Desktop version

Home arrow Sociology arrow A short guide to contract risk

RISKS RESULTING FROM ATTEMPTING TO CREATE A LEGALLY PERFECT CONTRACT

The first part of this chapter focuses on legal risks in forming a contract and discusses elements of contract literacy that must be understood by every negotiator. While these elements are important in enabling you to secure a sound legal foundation for achieving your contractual goals and to avoid becoming burdened with unwanted contractual commitments, other risks arise when too much emphasis is placed on creating legally perfect contracts.

In basic terms a business-to-business contract is defined as a value-creating agreement that is enforceable by law. Lawyers traditionally have focused on the enforceability component of this definition by thinking of the contract as a legal tool as they attempt to construct airtight agreements that maximize their clients' legal rights and minimize legal risk. The lawyers' orientation is not surprising given their mindset. Lawyers are trained to look at contracts through the eyes of a judge who might eventually have to rule on a contract dispute. Thus a good contract, from the lawyers' perspective, is one that is enforceable.

While the "enforceable by law” part of the business contract definition is important and cannot be ignored, legal enforceability must be balanced with the "value-creating agreement” part of the definition. In other words, while clients want their agreements to be enforceable, they also want contracts that enable them to achieve their business goals by serving as a management tool as well as a legal tool. As law professors Ian Macneil and Paul Gudel note in their book Contracts: Exchange Transactions and Relations, "[o]nly lawyers and other trouble-oriented folk look on contracts primarily as a source of trouble and disputation, rather than a way of getting things done.”[1]

A lean contracting strategy enables managers, along with their lawyers, to minimize legal complexity in their contracts. This strategy applies lean production concepts to the "production” of contracts by asking whether company contracts can be simplified through an examination of the costs and benefits of various contract clauses. For example, the in-house legal team at the brewer Scottish & Newcastle sensed that company resources were being wasted in the contract negotiation process. Their work in developing what they called the Pathclearer approach to commercial contracting—and what we call lean contracting—illustrates the benefits that are possible from reorienting contracting strategy.

The lawyers initially asked three fundamental questions. First, what is the purpose of a contract? In answering this question, they developed a traditional definition of a legal contract:[2]

[T]he only purpose of a contract, as opposed to a general statement of what a business intends to do with its business partners, is to ensure that rights and obligations which the parties agree to can be enforced in court (or arbitration). Put even more bluntly, the essence of a contract is the ability to force someone else to do something they don't want to do, or to obtain compensation for their failure.

With this definition in mind, they realized that certain terms, including price and product specifications, should always be captured in writing and that certain types of deals, such as "share purchases, loan agreements, and guarantees,” require detailed written contracts. But they also realized that many other scenarios—for instance, a long-term relationship between a customer and supplier—call for a "much lighter legal touch.” Realizing that in these situations the consequences of forcing contractual obligations on an unwilling partner through "begrudging performance” or litigation are not attractive, they concluded that leaving long-term relationships "to the irresistible forces of free market economics [is better than an] attempt to place continuing contractual obligations on each other.” In other words, freedom of the market should dominate the traditional freedom of contract philosophy that has led to detailed written contracts.

Their second of the three fundamental questions focused on the risks associated with traditional, law-oriented contracts: "What are the drawbacks of detailed written contracts?” In answering this question, the in-house lawyers reached a number of insightful conclusions. First, "[t]he apparent certainty and protection of a detailed written contract ... [are] often illusory” and wasteful as companies pay their lawyers first for drafting contracts that only the lawyers understand and second for interpreting what the contracts mean. The in-house legal team witnessed "bizarre attempts” by lawyers attempting to reach certainty, such as "external lawyers spending hours drafting and debating the precise legal definition of beer for insertion in a simple beer supply agreement.” They also recognized the futility of trying to predict the future.

Their second conclusion was that detailed contracts generate disputes rather than avoiding them.

Without a detailed contract, business people who become involved in a dispute will generally discuss the issue and reach a sensible agreement on how to resolve it. ... However, where a detailed contract exists, the same parties will feel obliged to consult their lawyers.

