Contracting in the New Economy

If you want to learn more about collaborative contracting, I strongly recommend you read Contracting in the New Economy by David Frydlinger, Kate Vitasek, Jim Bergman and Tim Cummins.

As young construction and infrastructure lawyer in what was then Australia’s leading construction law practice, I was fortunate enough to be exposed to alliance contracting and other forms of relational contracting (also known as collaborative contracting).  I was encouraged by Doug Jones AO prepare and present a paper on the topic of alliance contracting and so began my 20-year fascination with relational contracting.

My fascination has grown in recent years because, with the benefit of experience, I’m beginning to better understand various weaknesses associated with the way construction and infrastructure projects are typically contracted, and the role that more relational or collaborative forms of contracting can play in overcoming the weaknesses associated with transactional forms of contracting.

What I love about this book is that it’s aimed at contracting practitioners (like myself) and provides material that is ‘new’ to me.  Not once is alliance contracting as practiced in Australia mentioned.  Instead, the authors – who include a Swedish lawyer, an executive education faculty member at the University of Tennessee, the CEO of an advisory and training firm, and the President of World Commerce and Contracting (formally IACCM) – bring a perspective that is fresh (even for those experienced in alliance contracting) and grounded in science.

The book does this by presenting:

  • a solid basis for understanding the dynamics of relational contracts that covers social, economic and psychological factors. In essence, the book provides a scientific basis for understanding:
    • why a more relational contract will work better than a transactional contract in certain circumstances (the WHY); and
    • the circumstances in which a relational contract will serve the parties better than a transactional one (the WHEN); and
  • a methodology for developing formal relational contracts that is grounded in the science (the HOW) and illustrated by numerous case studies.

The science challenges many conventional dogmas and approaches to how organisations contract. 

I’ve learned an enormous amount from reading this book, and I’m sure others involved in developing contracts will too. 

I summarise my key learnings below.  Many are direct quotes from the book.

The WHY

The WHY is important because one can learn a lot from diagnosing the disease properly before recommending a cure.

Today’s economy is faster, more global, more complex and more volatile than ever before.  Contracting in the ‘new economy’ demands a new approach.  Using conventional transactional contracts does not work in complex strategic relationships where the parties depend on each other, future events cannot be predicted, and flexibility and trust are required.  Instead of supporting the partnership-like relationships needed to cope with uncertainty, conventional contracts undermine them.

Contracts are written because humans are opportunistic, ie often inclined to do what it best for themselves, disregarding the interests of others.  Contracts are used as a mechanism to protect against the other party’s opportunistic choices.  They are a risk mitigation instrument. 

When parties form long term commercial arrangements with one another, they can become dependent upon one another.  A customer can become dependent upon it supplier if it would be costly or difficult to switch to another supplier.  Likewise, the supplier can become dependent upon the customer if it has invested in adapting its business processes to the specific needs of the customer.  These dependencies give risk to the ‘hold-up problem’ and to ‘shading’.

Hold-ups occur when a party abuses another party’s dependency to extract benefits at the expense of the other – for example, by unilaterally raising or lowering prices.  Gaps in contracts exacerbate hold-up behaviour, so parties attempt to create ‘complete’ contracts to guard against the risk of hold-up. 

The search for complete contracts, that appropriately deal with all possibilities in complex strategic relationships, is an exercise in futility. Attempts to create complete contracts lead to long and complicated contracts that the parties find difficult to interpret and apply.  The gains from attempting to be complete get lost in the complexity.  Recent Australian PPP contracts are a good case in point.

There are other tactics that organisations use to prevent dependencies and hold-ups.  For example, by using several suppliers instead of one; but dealing with more suppliers is more costly than dealing with fewer.  Or by producing the good or service themselves (vertical integration); but the buyer may not be the one who can do the work most efficiently.

Shading is retaliatory behaviour in which one party stops cooperating, ceases to be proactive, or makes countermoves.  It happens when a party isn’t getting the outcomes that it expected from a deal and feels the other party is to blame.  Shading often launches a negative cycle of tit-for-tat behaviours. 

