Working without a safety net: Lessons for better relational contracting

How would you draft a contract you knew you could not enforce?

Why would you bother?

Contracting without the safety net of enforcement happens a lot.  In emerging markets, local courts frequently fail to deliver justice.  International arbitration may take too long, cost too much, or yield an uncollectible award.  Even in developed legal systems, remedies may fall short.  Smaller claims won’t bear the cost of litigation.  In many large cases, like original-equipment-manufacturer (“OEM”) procurement, remedies cannot make a wronged purchaser whole for breaches such as untimely shipment or defective components.[1]

Working without a safety net therefore represents more than an intellectual exercise.  Such work does, however, teach lessons that lead to better deal making - and better relational contracting. 

My own education started as an American lawyer working in Russia during its wild 1990s, when bankers were getting blown up on Main Street at rush hour.  As I would tell Western clients sourcing deals there, “The contract will remind both sides of what they agreed to, but it won’t make the Russian side do anything it doesn’t want to do.”

“OK,” the client would answer, “Now, what?”

Here’s what.

Contracting in low-enforcement environments teaches you to put first things first. 

• Have you clearly defined your own business goals?
• Do you understand the other side’s?

For example, a Nordic client operated timber mills.  The client found a recently privatized mill near St. Petersburg, Russia.  It was outfitted with the latest West European equipment, but, the mill’s managers could not run the equipment right.  My client estimated that he could quickly make the mill three-to-five times more productive.  He asked for a due diligence report on the mill’s privatization.  With a favorable report in hand, he would try to buy the mill.

I told him, “No,” for two reasons. 

• First, the report would cost $100,000 without providing a clean bill of health; Russian privatization had been so messy that no thorough report ever gave a clean bill of health.
• Second, making the mill that valuable would lure some gangster into challenging the privatization before a crooked judge and taking the mill.

Lacking a safety net made us think harder.  At root, the client’s goal was not buying and operating the mill, but arbitraging the opportunity arising from more skillful use of the equipment.  Finding a politically connected regional enterprise that could buy and keep the mill, we offered -- for an up-front finder’s fee and a monthly consulting contract -- to teach the enterprise how to run the equipment.  That’s what happened.

Defining business goals represents only the first step.  In the case of the mill, the client needed a partner with compatible goals.  Then, we had to craft a business relationship that would last long enough for the client to achieve his goals.

Relationships matter.  In low-enforcement environments, they are everything.  The concept “relational contracting” hammers this point home.  Contracts serve business relationships, not the other way around.  So, well-drafted contracts begin with recitals explaining the parties’ business goals and existing or desired relationship.  Without such context, the contract won’t make sense to someone unfamiliar with the deal.[2]

Steps for building relationships vary from place to place and industry to industry.  Some Americans who are sourcing deals overseas don’t realize how unusual American business culture can be. 

For example, the United States represented the first continental-size common market since at least the Mongol Empire, and perhaps since ancient Rome.  Taking advantage of a market this size means dealing with strangers.  But, such dealings require enforcement to a degree that does not exist everywhere.  U.S. business culture leads many Americans to think that the purpose of negotiations is executing a contract.  This is not the global norm.  In many cultures, people negotiate to find out what kind of person sits across from them.  With that knowledge, they know what kind of relationship they will have, and, consequently, what kind of bargain they can strike.

Here’s case in point.  A global food maker asked its U.S. distributor to take over a contract with an emerging-market sub-distributor.  In flew a “good ol’ boy” from Springfield, Missouri, U.S.A., who boasted a blunt style: “I look you in the eye.  I shake your hand.  My word is my bond.”  To demonstrate goodwill, he unilaterally offered the sub-distributor an extra penny per unit, worth $300,000 over the life of the contract.

The sub-distributor countered by demanding an additional $2 million in concessions.  Stunned, the “good ol’ boy” asked me what had happened.  I told him, “You approached the other side in a spirit of good faith and fair dealing.  Now they think you’re weak and want to see how far they can push you.  To fix this relationship, take the penny off the table.”

Of course, not every negotiating wound is self-inflicted.  Nor will every negotiation lead to a viable relationship and a signed contract.  Nor should they.  Sometimes the best deals are the ones you don’t do.