Third, the complexity of such contracts causes confusion and the risk that the parties will be unable to focus on key terms because it becomes "difficult to see the wood for the trees.”

Fourth, the general law of contracts provides "a fair middle- ground solution to most issues” and "[t]he beauty of simply relying on the 'general law,' rather than trying to set out the commercial arrangement in full in a detailed written contract, is that there is no need to negotiate the non-key terms of a deal.”

Fifth, negotiating detailed written contracts is expensive in terms of management and lawyer time and delayed business opportunities.

Finally, detailed written contracts can also cause the parties to focus on worst-case scenarios that "can lead to the souring of relationships. ... [C]ontinuing business relationships are like butterflies. They are subtle and hard to capture. When you do try to nail them down, you can kill them in the process.”

The third and final question the in-house legal team asked is whether there are other ways to achieve business goals without detailed written contracts. The Scottish & Newcastle lawyers answered this question in the affirmative by focusing on the concept of "commercial affinity,” the force that keeps parties together in "mutually beneficial commercial relationships.” The alignment of the parties' interests through carefully constructed incentives, combined with the right of either side to walk away from the deal if it ceases to be economically attractive, incentivizes them to meet the other side's needs and alleviates the need for "a myriad of tactical rights and obligations in a contract.”

in summary, the Scottish & Newcastle lawyers realized that a different approach is appropriate "when the parties are in a continuing business relationship, rather than just carrying out a snapshot transaction” that might require a detailed written contract. They did not advocate a complete return to handshake agreements. For instance, "exit arrangements (such as obligations to buy dedicated assets from the supplier ...) do need to be spelled out in the contract.” But by addressing the three fundamental questions, they realized that in many other situations leaner contracts were possible.

The company's Pathclearer approach in a continuing business relationship is illustrated by the lean contract that the company negotiated with a service provider. The two parties originally had a ten-year contract that ran over 200 pages. During contract renegotiation, they substantially reduced the size of the contract through the Pathclearer approach by giving each party the right to terminate after 12 months' notice—a mutual "nuclear button.”

By giving ourselves the ability to terminate at any time, we avoided the need to have to negotiate detailed terms in the contract. ... This is a much more powerful way of influencing the service provider than a technical debate over whether they were complying with the words set out in the contract.

Even when parties conclude that a detailed written contract is necessary, they might eliminate certain provisions that create inefficient contract negotiations. For example, Microsoft included an indemnity provision in its contracts that caused many contract negotiations to last an additional 60 to 90 days because customers did not like the clause. Microsoft softened the provision after realizing that the benefits of the clause were minimal in contrast to potential costs that included reputational costs (resulting from confrontational negotiations), resource costs (lawyer and management time) and cash flow costs (caused by delayed sales during the additional two to three months of contract negotiation).

In describing and commenting on these costs, Tim Cummins, CEo of the iACCM, concluded that "[r]isk management is about balancing consequence and probability. Here is an example where consequence was managed without regard to probability—and as a result, other risks and exposures [such as reputational and resource costs] became inevitable.”[3]

  • [1] Macneil, I.R. and Gudel, PJ. (2001). Contracts—Exchange Transactions andRelations. Cases and Materials, 3rd edn. New York, NY: Foundation Press, pp. vii-viii.
  • [2] All quotations in this section are from Weatherley, S. (2005) Pathclearer—Amore commercial approach to drafting commercial contracts. PLC Law DepartmentQuarterly, October-December, 39^6, available at http://www.iaccm.com/loggedin/library/nonphp/pathclearer article pdf.pdf and at http://www.clarity-international.net/documents/Pathclearer%20article%20in%20PLC-3.pdf.
  • [3] this example is drawn from Cummins, T. (2006) Best practices in commercialcontracting. In P. Wahlgren and C. Magnusson Sjoberg (Eds.), A Proactive Approach.Scandinavian Studies in Law, Volume 49. Stockholm: Stockholm Institute for ScandinavianLaw, pp. 131-47, 138, available at http://www.scandinavianlaw.se/pdf/49-8.pdf.
 
Source
< Prev   CONTENTS   Source   Next >

Related topics