will make the railway operator increase
the provisions from 0.25% to 2.5% of the ticket price, leading ceteris paribus to a general
price increase of roughly 2%.
A rise in prices in this range will be perceptible and decision-relevant only for few custom-
ers. As a matter of fact, this finding considerably changes as soon as the compensation
amount increases or is also triggered by minor delays. If, for example, the railway operator
had to pay every passenger 50 cents for every minute of delay, the loss of revenue would
considerably increase, and the consequential price increase would be quite perceivable. If
the average long-distance train is 10 minutes late and the train operator is required to re-
fund 5 €, on average, to every customer, ticket prices would go up respectively. Given this
scenario, one might wonder about the advantages of such a system over a world without
any delay compensations. Is granting a refund to a customer that she ends up paying for
through increased ticket prices a better world.
IV. A CONTRIBUTION TO MARKET EFFICIENCY
The main reason for an appropriate compensation of damages in general and transporta-
tion delays in particular is fair competition.
11
In a price-oriented market economy, market
participants expect the cost of a product or service to reflect a good or service that is free
of impairments. If customers pay the full price, but receive only faulty contract perfor-
mance without a compensation, their product choice and, thus, the functioning of the
market will be flawed. Companies will anticipate this mechanism and often interpret it as
a complimentary ticket to defer necessary investments in the quality and reliability of
products and services.
Of course, those misguided incentives for businesses will sometimes be alleviated by dis-
appointed customers sharing their experience with others and thereby lowering the mar-
ket expectation of product quality. For example, a frequent rail traveler will soon get a feel
for the delay she can expect when traveling by train and, if need be, switch to other means
of transportation like planes, buses, or rental cars. However, this mechanism only works
in markets where there is considerable competition and with either frequent deal iteration
or reliable information exchange between customers, e.g., within the framework of a qual-
ity rating system provided by a trading platform. In a market without these features, dam-
age compensation makes an important contribution to properly functioning competition
and, thus, market efficiency. This expectation, however, is based on several requirements
that a compensation scheme has to meet in order to actually make the market better off.
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11
This is, of course, a very condensed statement that is not meant to slur the extensive literature on the purposes
of compensator y dama ges; see, e.g., Steven Shavel l, Damages Measures for Breach of Contract, 11 BELL J.
ECON. 466-490 (1980); RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW 128-140 (9. ed. 2014)
with further references.
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COMPLIANCE ELLIANCE JOURNAL | VOLUME 4 NUMBER 1 2018
MARTIN FRIES | PRIVATE LAW COMPLIA NCE THROUGH SMART CONTRACTS?
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V. PRECONDITIONS TO AN EFFECTIVE SMART COMPENSATION SCHEME
The best enforcement mechanism cannot achieve a better result than the one determined
in the underlying substantive law. The special challenge for smart enforcement mecha-
nisms is their need for simple laws whose legal elements can be easily assessed. Lump-sum
compensation laws, like the airline passenger rights laid down in Art. 7 of the European
Regulation No 261/2004, are a good example for fairly automatable rules. At the same
time, such a simplifying regulatory technique comes at the expense of the merits of every
particular case where the appropriate compensation might not only vary, but also be dif-
ficult to quantify.
Another aspect to bear in mind is the coding design of the compliance software that is
used to cure typical events of default by issuing a money transfer, locking or unlocking
the object of agreement, or the like. The software needs to match the underlying contract
as far as possible, because if there is any doubt about the default, the contract itself has the
final say.
12
However, experience tells us that algorithms always come along with program-
ming errors, be it because of inadvertence or by intention of one party without genuine
willingness to comply. This calls for an algorithm check by some neutral agency as long as
the enforcement mechanism is not set up on neutral ground like on a blockchain. In the
case of passenger rights, this algorithm check could be performed by a government agency
like the British Office of Rail and Road, the French Autorité de Régulation des Activités
Ferroviaires, or the German Bundesnetzagentur.
Last but not least, it is worth mentioning that a smart compensation scheme can lead to a
distortion of competition if some competitors are obliged and others are not. Thus, if a
government decides to impose civil law compliance duties only on certain companies
while leaving others unregulated, this decision should be based on well-founded criteria.
Such criteria could be a factual opacity of product quality, or a monopolistic situation
that makes a business insensitive towards customer feedback. Both criteria might indeed
most likely be met in the field of passenger transportation as there is low competition on
many national and international routes, and even experienced customers can only rarely
assess the probability of an on-time arrival.
VI. CONCLUSION
Smart contracts combine legal obligations with a compliance mechanism. A conventional
contract is enhanced with software that automatically issues legal consequences once a
pre-specified trigger event is detected. Quite recently, discussions have been initiated
about using smart contracts as a means to achieve compliance with private consumer law.
It is debatable whether a public law obligation that forces companies to add an automated
enforcement component to their consumer contracts goes well with the traditional con-
cept of private rights being dependent on the proactive behavior of the claimant. Anyway,
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12
Martin Fries, Smart Contracts: Brauchen schlaue Verträge noch Anwälte?, ANWBL 86, 87 (2018).
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COMPLIANCE ELLIANCE JOURNAL | VOLUME 4 NUMBER 1 2018
MARTIN FRIES | PRIVATE LAW COMPLIA NCE THROUGH SMART CONTRACTS?
PAGE 18
if the use of smart contracts shall be imposed on businesses, the analysis has shown that
this approach will be most useful in monopolistic industries where the market does not
provide other effective mechanisms to ensure the quality of a product or service.
