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The perverse effect of contracts

July 2, 2018

The choice of contracts – and particular terms and conditions – is often driven by habit, rather than any form of scientific thinking. That’s in part due to a lack of data, but ultimately responsibility for fixing the problem lies with those who create the contracts. Their failure to examine the impact of the agreements they develop means that the world of contracting is often rather like mediaeval medicine – either ineffective or, at worst case, far more likely to kill than to cure.

Growing sophistication in data collection and analysis is steadily revealing the nature and scale of damage done by poor contracting practices. One current example is the debate over the use of non-compete agreements. These have become pervasive and in many cases grossly unfair, seeking to prevent even low paid workers from moving to a competitive business.

The price of non-competes

There are of course circumstances where an employer genuinely needs to protect valuable know-how or intellectual property. But non-competes are a great example of applying contracts without thought for their social and economic impact – or even perhaps the interests of the employer. Inevitably, they limit worker mobility, which (research suggests) holds down wages. On the positive side for workers, studies undertaken in the US show that employers in states that allow non-compete agreements tend to spend more on staff training. However, by constraining mobility, those states lose out on innovation and the rate of new business start-ups – surely a big price to pay in today’s competitive markets and certainly not good for longer-term employment or profitability.

Non-compete agreements provide just one example of the way that contracts affect behavior, often with significant economic impact. From other research, we know that approaches to risk transfer, the management of intellectual property, the rigidity of terms and the use of inappropriate templates are among the many instances where there is a disconnect between the contract and a desirable outcome.

A better way

In many fields of human activity, there is extensive research and testing before new ideas or methods are let loose onto the public. Not so with contracts. Even though contracts are fundamental to human welfare, anyone can introduce new terms almost regardless of their social impact. While the law provides a framework that prevents major abuse, it does not examine broader questions of ethical or economic desirability – those areas rest with policy makers and, when it comes to contracts, their involvement is largely reactive.

Contracts and commercial terms are themselves a source of innovation and competitive edge. The idea that they could be subject to a regulatory regime is both unrealistic and undesirable. However, those who design and introduce them should certainly be responsible and accountable for the results that they generate and top management should be far more engaged in their review. This demands a much broader appreciation of the impact of contracts and greater professional discipline for those who produce them.

 

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