Contracts are also written not only as a risk mitigation instrument but also as an expectation management instrument.  The contract provides reference points for the parties’ expectations as to how future changes will be managed.

Contracts should also be viewed as instruments for social cooperation.  They create relationships that rely on and ‘activate’ social norms (ie unwritten rules for behaviour) to succeed.  These social norms include reciprocity (the obligation to return in kind), loyalty to the relationship (the obligation to consider each other’s interests) and equity (proportionality).  Contract drafters need to understand that contractual relationships activate these social norms, which become part of the relationship.  The longer the duration of the relationship, the greater the role these social norms play.

The book includes a chapter on the psychology of contracting.  Why?  Because it is easier to write good contracts when you understand what motivates people and how common biases can slip into decision making. 

Classical economists assume people are only selfish and opportunistic.  Behavioural economics challenges this assumption by looking at what real people do. 

People suffer from cognitive biases and fallacies.  Three cognitive biases and fallacies of interest to relational contracting are:

  • the planning fallacy – we think we understand the past better than we really do (hindsight bias), which causes us to think the future is more knowable than it is. This leads us to make overly optimistic forecasts and predications about the future (optimism bias);
  • probability neglect – instead of rationally assessing risks as a function of probability and consequence, we get wrapped up in our feelings. If we can visualise a worst case scenario for a risk, we tend to neglect or ignore the probability of it occurring.  Consequently, we spend more time than we should negotiating clauses that regulate unlikely scenarios (such as indemnities and limitations of liability);
  • self-serving bias – we tend to make judgements that favour ourselves. When what is fair is not obvious to everybody, we tend to view the fairest solution as the one that is best for ourself.

Behavioural economics also shows that it is wrong to assume that humans are only selfish.  Numerous studies show that we have a strong sense of fairness.  This is why most of us think it is unfair for a shop to raise the price of umbrellas when it is raining.

Also, we also don’t like abuse of power.  Humans will often retaliate and punish unfair behaviour, even if it is against their best economic interests.  This is evidenced by the Ultimatum Game, where a Proposer is given, say, $100 and asked to propose how the money should be split between the Proposer and a Responder.  If the Responder accepts the split, the money is split accordingly.  If the Responder rejects, no one gets anything.  Classical economic theory says the Proposer will and should propose a $99/$1 split and the Responder will accept.  The Proposer, acting rationally, has no reason to offer more than necessary, and the Responder has no reason to reject since he/she will be $1 richer than before.  However, the result in the game is usually otherwise.  Results show that Responders tend to reject an offer below a 70/30 split.  The reason why Proposers offer fairer splits is because they anticipate this rejection.

The classical economic assumption that humans are pure egoists is also false.  But we are not all the same – some of us are more egoistic or more altruistic than others.  We exist on a motivation continuum from pure self-interest (the Opportunists) to pure altruism (the Strong Reciprocators).  By writing a relational contract that sets the right rules for the relationship, the contracting professional can create a context in which Strong Reciprocators will dominate, which will lead to better results for all involved.

The WHEN

There are many different types of contract.  One way to categorise different types of contract is by reference to the following spectrum of business sourcing models.

There is no single type that is best in all situations.  A relational or collaborative contract is not “better” than a transactional contract or an employment/vertical integration contract in all situations.  The goal is to recognise those situations where a relational contract is more appropriate than a transactional contract or an employment contract.

The above diagram simplifies the business sourcing models into three: transactional, relational and employment/joint venture/partnership.  Within each of these categories, there are subcategories.  For more information on the subcategories, see the white paper titled “Unpacking Sourcing Business Models” available at www.vestedway.com.

Most important characteristics to consider when deciding on form of contract are:  dependency between the parties, and risks in the deal and relationship.  Dependency is just one of the risks, but it is so important that it should be considered separately.

The higher the dependency and risk, the more critical is is to use a relational contract designed to continuously align the interests and expectations of the parties.  But when dependency levels are low and risks moderate, a more transactional style of contract is often a better choice.  Sometimes the dependency and risks will be so high that the best choice it to vertically integrative through employment contracts or a joint venture or partnership.  But if a party has made a ‘buy-decision’, then the question is whether to use a relational contract or a transactional one.

