Do we exist within the contracting paradox - “the delusion that we write contracts to make plans, but we cannot really plan accurately”1 And, as a nice twist, we trick ourselves into believing that we can plan
This paradox is an easy trap for contracting and commercial management experts to fall into. We are tasked to write forward-looking contracts that attempt to plan for every risk and limit every possible liability. But all too often we end up with a contract that – despite our best effort – is no longer fair and balanced. When this happens, one of three things typically result:
First – the worst case scenario we all fear: a highly strategic “good deal” gone wrong. Some end up in the courts and cost us tons of money in legal fees. Litigation attorneys are the only real winners -- charging billable hours to help you get even.
Second -- the dreaded “change order hell.” Many commercial managers believe suppliers often strategically sell low and then make up their losses with change orders after contract signing. But the University of Tennessee’s research3 in complex contracts reveals that often suppliers are simply using change orders to recover what they lost at the negotiation table. A key lesson: while all contracts should have a proactive way to manage changes, contracts written too rigidly are often fraught with tit-for-tat battles over what is in scope versus out of scope.
Third, and the most elusive result of the contracting paradox -- is “value leakage.” Contracting professionals make projections about negotiated savings or other “value
Obviously, all complex contracts are inherently incomplete; you cannot possibly plan for everything in your contract. Yet on the flip side contracts are essential. So, what to do?
Enter Relational Contracts
Relational contracts open the door to a smarter way to harmonize parties of a contract within our dynamic business world. But just what is a relational contract and why does it help us avoid the contracting?
A relational contract is a legally enforceable, written contract establishing a commercial relationship. It provides a flexible contractual framework based on social norms and jointly defined objectives. All parties prioritize the relationship by continuously aligning interests before making commercial transactions.1
A great way to understand a relational contract is to compare it to the dominant contract model, the transactional contract. Figure 1 below explains the comparison using five dimensions that illustrate the differences between a relational contract and a transactional contract.
But how does a relational contract help resolve the contracting paradox dilemma?
First and foremost a relational contract faces the contracting paradox
Second, in a relational
The parties also consciously codify the underlying framework for the relationship itself. This often means the preamble of the contract includes a formal shared vision and statement of intentions regarding desired behaviors. In addition, the contract includes formally documented governance structure and mechanisms for managing the relationship.
Third, a well-structured relational contract formally embeds social norms that promote non-opportunistic behaviors between the parties when “business happens.” A hallmark of a well-structured relational contract is the conscious choice to make social norms -- like trust, honesty
Lastly, the parties' views of risk will vary differently in a relational contract. In a transactional contract, lawyers often seek to shift risk away from their firm to the other party. But in a relational contract, the approach is to share risk as well as reward. Because the parties share risk, the parties are “in the same boat.” If the boat sinks, you both go down. As a result, the parties become much more likely collaborate to mitigate or even invest in solutions to eliminate risk.
Creating a Relational Contract
The process of negotiating and jointly creating the relational contract is not just a means to get to the written document, but an important part of creating what is actually in focus: the relationship.
Figure 2 further defines the dimensions in Figure 1 as steps in the relational contracting process.
Figure 2: Components of the Relational Contracting Process
Shifting to relational contracting
Although using a structured process to create a relational contract is recommended, many organizations are in an existing relationship and may conclude it is impossible to go back and lay the foundation from the beginning. If you are like many organizations, you may have entered into discussions with the intent to have a more strategic relationship, but along the way created a more traditional transactional contract. As mentioned, transactional contracts are built around classical legal theories of risk allocation, which often leads to frustrations and tensions, because the arm’s length nature of the contract structure encourages more opportunistic and adversarial behaviors.
If this has happened in a business relationship involving you, don’t become disenchanted because you didn’t do it correctly from the start. Consider embedding as many of the relational tenets as possible into your existing relationship with the goal to improve the relationship, moving from left to right along the continuum. Try adopting a no-blame culture and instead seek to improve processes for managing performance and joint problem solving to get to the root cause and focus on accountability, rather than blame. Or perhaps develop processes to improve communications and proactively managing changes.
Starting the Journey
As you shift to relational contracting, reflect on how relational contracting can improve the results for the organization. Four things your organization can start doing
- Investigate whether you suffer from problems in your transactional contracts and analyze whether the problems can be understood. Investigate your most successful commercial relationships and analyze whether success may be a result of using relational contracting elements.
- Involve the right stakeholders. Upper management should become aware of the potential advantages and economic upside associated with relational contracting. Make them your allies and sponsors.
- Start with lower-risk contracts and call it a pilot. De-risk and build a success story from which you can continue using relational contracting for bigger and more business-critical contracts.
- Be patient with naysayers and skeptics. Relational contracting likely will meet resistance, regardless of the evidence of its advantages in many situations. So, don’t confuse hesitation with bad intentions. Instead, try education as your change agent. The good news: a growing body of research, writing and case law now supports relational contracting.
Bottom line: It is time to put past dogmas, policies and contract templates aside and embrace contracting in the new economy. This does not mean you should abandon transactional contracts—rather use them when they are a good fit, leaving room for the relational contract when that contract model will work best.
If you would like to know more about relational contracts and how best to implement them, contact email@example.com
ABOUT THE AUTHOR
Kate Vitasek is a faculty member at the University of Tennessee’s College of Business and is author of Vested Outsourcing: Five Rules That Will Transform Outsourcing; The Vested Outsourcing Manual; Vested: How P&G, McDonald’s and Microsoft are Redefining Winning in Business Relationships; Strategic Sourcing in the New Economy; and Getting to We: Negotiating Agreements for Highly Collaborative Relationships.
- The contracting paradox - defined in a University of Tennessee; International Association for Contract and Commercial Management (IACCM); and Lindahl Law Firm white paper titled, Unpacking Relational Contracts: The Practitioner’s Go-To Guide for Understanding Relational Contracts (see link below).
- A white paper detailing more on the research behind this paradox is available. Click on at Unpacking Relational Contracts - The Practitioner's Go-To Guide for Understanding Relational Contracts by David Frydlinger, Tim Cummins, Kate Vitasek and Jim Bergman (Haslam College of Business; The University of Tennessee; IACCM; Lindahl Law Firm).
- See “Unpacking Collaborative Bidding: Harnessing the Potential of Supplier Collaboration” (2016). Available at http://www.vestedway.com/vested-library/.