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When Contracts Matter

November 23, 2011

My friend Henrik Lando has referred me to some work undertaken by Gillian Hadfield, a Professor of Law at the University of Southern California.

Prof. Hadfield apparently undertook an analysis of contracting practices across a number of businesses and concluded that:

“In relatively stable industries, business partners pay little attention to formal Contracts and rely on informal means to create and adjust their relationships and resolve disputes.

In industries that are relatively innovative and heavily dependent on external relationships for successful innovation and competitive success, businesses engage in substantial formal contracting. They turn to experts to create relationships and they revisit those documents to determine their own actions and to evaluate the actions of their contracting partner. Where substantial disagreements about contract performance arise, they engage in legally-informed problem-solving that can result in formal amendment or modification of contract documents.

Innovative businesses use formal contracting, however, with little expectation of turning to the courts to enforce their formal contracts; instead, they expect their contracting partners to perform either because of an alignment of interests or, when alignment fails, because of informal enforcement threats such as the threat of terminating or limiting a relationship or the threat of harm to reputation.”

These conclusions are interesting and probably represent a framework that many will recognize. However, to what extent do they tell the whole story and to what extent, if correct, do they explain some of the problems we encounter with contracting today?

First, I would suggest that ‘stable’ industries are frequently those that also face the strongest price competition and have therefore been forced to pursue supply from low-cost markets. In such cases, contracts are indeed viewed as being of limited importance, though commercial strategy is very important (for example, to protect IP, to limit obligations to enable switching, to establish an approach that protects against supply chain risk). In these industries, the power of the supplier is typically limited and therefore they have limited strength in negotiations – they are often forced to accept onerous risks, but these are deemed acceptable because of the relative stability of the industry.

Second, it is true that more innovative industries tend to rely more heavily on contracts (and, in the case of the technology sector, on litigation, at least in the area of patents and copyright). Sometimes those contracts are to achieve increased partnering; sometimes, they seem more designed to contain risk or establish competitive advantage (the current case between Microsoft and Novell is a good example). In this ‘innovative’ category we must also place business concepts, such as outsourcing or private- public partnerships – in other words, innovation today may actually be more focused on the structuring of the business relationship itself rather than any specific goods.

I think a number of factors have intruded to make this neat analysis more complicated. One of these is globalization and the fact that many relationships today cross cultural and business practice boundaries. The potential for misunderstanding (unintended or deliberate) frequently drives a need for greater clarity and more formality than would be the case in a ‘stable’ industry with ‘stable’ and long-term relationships.  The discipline applied to traditional contracts is therefore important in order to ensure there is mutual understanding of  goals and responsibilities.

Another factor that many businesses overlook is that few of them are absolutely ‘stable’ or ‘innovative’. This varies depending on the range of activities being undertaken – and therefore calls for a contracting strategy that reflects the portfolio of relationship needs. But in many cases those responsible for contracts may fail to grasp this need and thus design contracting process and structures that are sufficiently adaptive to the market in which they compete.

Overall, I think this simple perspective offered by Professor Hadfield is helpful and something we could use to good effect when considering the role and importance of contracting within our business.

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