Contract Theory and the art of Contract Management

This year’s Nobel Prize in Economic Sciences was awarded to Oliver Hart and Bengt Holmström for their contribution to contract theory.

Having worked in the Sourcing/ Procurement function in various roles across the years, I have been involved in various stages of Contract drafting, negotiation, management, termination, renewal and renegotiation. In most situations contracts are looked as a way of covering risks (business risk, market risk, forex risk etc.). The massive 100+ page documents which have been drafted by a lawyer for a lawyer. And at the risk of generalizing, I might add, contract negotiations are mostly lawyer driven, who might in situations get into heated and animated arguments over mere semantics. I have been in negotiations where there was hours of debate over usage of “shall or will” in certain contractual clauses and how each party interpreted it.

Its high time now the Sourcing/ Procurement/ Contracts Managers start to acknowledge the fact the signed document usually buried somewhere deep in shared drive is in no way “complete” and should not be pulled out only for post-mortem and desk banging (again unfortunately seen that happening far too many times).

Organizations need to start acknowledging these facts and take a paradigm shift towards active performance management which is based on the fact that there will always be information asymmetry in a “contractual relation”. Only way to deal with this is to design KPIs that are more in line with current business realities and have balanced incentives for both parties to be fair in their treatment so that this becomes non sum-zero (one party’s gain is not other party’s loss).

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