Many contracting professionals view dependency as something bad – to be avoided.  So they prefer shorter term contracts and the use of termination for convenience clauses.  Why become locked-in if you can prevent it?  Where the actual dependency and switching costs are low this is a perfectly rational way to contract.  But where the actual dependency and switching costs are high, such contract terms do not alter this reality.  Rather, they ignore the reality of the situation.

Dependency is not necessarily bad.  Firms can generate competitive advantages by consciously embracing and deepening the dependency between the parties, by investing in relationship-specific assets/efficiencies to create something unique with the other party that out-performs an arms-length relationship.  Short term contracts and termination for convenience clauses discourage the parties from making such relationship-specific investments. 

As already mentioned, humans react negatively to power abuse and unfairness.  In relationships of high dependency, if parties (ab)use their power to maximise profit to the detriment of the other, they will create friction in the relationship.  That friction can’t simply be avoided by switching to another contracting partner since dependency is high, so shading is likely.  The best way for the parties to avoid this outcome is to consider the other’s interests and minimise frictions which will ultimately hurt both parties because of the dependency that prevents them from leaving the relationship.

Risk is the other key factor to consider when deciding between a relational contract and a transactional one.  When the risks associated with a relationship are high, the likelihood of the parties’ interests and expectations becoming misaligned increases.  When the stakes are raised, the likelihood of one or both parties acting opportunistically increases.  Similarly, when the deal/project is complex the likelihood of events or circumstances happening that cause the interests of the parties to become misaligned increases.  Significant relationship friction can arise because of failed expectations, where the contract has created reference points against which the contract outcomes are compared.  The more complex the deal/project and the longer the relationship, the more likely it is that such frictions will arise.

Organisational readiness or lack of maturity is often cited by organisations as a reason for not adopting a more relational form of contract.  But an organisation’s maturity should not influence the analysis of which contract model is the best fit.  If a relational contract is considered the best fit, then the organisation’s readiness to make the shift will/should not affect this.  Rather, the organisation should be assessing the roadblocks and the cost to overcome them.

The How

When parties choose to adopt a relational contract, it is best to develop the contract in a particular sequence that departs from the standard way of developing and negotiating a contract for the following reasons:

  • Behavioural economics shows people are not rational and selfish, but are rational to a limited extent with a strong sense of selflessness. We are born on a continuum from egoism to altruism, and it will be the surrounding circumstances that will determine whether it is the egoistic or altruistic side of the people involved that will come forward.  So, deliberately laying a strong foundation at the start of the contract development process will help to build a sense of trust and fairness while avoiding opportunism, high transaction costs and value leakage.
  • Research shows that money makes us egoistic. So it’s better not to start by negotiating the deal, where money is a key component.  Rather, we should cultivate the seeds of a non-opportunistic relationship by firstly focussing on shared vision, strategic objectives and guiding principles, to minimise tendencies toward opportunistic behaviours later.
  • The organisations and individuals should feel there has been a fair process for establishing the contract. If the process is perceived as unfair, the outcome will lack legitimacy and the willingness of the parties to give effect to it will be diminished.  The process of getting to the written agreement is an important part of creating the collaborative relationship. 
  • Risk avoidance and mitigation through continuous alignment of interests and expectations, will avoid disappointments and thereby preventing shading. If the parties start by negotiating deal specifics (scope, services, price, quality etc) they will likely focus on specific matters that will be highly relevant to the early stages of the relationship.  For relationships involving high dependencies and risk over a long period of time, however, such matters will change over time and require adjustment.  This is why formal relational contracts espouse that the specific deal points should be flexible while the general framework should be more rigid.  The shared vision, objectives and guiding principles provide the general framework for the relationship.  By focussing discussions on these matters first, the parties lay the foundation for a long-term alignment of expectations, guiding them as they develop the specifics of the initial deal, and as they continuously re-align in response to change.

