How Better Contracts Can Strengthen Strategic Partnerships

[MUSIC] Deals not just another payroll platform, it's one your team might actually enjoy. HR, IT and payroll together finally. Built in-house, built for peace of mind. Visit d-e-l.com/hbrpodcast. [MUSIC] On May 20, join me at HBR's annual leadership summit with master classes, interviews with the CEOs of AT&T in Mattel, and an interactive case discussion led by Harvard Business School Professor, Kareem Lacani. This all virtual day will give you practical frameworks to lead with purpose and strengthen culture across your organization. To learn more, go to hbr.org/leadershipsummit, see you there. [MUSIC] Welcome to HBR on leadership. Case studies and conversations with the world's top business and management experts, hand selected to help you unlock the best in those around you. I'm HBR senior editor and producer Amanda Cursey. [MUSIC] If you've ever managed a long-term partnership, you know how quickly a contract that once felt solid can start working against you. Circumstance has changed, and suddenly what was meant to create certainty is driving tension instead. In this 2019 episode of HBR IDA cast, host Kurt Nikisch talks with two experts who argue for a different approach, one that helps leaders build agreements strong enough to handle the unknown. [MUSIC] 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. And that's why affirms 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 guest 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 simply outlines guiding principles of the strategic partnership. All of her heart is a Nobel Prize-winning economist at Harvard University and Kate Vitastic is faculty at the University of Tennessee. They're the co-authors, along with Swedish attorney David Friedlinger of the HBR article, A New Approach to Contracts. Kate and Oliver, thanks for being here. Thank you. Excellent. Glad to share our work with you. Oliver, let me start with you. You have spent a good deal of your career studying contracts, and you want a Nobel Prize for some of this work. I'm trying to figure out how to make contracts more effective. When did you realize that the traditional classic contracting approach couldn't be approved upon and something new needed to be tried? 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 standard economics assumptions that everybody was rational and self-interested, because that's what economists like to assume. But it turned out that although I made some progress on that with co-authors, 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. You know, 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, or I decided, that it was, behavioral things like a concern with fairness and that kind of thing, which was not the traditional approach, but it was a hard sell, because although the 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 Friedlinger who invited me to come and talk about my work, and it resonated with what he was doing in practice, part of which was with Cade. And so we joined forces. It was serendipity, actually. That's great. So why is the best contract not good enough? It turns out writing good contracts is very difficult. When we're talking about long-ish 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. So if you think about it from a business person'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 in the Canadian government, one of the health authorities, and their doctors, the hospitalist. The government passed a law for medical assistance 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 doctor. So how are we going to deal with this new situation that no one thought about? And so you get in this back and forth tip for tat. Well, that's not in the contract. They'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 tip for tat. And people get frustrated with that. And it's no one's fault. Business is dynamic. 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? What we really are 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. 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 a-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 invent 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 is the rule book of the relationship. So when business happens, how do we apply these guiding principles? Then we actually align the expectations and interest. We get to the meat of the deal and then we put in 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? It strikes me having a job is a relational contract in the sense that you really don't have a lot spelled out. And it's very spare when you look at 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 specific. And that's maybe one of the reasons why that it's more ambiguous, but that's also part of the strength of it. 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 arms, 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. And so it's the same with a supplier that you're invested in for a long time and a business who does not want to have to switch suppliers. Yeah. And dependency, you talked about switching. In the perfect world, we have zero switching cost. If you can just go to Amazon and just switch suppliers because you didn't get what you wanted, that's great. But in these more complex, especially service-oriented type things where you don't have a spec or you need innovation, you need that supplier to make investments on your behalf. So the more dependency, the more strategic impact, and the more risk, we can actually work together in a highly transparent manner to reduce risk, to mitigate risk, to eliminate them instead of shifting them. So your employment examples are very good one. And I think what we see