So, how can you avoid wasting your time with the wrong party or entering into deals with the wrong partners?

Here are some rules of thumb, especially when operating without a safety net:

• Know the other side

This rule sounds obvious.  But obvious is not always easy or implemented.  Businesses should conduct standardized due diligence on potential partners.  However, low-enforcement jurisdictions might not generate the usual red flags, because reporting (governmental and private sector) might be weak, with dispute resolution taking place privately.  Clients might therefore need outside investigative services, or atypical information sources, like trade-credit insurers.  Best-practices ask whether, in each case, to augment or adjust standard diligence.

Due diligence also looks beyond the absence of red flags.  Does the other side have a track record of solid, long-term, mutually beneficial relationships?  Nothing will be more telling about your prospects for a good relationship.

• Bake into the deal the parties’ ongoing need for each other

One-off deals, or deals in which one party’s contributions are front-loaded, create unstable relationships.  One-off deals discourage investment in the relationship.  All other things being equal -- repeated dealings, or prospects of repeated dealings -- offer better odds of success.

And speaking of front-loaded deals, human nature leads the other party, over time, to downplay the first party’s early contributions.  Temptations to squeeze out or cheat the first party will grow.  Numerous foreign investors in emerging markets have found themselves locked out of their own businesses by their local partners.  In any jurisdiction, managers controlling operations often force owners to sell at fire-sale prices.

Avoiding such dilemmas means structuring relationships of ongoing mutual need.  So, key technology might be licensed but not contributed, a rift between the parties leading to license revocation or non-renewal.  Key assets or proceeds might be held in a country with strong rule of law.  For export-related activities, one or both parties might own an offshore entity with exclusive rights to buy and resell output, giving some possibility to block or seize shipments made “out the back door.”  One cagey customer of a Chinese OEM brings the stamping molds to the OEM’s factory every morning and takes them home every night.

• Make dealings transparent

Transparency not only deters defection or breach by the other side, but it also helps prevent negligent or innocent mistakes.

Too often, people dealing in unfamiliar territory leave their common sense at home.  One successful U.S. financial advisor invested money from family and friends in a string of emerging-market street-food kiosks.  He ignored counsel to appoint the local bookkeeper, outside accountant, and outside lawyer.  After 18 months, the local partner stopped returning calls.  The set-up had been a scam.  The local partner had falsified reports of activity, even sending fake photographs of the kiosks.  The advisor lost his license and faced lawsuits from his relatives and closest acquaintances.

Transparency does more than deter or catch thieves.  Often, a party cannot afford negligent or innocent mistakes by the other side.  OEMs can go to extraordinary lengths to monitor and guide suppliers’ performance.[3]  That’s because switching suppliers may be difficult and costly.  Also, potential damages from late or defective parts lie beyond many suppliers’ ability to recompense.  Fallout from defective Takata airbags, for example, reached $30 billion dollars.[4]

• Raise the reputational cost of cheating

A business’s most valuable long-term asset is its reputation.  How reputational concerns bond behavior depends upon timing, circumstances, and the nature of the industry.

In tightly knit fields, like U.S. diamond and cotton exchanges, reputational concerns drive contract performance and voluntary resolution of disputes.  Filing lawsuits is almost unheard of, since bad buzz alone will drive a diamond dealer or cotton broker out of business.[5]  Although very few industries will match the conditions of diamond or cotton exchanges, understanding and leveraging reputational risk will shape relationships for the long haul.

The next step in contracting is structuring the contract.  One can think of contracts as allocating risks between the parties.  Such risks include:

• Market risk - Who gains or loses from changes in prices?
• Credit risk - What happens if a supplier or customer doesn’t perform?
• Operating risk - What happens if a party fails to perform?
• Business volume risk - Who gains or loses from swings in demand?

Generally speaking, efficient contracts place a risk on the party that can best avoid, mitigate, or bear the risk.  Effective contracts keep the consequences of a risk on the party who accepted it.

• Stress test contractual provisions with business owners by asking, “And what if the other side doesn’t?”

Working without a safety net breeds the happy habit, when reading contractual undertakings, of asking, “And what if the other side doesn’t.”

