Author: Charlotte Rydlund
The world’s contract managers finally got their five minutes of fame last month when Oliver Hart and Bengt Holmström were awarded the Nobel Prize for Economic Science. Their work on contract theory not only proves how contracts help us deal with conflicting interests but also show the importance of contract management.
Contracts help us regulate future actions. They are in essence the rulebook for the interaction between two parties. Contracts are everywhere. For example, employment contracts set the bar for good performance and conditions for dismissal. Purchasing contracts regulate the who, what, where and how of delivery. But contracts also have other purposes such as sharing risk among the parties to the contract.
The distinguished Nobel Prize winners Oliver Hart and Bengt Holmström looked at the factors that affect the act of contracting and how to improve the outcomes of contracts.
Tension, conflict of interest and measurement.
The old saying “The right price is what one party is willing to pay and another is willing to sell for” only tells half the story. Price, payment terms and delivery schedules are visible indicators of contract performance. But what about the things that are harder to observe; things such as Representations and Warranties and Limitations of Liability. How about anti child labor clauses or anti conflict mineral regulations?
The conflict of interest between the parties and the lack of visibility (this is what Holmstöm calls Measurement) creates tension. This tension is what prevents a contract from becoming a true win-win situation.
Measuring contract performance requires visibility which can only come from proper contract management processes, procedures and tools to proactively manage contracts.
How to overcome tension in contracts?
Two good examples of using contract performance as an incentive is found in employment contracts and insurance contracts. Since the employee or the insured party’s actions are hard to observe for the employer or insurance company it is often a good idea to include performance incentives in the contract. Take a sales person as an example. They are often paid based on meeting sales quotas. If the sales person acts in the best interest of the company (i.e sells more) they get higher pay. In the insurance space it’s the same. If the car owner doesn’t have any accidents or speeding tickets within a certain period of time their premiums go down.
So how do you ensure contract performance in business contracts?
Measuring delivery performance or payment on time is fairly easy with today’s modern procurement processes. The use of ERP and inventory management systems combined with strong internal procurement processes have made this an easy task. But how about those other contractual obligations? The ones that are less visible? And what happens when performance drops?
What is contract management systems role inimproving visibility of contractual obligations?
Hart’s work in contract theory touches on what many believe is contract management; the question of how companies manage decision-making and collaboration around complex contracts. But this is only one piece of the contract management process. The larger piece, and this is where most companies and CLM systems fail, is visibility.
Providing clear visibility into the less obvious obligations of a contract increases overall business results, ensuring win-win situations between the parties. Contract Management Systems need to support internal processes in order to enable this to happen. Most of today’s best CLM systems do not provide the ability to view a contract and its place in the bigger picture. It is key knowing that a vendor contract affects two other contracts, or that the vendor actually sources materials for a product from the place they state.
But my vendor told me they don’t use child labour.
Using tools like Digital Signatures and Blockchain enabled contract management systems ensures that what the vendor says is actually true. These third party verification mechanisms improves visibility (or to use Holmström’s word, measurement). Furthermore, it decreases transactional costs and overall complexity.
This brings us to the other part of the problem. What happens when the counterpart breaches a clause in a contract?
Breach of contract prevention or punishment
Often a breach of contract is unintended, such as missing a notice date, or a late payment. Usually these situations have a way of working themselves out (although a proactive contract management system would have prevented it from ever happening). And then there are the ones that are intentional or at least seem to be intentional.
As mentioned before, modern ERP systems and inventory management systems combined with modern sourcing processes are good at catching a missed payment or late delivery. These types of breeches are often well regulated in a contract and it’s clear what the penalties are. But how about the less measurable performance breaches? Or even worse, when a particular action or inaction is not covered by the contract language? How do we ensure that a contract covers everything?
The simple answer is we don’t.
Hart’s theory of “Incomplete contracts” looks at what to do when we can’t realistically articulate detailed contract terms in advance. The main idea is that if we can’t explicitly specify what the parties should do in future eventualities, we must instead specify who has the right to decide what to do when the parties cannot agree.
This way the party with this decision right will have more bargaining power, and will be able to get a better deal once the eventuality has materialized. In turn, this will weaken incentives for the party with fewer decision rights to see the eventuality come to life. In complex contracting situations, allocating decision rights becomes an alternative to paying for performance.
Why your contract management software didn’t win the Nobel Prize
Unless your contract management system is backed by a solid contract management process and a solid sales- or procurement process you are only tackling one part of the problem. Without the right processes in place you might as well have saved the money you spent on your expensive enterprise CLM system and used a contract tracking spreadsheet. The right technology can help you bridge the conflicting interests in a contract negotiation and allow you to accept incomplete contracts as a way to close deals faster.
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