In some employment situations is a corporate culture, which is very important and just ways of doing things in that company that are sort of entrenched and that protects people against bad treatment. That's just not the way we do things here. Yeah. I heard a story about WL Gore, where the managers will often say to somebody, "Is this a good deal for the supplier?" The values of the company in that sense and the company culture are built into how they try to do business. But it sounds like relational contracts help you take that kind of culture and build it into a joint agreement or into the culture of a long-term strategic relationship. Yeah. We like to use analogy that your contract is a playbook. It's not just this legal document and many people are afraid of the legal document. They want to put it in that you've heard it. We put it in the drawer, the perfect contract, and when we put in the drawer and ignore. It's also about seeing this deal as a way of creating some surplus. When the parties sit down together and talk about their vision and all that kind of thing, they are really thinking in those terms as opposed to just, "I want as much as I can get." I don't care about you. I want to minimize what you get so that I get more. It's more about how can we make the pie bigger and then, you know, and also come up with a reasonable way of dividing it. I love this idea of disruption almost of the way contracts have been done. What kind of financial benefits do you see here? Can you give some examples of relational contracts in practice where there's been a payoff like this? Yeah. For example, Dalland FedEx had been working together for eight years. So this is a computer manufacturer and a shipper? Yep. So especially back in the day, Dall manufactured computers. FedEx wasn't necessarily shipper. They were the reverse logistics supplier. So think about your Dall computer broke and it goes off to be repaired. The entire repair process, all aspects of that were with, at the time, a company named Jen Cove's now part of the FedEx family. If you look at their baseline for their cost, they had what they called a cost per box. They wouldn't negotiate, bid it out, and FedEx would always win. They're the best supplier. They're like, FedEx won again. So they try to have the hammer. So Dall being a big company could put these competitive pressures on FedEx. So yeah, I don't want to lose the work. So I'm just going to lower the price a little bit every year. Dall's demanding 2%, 3%, 5%, 10% every year. Oh, the economy's bad. We have to do this. All of a sudden you have a client that you can't live without that is actually costing you money. Exactly. And so when it gets so bad, these shading and shirking happens where you're not acting as fairly, you try to get even. And so the relationship was very unhealthy. So what did they do? So they reached out one of the executives in the supply chain, group of vice president supply chain was familiar with our research and said, we've tried other ways. It's not working. Let's pilot this vested methodology. Give it a try. And so they had a two day offsite meeting. And in Dallas, it was kind of a funny story. It wasn't in Austin and it wasn't in Nashville. They met in a neutral place and discussed trust and why their contract wasn't working. And so they committed then that they would look at their relationship very differently. And they followed the process in nine months. They had reduced the cost, the total cost of ownership reflected through the cost of drugs by 40%. Right. It is absolutely amazing. And why can they do that? It's because now they're being transparent. So it's not FedEx looking at just their four walls and Dell looking at theirs. They're looking at the total cost of ownership. They're looking for all this, the friction and they're developing co-creating projects to eliminate the friction. We call them ponies. Right. Everybody wants to find a pony when they're a kid. They're saying, wow, what if we could go do these big ideas? How would we work together to do that? So they're contracting around the behaviors. It builds trust. So every single metric that they looked at improved. Oliver, when you hear Kate talk about that, you hear a lot of emotion, right? In this business relationship. Right. So what stops people from doing this? Very good question. I think, you know, they need to be nudged into it. I mean, it's, I would like to think that people just haven't realized it. Jumping in here, because this reminds me a lot of the old adage, you know, in the day nobody got fired for buying IBM. It's like, nobody got fired for saying, let's have the lawyers look at this. Yes, that's right. Very good. Yes. It's the way they've done it. And I've even been involved in legal cases as an expert where I've seen contracts that very, very sophisticated firms write with each other, which I find incomprehensible. I define it, but you know, it's just not clear what on earth it all means. So, you know, why do they do it that way? I mean, it does it really have to be done that way. I think the answer is no, but I think people haven't systematically thought about alternative. So what I think is potentially exciting about the work we're doing is because it combines practice and theory. I think it's that combination which may get people to take this stuff more seriously. Yeah. What? Yes. I have a, you know, saying, you know, the only person that likes change is the wet baby. And the better we are at something, the more expert we get, the less we want change. These companies have policies. You must use our standard terms and conditions. You need a special waiver. You've got politics and processes that are wrapped in