Eight to Late

Sensemaking and Analytics for Organizations

Some pitfalls of contracts

with 5 comments

Introduction

Individuals or organizations who have agreed to work together often formalize their agreement through contracts. One of the main functions of such contracts is to reinforce trust between the two parties – i.e. to assure each other that they will do as they say. Another function is to reduce risk. In an article published in the May 2009 issue of the Harvard Business Review,  Deepak Malhotra argues that in some situations contracts end up destroying trust and/or increasing risk. In this post I present the pitfalls he discusses,  along with comments and observations drawn from other sources.

Three pitfalls of contracts

The first point Malhotra makes is that  overly detailed contracts can reduce trust by preventing spontaneous displays of good intentions. Here’s how the reasoning goes: extremely detailed contracts are a sign that the two parties do not trust each other fully (hence the need to write down every possibility that comes to mind). In such situations, the relationship between the two parties tends to be managed by contract, which acts as a disincentive to do things that aren’t written down.

More generally, it is obvious that trust cannot be created by writing it into a contract. At best, contracts might help in reinforcing trust that is built up by other means. How does one build up trust? Well, there are a couple of ways that come to mind;

  1. Through consistent actions that demonstrate good intentions.
  2. Through building relationships between individuals in the two parties.

Neither of these behaviours can be mandated by contract, but a detailed, hard-to-interpret contract can very easily discourage them.

The second point he makes is that rigid contracts can increase risk by discouraging adjustments down the line. Those who draw up contracts cannot be aware of all the possibilities that might unfold as a project progresses (a consequence of bounded rationality). For this reason, contracts should be flexible enough to permit changes as new information comes to light. Ironically, many organizations view rigid contracts as a means of reducing risk. Most often this is because the parties involved tend to underestimate the uncertainties in their environment.  The point here is to put off contractual decisions regarding uncertain elements of the agreement, but to put in place arrangements to deal with some of the foreseeable outcomes.  As  Malhotra puts it, “Wisely structured contracts postpone agreement on terms that would be more effectively handled after more information is available, and they include contingencies commensurate with the current level of uncertainty.

As I’ve written in my post on outsourcing and transaction costs, parties involved in contractual agreements need to take a farsighted view. Such a view would acknowledge the tension between the need for uncertainty in the face of an uncertain world.

The third point Malhotra makes is that incentives in contracts can signal mistrust. This often happens in contracts between high performing individuals and organizations, where a large portion of the individual’s compensation is tied to performance. Such an arrangement can actually end up demotivating the individual. How so? Well,  employee performance in knowledge-related work such as programming, is directly related to intrinsic motivation – i.e. the internal drive (or inclination) to do the assigned work.  Further, as I have discussed in this post, intrinsic motivation has more to do with interesting work than with tangible rewards or incentives.  More to the point, intrinsic motivation cannot be fostered or enhanced by contract. So, in cases where one is dealing with high performers, a better strategy might be to  empower them to make decisions on how their work gets done or , where possible,  matching assignments to  professional interests and aspirations.

Summarizing

Contracts are part and parcel of cross-organisational agreements. They are designed, among other things, to reinforce trust and reduce risk. If one isn’t careful, however, they may  do just the opposite:  contracts that  are overly detailed or  overemphasize monetary incentives can end up reducing trust and increasing risk.

Written by K

January 22, 2010 at 6:28 am

5 Responses

Subscribe to comments with RSS.

  1. K,

    The quote “there are three kinds of people in mathematics, those that can count and those who can’t”

    The profession of contracts management – at least here in the US, has a certification process.

    Most of the examples I hear about with the outcomes you describe started with a BAD contract, written by people with no business writing contracts.

    This of course doesn’t solve the problem, but like other process based problems, the solution starts by not doing the wrong thing then asking how to fix it.

    Like

    Glen B Alleman

    January 23, 2010 at 3:55 am

  2. Glen,

    Fair point: it ought to be obvious that contracts should be flexible and farsighted to allow for uncertainty and bounded rationality. Unfortunately, this is often forgotten in practice. As Williamson writes in this paper:

    “…all complex contracts are unavoidably incomplete, on which account the parties will be confronted with the need to adapt to unanticipated disturbances that arise by reason of gaps, errors, and omissions in the original contract…”

    I’ve written about this in more detail in a post on outsourcing and transaction costs.

    Regards,

    K.

    Like

    K

    January 23, 2010 at 12:35 pm

  3. K,

    You have it. I’m managing contracts for gvt projects here and we have detailed contracts but most people still manage to rook them, resulting in a poor performance overall.

    Another complication seems to be staff in large orgn shifts every 2-3 years. This does not permit personal relationships to be set up nor does the client body have instantaneous recall of background/ history of changes/ increase in scope of work etc. Hence they lose again, despite strong contracts.

    However, looking at the lessons learnt portion, govt orgns cannot seem to initiate sweeping changes in procurement processes, even based on their feedback.

    And yes, these contracts make you spend more time in corresp than in actual delivery of work or design etc!!

    Like

    Narendra

    January 26, 2010 at 10:37 pm

  4. Narendra,

    Thanks for sharing your experiences with managing contracts on government projects. An approach that’s catching on in Australia – particularly on large government initiatives – is project alliancing. I hope this will be the way of the future. But perhaps that’s being a tad optimistic?

    Regards,

    K.

    Like

    K

    January 27, 2010 at 8:33 pm

  5. […] theory, I suspect that the respondents may have glossed over difficulties –  see my post on some  pitfalls of contracts for more on […]

    Like


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: