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Contract Terms As A Driver Of Behavior

September 26, 2010

Contracts provide a record of needs and obligations. They also include a range of provisions that relate to the performance of the contracting parties, both defining expectations and also establishing consequences for failure or ‘misbehavior’.

The extent to which performance expectations are defined within a contract has grown steadily in recent years. The terms frequently specify obligations regarding confidentiality, security, the quality of staff, non-compete undertakings, service levels and compliance with a range of rules and regulations. They then proceed to define a variety of penalties that will apply in the event of non-compliance. These range from specific indemnities to rights to damages, termination and perhaps even reimbursement of consequential losses.

Given the extent to which contracts address issues of behavior, it is interesting how little attention the contracts and legal profession has paid to the field of behavioral economics. The principles of most contracts remain firmly wedded to classical legal theory, which is primarily fixated on punishment for wrong-doing. It relies on a legal system in which courts of law determine right and wrong. While this method aligns with the adversarial techniques taught within many law schools, it is questionable whether it operates to the benefit of business.

As behavioral economics permeates deeper into other disciplines – finance and marketing in particular – it is important that we start to assess the effect of terms and conditions on behavior. A simple example is liquidated damages, on which I have written before. The standard approach to liquidated damages causes the supplier to hoard information which will protect them from blame, rather than engage in proactive discussion to reduce the consequences of failure. It is also clear that many of today’s ‘key performance indicators’ result in negative consequences. For example, demands for low cost frequently cause a steady fall in quality. Demands for high levels of availability may cause compromises on safety.

Overall, penalty-based contracts tend to result in behaviors that increase the risks of failure and therefore jeopardize the economic interests of both parties. However, with small suppliers, that may not be true. A small supplier is less intimidated by onerous penalty clauses because their customer would generally be unable to collect, or collection would not be economically efficient. Therefore the small supplier may in fact be incented to find more creative ways to avoid risk.

As behavioral economics moves to the mainstream of business thinking, the contracts profession should be at the forefront of those reviewing how the way we structure our agreements and individual terms and conditions affects the behavior of the contracting parties – and the impact this has on business risk and contract outcomes.

2 Comments
  1. Stan Kablukov permalink

    I agree that the need for value creation is often prevented by legal terms. I think this situation has to do with the need for contract professionals to justify why certain risks have to be accepted to create value for the company and, the most important, to quantify these risks in $ value to prove that value outweighs the risks. If there is a study or a practice, I would like to see it.

    • Thanks for your comment on my blog re: risk and behavior.

      I expanded on this recently in the IACCM newsletter – see http://iaccm.com/contractingexcellence.php?id=102 ‘Risk Management As A Source of Risk’.

      I think the key point here is that as part of a thorough risk assessment, consideration should be given to the way the other side will react to the use of specific risk provisions and whether this will potentially undermine the objectives of the agreement. An example might be in an area such as innovation. Innovative products and services are by their nature more likely to fail or go wrong. Therefore if innovation matters, it is not appropriate to manage that risk through onerous liabilities terms. It is much smarter to manage the risk through a more robust, mutual governance procedure where both sides engage in open discussion regarding progress, problems etc and which reflect the mutual interest and responsibility for success.

      So the ‘method’ here is to ensure that the contracts / legal professionals fully understand the goals of the relationship and shape the agreement in a way that enables / encourages those goals. This appears common sense – but often this alignment is missing.

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