Accordingly, the authors suggest the following 5 step process:

Step 1: Lay the foundation for a partnership, by creating internal and external alignment on trust, transparency (open communication) and compatibility (ie alignment of preferences for decision making, innovation and and teaming).  This is achieved by the parties discussing each of these concepts, typically in a workshop facilitated by a professional facilitator.  The book includes some suggested questions to promote this discussion

This first step recognises that the parties are building a social relationship, and not just an economic one.

Step 2: Co-create a Shared Vision and Strategic Objectives, both long term and short term, and at both a high level and a more granular level. This second step is essentially an alignment exercise. The parties align their interests and expectations at the highest level, in the form of a Shared Vision, before working their way to more concrete Strategic Objectives.

This second step recognises that the usual risk mitigation mechanisms in transactional contracts of state power (ie the ability to legally enforcing the contract, by going to court) and market power (ie the ability to coerce the other party to do what you want by threatening to leave the relationship) are often weak in high dependency situations because of the high switching costs.  The parties are less likely to sue the other party or leave the relationship unless there is an extreme situation that justifies the switch.  It also recognises that aligned interests places the parties in the same boat and thereby reduces opportunities one party to benefit at the other’s expense. 

A Shared Vision and Strategic Objectives will also serve as a reference point for the parties expectations.  When “business happens”, which causes the expectations of one or both parties to not be met, the vision and objectives become the beacon – or true north – that will guide the parties in adapting their contract, to ensure continued alignment.

Step 3: Adopt Guiding Principles for the Partnership.  Mutually discover and agree on social norms that will be explicitly included as contractual obligations.  Usually there are six: 

  • reciprocity, ie fair and balanced exchanges that build trust;
  • autonomy, ie allowing each party to make its own decisions, free from the power of the other;
  • honesty, ie tell the truth, about facts and intentions
  • loyalty – to the relationship, which typically involves allocating risks and workload appropriately; and eliminating information asymmetries;
  • equity, ie sharing rewards in proportion to contributions, resources invested, and risks taken; and committing to remedy inequities
  • integrity, ie consistency in decision making and actions.

The Guiding Principles, together with the Shared Vision and Strategic Objectives, form the foundation for designing and negotiating the deal.  Following these six social norms will enable the parties to align interests and expectations in a fair and balanced manner both during contract development and after the contract is signed.

Research shows that parties can avoid conflicts of interest more effectively by applying social norms to their relationship than by using power.  Research also shows that (ab)use of power can generate conflicts of interest and lowered motivations to perform.

Most lawyers are uncomfortable with the inclusion of these Guiding Principles as contractual obligations.  Most lawyers generally prefer that they are recorded informally in a separate document to the contract or, if they are included in the contract, a provision is added that expressly states they are not legally binding.  As the book notes, both approaches are folly, as an obligation to act in good faith will be implied in a relational contract governed by Australian or English law, absent express provision to the contrary. It is preferable for the parties to guide a court as to the content of the good faith obligation, than to leave it to the court to determine. 

Their inclusion also sends a very strong signal for building trust between the parties, and preventing distrust.  Refusing to make the Guiding Principles legally binding sends the opposite signal.

Making them legally binding is also an important risk mitigation tool.  A transactional contract that has been administered by reference to non-binding social norms, can be administered differently when a “new sheriff” comes into town, who does not feel bound by the parties historical relationship, or the old sheriff receives new orders from senior management.  By making the Guiding Principles legally binding, the parties can better protect themselves against the risk of short term opportunism – including by themselves – because such conduct will constitute a breach of contract.

Step 4: Align expectations and interests (architect the deal points).  The deal points that needs to be agreed will differ from deal to deal, but will typically include responsibilities (scope), price or pricing model, how the parties will measure success, liability, term, termination, governance arrangements, intellectual property rights and other legal terms.  The parties are encouraged to negotiate these deal points with a ‘best for we’ mindset, informed by the Shared Vision, Strategic Objectives and Guiding Principles, rather than a traditional ‘best for me’ mindset.

