As the global power balances and international trade patterns shift, the role and purpose of contracts increasingly comes to question. We face growing conflicts between transactional and relational cultures, between the forces of law and economics, and regarding the way risks are allocated and managed. Businesses thus face an urgent need to re-think the approach to business relationships and the results they achieve.
This section brings awareness of the need for a paradigm shift in international contracting. See Solutions for more information on how to overcome this shift in contracting practice. In order to assess the direction of future contracting, we will use data available from the IACCM survey on top 10 negotiated contract terms.
According to IACCM, negotiations must become more focused on the things that really matter to businesses. There is a broad consensus that greater segmentation of contracts and relationships will improve the body of approved terms and lead to a growth of commonly accepted standards and eventually a shift in the focus on negotiation.
|Top Ten Contract Terms that would be more Productive in Supporting Successful Relationships||Top Ten Contract Terms that are Negotiated with Greatest Frequency|
|1.||Change Management||1.||Limitation of Liability|
|2.||Scope and Goals||2.||Indemnity|
|3.||Responsibilities of the Parties||3.||Price/Charge/Price Changes|
|4.||Communications and Reporting||4.||Intellectual Property|
|6.||Limitation of Liability||6.||Liquidated Damages|
|9.||Service Levels and Warranties||9.||Applicable Law/Jurisdiction|
|10.||Price/Charge/Price Changes||10.||Confidential Information/Nondisclosure|
The dominating view, that there is a need for a paradigm shift in contracting, is supported by research conducted by IACCM. In the table above, the right hand side constitutes what negotiators actually negotiate with greatest frequency and, on the left side, what they believe would be more productive in supporting successful relationships. In fact, more than 80% of the negotiators acknowledge that the present practice does not result in the best outcome.
The negotiators would prefer focusing on areas of cooperation, economic exchange and planning for the future, i.e. what are the common goals of business relationships. Thus, when comparing today’s negotiation with the negotiation of the future there is a clear gap.
The negotiators’ ex ante view of what deserves most focus in the future is very well reflected in the view of Ian Macneil, who believes that the five basic elements of contracts are:
2: Economic exchange,
3: Planning for the future,
4: Potential external sanctions and,
5: Social control and manipulation.
Today’s focus clearly fails to achieve the promotive elements that are stated on the left hand side of the table. Instead the focus of today’s contracting is dominated by the potential external sanctions that are in fourth place of Macneil’s list of priority. The dominance of risk-averse terms tends to emphasize the things that separate the parties and reflect their selfish interests.
The focus of present contracting thus fails to facilitate a relational framework, and thereby also leads to failure of the business that we seek to protect.
However, as the present picture is dominated by a reactive approach to contracting and law, there is hope that this might change in the future. The IACCM survey shows that business negotiators want to focus on the elements, which constitutes a more proactive approach to contracting.
A legitimate question is why have they not already gone there? According to IACCM 75% of the negotiators believe that changes are necessary, but they are unable to make these changes primarily because the negotiators are not decision-makers, but rather positional advocates. This means that the room for them to maneuver is quite limited, and in the end the lack of empowerment is accompanied by a lack of will or motivation to push changes. The IACCM investigation shows that most negotiators wish to do things differently, but they do not know how to do it. They need tools and understanding in order to go there, and the managers and decision-makers need education in order to identify the possibilities of the new approach.
In the words of Tim Cummins, the need for a paradigm shift is supported by the fact that: “Market volatility, regulatory uncertainty, the complexity of international relationships… are critical issues for today’s business managers and they demand innovative, flexible approaches to traditional legal solutions”. The proactive approach to law invites to this paradigm shift and thoroughly fulfills the needs for businesses to compete and win in the future of contracting.
Attributes of Traditional Contracts:
From a legal point of view, traditional contracts serve three legal functions. These functions are recognized as serving contractual safeguarding, coordinating and concerning adaptability of contingencies.
In order to establish contractual literacy, we need to elaborate on these functions. Recall that proactive contracting is not trying to rethink the way businesses are transacting in general. The functions below will still exist in the future of contracting, however proactive contracting seeks to fulfill the needs of these functions through a more relational and promotive way. In order to enlighten this statement, proactive contracting changes the way businesses are safeguarding their transactions by e.g. balancing risk and reward instead of merely seeking self-interest.
The Safeguarding Function
The first mechanism in today’s contracts serves to mitigate the risk concerns that a business partner does not comply with the spirit of cooperation and instead seeks self-interest. We call this the safeguarding function, which safeguards investments and property against misappropriation by the business partner. The safeguarding function typically deals with property rights, confidentiality, unilateral early termination and dispute resolution.
The safeguarding provisions supply incentives to prevent the occurrence of opportunistic behavior, as well as providing clear guidance in case of breach of contract for enforcing adequate penalties. The traditional safeguarding function of contracts is clearly visible and has been confirmed by empirical research.
The Coordinating Function
Secondly, a contract serves a purpose regarding performance risk, which refers to the risk that the relationship may not be accomplished, even though the cooperation between the parties is satisfactory.
