Towards a Theory for Enforcing Contract, Resolving Disputes & Incorporation

Residents frequently point to several challenges in SL, often described as "impossibilities." Some insist that these challenges cannot be overcome without central management tools yet to be created by Linden Lab. Among these are the following:
* Enforcing agreements to be performed in the future and collecting debts.
* Resolving disputes between residents or between residents and others.
* Forming corporate entities to pool capital at risk for common purposes.

Please comment on the following theory of a protocol to provide a solution to these and related challenges. A key part of the theory is that each solution requires the contribution of the other two solutions, so that no one of them can be implemented in isolation. The theory is presented that only by combining all three into a single system can any one be solved given present SL methods.

Summary

The theory calls for the use of an organization that has "top level" ownership of a one or more sims of land (subject to LL and the TOS) and includes a judicial body. Let's call this organization the "corporation." The corporation sells to "shareholders" grant deeds of land that are subject to recall if the shareholder breaches the covenants of the deed. In addition, the land cannot be sold except with the consent of the corporation. By their investment in the covenanted land, shareholders obtain the right to vote on who serves on the judicial body. Among the covenants are a commitment to accept the decisions of the corporation's judicial body in the event of a dispute between that shareholder and the corporation or any other party. The covenant includes a provision that if the shareholder does not abide by a judgment of the adjudicator, the shareholder's land is forfeit and may be sold with the proceeds used to satisfy the adjudicator's judgment.

Discussion of the Theory Relative to SL Challenges

Remedies

Enforcing agreements and debts requires some form of remedy by the obligee party against the obligor party. Avatars in SL have a high degree of "escape" potential. This is because an avatar can sell its land for Lindens, convert the Lindens to US dollars and exit the game or reinvest in a new or alternative avatar. For agreements and debts to be enforced reliably, the party to be held responsible needs to put up some collateral in a form that cannot be so converted without a release from the counterparty to the agreement or debt. This collateral may be land or Lindens. Think of this collateral as a "hostage," or in terms of a "pledge" or "lien."

Lien Attaching to Land

Typically, pledges are property held by the obligee party (such as when an object is pawned or land is put up as collateral for a mortgage loan) or by some trusted third party (such as an escrow agent). In real life, collateral can be locked down by the filing of a "lien notice" on government land records. A "lien," oversimplified, is a legal hold on property (often land) granted by a party that owes something to another party. This lien is documented in papers filed with whoever controls the collateral property.

In SL, there is no central government that will perform this function. Linden Lab declines to do so. This theory proposes that the function of recording and enforcing a lien be handled by the corporation proposed in the summary.

Because the land is not permitted to be sold without the consent of the corporation, placing the lien protects creditors from the obligor selling out and disappearing. The resale limitation can be publicly posted, so that anyone contracting to buy the land contrary to the rule prohibiting sale without consent is aware of and bound by the limitation.

Prior agreement to dispute resolution adjudicator and process

Parties entering into contracts or loan agreements need a process to resolve disputes over whether the contract was performed or the loan paid as agreed. Those who grant liens need some protection against their collateral being misappropriated by the party controlling the collateral. Disputes over such things need a process for resolution before people will have confidence that they will work fairly.

Under this theory, parties to an agreement or loan would agree in advance that the corporate judicial body would adjudicate any dispute between them. The designation of the adjudicating person or organization and a description of the adjudication system would be set out in the initial documentation of the agreement or the loan. The documentation would also include the commitment of each party to abide by the decision of the corporation's judicial body and recognizing the corporation's right to reclaim and to sell the shareholder's land interest to raise funds to satisfy the judgment rendered (if the losing party fails to do so).

A party wishing to subject itself to the jurisdiction of the corporation without buying land could instead post a bond in the form of Lindens deposited in escrow with the corporation's treasurer (or such other arrangements agreeable to the counterparty).

Shareholders in this Corporate Organization May Gain Commercial Advantage

By setting up a corporate entity with this structure, shareholders are able to offer to their business counterparts security not available from most competing business operations. This theory supposes that those contemplating entering a contract with or making a loan to another avatar will provide more favorable terms if contracting with an avatar that is a shareholder in such a corporate organization. That is because they can incorporate the dispute resolution provisions in their contract or debt instrument and know that there is a pre-agreed body available to decide disputes and that if the shareholder fails to perform, their entire investment in the corporate organization is at risk and can be executed upon to pay their obligation.