Accepting risks on paper does not mean bearing them in practice.  Asking “what if” forces drafters to think through contingencies, particularly self-help remedies, such as automatic price discounts, holdbacks, and offsets.

“What ifs” also push drafters to stress test contractual provisions with business owners.  Too often, owners tell drafters what contracts should contain, but without laying out the commercial context that underpins these requirements.  Without context, provisions might not work, or only work badly.  A Fortune 500 company, for example, needed to migrate client data to a new IT system.  The business owner told the IT Department that this work had to wrap up on time.  So, IT contracted with an outside vendor to finish by a specified date.  Mission accomplished?

Far from it.  The business owner failed to mention that late migration of a major client’s data would threaten the account.  This fact fortunately surfaced before project launch.  For an extra $10,000, the vendor migrated the key client’s data early.  As often happens, the project ultimately ran late.  Had the company not accelerated migration of the key-client’s data, a multi-million-dollar account would have been lost![6]

Contract drafters and managers do more than take orders; they manage risks and solve business problems.  Stress testing contractual provisions with business owners and other stakeholders aligns the contract with business goals and relationships.

Lessons learned:  Drive as if you’re not wearing a seat belt…

Management guru W. Edwards Deming once observed, “If you can’t describe what you are doing as a process, you don’t know what you’re doing.”

Contracts represent a deliverable in a process called “contracting.”  Relational contracting begins with defining business goals, shaping the relationship between the parties, memorializing the parties’ deal with a contract, and then monitoring and implementing the contract consistently with the goals and relationship.

Goals and relationships spring from the fundamental economic interests of the parties, as well as the outlooks and character of the people who work for these parties.  Working as if there is no safety net of enforcement spurs mindsets, habits, and techniques that lead to better deals and better relational contracting.  By analogy, driving as if you’re not wearing a seat belt, even if you are, helps you reach your destination more certainly and safely. (See also IACCM’s report titled Unpacking Relational Contracts.)⁷

Bon voyage!

Copyright © 2020 by Robert Zafft

ABOUT THE AUTHOR

Robert Zafft advises business of all sizes on general legal and commercial matters.  As a former McKinsey Company consultant with significant overseas experience, he emphasizes practical, business-focused problem solving.  His book, The Right Way to Win: Making Business Ethics Work in the Real World, will be offered by IACCM for continuing professional development (“CPD”) credit and certification via the IACCM website.  Visit www.therightwaytowin.com and follow: TheRightWayToWin@robertzafft.

Areas of Expertise:

Corporate Governance, Business And Government, Business/Corporate Strategy, East Asian Business, International Business, Law and Economics, Political Economy, Corporate Governance, Critical Thinking, Technology Management, Organizational Design, Business And Government, Business/Corporate Strategy, Corporate Governance, Critical Thinking, East Asian Business, International Business, Law and Economics, Organizational Design, Political Economy, Technology Management

END NOTES

1. Lisa Bernstein, “Beyond Relational Contracts: Social Capital and Network Governance in Procurement Contracts,” Journal of Legal Analysis, Volume 7, Issue 2, Winter 2015, Pages 561-621.

2. Ackoff, Russell L., Ackoff’s Best: His Classic Writings on Management (New York: John Wiley & Sons, Inc., 1999), pp. 15-19.

3. See, Bernstein, cit. 1.

4. Maki Shiraki, “Exclusive: Takata Creditors Seek $30 billion, Far More Than It Can Pay– - Court Filing,” Reuters, November 8, 2017.

5. Lisa Bernstein, “Opting out of the Legal System: Extralegal Contractual Relations in the Diamond Industry,” The Journal of Legal Studies, Vol. 21, No. 1 (Jan.1992), pp. 115-157; Lisa Bernstein, ‘Private Commercial Law in the Cotton Industry: Creating Cooperation Through Rules, Norms, and Institutions,” 99 Michigan Law Review 1724 (2001).

6. Robert Zafft, “A White Elephant is Not a Black Swan: Why You Can Do More about IT Project Risk Than You Think,” Risk Governance & Control: Fin’l Markets & Inst. Vol. 2, Issue 3, 2012, pp. 54-63.

7. Unpacking Relational Contracts, David Frydlinger, Tim Cummins, Kate Vitisek and Jim Bergman.