Both parties to an agreement face the performance risk, i.e. the risk of failure to achieve expected outcomes of a transaction, because of e.g. complexity, uncertainty regarding tasks, or lack of competence to handle challenges. In practice contracts handles the performance risk through provisions that deals with roles and responsibilities.
When complexity increases the need for coordination is increasing accordingly, in order to harmonize the interface of activities and products. Thus, the coordination concerns refer to the difficulties of aligning actions. Contracts thus carry the highly important function of forcing the parties to consider details of their collaboration before the signing of the deal, and thus act as a kind of blueprint for the exchange. Coordination provisions typically deal with description of responsibilities, reporting procedures, milestones, and designation of project managers.
The final role that contracts serve is providing tools to cope with unforeseen events. We call this the contingency adaptability function, which deals with principles and guidelines in the contract on how to handle such situations.
The Contingency Adaptability Function
The safeguarding and the coordination functions of business contracts deal with the meeting of the minds at an early stage of the relationship in order to align incentives and clarifying the responsibilities of the parties prior to the transaction. As the initial negotiation takes place prior to a per se uncertain future, additional risk might be difficult to foresee. This challenge the already agreed terms that ensure balanced alignment achieved in the initial negotiation process.
As the future potentially involves ex ante transaction costs, mechanisms in the contract should mitigate this risk. This is the third function of a contract, according to Eckhard and Mellewigt. A way of handling contingencies is by including provisions that specifies and guides through the risk of fluctuations in demand, supply or technology. In practice, contingency provisions typically deal with force majeure, price adjustment and engineering change procedures.
Summing up, the role of contracts and contractual functions can be considered as providing safeguard, coordination and contingency adaptability devices. These functions are all dealing with the management of special type of concerns in the relationship and are all empirically recognized, but vary depending on the complexity and size of the transaction.
The attention to each of the three functions in a business contract of course depends on what can be mutually agreed upon.
Now that we have elaborated on the three main functions of contracts, we need to narrow down and investigate the specific terms that in combination constitute the contract, as these characteristics needs to be present in the future.
Contractual Terms – The Five Characteristics
The view of a contract and the importance of its elements vary across professions. Legal professionals tend to evaluate the elements of a contract as they were taught in law school, by paying attention to and emphasizing the careful wording of contractual terms, as well as determining the rights and obligations that should be incorporated into or excluded from the contract. They consider pre-contractual promises and pay attention to mandatory law, and take account of both express and implied terms, etc.
This view does not comply with the view of business managers. They see contracts as a vehicle to generate revenues and profits, and in that manner business, technical, and financial concerns are crucial.
To business managers, relationships and reputation are more important than the terms written in the contract, as they are primarily concerned about achieving their objectives and creating profit and goodwill. This is supported by a survey conducted by IACCM showing that on average nearly 80% of the terms in a business-to-business contract are not areas of significant legal concerns, but rather business and financial terms, such as Statements of Work, Specifications, and Service Level Agreements.
From a holistic point of view, the contractual terms can be divided into five general parts of which the legal part only represents one of the pieces. These overall contract capabilities are divided into pieces of technical implementation, business/financial, coordination, and legal parts.
If the contracting puzzle is correctly assembled, the parties’ individual and mutual expectations are linked together, ensuring a successful, synchronized business deal that reflects the goals of the parties. Of course the solution must reflect the resources invested in the contracting process, otherwise cost overruns, and disappointments, claims, and litigation may follow.
Contracting success thus depends on much more than legal knowledge and skills. Managerial and technical skills come to the fore, not only at the implementation stage, but also when contracts are planned and put together.
In order to create a foundation for the deal and construct operationally efficient contract terms, the input of managers and engineers with intimate knowledge of the business and technology is needed in all key areas.
The glue in this contracting puzzle that ensures that the parties involved complement each other is communication facilitated through clearly stated roles, teamwork, and responsibility both inside the businesses and between the businesses.
It is important that all participants understand each other’s role and responsibility in order to ensure coordination and success.
As many different professions may be involved e.g. procurement, IT, financial managers, legal professionals etc., it is important to appoint a project manager that is capable of setting the stage for successful project completion. It must be emphasized that all team members must commit to making it happen.
As regards the legal professionals, some of them mainly see contracts as a source of trouble and disputation, rather than a way of getting things done.
Due to the traditional view of lawyers and legal professionals, they are often involved after things go wrong and do not provide their valuable knowledge proactively. Legal professionals have knowledge that may be used in contracts to clarify e.g. implied obligations and to prevent negative surprises, through pre-contract communication and clarification. Such clarifications could be based on questions concerning goals, strategy and task allocation in order to obtain a successful performance.
Now we have investigated on the elements of contracts and contracting, we have the foundation to develop processes that fulfills the need of traditional contracting, as investigated above, and at the same time takes advantage of proactive contracting. This may eventually prove to constitute a significant competitive advantage when incorporated properly in the business processes.
In order to create a sound business foundation that is ready to take advantage of the benefits of future contracting, your business can take advantage by consulting our expertize in proactive contracting, as we recognize this as being a key in breaking the Gordian Knot of bringing contracting from the present stage to the future stage.