Monday, November 16, 2020

Relational Contracts in a COVID-19 World

A number of years ago, I became acquainted with Kate Vitasek, a colleague in The University of Tennessee's Haslam College of Business.  She introduced me to a way of supply contracting called "vested."  Vested relationships are characterized by the following attributes that may differentiate them from traditional contractual relationships (as identified in the FAQs on the vested website):

  • "Uses flexible Statements of Objectives, enabling the service provider to determine 'how'”
  • "Measures success through a limited number of Desired Outcomes"
  • "Uses a jointly designed pricing model with incentives that optimize the overall business and fairly allocates risk/reward"
  • "Focuses on insight, using governance mechanisms to manage the business with the supplier"

When I first talked to Kate and her colleagues about vested, I remember noting for her that the vested approach sounded like a specific type of relational contract . . . .

Recently, Kate and I reconnected.  She informed me about her recent coauthored Harvard Business Review article.  It merits  promotion here.

The main point of the article is to highlight the possible advantages of relational contracting in the current environment. Here's the crux:

For procurement professionals at large multinational companies, the temptation is to use their company’s clout to pressure suppliers to reduce prices. And when the supplier has the upper hand, it is hard to resist the opportunity to impose price increases on customers. Witness how the shortage of personal protective equipment (PPE) and ventilators led to skyrocketing prices. . . .

A better alternative is formal relational contracts that are designed to keep the parties’ expectations continuously aligned. This kind of agreement is a legally enforceable written contract (hence “formal”) that puts the parties’ relationship above the specific points of the deal. The parties embrace the fact that all contracts are incomplete and can never cover all the contingencies that may occur. This time it is a pandemic. Next time it will be something else.

The coauthors conclude:

Given the uncertainty that lies ahead, it is especially important now that companies try to avoid antagonizing the members of their ecosystems. Formal relational contracts, which can turn adversarial relationships into mutually beneficial partnerships, is a proven means to such an end.

This all makes great sense to me, especially for contracting parties who have long-term relationships or are repeat players in the same market.  The article both explains the concept and offers several examples of how relational contracting can foster more collaborative relationships that enable contracting parties to "ride the bumps" in their relationship.  Specifically the parties are incentivized to work together to devise solutions to transactional problems as they arise.

The article reminded me about the relational aspects of M&A contracting and, more specifically, Cathy Hwang's Faux Contracts as well as her work with Matthew Jennejohn--including their Deal Structure article.  In Deal Structure, Cathy and Matthew write that "[r]elational contracts blend formal contract terms, which are enforceable in court, with informal constraints, such as reputational sanctions, to create strong relationships between parties." [p. 311]

Law folks and business folks should talk more often.  As the pandemic continues, parallel avenues of work like this in business and law can have important practical implications for business.  This collective body of business and legal scholarship may have significant value to both business managers and the legal advisers who represent them.  Collaboration between business and law experts can only enhance that value.

Contracts, Joan Heminway, M&A | Permalink


Great topic to address. The nugget I would add is that so often in academic environs, the macro (large) business is a focus despite the fact – in “normal” times – small business is the jobs creator, quite the individual revenue producer and had adopted concepts well ahead of the curve as a result of necessity. The tensions in a small business result in very different and very fluid business relationships. On one side, a small business is generally far more undercapitalized and working capital comes at a premium (ROI vs. ownership). On the flip-side, small business is also far more nimble for most short-term market shifts. In general, this snapshot from 2019 (Pre-Covid) is consistent with small business performance.

For instance, the vogue of the 1980’s in large business was statistical process control and “just in time” inventory. Although these were promoted as new and forward thinking concepts, small business inventories were dictated well ahead of the curve by cash liquidity needs well before large business “discovered” the concept.

In turn, the statistical process control (a method of both maximizing raw material usage and reduction of product deviation reducing errors, remanufacture, etc.) was actually developed in the United States in the 1920’s. Edward Demming played a huge role of proliferating the concepts in Japan post-WWII which was repatriated to the larger US corporations as a result of a major loss of market share by US manufacturers where Japanese manufacture (autos, electronics) swallowed markets due to their efficiencies (price and quality) driven by SPC.

Although PERT/CPM (critical path planning) was adopted at GE and other aerospace companies in the late 1960’s, the adoption of the broader concepts of what came to be known as SPC was slow to larger manufacturing businesses simply because they had the luxury of much broader capital access. Small business made the transition far earlier and far quicker simply because of more immediate demands.

In conclusion, I would state that these concepts ((1) Uses flexible Statements of Objectives, enabling the service provider to determine 'how'” (2) "Measures success through a limited number of Desired Outcomes"(3) "Uses a jointly designed pricing model with incentives that optimize the overall business and fairly allocates risk/reward"(4) "Focuses on insight, using governance mechanisms to manage the business with the supplier") are prescribed by the limitations of small business. The dynamics between the micro and the macro (small vs. large) are so distinct that small business adjusts because it must whereas for large business it is a board-level, ponderous behemoth that rediscovers the old, well trodden as “new.”

(For instance I sat in bewilderment when Jeffrey Immelt was tapped by President Obama to advise on small business (job creation). Even as succeeding history showed the almost total destruction of GE under the Immelt leadership after the “high water” mark of Jack Welch, it was breathtaking that anyone could think he would have any insight into the dynamics of small business. ).

Posted by: Tom N. | Nov 18, 2020 2:10:06 PM

Thanks, Tom N., for these wise words.

Yes, many of us in the academy tend to focus on large businesses. Often, the reason for that is that data is not available in quantities and on issues that meet the needs of academic inquiry. Nevertheless, some law academics (including yours truly!) do endeavor when we can to make observations on businesses that are not large or public or organized in Delaware . . . .

And you also are correct that the norms of relational contracting--including those associated with vested contracts--represent reality for small business in operation. Small firms must work things out with their business partners as a matter of course. It is the way they survive and thrive. I know two small business folks in the clothing and accessories design and sales industry who have told me many stories . . . .

Anyway, I wanted to acknowledge the value in your reply post and the provided links. Many thanks. Keep reminding us of what we forget . . . .

Posted by: joanheminway | Nov 18, 2020 2:24:50 PM

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