Contract negotiations and ineffective risk sharing

I’m in Australia, reading the Financial Review. An article on infrastructure projects asks the question: ‘Will this investment surge allow Australia to ride the global economic upswing? Or. amid the rush to compete, are high profile commercial disputes a sign that government and business are failing to effectively share risks for taxpayers and investors?’

A great question – and one that I am encountering everywhere I go. During the weekend, it was the subject of an online discussion with a leading academic in Denmark. Last week it was with the CEO and General Counsel of a major European outsourcing provider. The week before, it was a conversation with the Canadian government …. the list goes on, but ultimately it all comes down to the point that contracts and negotiations are overwhelmingly focused on the wrong thing.

Most negotiated versus most disputed terms

This week will see the release of IACCM’s latest annual report on ‘the most negotiated terms’. Once again (and this is the eighteenth year of reporting), it reveals that contention over risk allocation dominates the typical agenda. Contracting remains primarily driven by issues of relative power and theoretical protection of assets through the application or avoidance of onerous terms. Hence – other than price or charge – the top negotiated terms remain focused on liabilities, indemnities, intellectual property, termination rights and warranties. The only encouraging news is that scope and goals has crept into fifth place.

Why is this a cause for concern? Quite simply because these terms are in general not relevant to achieving business goals and, in fact, success in risk transfer increases the likelihood of a failed outcome.

Right diagnosis, wrong remedy

The world is volatile. It is not possible to accurately predict market and competitive conditions a few weeks from now, let alone several years ahead. This uncertainty lies at the heart of risk and business people are absolutely right in wanting to establish mechanisms that protect against those risks. Today’s business requirements or social imperatives may look very different in the future. So contracts quite naturally become a vehicle through which the parties seek to limit their exposure to possible harm. The problem is that they are going about this the wrong way – they are seeking to protect themselves at the expense of the other party, rather than working together to develop shared protection. They create contracts that are prescriptive, rather than adaptive.

Ultimately, using power to impose or resist terms and conditions leads to adversarialism. Perhaps more important, it means that contracting parties fail to deal with the issue of uncertainty. It often starts with the very things that they believe are certain – their core goals and objectives. Economics guru Professor Richard Thaler has written about this in the context of behavioral economics and the fact that people frequently think they have agreed, but actually have a very different understanding of what they have committed to do. This is one reason why the number one cause of contract dispute is disagreement over the price or charge, tightly linked to issues around scope and goals. According to Professor Thaler, a remedy for this is to have everyone document what they think has been agreed – and then make sure they deal with the differences.

The remedy for improved success is to spend time establishing and formally agreeing the mechanisms for handling uncertainty and avoiding confrontation, of which one element is having clear and understandable documentation. There will be disagreements; there will be performance shortfalls and errors; there will be times when one or both parties need to compromise. If resolving these situations is left to chance, they will frequently lead to problems. If, on the other hand, the parties have established and implemented effective methods for early identification and resolution, they will typically arrive at a successful outcome.

This isn’t just a theory

IACCM has been promoting new and better ways of contracting and negotiation for many years. Since 2011, this has been through encouraging what we term ‘relational contracting’. This well-defined approach brings increased discipline to the way that contracting parties interact. It stops leaving ‘a good relationship’ to luck and actually institutes formality into the way they will handle their day to day interactions, especially around unexpected or unanticipated events.

The important point is that it works. We have implemented this approach in a variety of major project and services agreements, both public and private sector. They come in on time, on budget and with a workforce that is energized and motivated by positive results and positive relationships. Success like this becomes self-reinforcing.

Major projects and large outsourcing relationships require similar thinking to managing and structuring a large organization. People need clarity over the processes they will use, the ways they should communicate, the shared goals and objectives they are pursuing. Imagine if the functions within an enterprise tried to operate using only an incomprehensible legal document that focused on the consequences they would face when they failed. Motivating? Productive? Clearly not.

The new edition of The Most Negotiated Terms sets out a series of steps that would embed a new approach to trading relationships. But already, through the adoption of relational contracting principles, organizations could be making a dramatic shift in contract success. It’s just a question of whether we are ready to address the question posed by the Financial Review – are we willing to start sharing risks so that we can also share benefits, or are we just too invested in fighting over whose losses will be greater?