Under this theory, the advantages thus offered to shareholders may be recognized in the marketplace, making an investment in the corporate organization desireable and sought after, helping to support or enhance the market value of land investments in the corporation. "Nomad" contractors will be at a disadvantage if they have no way to reliably provide prospective clients with comparable protections. Nomads may even be motivated to subject themselve to the jurisdiction of the corporation by agreement and posting of cash collateral.

Features/Limitations

Under the writer's understanding of present SL tool sets, a shareholder would have to be a group of at least three avatars, possibly including two alts of the primary avatar, and in addition to the upfront payment would have to pay a regular fee to cover the trustee's monthly "tier" obligation.

Shareholders might be themselves larger groups, such as craft guilds, labor unions or merchantile cooperatives.

This system is vulnerable to defalcation by the "trustee" avatar required to title to the island and grant deeds to shareholders. Shareholders would have to place a lot of trust in that individual. If multiple sims are included in the corporation, that risk could be distributed by having separate "trustees" for each sim. The corporation could insist that the trustee post some security in the form of land or value outside of the corporate body of land, or assume the risk of defalcation as a cost of doing business.

This system would not offer benefits to most SL residents, nor limit their freedom.

It might appeal most to those offering professional or financial services and those seeking to borrow money.

Only those who consented would be subject to the jurisdiction of the corporation's judicial body or benefit from this structure. Consent would be evidenced by buying land there or by submitting to its jurisdiction in an agreement or debt instrument.

The limited liability of a corporation would be provided because each shareholder's potential liability under the system would be limited to their investment in the island. Each shareholder would be liable only for his or her own obligations, not those of other shareholders. (A variation might subject all shareholders to responsibilities to the debts of any other, much as in a First Life partnership).

The commitment of capital to the corporation would be through the necessity of a significant investment by the participating shareholders. At private island prices of about $1000 (~L$265,000) down and $200 (~L$53,000) /month, 10 equal shareholders would get about 6,000 square meters each for about $100 (~L$26,500) down and $20 (~L$5,300) per month.

Shareholders could make their land productive as they saw fit (subject to any island zoning restrictions), or leave it fallow or as a personal residence. Shareholders might agree to have a common space reserved for a market, meeting or event venue.

Shareholders could choose to post their stake as security for commitments made by other avatars, essentially providing surety or guaranty services (for whatever consideration they chose).

Shareholders could post their stake as security for repayment obligations, such as those that arise out of taking demand deposits like a bank or investment fund does.

This theory has other potential applications that may be the subject of further research and discussion.

Comments on this theory?

Strengths and weaknesses?
Flaws in the logic?
Improvements or variations you can propose?
What structures presently exist in Second Life with similar features?
What has been your experience with similar structures and processes?

humm...

i dont really like that.
but as far as i am not concerned ^^ good luck you will need it if you really need such paperjob

Wow. First part was interesting. I'll have to try again later for the full effect.

Frank, I've read your post twice, and it still strikes me as a proposal for a system that addresses those three challenges rather than being a theory per se. It's an attractive system, and I agree with your characterization:

Like the Neualtenburg system this one requires substantial volunteer work on the part of participants who stand for election, and serve (in this case) as adjudicators. The system falls apart if nobody is willing to do this community service. It seems to me that most residents in SL are here to relax after work, play with the toys (yes!) or to socialize as a more glamorous version of their FL selves. In my experience volunteer work isn't relaxing or glamorous, but it certainly can offer good fellowship.

One category of SL residents might be prepared to make the committment: those dedicated individuals who spearhead enterprises involving substantial development effort, intellectual property and financial outlay.



If I understand your outline, people would have a choice of pledging land to serve as business collateral or in effect posting a $L bond (in which case the person pays for the service just as we pay to notarize a contract at Nota Bene). In the case where the collateral is land you want to make sure that the value of the land remains high enough to dissuade the owner from defaulting, leaving the other party with an illiquid asset and its associated tier burden. For this reason the land should be protected by zoning as found in the better private island developments.