To achieve alignment of interests and expectations, the book suggests:

  • Thinking about the deal point through 3 Pillars: (1) Value Provided (ie the goods or services that are to be provided; (2) Compensation for the Value Provided; and (3) all the Other Terms.  See diagram below.
  • Using win-win economics so that the parties win together, or lose together;
  • Ensuring the parties should contract with realistic expectations to consider unforeseen events. If unforeseen events occur that decrease value, the parties should lose together equitably; and
  • Ensuring the Pillar 3 clauses are aligned with the Guiding Principles, to make them fit for purpose.

The last point is of particular interest to lawyers because inconsistency can lead to unintended outcomes.  For example, a termination for convenience clause that allows a buyer to terminate what was to be a long term contract on short notice, yet does not compensate the seller for investments made, would be in breach of the equity principle.  This could result in a court interpreting the termination for convenience clause in a a manner that avoids the inconsistency.  Most lawyers will see this as an argument for making the Guiding Principles subservient to the other contractual clauses.  But this would create uncertainty.  It would also create opportunities for one party to use the clause to benefit at the other party’s expense, which will lead to disappointment and shading.  A better approach, for relationships with high dependency and risk, is to avoid these outcomes by drafting the other contract clauses so that they are aligned with the Guiding Principles.

Often the Pillar 1 and 2 clauses are negotiated between businesspeople, whereas the Pillar 3 clauses are left to the lawyers to negotiate.  This approach is flawed.  The lawyers and the business people should work together on all 3 Pillars.  Doing so will ensure the lawyers understand the intent of the relationship and increase the likelihood of the contract clauses being drafted in a manner that aligns with the parties’ Shared Vision and Strategic Objectives.

If I was asked how the book could be improved, my response would be in relation to step 4.  I expect most parties could use further guidance on how to use win-win economics so that the parties win together, or lose together.  Appendix 2 of the book does, however, point readers to to further resources to support continued learning.  People wanting to learn more about how to develop pricing models that use win-win economics should read the white paper titled “Unpacking Pricing Models” available at www.vestedway.com.

Step 5: Stay aligned, by openly accepting that complete planning is impossible for complex contracts and by developing a governance framework that will enable the parties to collaboratively manage change and uncertainty and stay in continual alignment.

Continuous communication is the only way to avoid misaligned expectations and consequent shading.

Even though the contract is legally binding, the primary risk mitigation mechanism in the relational contract is not enforcement via litigation.  Rather, it is through the parties continually aligning their interests.

Skipping governance meetings because things are running smoothly can be a big mistake.  Just because the relationship is running well doesn’t mean it doesn’t need maintenance.

Conclusion

I’ve learned an enormous amount from reading this book.  It has improved my understanding of the science of contracting and why formal relational contracts work best in situations of high dependency and high risk, such as complex high value construction projects and long term operation and maintenance agreements.

I have long felt that the Australian Government guidance regarding the circumstances in which project alliance contracts should be used is too limiting and results in under-use.  The guidance focuses primarily on whether the project risks can be dimensioned and transferred at an affordable price, and ignores the dependency issue.  The reality for project owners contracting complex major projects is that they become highly dependent upon their contractors and key suppliers within the supply chain, and that switching during the construction process is very costly and sometimes impossible. 

A cheap initial contract price delivered by a competitive tender process doesn’t guarantee the best whole of life price or best ‘value’ (when non-price factors are taken into account).  Indeed, a fixed price within a transactional contract for a complex high value project involving significant risks will drive the project cost up, for the reasons I’ve explained previously.

For such projects, a more relational contract will serve the interests of the project owner (and its contracting counter parties) better than the transactional contracts that currently dominate the construction and infrastructure sectors.

The book provides excellent guidance on how to develop formal relational contracts, strongly grounded in the science of contracting, and I highly recommend it to anyone involved in the development of contracts.

Want to learn more?

You can purchase a copy of the book via this link: https://www.palgrave.com/gp/book/9783030650988

You can access the white papers and case studies published by the University of Tennessee via this link: www.vestedway.com

The University of Tennessee also offers short courses on relational contracting.  I’ve enrolled in a 5 day executive education course on Vested Outsourcing in August/September, and a 2 day course on  Collaborative Contracting in August.

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