dogma of 20, 30, 50 years. So where people have chased the perfect contract, it's only until it's impossibly broken that they're willing to change. You know, Dell, one of the executives says, this is radical common sense. How come we don't do it? We have policies that actually prevent us from it. Yeah. It's as fluffy. Contract for the relationship, really. Where's my statement of work? Yeah. What about, let me ask a lawyer question then here. What happens if this goes to court? Like how do you say that somebody didn't follow those guiding principles? So fantastic question. Because it's your playbook and it's the mechanisms for the relationship, we find it actually keeps people out of court because now they have a way of solving problems. They have an expectation to put the elephant in the room, to be transparent, to be honest, to act consistently, to accept the fact that, you know what, business will happen. We will be in disputes. So rather than then, then fight it, we're going to embrace the fact that we have to have mechanisms to get through this and to stay in economic equilibrium. The deal is not about the price for the point in time. It's about the relationship and how we unlock the potential of that relationship and solve problems because it will happen. And one of the things that Kate and David and the others have found is that the parties will actually refer to the guiding principles. So you know, I'll say, or you'll say, look, we're in this situation, wasn't covered by the contract, and you agreed to be equitable or to be loyal or to show this. And I'm out of forgotten that I did say that, but when you point to it, this is one of the reasons it's good to have it written down as part of the contract that you can point to it and I'm going to say, ah, that's true. I did do that and now I'm going to therefore adjust my behavior. And that can keep us out of litigation. But the other thing is, if you imagine going before a judge or a jury or whatever, I mean, the fact that we use these words, they can take those into account in deciding what the right outcome is. So in that respect, these things are potentially enforceable. But personally, I think their main role is when we're resolving the things ourselves. Yeah, you're forced to say, this doesn't feel equitable to me. Yeah. For these reasons. And you have to talk through that problem. Right. And you commit it to transparency. Yeah. I can check your numbers. You can check, right? And so it creates an environment that's very conducive to work on the optimal situation. So in these contracts, you know, we call them vested because you're vested in each other's success, the best outcome is when we create the optimal solution, we expand the pie, we share the pie. Or if it's a losing situation, we lose together or we win together. You're far in a better situation, if you're in the same boat, both bailing, instead of one party winning at the other parties expense, then you start to get crazy behaviors. Yeah. That just their exponential in cost and psychological damage. Does this work across country lines where legal relationships and laws get even more complex? Yeah. Actually, most of the deals that we see are very large complex deals. Maybe global in nature, definitely cross country, tell you the Swedish telco, cross-nordics, so different laws. And the more complex it is, the more that this makes sense. Yeah. Corporate culture can trump national culture. Because people have asked me, I don't know, can this work, let's say, between the American company and the Chinese company or an American company and the Indian company? And I think your feeling is, or David's feeling is, yes, it can. Yes. You can activate these norms, even if people come from different backgrounds. Absolutely. Culture, country culture does play a sum, regards. So the Nordics, for example, much more into these kinds of behaviors. You know, when we teach a class over there in the Nordics, they go, wow, of course we should have been writing our contracts this way. But in the US, it's more, this is not the way we've done it. You have a company ethos that says, innovations important to me, yes, we're in these relationships. We need to move fast. We need to do this. It's our culture to embrace flexibility. And they've only had the traditional way. You know, don't fight the buggy whips. You're in buggy whip manufacturing mode. The automotive industry is coming. We're in the 21st century and we have to embrace a more dynamic way to address these complex contracts. Oliver and Kate. Thanks so much for coming on the show to talk about this. You're very welcome. Excellent. And as we like to say, change the world one deal at a time. That's Oliver Hart, professor of economics at Harvard University and Kate Vitassick, faculty at the University of Tennessee. There are co-authors, along with the Swedish Attorney David Friedlinger of the HBR article, a new approached contracts, how to build better long-term strategic partnerships. HBR on leadership will be back next Wednesday with another hand-picked conversation from Harvard Business Review. If this episode helped you, share it with your friends and colleagues and follow the show on Apple podcasts, Spotify, or wherever you listen to podcasts. And while you're there, consider leaving us a review. When you're ready for more podcasts, articles, case studies, books, and videos with the world's top business and management experts, find it all at hbr.org. This episode was produced by Mary Doe and me Amanda Cursey. On leadership's team includes Marine Hook, Rob Eckhart, Tina Toby Mack, Erica Trexler, Ramsey Cabaz, Nicole Smith, and Ann Bartholomew. Music is by coma media. Thanks for listening.