Abstract
In this essay I reflect on the fundamental impact of global networked communications on trading relationships and the overall value chain. Based on my observations as Executive Director of the International Association for Contract and Commercial Management, I argue that the influences and complexity of today's market conditions demands fresh approaches to the way that relationships are formed and managed, promoting the role of contracts in shaping organizations and determining their success. I conclude that in a modern networked economy, the contracting process provides the essential glue that ensures integrity across the links in the value chain. Therefore contracting, until now the ugly duckling of commercial endeavor, must take center stage as a strategically critical capability that will be strengthened through the academic rigor and research such a professional practice demands.
“Each advance in human communications has been accompanied by more diverse and more complex trading relationships.” – Nicholas Wade Before the Dawn: Recovering the Lost History of Our Ancestors (2006:
Nicholas Wade made this remark in the context of human evolution. His assertion is that the human species uniquely grasped the benefit of trade – and that, with each advance in communication, the complexity of those trades has grown. Today, with the aid of the microchip and fibre optics, the evolutionary process continues. Nicholas' observation explains the foundation for this journal and for the existence of the IACCM (International Association for Contract and Commercial Management). 1
Our digitally networked world is transforming the nature of trade. It is shifting the patterns of movement, the methods of transfer, the perceptions of value and the rules under which transactions are undertaken. As the nature of modern global and local relationships have never been so uncertain and complex, how organizations form relationships, and are bound to those relationships, has become one of the most problematic domains of strategic practice and research. While much is said about the importance of unified, integrated organizational relationships, the reality is that such relationships are more often than not fragmented.
This is strange given that Ronald Coase’s (1937) seminal paper, The Nature of the Firm predicted the breakdown of the integrated enterprise. It is, he prophesied, ultimately inefficient. The model, epitomized by the Ford Motor Company and others, was not flexible enough to handle change. On the other hand, Coase recognized the challenge posed (at the time) by outsourcing production or services. In a world with limited means of communication, it was difficult to identify and manage contract labour. Essentially, the cost of contracting was too great. It must be noted that Coase’s analysis focused on issues of transactional cost. He identified contracts at the core of economic value and cost analysis.
Since 1937, however, networked technologies have overcome and transformed Coase’s issues. They have allowed previously integrated enterprises, such as the Ford Motor Company and IBM, to outsource production to more economic parts of the US. Indeed, they can move just about any activity to almost any part of the world that might reduce costs, provide superior skills or otherwise create competitive advantage. And with the same networked IT, management has instant visibility of those global operations, which in theory offers the ability to control them from any point they choose. However, as events continue to demonstrate, the networked world is much more complex in reality – and certainly not the simplistic environment depicted by Thomas L Friedmann (2005) in his book The World Is Flat: A Brief History of the Twenty-First Century.
Impacts of a networked world
Advances in technology, concomitant with globalization, have brought enormous opportunity, opened entire new markets, created new ways of doing things and, of course, raised new risks and challenges. Protecting intellectual property, complying with multiple jurisdictional laws and regulations, maximizing tax efficiency, understanding the effects of culture, tackling the diversity of language – these are just some of the commercial realities of operating in a global, networked economy.
And the evolution continues apace with an explosion of new, customer-centric services and transformational technologies that create – amongst other things – driverless vehicles, drones and three-dimensional (3D) printing. Each technical advance allows innovative business models and new ways to deliver value. Each causes a shift in the nature and allocation of risk, reward and liability.
In 1937 Ronald Coase placed contracts at the heart of his economic analysis when studying organizational dynamics. However, often ignoring the fact that decisions on contract terms or structures would have a fundamental impact on economic outcomes, subsequent generations either viewed contracts as having little relevance or allowed them to be subsumed to the study of law. Contracts often became a battleground, in which the parties abandoned the search for mutual ground or interests and instead became focused on relative power and the ability to allocate risks. As the Dean of one law school explained, “We don’t teach law graduates win-win”.
Negotiation, risk and adversarialism
In many parts of the world, the prevailing view of contracts remains focused on their legal purpose. This is reflected in the IACCM’s annual study of the most frequently negotiated terms. As Figure 1 shows, business negotiations tend to be dominated by provisions that deal with the consequences of default or failure – liabilities, indemnities, liquidated damages. Yet as we will see later, a focus on failure distorts the management of risk. It forces a concentration on what will happen if something goes wrong at the expense of considering the likelihood of it happening at all.
The most negotiated terms in contracting 2013/2014 (IACCM, 2013/2014).
This focus on risk consequence at the expense of open discussion of risk likelihood (probability and frequency) means that current contracting practices frequently increase risk. This tends to occur in several ways. For example, a transactional view tends to dominate and ignores portfolio experience. Research tells us that the areas most likely to undermine performance are uncertainties over scope or goals, poorly defined responsibilities and weaknesses in the management of change. Yet these repetitive experiences do not drive the risk agenda or negotiation priorities. More broadly, short-term measurements and incentives often undermine longer term business interest. This may be in the conflict between immediate savings on price versus longer term value; or the pressure for budget certainty (e.g. with a known solution) versus dealing with the uncertainty created by a more innovative approach. It is not uncommon for short-term goals to be in direct conflict with declared business or organizational strategies.
