125. Steven Phelan on Innovation In Contracting

Entrepreneurs seek to provide markets with new value through innovation wherever they can identify an opportunity. Their vision is broad enough to include free market institutions such as contracting, where they identify new and better ways to expand the mutuality of value and better relationship models than those in the traditional legal approach.

Key Takeaways and Actionable Insights

Traditional contracting starts from an adversarial mindset.

Traditional contracts are written in anticipation of conflict. They aim to anticipate everything that can go wrong. Then they try to put every contingency in black-and-white. Clauses are inserted to give one party the upper hand over the other. This approach fosters negative behaviors that undermine the relationship and the contract itself. Often, little room is left for flexibility when conditions change in unexpected ways, leading to costly problems like litigation, mediation/arbitration, renegotiation, churn, and shading (withdrawal of effort by one party due to lack of trust).

A new form of contract called a relational contract aims to address the problem.

A relational contract approaches negotiation not from a transactional perspective but from a relational perspective: what are the best provisions to ensure a lasting and mutually beneficial relationship between the two contracting parties? Instead of focusing on how the value pie is divided between two parties, the shared goal is to maximize the total amount of value that can emerge from the partnership. There is a genuine good faith effort to align the two parties’ interests and to develop a fair and flexible framework to handle unexpected changes and events in the future.

The relational contract is designed to try to solve what economists call the hold-up problem.

Contracts refer to future events, and specifics (such as delivery times) can never be determined with certainty beforehand. The contract is said to be incomplete — not every contingency can be specified. The hold-up problem occurs when one party uses this situation to extract concessions from the other party, knowing that it would be costly for that party to change the arrangement.

Defense contractors, for example, are notorious for under-bidding costs and then adding to their revenue and profits via change orders. A contract may call for “best efforts” but this can never be defined specifically or completely.

The new approach is said to produce healthier and more sustainable partnerships.

In the article A New Approach To Contracts, the authors call for a “what’s in it for we” partnership mentality in contracting, where both parties have a vested interest in the other party’s success. Included relationship-building elements such as shared vision, guiding principles, and “robust governance structures” to keep the parties’ expectations and interests aligned.

Our guest, Steve Phelan, has written extensively about expectations management in negotiations, and concurs that contracts can perform as instruments of expectations management. However, they can’t be perfect, and the authors’ integration of trust-building mechanisms into contracts (e.g., regular scheduled trust-building meetings) seemed to him to be a bit artificial.

A better approach is to focus on identifying good-faith actors — those who work hard to follow both the letter and the spirit of the agreement. As is always underlined by the “Think Austrian” approach, subjectivism (in this case good-faith actors) brings better business solutions than hard and fast rules and mechanisms regarding how to build contractual trust.

It’s important to get there by the best route, since trust lowers transaction costs.

The new approach to contracting extends to psychological contracts.

Psychological contracts are unwritten relationships in which an individual holds a belief in mutual obligations between themselves and another party. An often-cited example is an employment relationship. There may be a written employment contract but, beyond that, an employee may have tacit expectations about job security, personal development, recognition, promotion, growth, personal well-being and respect. If these are not met, they may withdraw effort. Employers are well-advised to empathize with the unwritten expectations of the psychological contract in order to optimize employee motivation.

A brand promise can be a similar psychological contract. Brand make overt promises regarding the benefits they claim to bring to users. In turn, users create their own expectations — as we always emphasize, value is subjective and customers engage in a value learning process when they interact with brands. Their subjectively-defined expectations undergo continuous change, especially as they make comparisons with alternative offers and alternative sources of satisfaction. It’s imperative for brand owners to monitor the evolution of customer-perceived mutual obligations. Customers hold a strong perception of how much consumption work they have to do to receive the benefits that the brand promised, and if the equation gets out of balance, they’ll withdraw their effort.

Additional Resources

“Contracting In The New Economy” (PDF): Download PDF

“A New Approach To Contracts” (PDF): Download PDF