How Better Contracts Can Strengthen Strategic Partnerships

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0:20Kate Vitasek: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 Kersey. 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 Kurt Nickish talks with two experts who argue for a different approach, one that helps leaders build agreements strong enough to handle the unknown.

1:09Oliver Hart: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 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.

1:48Oliver Hart: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 simply outlines guiding principles of the strategic partnership. Oliver Hart is a Nobel Prize winning economist at Harvard University, and Kate Vitasik 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.

2:27Oliver Hart:Kate and Oliver, thanks for being here.

2:30Kate Vitasek:Thank you. Excellent. Glad to share our work with you.

2:33Oliver Hart: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 approved upon and something new needed to be tried?

2:54Kate Vitasek: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, 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?

3:34Kate Vitasek: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. 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.

4:20Kate Vitasek: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. That's great. Yeah.

4:31Oliver Hart:So why is the best contract not good enough?

4:36Kate Vitasek:It turns out writing good contracts is very difficult when we're talking about longish-term relationships. So 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, you know, 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.

5:25Kate Vitasek:and their doctors, the hospitalists. The government passed a law for medical assistance in 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 in this back and forth tit 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 tit for tat. And people get frustrated with that. And it's no one's fault.

6:01Kate Vitasek:Business is dynamic.

6:02Oliver Hart: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?

6:15Kate Vitasek: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 aha 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.

7:06Kate Vitasek:Where is it we want to take this relationship? 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 as 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 and package it with our governance mechanisms. How do we stay aligned?

7:46Kate Vitasek:What are the governance mechanisms to keep us in economic equilibrium as business happens?

7:51Oliver Hart: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, you know, it's more ambiguous, but that's also part of the strength of it.

8:19Kate 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.

8:41Oliver Hart: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.

8:49Kate Vitasek:Yeah. And dependency, you talked about switching. In the perfect world, we have zero switching cost. You know, if you can just go to Amazon and just, you know, 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.

9:26Kate Vitasek:So your employment example is a 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.

9:50Oliver Hart:I heard a story about W.L. Gore where the managers will often say to somebody, you know, is this a good deal for the supplier? Like 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.

10:23Kate Vitasek:Yeah, we like to use analogy that your contract is a playbook, right? It's not just this legal document, and many people are afraid of their legal document, and they want to put it in the, you've heard it, we put it in the drawer, the perfect contracts, and when we put it 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. And I don't care about you. I want to minimize what you get so that I get more.

11:01Kate Vitasek: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.

11:09Oliver Hart:I love this idea of disruption almost of the way contracts have been done. What kind of financial benefits do you see here? And can you give some examples of relational contracts in practice where there's been a payoff like this?

11:25Kate Vitasek:Yeah. For example, Dell and FedEx had been working together for eight years.

11:29Oliver Hart:So this is a computer manufacturer and a shipper.

11:32Kate Vitasek:Yep. So especially back in the day, Dell manufactured computers. FedEx wasn't necessarily a shipper. They were the reverse logistics supplier. So think about your Dell 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 Genco's, now part of the FedEx family. And if you look at their baseline for their cost, they had what they called a cost per box, right? And so they would negotiate, bid it out, and FedEx would always win. They're the best supplier. I'm like, oh, FedEx won again. And so they try to have the hammer.

12:12Kate Vitasek:So Dell being a big company could put these competitive pressures on FedEx. And so, yeah, I don't want to lose the work, so I'm just going to lower the price a little bit every year, right? Right. Dell's demanding 2 percent, 3 percent, 5 percent, 10 percent every year. Oh, the economy is bad. We have to do this.

12:30Oliver Hart:All of a sudden you have a client that you can't live without that is actually costing you money.

12:34Kate Vitasek:Exactly. And so when it gets so bad, these these shading and shirking happens where you're not acting as fairly or try to get even. And so the relationship was very unhealthy.

12:45Oliver Hart:So what did they do?

12:46Kate Vitasek:So they reached out. One of the executives in the supply chain group, a vice president of the 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 off-site meeting. And in Dallas, it was kind of a funny story. It wasn't in Austin and it wasn't in Nashville. They met at 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 products by 40%, right?

13:33Kate Vitasek: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.

14:15Oliver Hart: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?

14:25Kate Vitasek:Very good question. I think, you know, they need to be nudged into it. I mean, I would like to think that people just haven't realized it.

14:34Oliver Hart:I'm 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.

14:45Kate Vitasek: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 defy anybody. It's just not clear what on earth it all means. So why do they do it that way? I mean does it really have to be done that way? I think the answer is no, but I think people haven't systematically thought about alternatives. 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.