Relational contracts are agreements that rely more heavily on the relationship of trust between parties, rather than solely on the explicit documented terms of an accord. It includes elements of being a social contract with moral obligations. These are meant to guide the business behavior of the actors and contributors who deliver on the expected obligations of the agreement. A Harvard Business School publication defines relational contracts as “an economist’s term for collaboration sustained by the shadow of the future as opposed to formal contracts enforced by courts.” In simpler terms, the HBS research introduces the notion that the agreement is forward-looking to develop long term relations, rather than merely to create legal writing as an enforceable document.
An extreme case of such an agreement is the old notion of a ‘contract by a handshake.’ Although no one is rationally pushing for this extreme, and it is impossible to fully grasp or enforce this method – there is still room for improvement to the current state of contracts.
RETURN TO OLD CONCEPTS
Wikipedia singles out Ian Roderick MacNeil and Stewart Macaulay as the legal scholars who originally developed the concept of relational contracts. MacNeil was a professor at Northwestern University School of Law, and Macaulay was a professor at the University of Wisconsin Law School. There is still room for improvement to the current state of contracts.
If contracts that involve social norms and moral obligations feel like a throw-back, they are. MacNeil & Macaulay introduced and promoted this idea in the 1960s. In MacNeil’s words, this notion provided a response to the “Death by Contracts” concept of hundred-page documents. Such contracts often serve to scare, rather than motivate the employees at either party who must deliver on the obligations and performance measures.
Kate Vitasek’s points out in her Forbes article that “simply put, (MacNeil) felt contracts should not simply be about the legal terms and conditions, but also promote moral and ethical behaviors in business.”
FALL AND REVIVAL
Relationship-based contracts fell from grace circa the 1970s. Instead, it was replaced with the concept of the all-inclusive agreement. These often resembled thick telephone books (yellow pages) of the past. Here, the intention was to capture every possible scenario and eventuality, instead of relying on social norms, moral behavior, and ethics in standard business practices.
However, in recent years, there has been a revival and rising popularity of relational contracts, while also focusing on their brevity. Hence the popular push for the one-page contract, for example.
AUSTRALIAN NAVY
Vitasek’s 2014 article Relational Contracting On The Rise With The Success Of The Australian Navy details a particularly successful case. The Australian navy undertook a relational contract experiment with the Guided Missile Frigate (FFG) Enterprise Sea Day project. Their mission was to have contracted companies provide seaworthy guided-missile frigates. No surprise, the military needed these ‘on time, every time.’
In the article, Captain Greg Laxton, FFGSPO Director, FFG Enterprise Chairman states that “In the 18 months since adding our relational contract charter, the FFG Enterprise has achieved cultural and relational dividends, a significant reduction in sustainment costs, and a marked increase in the availability of Australia’s primary naval air warfare asset to conduct operations.”
Part of the intention was to avoid a blame culture, instead of focusing on problem-solving, continuous improvement, and growing the relationship between the navy and suppliers. Astoundingly, their results were a:
- 44% decrease in labor costs per hour
- 38% decrease in defect incidence
- 100% on-time delivery
CHALLENGES
Naturally, one of the challenges with relationship-based contracts is balancing. What is the right balance of wording to be a reasonable representation of the agreement’s intent? Is there enough in the agreement to mitigate risk, while holding to the concept of brevity in contracts? Then, balance this against the unwritten elements of the contract that build the relationship. And, this refers back to the HBS concept of the accord ‘sustained by the shadow of the future.’
However, the problem that relational contracts addresses are what David Frydlinger (partner at Lindahl Law Firm) coins as the ‘contracting paradox.’ This being the “delusion that we write contracts to make plans, but we cannot really plan accurately. And, as a nice twist, we trick ourselves into believing that we can plan.”
In this regard, the IACCM offers sound insights on tenets and principles for relational contracts. There must be a healthy level of contract negotiation and scrutiny on the terms of the contract.
NINE TENETS
Below, IACCM research has shown there to be nine critical tenets to making relational contracts work. These include:
- Communication
- Risk management
- Open problem-solving approach
- Avoiding a blame culture
- Collaborative working across agreement parties
- Gain & Pain sharing
- Common goals & objectives
- Clear performance metrics
- Pursuing a continuous improvement approach
Yes, many of these seem idealistic and philosophical. However, they are important to the approach to building strong relations with the contracting partners.
IACCM’S FIVE STEP PROCESS
Beyond tenets, IACCM also recommends five steps as a process for creating relational contracts. These are:
- Focus on the relationship rather than the deal
- Create and nurture a partnership rather than arms-length relations
- Include social norms in the relationship
- Align interests rather than avoiding and mitigating risks
- Create a flexible and fair agreement framework
DO RELATIONAL CONTRACTS MAKE SENSE?
Now, my intent in this discussion is not to focus on how bad the state of contracts is. It isn’t about chastising the philosophy of trying to capture every eventuality and possibility in the contract, in a risk reduction effort. It certainly is not to promote, recommend, or even suggest that a return to the simple handshake agreement, is enough. No, it is NOT.
Rather, there is room for contracts to improve. The Australian Naval example truly captures the idea that even in industries well known for detail scrutiny, there is room for positive change.
As a result, formal agreements and contracts must never go away. They are the lifeblood of business, that allow transactions, relationships, and commerce to work well. Also, there must always be a healthy level of contract negotiation, and scrutiny on the terms of the contract. It is important to bring consensus such that all parties agree on the important parts of an accord. But, there must also be an element of sensibility, social norms, moral business behaviors, ethics, and the notion of building a long term relationship – built into our contracts. In the end it is all about creating an equilibrium between all these things.
Does it make sense to test out a relational contracts approach? Without the ‘shadow of a doubt’ – YES!
So, is the relational contract a step back? It is a step back to using an old notion to renew our intensity of focusing on the minute details of every clause. Although it is important, relational contracts have a focus on the future – toward building positive relationships between enterprises. Progress. Check out our next blog in this series, on formal relational contracts.
Author:
Manpreet Dhillon
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