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Overcoming contractual incompleteness: The role of guiding principles

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Via VOX EU

Contracts for complex outsourcing and supply-chain deals are challenging to write and vulnerable to bad behaviour. Rather than recommend that each party hire an army of sophisticated lawyers to anticipate and litigate the eventualities of an incomplete contract, this column explores a different approach. In a ‘Vested’ contract, each party agrees to shared goals, guiding principles, and structured communication to fall back on when conflicts arise. Used by a growing number of organisations worldwide, Vested contracts build trust and encourage parties to respect one another’s interests, facilitating communication and problem-solving. 

The future is uncertain, making contracts in complex outsourcing and supply-chain deals challenging to write. The traditional remedy is either that each party hire sophisticated lawyers to anticipate as many eventualities as possible and include them in the contract, or that they vertically integrate (Coase 1937, Williamson 1975, Grossman and Hart 1986). Theoretical literature also suggests that parties overcome contractual incompleteness by making observable information verifiable through the use of revelation mechanisms (Maskin and Tirole 1999).

We argue that there is a better approach in some situations, one used by a growing number of organisations worldwide, including the Canadian government, Dell, Intel, and the Swedish telecommunications operator, Telia Company. In this approach, known as ‘Vested’, parties accept that their contract will be incomplete, but they adopt shared goals, guiding principles, and structured communication as ways to resolve that incompleteness. The organisations using Vested report significantly improved results – the new approach has helped them to overcome long-standing obstacles and frictions that have proven hard to resolve through traditional contracts.

In our study, we explain how and why the new approach works (Frydlinger and Hart 2019). Contractual incompleteness implies that events not covered by the contract may occur, and that the contract may be open to more than one interpretation. In both cases, the parties will have some discretion to fill in gaps of the contract. If the final outcome is seen as unfair by one or both of the parties – which is quite likely given that both are subject to self-serving biases – there will be bad feeling or ‘aggrievement’ (Hart and Moore 2008). Aggrievement can lead to several types of deadweight losses. First, the aggrieved party may engage in ‘shading’ behaviour, punishing the other party by withholding favours out of anger, even though this does not increase the withholding party’s payoff. Second, the aggrieved party may ‘shirk’ by performing within the letter rather than the spirit of the contract so as to recover some of the profit he or she feels entitled to at the expense of the other party. Third, the aggrieved party may have to ‘eat’ the aggrievement and incur psychic costs. Finally, the parties may have to expend time and resources ‘placating’ the aggrieved party in order to eliminate the aggrievement and any counteractions. 

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In all of these cases, deadweight losses will hinder the relationship going forward.  We argue that the parties can mitigate these losses by adopting guiding principles as part of their initial contract –  such as equity, loyalty, and honesty – and agreeing to communication processes to avoid future misunderstandings. Guiding principles and communication can help when an eventuality not anticipated by the contract arises, giving the parties a way to deal with the new situation. For example, agreeing on a fair and reasonable outcome may be relatively easy if the parties have adopted a loyalty principle such as the one included in a contract between Vancouver Island Health Authority and South Island Hospitalists, which says “we will treat the other party’s interest as having the same importance as our own”. Because principles of loyalty, equity, and honesty rest on strong social norms, we believe they are likely to work better than abstract revelation mechanisms; it is more accurate to call the guiding principles ‘activated’ than ‘chosen’ by the parties. We report on case studies and other deals to show how this approach has worked, two of which we describe here. 

Our first case concerns the Vancouver Island Health Authority’s contract with South Island Hospitalists, a group of doctors in British Columbia, to provide inpatient care. Prior to 2016, the parties had a conventional contract that was not working well. In 2010, for instance, the service model changed, causing family practitioners to no longer care for their patients in hospitals. As a result, the hospitalists’ workloads soared, hospitalists became fatigued, and many felt that they could not provide safe, high-quality care. Feeling that the Health Authority had implemented the new service model without adequate regard for their work, some hospitalists responded with a shading/shirking action – refusing to admit patients from the emergency room, which was required to facilitate flow into the hospital. This relieved their stress but was inefficient.

