Even the most carefully worded and meticiously reviewed contracts can fall apart once they hit the reality of modern business dynamics. Oliver Hart, Nobel-winning Harvard economist, and Kate Vitasek, faculty at the University of Tennessee, argue that, when it comes to contracts, one side often ends up feeling like they’re getting a bad deal, and it can spiral into a tit for tat battle. Hart and Vitasek say that companies should instead consider so-called relational contracts. Their research shows that creating a general playbook built around principles like fairness and reciprocity offers greater benefits to both businesses. Hart and Vitasek, with the Swedish attorney David Frydlinger, cowrote the article “A New Approach to Contracts.”
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If you’ve ever managed a long-term partnership, you know how quickly a contract that once felt solid can start working against you. Circumstances change, and suddenly what was meant to create certainty is driving tension instead. In this 2019 episode of HBR IdeaCast, host Curt Nickisch talks with two experts who argue for a different approach, one that helps leaders build agreements strong enough to handle the unknown.
CURT NICKISCH: Writing a business contract is like predicting the future. It’s a series of if/then statements – if this happens, then such-and-such party is responsible for that.
The idea is that neither side really trusts the other. So a contract, backed up by the highest legal authority, gives a company something that it can put its trust in. That’s why a firm’s lawyers include every little thing they can think of.
But the one thing we know for certain about the future is that it is uncertain. The most carefully-worded, bulletproof contracts can fall apart once they hit the reality of modern business dynamics. Inevitably, when one side gets the short end of the stick, since they can’t change the contract, even subconsciously, they try to get even.
Our guests today show a better way to make complex deals between firms – a so-called “Relational Contract.” Instead of trying to spell out every scenario that could ever happen, this style of contract outlines guiding principles of the strategic partnership.
Oliver Hart is a Nobel Prize winning economist at Harvard University. And Kate Vitasek is faculty at the University of Tennessee. They’re the coauthors, along with Swedish attorney David Frydlinger, of the HBR article “A New Approach to Contracts”. Kate, and Oliver, thanks for being here.
OLIVER HART: Thank you.
KATE VITASEK: Excellent, glad to share our work with you.
CURT NICKISCH: Oliver, let me start with you. You have spent a good deal of your career studying contracts and you won a Nobel Prize for some of this work – trying to figure out how to make contracts more effective. When did you realize that the traditional, classic contracting approach couldn’t be improved upon and something new needed to be tried?
OLIVER HART: Well, for me it was an interesting journey. I actually – most of my work didn’t have these notions of fairness in it. I was approaching this under the sort of standard economics assumptions that everybody was rational and self-interested.
That’s what economists like to assume. But it turned out that although I made some progress on that with coauthors, and that’s really the work that was recognized by the Swedes, I eventually hit a brick wall because in a way it’s like what you were saying: Can’t you always do a little bit better with a standard contract? Why can’t you get all the way?
At some point I realized something must be gumming up the process. And I realized it was – I decided it was behavioral things like a concern with fairness and that kind of thing. Which was not the traditional approach. It was a hard sell. Because although behavioral economics has become very big, it’s not so much the case in the contracting area.
The good news for me was that when I went to Sweden to get the prize, there was this Nobel week where you get all sorts of invitations – far too many, you can’t do. But one that looked attractive was from a Swedish law firm. And it was David Frydlinger who invited me to come talk about my work.
And it resonated with what he was doing in practice, part of which was with Kate. And so we joined forces. It was serendipity actually.
CURT NICKISCH: That’s great. So why is the best contract not good enough?
OLIVER HART: It turns out writing good contracts is, is very difficult. When we’re talking about longish term relationships, or anything other than a simple transaction, which is over fairly quickly. However much time you spend trying to think about all the things that can happen, you’re never going to cover them all.
KATE VITASEK: So, if you think about it from a businessperson’s perspective, business happens. We live in a dynamic world, and it is going to change. So, no matter how much you think about what you want to write in that contract, it’s obsolete day two, day 20, two months in, two years in.
So, a great example would be in the article we talk about Island Health and the Canadian government, one of the health authorities, and their doctors, the hospitalists. The government passed a law for medical assistants and dying. No one knew that that law was going to happen. Well, that put a new workload on the doctors.
It wasn’t in how they paid the doctors, so how are we going to deal with this new situation that no one thought about? And so, you get into this back and forth tit for tat. Well, that’s not in the contract, I’ll have to charge you for it. And you get in these little battles, and if you don’t manage them fairly it creates a negative cycle of tit for tat, and people get frustrated with that. And it’s no one’s fault. Business is dynamic.
CURT NICKISCH: So, you together have helped develop a framework and a toolkit for businesses to create these kind of relational contracts. What’s important to understand about this kind of contract?
OLIVER HART: What we are really arguing in this article is that a better approach is to acknowledge that you can’t cover everything in the contract, and try to figure out procedures you’re going to use to deal with situations which the contract doesn’t cover.
KATE VITASEK: And the process is equally as important as the end point. So, step number one, is laying the foundation, and having a candid discussion about what type of relationship do you want. Do you want to have a transactional relationship, or do you want to have a relational contract? And they are different animals.
And once you have this ah-ha moment that we’re in a relationship, and I need to approach how we get to the contract through the lens of a relationship, then and only then, can they continue with the process to co-create a shared vision.
Where is it we want to take this relationship. How, what do these guiding principles mean? The guiding principles are social norms. We didn’t event them, right? Honesty, reciprocity, they’re known and well researched social norms that are proven to make societies work better.
All we’re doing is having the parties manifest them as the rulebook of the relationship. So, when business happens, how do we apply these guiding principles. Then we actually align the expectations, and interests, we get to the meat of the deal, and then we put, and package it with our governance mechanisms. How do we stay aligned, what are the governance mechanisms to keep us in economic equilibrium as business happens.
CURT NICKISCH: It strikes me having a job is a relational contract in the sense that you don’t really have a lot spelled out. It’s very spare when you look at, you know, what your hiring contract says, and your work can take you in many, many different directions. And that’s a relational contract that just isn’t too, too specific. And that’s maybe one of the reasons why that, you know, it’s more ambiguous, but that’s also part of the strength of it.
KATE VITASEK: Right, and when your personal goals are aligned with the business, you can do some really cool and innovative things. You’re passionate about your job. And if you’re treated as, you know, arm’s length, you’re just a transaction, and I’m paying you per hour, you tend to get disconnected with that work, and you lose a lot of the innovation, the passion, the commitment for that.
CURT NICKISCH: And so, it’s the same with like a supplier that you’re invested in for a long time, and a business who does not want to have to switch suppliers?
KATE VITASEK: Yeah, and dependency – you talked about switching – in the perfect world we have zero switching costs. You know, if you can just got to Amazon, and just switch suppliers because you didn’t get what you wanted, that’s great.
But in these more complex, especially servic