At first glance it looks like you're proposing a themed sim: an Enforcing Contracts, Resolving Disputes and Forming Corporate Entities themed sim! This might require a bit of promotion -- say giving out coupons or gift certificates good for one free dispute. : )

The following point is important:

I examine ideas for systems of rules from a biased viewpoint. I don't want to see a system take root here, then be twisted and exploited by some power-hungry newcomer, perhaps with a lot of money to leverage the twist, and replicate the system across one sim after another until it becomes a de facto SL government. The present proposal appears to be an unlikely candidate for that scenario. Even if it formed the basis for Frank's Federation of Sims (outlined in this forum) it is unlikely to be a best seller with residents who value unfettered self-expression, and don't run businesses.

As you have presented this as a theory, I will move up to a more theoretical level to discuss some points.

Two of the characteristics in your proposal that could be critiqued at a theoretical level are the reliance upon a non-arms length group, and the apparent disconnect between the value of the investment and the value of whatever contract or transaction is to be protected by the investment.

As the whole "corporation" is essentially a joint endeavor, you are relying on people who are engaged in the corporation to resolve disputes. This may not be more effective than relying on arms length adjudicators, who will need to develop and maintain a professional reputation to be successful over time. By using a related group, you bring in the political factors one typically finds in a membership based organization.

That isn't to say this can't work, but I wonder whether some aspect of community isn't required in addition to the pure organizational and financial structure. I'm not an anthropologist, but I think there have been some studies that show that a lot of what we regard as conscience and ethical behaviour depends on some feeling of familiarity between individuals.

The second point relates to putting the value of the pledge into relation with the value of the contract. From your description, it appeared that shares in the corporation would be equal or essentially equal, so the degree of risk for an individual is fixed. However, to use this mechanism for a variety of different types of contracts, it would be more effective to relate the magnitude of the risk to the magnitude of the action.

If the contract represents considerably more value than what is pledged to the corporation, the "punishment" value is reduced and the effectiveness of the approach is less. OTOH, if the contract is small, would a default forfeit the entire amount pledged? That might mean that this mechanism was used only for a narrow range of activities where the risk value is in approximate proportion.

A final thought relates to using land as opposed to using L$. For a short term contract, backing the transaction with land would be reasonable. However, for a longer term agreement, the never-ending financial impact of tier, which can seldom if ever be offset by economic development, would tend to make the protection not worth the cost. The use of L$ would also allow matching the risk amount to the contract value.

I suspect the fundamental flaw might lie in the matter of 'alts'.

Consider an escrow company operating in bad faith (members of the escrow company themselves entering into contracts as alts).

Thus the escrow, which is supposed to be held by an impartial party, is actually still in the hands of the owner.



On a more practical level, there are on the order of ten thousand active people on the grid. The business world is even smaller.

As business transpires, everyone pretty much knows and interdepends upon each other. There will be a cost to enforcing your contract, insofar as you will still have to deal with the defaulted party's brother, girlfriend, &c.

Thus adding a 'cost' beyond escrow to contract enforcement, but also protections for others, based upon the 'reach' their business has.

For instance, who would be stupid enough to rip off Phoenix or Katt, who run the Metaverse Messenger?

I think Ferren Xia said much of what I was planning to say. So: "ditto!".

I'd like to add that I chafe a little on a dispute resolution theory that depends on substantial monetary investment. It makes the system only available to wealthy.

The proposed system could be modified a bit, to address both Ferren's and my concerns. First, the land holding escrow aspect of it should be a distinct group from the mediation / arbitration group. Second, use of land escrow should be at the option of the parties involved, and to a financial degree as appropriate to the matter at hand.

The escrow agent is agreeing to hold the land (and/or L$) until such time as the parties are satisfied (and the holdings returned to the original doner), or the matter arbitrated (and the holdings divided as per the arbiter's instructions). A nice aspect of this is that the hold body and the adjudicating body are (or should be) separate. Indeed, there could be multiple escrow agents, and multiple adjudicating bodies. Leaving the choices up to the parties involved.

Two more limitations (I won't call them problems) with the corporation approach, or even with the arms-length adjudicator approach when they rely upon property in escrow, are the difficulty in valuing intellectual property, and handling essentially perpetual license agreements.

If A has created intellectual property and wishes to license it to B for a limited purpose, the first question would be what actual L$ or land value would be appropriate. This would have to be agreed by the principals, and they would also have to agree on appropriate penalties for each potential breach of the licensing agreement. You start to see the role lawyers play in working out these details!

In the corporation approach, the agreed value of IP (if there is one) would have to be translated into some level of investment in the corporation. A real difficulty with IP is that the value can fluctuate wildly over time. When people want to generally use the idea, the value goes up. When another idea supplants it, the value plummets. This makes it hard to align the escrow with the value of the IP.

The second issue relates to granting a perpetual license. Assume A creates a texture, and wishes, for a fixed fee, to let B use it in a limited way (most likely not reselling it). If there is to be a pledging of escrow assets against violating the agreement, that will have to be a perpetual pledge, which effectively could remove the asset from the game permanently.

These types of situations are best handled by a mechanism to impose a penalty, so that no upfront asset is affected yet there is still a sanction for violating a contract. There is no such method in SL, so I count that as a major deficiency in terms of creating a fully featured business structure.

Traxx, I agree on the first point, and recognize that a sim with the theme you mention would not sell. What I had in mind was a sim occupied by capitalists whose land is economically productive (produces more revenue than the cost of capital plus tier plus risk loading). Those capitalist joint venturers could band together per my theory to offer their customers with the benefits outlined above, with their independently productive real estate (and supplemental escrowed Lindens) as collateral security for their performance and fidelity.

Identifying such economically productive uses of land in SL, I've spotted only a few (and invite all to add to the list):

1. zoned residential sales/rentals (including some real estate investment pools)
   
2. Retail malls
   
3. Gaming venues that are cash-flow positive without Dwellfare.
   
4. Entertainment venues where attendees might pay to play
   

In a parallel inquiry, I've been trying to identify capital goods in SL, which could support a venue for an industrial base. So far, I've identified very few, but they may be yet to evolve. The value and importance of capital goods in other realms (Eve Online comes to mind) have led to the organization of user corporations and equity ownership in such, but little of that in SL.



Both excellent points. From many years experience, I agree that there is politics even within a corporation. And there is undoubtedly a conflict of interest between being perceived as "fair" and defending against customer's claims for relief. At some point, the transaction cost has to be taken into account when deciding how much power to invest in a "disinterested" or third-party adjudicator. Many corporations do this by appointing an "ombudsman" to represent consumer or employee interests when they conflict with that of management. In the end, if the interested parties don't adjudicate consumer claims themselves, they can expect that whoever provides this service will expect to be compensated.



Excellent point. This might be addressed through the principal of leverage of confidence. Once a land-based foundation is established, that corporation might become trusted enough for participants or third parties to actually entrust it with cash collateral to be held in trust and released only upon the satisfaction of specified terms. The corporation might thus hold assets in excess of the value of the land itself.

It would be important for the trustee to receive some compensation for its service as a trustee or escrow agent. Its incentive not to steal the money would be the "shadow of the future" ... the expectation that if it continues to merit trust, it will continue to be entrusted with funds and to earn the compensation for acting as trustee or escrow agent.

Contrast this situation, where residents actually pay others to hold funds, with the situation in which residents are actually paid by those holding funds. One must think about which of these situations presents the greater temptation for the escrow agent (creditor) to disappear with the money.

Posting Lindens instead of land would then be made more feasible, addressing your concern for closely relating the value of the collateral to the value of the obligation, and offering an alternative to having to deal with the tier cost of land used as collaterai. The tier cost issue would be neutralized if the collateral land were economically productive, as discussed above.



Desmond, excellent point in favor of an escrow company composed of well-known, well-established principals, and avoiding placing escrow funds or lands in an ad-hoc agent that could be a "straw man" like you describe.



