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Opportunism in contracts

June 7, 2017

A major reason for contracts – and why they are often so complicated to agree – is fear of the other side. In part, this is fear of what they won’t do. For example, will they deliver what they promise and will it be on time? Will they pay the bill? But these issues of core obligation and potential consequence are well established and in general are fairly easy to agree. Ironically, they are also the areas where most organizations (and many professional associations) continue to focus their training efforts.

The thing that is often more complicated is a fear of what the counter-party WILL do – particularly in the context of opportunistic behavior. This is especially the case in situations where there is an individual and to some extent customized scope – for example, in construction, engineering and in outsourcing or complex services.

Opportunism comes in two major forms. One is potentially the contract itself. If the proposed terms have been developed by one party (rather than using, say, an industry standard), there is a natural expectation by the counter-party that they will somehow be disadvantaged. Given the complexity and length of many agreements, these issues of ‘guile’ can be very hard to spot – until they are used against you.

The other big issue is around the scope and goals – the fear they are incomplete, ambiguous, flawed. Indeed, in the construction industry, research has shown that bidders welcome flawed design because this represents an opportunity for future price increases. Anecdotal evidence suggests that the same is true in many services engagements.

Dealing with the potential for opportunism is complicated. It depends on a mix of decision rights, potential remedies and consequences, incentives and relationship integrity. Unfortunately, procurement policies and sales practices frequently stand in the way of effectively discussing and balancing these factors. For example, a good procurement process might encourage and reward suppliers who point out design flaws, rather than allowing them to be used as a way to recover margin on a low-price bid. Intelligent acquisition methods would also explore information flows to ensure greater control and balance in effective decision rights. Good contracting practices would embed robust governance methods into the agreement and ensure they were effectively operationalized.

As we deal with ever-increasing levels of uncertainty and change, IACCM‘s work (and training materials) focus on the need to structure agreements and relationships in different ways. Far too many projects are still undermined by inappropriate approaches to supplier evaluation, negotiation and contract management – along with the wrong form of contract. If they really wish to reduce costs and improve margin, it is in these areas that organizations should focus their training and development.

 

 

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