We know that contracts by their nature are incomplete. We also know, more than ever, that contracts should embrace a firm grasp of guiding principles as the foundation of business interactions.
A National Bureau of Economic Research paper highlighted new research on how to overcome contractual incompleteness. Traditional contracting approaches have inherent flaws, and a “new approach” that embeds informal social norms formally into a contract can help parties mitigate opportunistic behaviors, the paper says.
“Overcoming Contractual Incompleteness: The Role of Guiding Principles” was released in September 2019 and is the result of a collaboration between the Nobel laureate Oliver Hart, Department of Economics, Harvard University, and David Frydlinger, Managing Partner of the Sweden-based Cirio law firm. Together they provide the math formulas and the case-based evidence that bring the concept of behavioral economics from theory to practice for complex contracts.
The premise of the paper is that contracting parties normally expect each other to behave “reasonably,” but given self-serving biases, their views of reasonableness may not align – especially as events and circumstances change. The authors explain how and why the “new approach” works, and why traditional approaches fall short. The basic answer is that “in complex relationships contracts are inevitably incomplete.”
The concept of contract incompleteness is not new. It was central to 2009 Nobel laureate Oliver Williamson’s research on transaction cost economics. Oliver Hart’s further work into incomplete contracts also led to him receiving the Nobel-prize in 2016. This incompleteness factor can lead to gaps, misinterpretations, and discord, or “aggrievement,” and losses. Frydlinger and Hart point out a common mistake that organizations make is for the parties to hire sophisticated lawyers who can help write contracts that anticipate events and that are less open to interpretation. In short, get lawyers to write the perfect “complete” contract. Frydlinger and Hart maintain that in practice “this is often a fool’s errand.”
The duo argues that a better approach—and “one that is increasingly being adopted”—is for the parties to accept a certain degree of incompleteness and then instill guiding principles, such as loyalty and equity, and structured communication processes – often referred to as governance mechanisms – into the formal contract.
In order to make the above idea – the better approach – more precise, Frydlinger and Hart developed a “stylized model” that focuses on one negative consequence of contractual incompleteness—the occurrence of events not covered by the contract—and just one deadweight loss—”shading.”
They explained, “Each party will expect the other to behave ‘reasonably’ or ‘fairly’ in interpreting or completing the contract, but given self-serving biases the parties may have different views of what is reasonable or fair. This can lead to bad feelings and counteractions, causing deadweight losses.”
The paper argues parties can mitigate these losses by incorporating guiding principles (social norms such as loyalty and equity) into their formal contract. The parties should couple the guiding principles with structured communication and governance mechanisms – also embedded into their formal contract – to keep the parties aligned.
Hart and Frydlinger explain the guiding principles, which are fundamental social norms, can be ‘activated’ through communication. “We argue that a contract that specifies standard elements such as the price and the nature of the good or service to be traded can, in combination with the adoption of guiding principles, perform better than either a standard contract alone, or the adoption of guiding principles alone. The contract will also perform better than one based on standard mechanism design theory.”
The model describes an “optimal contract” that has standard assumptions of rationality and self-interest. In subsequent sections of the paper the authors explain why they do not think a “standard solution” will work in practice, given the behavioral biases of the parties. But loyalty and equity principles can help, and they present evidence, mathematical equations and technical analysis to support that premise.
They also examine several real-life examples of organizations that have put the concept into practice. Also see the September-October 2019 Harvard Business Review article, “A New Approach to Contracts,” by Frydlinger, Hart and Kate Vitasek which profiles examples from Dell and the Canadian government.
Frydlinger and Hart stress that “more work needs to be done to explore the generality of our ideas.” But they believe that theory, empirical work, and experiments “are all promising directions to pursue to clarify the role of guiding principles in overcoming contractual incompleteness.”