Zarf, also excellent points. Those who are not wealthy could gain benefits under this system, but they would need to find someone who is "financially responsible" to vouch for them and post security on their behalf, much as one posts evidence of insurance in a state that requires financial security as a condition of owning a motor vehicle.

I've addressed the cost/benefit considerations of separating the adjudicator from the obligor. Clearly a trade-off.



Ferren, excellent insights. I think the valuation of IP and the perpetual license issues are not peculiar to this theory, but relate more to the underlying contracts to be enforced. And it would be ideal to have some recourse that would not require an "upfront asset," but I've not been able to figure that out yet. Even the loss of reputation is the loss of an "upfront asset" if one considers a reputation as an asset built over time and destroyed in an instant.

The tone and content of all the responses has been measured and thoughtful, for which I thank everyone. I don't think we've got a solution, but we've got some additional things to think about and (with what else may yet be added) a useful "mini-symposium" to compile and add to the Proceedings of the Law Society to be published and added to members' libraries.

A Land and Economy thread discusses the issue of banks in SL, and the issues of enforcement that make them challenging. It ends with the perennial call for LL to take charge and run a government. I posed a few comments based on the history of banks and referencing this thread in: "Failure of Contract Enforcement in Second Life and its Economic Effects".

Comments on how the Theory in this thread might be adapted to provide for a banking establishment that could be more trustworthy than the "Trust Me, I'm a Bank" programs now in competition?

the real question is, do we really need so many things like this? that contain scary concepts as "enforcing" , "limited" ,"corporation"

are you sure these horrors of the real world have a place in our second life?

Kyrah, not all of us do need the tools. Some have expressed a desire or need for them as a precondition to provide some advanced services, such as development contracts, or the operation of banks or credit unions with some accountability.

So this thread analyzes some possible responses to that need, which was one of those expressed in response to a poll late in 2005. Not all will share the need. And not all think that such things are "horrors," but rather as the core foundation of modern commerce and civilization.

Neualtenburg is going through growing pains as it evolves from a start-up and works toward a long-term operational pattern.

In an onging thread about that process, Gwenyth proposes leveraging Neualt's existing government structure in a way similar to the theory proposed in this thread: "An Economic Foundation for the Vision of Neualtenburg"

She does so as a way of offering unique value to business and professional interests.

The Neualt project is worth following for those of us who are interested in seeing field experiments that might serve to explore this Law Society topic.

Half the pieces of the puzzle are present in the various skeins of discussion on this topic, both in the Neualt group forum, and Frank's Law Society group forum thread on Neualt.

The other half is enforcement.

Right now the answer to enforcing the Neualt rules seems to be exile, as mentioned by Aliasi in the Neualt group forum (post #8 in a long thread) here .



Exile (i.e. you broke our rule, so you get kicked out of Neualt) only works for residents of Neualt. Even for Neualt citizens it's not a huge punishment in those cases where the offence involves something serious like defrauding a fellow resident or breach of contract involving theft of IP rights.

On the other hand, there's also the social cost of "you got kicked out". Sending someone to Coventry can be a pretty effective punishment if you trade on your reputation.

just look around you what kind of evil dishumanised cosporations it gave birth in SL , i really would like to avoid SL evolving into this

I propose.....






































TRIAL BY COMBAT to settle all disputes

begins humming hand to nand combat music from original Star Trek

I've been whining about LL's cluelessness with regards to this kind of issue for almost two years. We need a rule-based contract system, sort of like those spam filters you can make in outlook.
"I agree to pay X to person Y every Z days/weeks/months"
"When money enters group give X percent to person A, Y percent to person B"

Edgy, do you think the original posting presents a possible solution?

We're trying to explore alternatives that would support more complex agreements than you mention.

Sorry, I was in a wierd mood yesterday, shit in RL, shit in SL, and Ulrika leaving the forums (and SL)

Hey Lucifer -- no need to apologize for faithfully representing the views of many sandboxers. This forum needs more fun viewponts.

As Neualtenburg reviews its structure, some of its citizens have proposed that the self-governing municipality become a domicile for in-game corporate entities. Neualtenburg TOS Review - Part II - What is a Person?