Eight to Late

Introduction

Individuals or organizations who have agreed to work together often formalize their agreement through contracts. One of the main functions of such contracts is to reinforce trust between the two parties – i.e. to assure each other that they will do as they say. Another function is to reduce risk. In an article published in the May 2009 issue of the Harvard Business Review,  Deepak Malhotra argues that in some situations contracts end up destroying trust and/or increasing risk. In this post I present the pitfalls he discusses,  along with comments and observations drawn from other sources.

Three pitfalls of contracts

The first point Malhotra makes is that  overly detailed contracts can reduce trust by preventing spontaneous displays of good intentions. Here’s how the reasoning goes: extremely detailed contracts are a sign that the two parties do not trust each other fully (hence the need to write down every possibility that comes to mind). In such situations, the relationship between the two parties tends to be managed by contract, which acts as a disincentive to do things that aren’t written down.

More generally, it is obvious that trust cannot be created by writing it into a contract. At best, contracts might help in reinforcing trust that is built up by other means. How does one build up trust? Well, there are a couple of ways that come to mind;

1. Through consistent actions that demonstrate good intentions.
2. Through building relationships between individuals in the two parties.

Neither of these behaviours can be mandated by contract, but a detailed, hard-to-interpret contract can very easily discourage them.

The second point he makes is that rigid contracts can increase risk by discouraging adjustments down the line. Those who draw up contracts cannot be aware of all the possibilities that might unfold as a project progresses (a consequence of bounded rationality). For this reason, contracts should be flexible enough to permit changes as new information comes to light. Ironically, many organizations view rigid contracts as a means of reducing risk. Most often this is because the parties involved tend to underestimate the uncertainties in their environment.  The point here is to put off contractual decisions regarding uncertain elements of the agreement, but to put in place arrangements to deal with some of the foreseeable outcomes.  As  Malhotra puts it, “Wisely structured contracts postpone agreement on terms that would be more effectively handled after more information is available, and they include contingencies commensurate with the current level of uncertainty.”

As I’ve written in my post on outsourcing and transaction costs, parties involved in contractual agreements need to take a farsighted view. Such a view would acknowledge the tension between the need for uncertainty in the face of an uncertain world.

The third point Malhotra makes is that incentives in contracts can signal mistrust. This often happens in contracts between high performing individuals and organizations, where a large portion of the individual’s compensation is tied to performance. Such an arrangement can actually end up demotivating the individual. How so? Well,  employee performance in knowledge-related work such as programming, is directly related to intrinsic motivation – i.e. the internal drive (or inclination) to do the assigned work.  Further, as I have discussed in this post, intrinsic motivation has more to do with interesting work than with tangible rewards or incentives.  More to the point, intrinsic motivation cannot be fostered or enhanced by contract. So, in cases where one is dealing with high performers, a better strategy might be to  empower them to make decisions on how their work gets done or , where possible,  matching assignments to  professional interests and aspirations.

Summarizing

Contracts are part and parcel of cross-organisational agreements. They are designed, among other things, to reinforce trust and reduce risk. If one isn’t careful, however, they may  do just the opposite:  contracts that  are overly detailed or  overemphasize monetary incentives can end up reducing trust and increasing risk.