Finally, the way that risk consequences are allocated can lead directly to negative behaviour. For example, someone facing the possibility of an onerous claim for damages will make sure nothing is left to chance. This will include avoiding risks associated with innovation or reduced costs. Through a myopic determination to “win” on points of law or price, many negotiators unintentionally undermine the long-term health and profitability of their organization.
A critical disconnect
Top management is well aware of the challenges that their organizations face in this networked world. Studies consistently show that they recognize that business dynamics have changed. Successive annual reports of CEO sentiment from IBM (IBM Corporation, 2010, 2012) talk about the need for management to better manage interconnections, interdependencies and “growing global complexity”. PwC’s 2014 CEO study “Building Trust and Growth” showed a top issue in 2014 was trust – a finding reinforced during the 2015 World Economic Forum in Davos, where falling trust in institutions and business was a key point of discussion.
Management has failed to appreciate the role that contracting strategies and negotiation practices play in tackling these issues. Interconnections and interdependencies are defined and managed by contracts. Global differences and cultural gaps are bridged by negotiation. Trust is created by contract terms and our performance against those terms.
Almost every day the newspapers report on problems caused by a lack of a unified contracting process or strategy. Here, the failure to honor contractual obligations leading to loss: there, the winning or failure of a contract through fraud or corruption; everywhere, the abuse of a dominant position to impose unfair or unethical terms and conditions. In 2008 the finance industry was brought to its knees – and the world economy was left staggering. Essentially, this was due to a failure of contract risk management.
It is no surprise, therefore, that governments feel obliged to regulate, as business often seems unable to adequately control or self-regulate its own behaviour.
The purpose of contracts and how their purpose is changing
Some 20 years ago, IBM Chairman and CEO Lou Gerstner revealed be believed contracts to be fundamental instruments in the creation and support of brand image. He saw them as marketing tools as much as they were legal tools. Yet even he may not have grasped the extent to which a contracting strategy underpins and impacts economic and financial results. However, increasingly we are gaining insight to the scale of that impact – perhaps never better described than in the September 2014 report by the UK’s National Audit Office, “Transforming government’s contract management”.
Rigorous study of contracting has been limited due to the scale of variance between individual contracts. They have no uniform structure. There is wide discretion in the use of words and the authoring of terms and also how people make sense of and interpret these words and terms. Indeed, individual attorneys take great pride in their specific authorship and, in common with many professionals, believe their approach to be superior to that of anyone else’s. Such an approach is itself under challenge, as questions increasingly arise over charging mechanisms (such as the hourly rate) and as all professionals face growing demand to demonstrate the precise value of their work in terms of the outcomes achieved.
A lack of consistency has restricted both management insight and academic study on the impact of contracts or terms and conditions. For many, the purpose of contracts and negotiation has been more about avoiding risk than creating value. Indeed, when challenged to describe their precise contribution to the business, many lawyers and contract professionals struggle to answer in a positive context. They often respond in terms of being the last line of defence against the bad things that might happen, rather than being in the vanguard of making good things happen. As a result, contracting has been a highly transactional activity and there have been few efforts to undertake analysis, except of relatively small samples of agreements. Also, as pointed out in the National Audit Office report cited above, business leaders have failed to grasp the true significance of contracts and the process that surrounds them.
Despite the many challenges, I believe there is much to look forward to in the future of contracting. Modern analytical tools give us greater ability to extract and interpret data. Furthermore, management is starting to appreciate the costs and value of the contracting function. They are questioning how they are constructed and drafted. For example, since many contract terms are instructions for technical or business people, would it not make sense to use terminology that those people can understand? Early experiments reveal that the use of graphics as opposed to paragraphs of legalese can be far more effective in delivering a positive mutual outcome of a contract. The more advanced practitioners are exploring the use of video and virtual reality to improve the use of contracts.
Another positive step can be seen in those industries and sectors that question the validity of individual companies needing their unique form of contract and terms. A few industries – garment manufacturing, entertainment – have introduced extensive standardization. Others – oil and gas, construction – have tried to do the same, although with limited success.
One problem with contract standards in today’s fast-moving business environment is that terms are in a state of almost constant change. If the standard depends on consensus, the updating process can be costly and laborious. Yet once again, networked technology has the potential to streamline the creation and update of standards, thereby eliminating the time-wasting and risky “battle of the forms”.
Inherent in what I have discussed thus far is the point that contracting and – for that matter – negotiation, is a strategically critical part of life. It does not matter whether the relationships are between private organizations or individuals, between public organizations or agencies or between states or nations. Choose almost any day and the headlines indicate that we must approach contracting as a strategic imperative: for example, the large-scale failures of IT procurement in Victoria and Queensland; the UK government experiences with major outsourcing contracts; the US issues with the introduction of healthcare reform; the emerging corruption scandals in Brazil; waste in defence procurement contracts in Germany … the list goes on and does not even start to address some of the commercial innovations that today’s world requires.