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After 2016, the parties switched to a Vested model, including the adoption of guiding principles, which improved matters considerably. In interviews, participants report that the guiding principles have provided them with a common language and a ‘platform’ on the basis of which unexpected events can be discussed and dealt with in a fair manner. They report frequently bringing out their statements of guiding principles, discussing and ‘reactivating’ them. For instance: at about the time the Vested contract was written, a Canadian law legalising medical assistance in dying went into effect (Frydlinger et al. 2019). In the past, battles would have ensued about whether or not the new services were within the scope of the existing contract. Under the new approach, a spirit of “How can we fairly solve for this given our statement of intent? And how can we do this in a respectful manner for the benefit of the patients and the system in which we work?” guided the process. An agreement on how to change the pricing model to include the new services was reached quite easily.

Our second example concerns Accenture (a multinational professional services company that provides services in strategy, consulting, digital, technology and operation), which contracted with ISS (a workplace experience and facility-management service provider) to manage its Dutch facilities, including catering services. Prior to entering their Vested contract, the parties had a performance-based contract whereby ISS was compensated according to whether it met key performance indicators (KPIs). The contract was incomplete in the sense that it gave Accenture some discretion in deciding whether the KPIs were met. This led to tension. Based on interviews, it seems that Accenture used the discretion opportunistically. Accenture expected ISS to perform above the minimum levels set in the contract, and tended to give more negative scores on the KPIs if ISS did not meet those expectations. ISS responded to this shading/shirking behaviour by engaging in such behaviour itself. It ‘gamed the system’ by ensuring high performance during the periods when the KPIs were assessed. The interviewees found the tit-for-tat behaviour by Accenture and ISS frustrating and inefficient. 

One interviewee described an incident that triggered tit-for tat behaviour. The number of customers eating meals increased. According to the contract, ISS was entitled to a larger payment because the number of ‘tickets’ had risen. Accenture felt that it was unreasonable for ISS to receive more, since they believed that ISS’s costs had not increased. ISS disagreed.

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In 2017, both parties agreed to adopt the Vested model, which improved matters. Both parties report that the guiding principles have given them ‘a language’ to talk about and deal with challenges. The guiding principles have helped the parties build trust, which has decreased tension levels. According to interviewees, the parties now take each other’s interest into account, which facilitates communication and solving problems. The gaming of KPIs seems to be a thing of the past. 

Finally, while we believe that informal agreements about guiding principles can be helpful, we want to emphasise the importance of formalisation. The signing of a contract has significant symbolic meaning. Though it may be challenging to litigate the breach of a guiding principle, we believe that parties will be more reluctant to commit a breach if the guiding principle is formalised. Formalisation is also useful in the eventuality that the individuals who negotiated the original deal are no longer the ones overseeing it.

Caution should be exercised when drawing strong conclusions based on a small number of studies. But we believe that the reported results provide support for our claim that shading and other deadweight losses occur under standard contracting, and that adopting guiding principles such as loyalty and equity can mitigate these losses. Theory, empirical work, and experiments are all promising directions to further clarify the role of guiding principles in overcoming contractual incompleteness.

References

Coase, R H (1937), “The Nature of the Firm”, Economica 4(16): 386-405.

Frydlinger, D and O Hart (2019), “Overcoming Contractual Incompleteness: The Role of Guiding Principles”, Harvard University working paper.

Frydlinger, D, O Hart and K Vitasek (2019), “A New Approach to Contracts”, Harvard Business Review, September-October.

Grossman, S J and O Hart (1986), “The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration”, Journal of Political Economy 94(4): 691-719.

Hart, O and J Moore (2008) “Contracts as Reference Points”, Quarterly Journal of Economics 123(1): 1-48.

Maskin, E and J Tirole (1999), “Unforeseen Contingencies and Incomplete Contracts”, Review of Economic Studies 66:83-114.

Williamson, O E (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: The Free Press.


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