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Contracts As Instruments Of Innovation

February 8, 2012

At the IACCM Global Forum in Arizona (October 28th, 2011), there were several executive roundtable discussions. One theme that the groups tackled was the question of contracts and their role in enabling innovation. The overall session was led by Professor Tom Barton from California Western School of Law and here is his summary of one part of those discussions. I reproduce it because it may inspire ideas – or perhaps even on-going discussion. Please add your comments or experiences below.

Five tables reported back their respective thoughts on the topic “Contracts as Instruments of Innovation.”  The items covered at each table had limited overlap, demonstrating the breadth of the topics that can be considered.

I am grouping the thoughts in a way that hopefully could make them a bit easier to process, rather than table by table.  In general, people reported back some particular immediate innovative ideas; thoughts related to improving the processes leading to ongoing creation of innovation; and reflections on the organizational and attitudinal barriers to innovation.

I.  Immediate Ideas

A.  Some tables adopted the framework about contracts consisting of three circles: (1) the economic exchange relationship, or content of the bargain; (2) the personal relationships that accompany the exchange; and (3) the legal relationship.  These same tables seemed to agree that the legal circle has come to dominate contracting, creating barriers to innovation.

1.  Those who spoke this way brainstormed various ideas for bringing the three relationships back into better balance.  Ideas included the following:

a.  enlarge the exchange and the personal relationship circles, especially if the other circles could grow so as to overlap once again with each other and with the legal circle.

I.  This could occur, for example, by having someone from the legal side participate regularly and early in the exchange negotiations, as part of established teams.  One person reported using this structure, saying it had the effect of helping the lawyers understand the business needs better, as well as building far better internal personal relationships.

ii.  The personal relationship circle could also grow through a systematic personnel exchange, at a middle-management level, between counterparts in strategic contracts.  Two different table suggested this as a way to advance trust and mutual understanding between the contracting parties.  Obstacles to this idea were possible disclosure of internal policies/trade secrets, and the fast turn-over of personnel.  One person reported successful experience with the idea.

b.  another idea was to approach lawyers on their own terms, so as to persuade them to shrink their own domain.  The thought was to tell the lawyers that their desire for a “zero risk” contract was not only a fantasy, but that in addition to raising transaction costs it actually generated a significant new risk: that an otherwise desirable contractual counterpart would ultimately refuse to do business with the lawyer’s company.   If that happened, the company is shrinking its alternative contracting partners, potentially ceding bargaining power to an oligopoly.  A second sort of new risk that ironically grows out of the unrealistic “zero risk” mentality is what happens when an ongoing contract encounters some completely unforeseen occurrence or change in background environment.  Legal departments, it was suggested, must understand that their job is to cope with not only current risks, or “unknowns,” but also those risks which cannot currently even be imagined: the “unknown unknowns.”  Only a contract with some flexibility and discretion built in could handle the unknown unknowns.  And if that flexibility is absent, the parties could experience significant costs that otherwise could have been prevented by the more flexible contract.

c.  putting together thoughts from two tables, a third idea was to have contracting parties always disclose their strategic interests, as well as their immediate transactional interests, in initial negotiation sessions.  Doing this would generate risk profiles for each party.  Contracts could be crafted so as to acknowledge both of these risk profiles, to meet the interests of both parties.  Through presenting the risk profiles to the legal departments, the exchange personnel would be taking a stronger role than simply abdicating issues about risks for the lawyers to resolve on their own.

d.  another idea was to move U.S. business practices, at least with respect to strategic contracts, toward the Japanese model in which top management from both sides to an agreement personally work out the agreement in private meetings.  And then they specify that their agreement should be memorialized and formalized.  This would, clearly, expand the exchange relationship circle and perhaps also the personal relationship circle.

e.  a dramatic fifth idea was to make some contracts, or parts of some contracts, explicitly not legally enforceable.  Hence they would in whole or in part look more like informal letter agreements.  Obviously this would significantly reduce the importance of legal rules, and correspondingly increase the importance of the exchange and personal circles.  When asked what would ensure the dependability of the undertakings, one suggestion was that perhaps both parties could supply insurance bonds–to guarantee performance on one side, payment on the other.  Gradually, the risks of non-performance by a given company would raise insurance rates for that company, thus making it in the best interest of that company to keep its promises.  One person did express skepticism, however, that insurance companies would issue bonds on contracts that were not legally enforceable.

f.  finally, one table suggested that a fourth circle should be added to the existing three that had been identified, because this circle–sales–had significant influence over the other three circles.  By controlling the sales teams more carefully, the legal circle could be diminished.

One Comment
  1. Alan Roach permalink

    Tim, I like to circles but, to me, a contract is an agreement to buy or sell (depending on your side) a service or good. Where innovation comes is from either (a) the long term relationship;
    Looking for change, encouraging change, measuring “both” sides performance, working to cut costs out and sharing the gain.
    (b) codifying innovation in the contract;
    Who pays for it, how do you share it, who owns it, benefits for both?
    So I like the circles but I don’t see the “contract” as the best tool for innovation. I believe that tool is in the relationship and management of the supplier/customer relationship at all levels of the organization.
    PS: On “C” if everyone was transparent on their true strategic interests you wouldn’t need as many people like me. Negotiations would be far simpler.

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