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Relational Contracting

August 23, 2011

There is increasing mention of ‘relational contracting’. It implies a higher level of collaboration, a greater commitment to partnership and innovation. Hence it is very much a ‘theme of our times’.

But what is it? As with so many expressions, it is, for many, precisely that – an undefined concept. So given the interest, I thought it would be helpful to provide a summary of my views on this topic – and I hope readers of this blog will add their own thoughts and ideas.

First, I should be clear that many traditional relationships have been deemed to supplant the need for contracts. In major parts of the world, this remains the case. Typically, there will of course be some documentation and if push came to shove, I imagine it would have legal significance, but the parties don’t tend to think that way.

From my perspective, the extent to which there is a formal ‘contract’ is entirely optional, but the parties should mutually agree their contracting strategy – in other words, what level of formaility do they intend to have, what aspects need to be documented and how will these be maintained?

Moving on from there, let us assume that a high proportion of relationships today will in fact be accompanied by a contract. In that case, what form should it take?

My view is that there are three distinct aspects to the overall contracting process that leads to a collaborative relationship: 

Selection. Do you understand your own organization and how it will behave? What characteristics are needed from the supplier or the customer for a ‘cultural fit’? How do these get evaluated and to what extent do they form part of the selection or bidding process? For example, we see a growing number of cases where suppliers are provided with ‘scenarios’ as part of the selection process, and invited to describe how they would respond to such situations. Customers increasingly review a supplier’s past performance (with them and others) to see whether collaboration and innovation are actually part of their DNA. A supplier should undertake similar reviews of their prospective customers. Finally, I recommend that each side explores the organizational structure of the other – in particular, how the relationship will be managed and by who (not a name, but the relevant team and job titles). If there are no resources, or they are strongly ‘compliance oriented’, collaboration will be hard to achieve.

  1. Negotiation and contract. ‘Enforced’ collaboration and innovation are unlikely to work; similarly, if there is no sense of shared risk and joint commitment to results. I believe strongly that negotiations today focus on the wrong areas – and there is a lot more on this topic within this blog or at the IACCM website (see IACCM’s annual report on the Most Frequently Negotiated Terms). The number one challenge in many contracts appears to be clarity over the true requirements. If they are not clear, it doesn’t mean inevitable disaster – but it should affect the way the contract is structured and how funds are released. If there is inconsistency or lack of clarity in the transition from scope, to goals, to selection criteria, to performance measurement, to change management, then it is probable that there will be disputes rather than collaboration. So contract terms must reflect the extent to which a) requirements are fully understood and b) the likelihood of substantial change during the life of the contract. In practical terms, there must be real thought given to areas such as IP rights, liquidated damages, termination rights and consequences, change management procedures, performance reviews, communications and reporting, escalation and resolution process, price and price changes, rights of audit, data protection.
  2. Governance and management. I make these separate because I am looking at ‘governance’ as the area that relates to the relationship and ‘management’ to the more operational aspects of day-to-day contract oversight. The people and process required for performance management are mostly not the same as those who need to be involved in periodic relationship (and innovation) reviews.

In general,  the best relationships are those that have greater depth than a single deal. The ability to offer flexibility, for example, is far greater when there are potential ‘trades’ during the relationship. But this can be challenging to many client organizations because they are rarely set up to see relationships as a portfolio – the internal operations and especially the motivations of Procurement are to make everything about specific contracts and transactions.  So the fundamental challenge is often whether the client is ready to think through the operational changes they must make in order to be collaborative; and for the supplier to behave in a way that earns trust and dispels fears that ‘relationships’ undermine competitiveness.

One Comment
  1. John Jorgensen permalink

    Tim, as an ‘undefined concept’ for many, I would refer to the initial works on this subject by MacNeil who provides us with the ‘norms’ of relational contract theory, whilst the various strands of norms presented by MacNeil at the time were somewhat confusing, subsequent works by many academics have brought more refinement to the subject, including for example Klein’s argument of the economic wrapper for efficient breach called the ‘self-enforcing range’, and those who focus on the ‘implementation of planning’ (the ‘point of the deal’ to coin Ertel and Gordon). Others more lately such as Austen-Baker and Diathesopoulos have now taken on the mantle and moved it a step forward, towards a paradigm for analysing and hopefully constructing more efficient contractual provisions, using outsourcing agreements in particular as a context, being by default highly relational constructs.

    It is interesting to see a questioning over the further expansion of highly relational contracts such as outsourcing (e.g. ref. the Economist article recently), and one can see contract terms reducing, which makes implementing the strategic objectives of an outcource relationship all the more difficult to achieve. This is likely to be a reflex to the current global economic prolapse – someone once told me that ‘when poverty knocks on the door, love jumps out of the window’ applies to all facets of society. Now is the time that when the ‘self enforcing range’ of agreements are stressed it is the strength (and risk to) Reputational Capital, based on Trust (anyone who has not read Fukuyama’s book ‘Trust’ should do so!) matters that cannot be fully achieved through presentiation and classical legal doctrine, will come to the forefront in contracting. Moving the initial academic work of MacNeil into a practical tool for contracting can provide an effective paradigm for highly relational contracts.

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