Incomplete Contracts Takes On Added Relevance

The theory of ‘incomplete contracts’ was first introduced by Oliver Hart in 1995. This is the theory that says no contract is complete because none can anticipate all the future events that may have impact upon it.

This incomplete contract theory is especially important today, when you consider how many areas are not easy to anticipate. For example, global contracts operate under a whole range of uncertainties and gaps in knowledge; the speed of change also causes uncertainty; new competition, regulation, political instability, economic shifts, climate change, technology and communications, social values – these are just some of the areas that can be disruptive to any contract relationship and are probably impossible to predict.

Indeed, even attempting to predict every eventuality would cause so much delay and prove so controversial that it is clearly impractical to beleive that all factors or risks can be anticipated. The one risk about which we can be relatively certain is that unexpected changes will occur.

Therefore the chances of achieving successful outcomes would appear to be improved if:

• The people involved in contract design have a wide array of information and insight
• Mechanisms are created that will help to identify relevant changes as early as possible during the life of the contract
• Methods by which changing circumstances will be handled by the parties are agreed during the initial negotiation and incentives are designed to ensure they are followed 

This thinking is reinforced by the results of IACCM’s latest studies of the most frequently negotiated terms. Negotiators recognize that today’s focus on risk allocation (liabilities, indemnities, liquidated damages) and rights (intellectual property, confidentiality) is not optimizing results and they are also clear about the areas that are important for future focus. For example, scope becomes critical because we need a firm baseline against which changes can be measured. When change is so frequent and rapid, the number of arguments over whether things are in scope or out of scope inevitably increase. 

And then of course change management and communications become key; not because of whether or not you anticipated changes, but because you must have a clear and agreed way in which all those changes can be handled without causing disputes or termination.

It seems that the contracts and negotiations community has a good sense of what they need to do in order to drive greater value from contract relationships. More time needs to be spent on ensuring mutual understanding of the goals and how they will be safeguarded. But achieving the shift is proving to be a struggle. Timing of involvement, resistance by internal stakeholders or the other side, lack of resource, absence of executive support for change – these are among the top reasons why things have not altered.

Achieving this shift in focus is the main goal of IACCM’s current work – and any contributions on ways that it might be achieved will be welcome.