A strategic view
Contracting strategies matter because they must reflect organizational needs or capabilities. Indeed, leading-edge organizations have grasped that their contracting process can be used as a source of quality control. The contracting process itself will test the resilience of the organization and its alignment with the market by ensuring that core value propositions are supported by performance capabilities or that strategic business goals are not undermined by the wrong form of relationship. Such steps also avoid the old syndrome of marketing or sales promises being contradicted by contract terms.
As interdependency grows so the mechanisms and tools for successful relationships become more nuanced and variable. Research is a major component of the IACCM’s activity and a reason behind our success. We have explored the importance of factors such as the type of agreement, the selection of terms, the allocations of risk and how these impact results. Our recent studies have proved that the failure of contracting practices to keep pace with the business environment is eroding value, creating conflict and causing loss.
The IT sector’s transition to cloud computing is an illustration of how traditional product sales have transitioned into the sale of services and solutions. This transition is a prime example of where contracting practice has lost touch with business reality. This move towards services demands clarity over the precise scope of work to be performed and measurements around its delivery. Few organizations have developed a robust approach to negotiating or managing such services – indicated by the fact that (as shown in Figure 2) it is the number one cause of claims and disputes. In fact, material disagreement over scope and goals is several thousand times more likely to occur than litigation. Yet contracts – and the most frequently negotiated terms – focus on the legal issues that will be important in a courtroom, rather than tackling the underlying causes of claims and disputes revealed in Figure 2.
What are the major causes of value erosion? (IACCM/National Audit Office, 2013)
Disciplines such as sales, procurement and project management need appropriate forms of contract to support their activities. Yet most professionals within these disciplines have made little effort to know or understand the purpose that contracts can fulfil and have abdicated responsibility to other functions. Businesses need overarching commercial strategies that enable the portfolio of relationship types required for market success. In general such strategies do not exist. Instead, contracts are designed and negotiated more in a sense of legal and regulatory necessity than as a core business operation.
Contracts are economic assets. They are core to the value of a business and the performance of its market relationships. Ironically, given the criticisms often levelled at government, it is increasingly the public sector that is recognizing the importance of contract and commercial capabilities. The winds of austerity are forcing a fundamental rethink of the way public services are delivered, moving from state-run to increasingly outsourced provision. This cuts costs, increases flexibility, generates innovation – but only if the management skills are there to select, motivate and manage suppliers and only if those suppliers have the integrity and competence to perform on the contracts they win. Well-publicized cases from around the world continue to illustrate what happens when those skills or competencies do not exist.
Over the centuries, society has developed new fields of skill, knowledge and expertise in order to both make sense of and also drive its own innovations. Most have steadily codified the disciplines needed for their continued progress and security – for example through the law, medicine and engineering. That evolution has accelerated in recent years, with academic fields and programmes exploding to cover a range of social sciences, computer sciences, project management and supply chain management, and the list goes on.
Today, weaknesses in contracting and negotiation skills regularly undermine the value achieved from trading relationships. Within all those established disciplines, no one has been looking specifically to understand how the different disciplines interlock to support successful trading relationships, their formation and management. While many have touched on the subject, it was from the perspective of their particular specialism, but there has been no consolidation of research or knowledge, which is a core aim and intent in starting this journal.
This journal – and the work of the IACCM – is directed at better understanding how we deal with the diversity and complexity of trading relationships: be it how we negotiate these relationships or bind them together through contracts in their various forms. More importantly the journal recognizes the need for a strategic view of contracting and negotiation within, between and across business, public sector, third sector and market interactions, especially how they communicate with each other and how they then record and manage their commitments and obligations.
With the introduction of The Journal of Strategic Contracting and Negotiation (JSCAN), and in collaboration with Sage Publications, we provide a nucleating point for global scholarly research into trading relationships and the role of commercial and contracting disciplines in delivering economic growth and increased harmony in world trade.
Some may question the very future of all professions and others argue that contract management or commercial management will never merit the status. Come what may, rigorous research into the way that successful trading relationships are formed and managed remains fundamentally important to human development.
Professionalism in any field is driven by the interaction between academics and practitioners. Until now, interaction in this field has been confined to pockets of activity, which do not start to fill the gaps highlighted in my essay. It is not that no-one is writing about this gap, it is more that bringing together people to connect and span boundaries to lessen these gaps is best served through a quality, scholarly journal. This work will then become embedded in the world’s leading association, whose members deal with many of the issues and phenomena that scholarly researchers study, theorize about and write about. JSCAN should be seen to be at the nexus of connecting good theory, research and practice because the journal provides a medium through which researchers can speak directly to the practitioners; and in which practitioners can directly engage with scholarship.
We opened this paper with an observation made by Nicholas Wade in his book, Before the Dawn. So perhaps in closing, it is worth also capturing his observation that the human species is the only species to have recognized the value of trade – and it is arguably this attribute that underlies our history of innovation and continued development. That is why the skills of contracting and negotiation are so fundamentally important and why we need to discover and analyse as much as we can.
Footnotes
Funding
This research received no specific grant from any funding agency in the public, commercial or not-for-profit sectors.