Joint ventures, strategic alliances, purchasing agreements, and other types of partnerships between organizations often begin with a great deal of promise—and a hefty amount of risk. Serious misunderstandings and opportunistic behavior are relatively common in such relationships. Formal contracts offer a method for reducing such risk, but negotiators and their attorneys are often unsure about how to write a contract that stands the test of time.
To understand how organizations can craft contracts that reduce the risk of a serious rift and help them recover from disputes, professors Deepak Malhotra of Harvard Business School and Fabrice Lumineau of the University of Technology in Sydney analyzed 102 interfirm contract disputes handled by a corporate law firm in Western Europe from 1991 to 2005. Their findings can business negotiators gain a better sense of how to write a contract that lasts.
Contract Characteristics
When weighing how to write a contract that lasts, it is useful to consider what qualities of contracts help a business partnership survive a serious dispute. In a 2011 article in the Academy of Management Journal, Malhotra and Lumineau theorize that the quantity and quality of contract terms can influence trust between the parties, which in turn influences the decision to continue the relationship or not.
The researchers note that the typical business contract includes two main types of provisions: (1) control provisions designed to prevent cheating and reneging through the threat of sanctions, and (2) coordination provisions that clarify each party’s responsibilities with the goal of reducing future misunderstandings.
Malhotra and Lumineau also identify two types of trust between business partners: (1) goodwill-based trust, or our perceptions of the other side’s intentions to behave in a trustworthy manner, and (2) competence-based trust, or our beliefs regarding the other side’s ability to meet our expectations.
Control vs. Coordination
In their analysis of the 102 disputes, the researchers found that the presence of control provisions in a contract can erode goodwill-based trust, making partners less willing to rebuild their relationship after a dispute. By contrast, the more control and coordination provisions there were in a contract, the greater the competence-based trust between parties after a breach; competence-based trust also motivates parties to continue their collaboration.
The results suggest that negotiators would be wise to distinguish between control and coordination provisions when considering how to write a contract that lasts. They may be able to enhance mutual perceptions of competence and goodwill during dealmaking by focusing more on coordination provisions and, to the extent possible, limiting control provisions. This may be especially important when you are attempting to build a long-term relationship and when future conflict seems possible, as with cross-cultural deals.
How Detailed Should It Be?
In their second study, published in the Strategic Management Journal, Lumineau and Malhotra looked at whether the level of detail in a contract affects the approach parties take to contract dispute resolution if a conflict flares up, as well as the costs of these approaches.
As any experienced negotiator knows, contracts vary widely in their complexity. Meanwhile, approaches to resolving contractual disputes also vary: they can be cooperative (aimed at understanding each other’s interests and reaching mutually desirable outcomes) or competitive (with the goal of asserting one’s legal rights and “beating” the other party), or somewhere in between.
In their analysis of the same 102 contract disputes, Lumineau and Malhotra found that the higher the level of contractual detail, the more likely parties were to use a competitive approach to conflict resolution. However, when even highly detailed contracts focused more on coordination than control, parties were more likely to use a cooperative approach. In addition, disputants incurred higher legal costs in more competitive negotiations than in more cooperative ones. Finally, a cooperative approach was most effective at reducing costs when one party was much more powerful than the other; when parties are more evenly matched, the discrepancy may fuel greater competition.
In this study, clauses aimed at coordination—clarifying roles, responsibilities, and so on—promoted more constructive, cost-effective negotiations than control clauses, such as specifying noncompliance penalties.
Overall, this research shows the importance of thinking carefully about how to write a contract when trying to negotiate a deal rather than simply agreeing to the spirit of the deal and leaving the details to their attorneys.
What other advice do you have regarding how to write a contract that lasts?
We have found that rigorous discussion around What Ifs and how conflict will be managed in the event that it occurs. Much easier to discuss management of disputes prior to becoming embroiled in one. Than include dispute resolution clauses to reflect the outcome of those discussion. This is cheap litigation insurance!