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Focus Your Contracts on Business Objectives for Value Creation

Focus Your Contracts on Business Objectives for Value Creation
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There’s one last cluster of issues that I want to explore relating to creating a contract, and that is the tension that arises between business objectives and legal objectives. This tension is inherent in the definition of a contract. Earlier we defined a contract as an agreement enforceable by law. The agreement part relates to the business deal. The enforceable by law part relates to the legal aspect of a contract, and this creates an inherent tension. The focus of law, the focus of lawyers is on preventing losses. They want to create a legally perfect contract, whereas the focus of people in business is value creation. They want to create value and they want to achieve their business goals.
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And this contract tension between the legal aspects and the business aspects lead to two key questions. First of all, how can we refocus our contracts so that the business objectives do not become lost in the legalities of the written agreement? And second, how can we make the legal terms more understandable? So let’s start with this first question. How can we refocus contracts so that the business objectives do not become lost in the legalities? As I mentioned earlier, lawyers view contracts from the perspective of trying to create a perfect contract. Here’s a definition of a legally perfect contract. The conventional goal, an agreement that is final, binding and enforceable. The contract documents should thus be as legally perfect as possible.
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In other words, lawyers view the contract through the eyes of a judge. They’re asking, what happens if something goes wrong? What happens if we end up in court? Will the promises made by the other side be enforceable? That’s their concept of a legally perfect contract. What’s the problem, however, with trying to develop a legally perfect contract, especially if you’re not the lawyer, if you’re the person in business who must perform the contract? Why don’t you press pause for a second and try to think of problems that arise when there’s so much emphasis on the legalities of a contract.
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First of all, you end up with a contract that is long and complex. What used to be handshake deals between people in business now can morph into contracts that are 40, 50, 200 pages long. Another problem, transaction costs. Takes you a lot of time and money to work with lawyers when the contract is drafted. But then because most of us don’t understand the legal terms, and what they mean, and the implications. If there is ever a problem then you have to go back to the lawyers and ask them, what does this mean? Which results in more time and expense.
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The contract becomes the focal point when future disagreements arise. Rather then business problem solving. Without that legal contract, if there’s a problem in business, you and the other side would simply work out the problem. You would use common sense. However, detailed contracts often have procedures that you have agreed to follow in the event of a dispute. And so all of a sudden your resolution of the problem becomes very legalistic. I recall talking recently with the CEO of a fairly large company that he founded, and we were talking about contracts, and he said, in my opinion, all the contracts do is give you a right to sue, and I ignore them.
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When I have a problem with a customer, we work it out and try to do what makes sense in business terms, not according to the contract. There are big problems when you’re negotiating a cross cultural contract, because in certain cultures, the focus is more on relationships than it is on a legal document. In some cultures, rather than being the end of a negotiation, signing the contract is the beginning of a negotiation. And the focus is on finding partners in business who you trust, and who you can work with and continue to negotiate, realizing that circumstances change over the course of a contractual relationship. Finally, contracts tend to focus on the negatives, rather than positive business opportunities.
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So lots of problems with trying to develop a perfect contract. Here’s a quote from a recent report conducted by an organization called IACCM. Stands for International Association for Contract and Commercial Management. It’s the largest network of negotiators, contract negotiators, in the world. They have around 28,000 members. The members are from around 160 countries. And so they conducted a world wide survey, and this is their conclusion of the way businesses is conducted today. Most business-to-business negations are dominated by discussions over financial issues such as price and risk allocation, that’s the legalities, such as limitation of liability and indemnification. They do not contribute to the win-win approach that negotiators claim they prefer.
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In other words, what’s going on in the world today is that these prominent negotiators who belong to IACCM are claiming that this is where we spend our time, but these are not the issues that are most important.
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So let’s look at an alternative to the way that business is done today. There’s a group of lawyers who work for a beer company in Scotland who have developed what I call a lean contracting approach. And their philosophy is that contracts should emphasize free market economics rather than legalities. They have a minimalist approach, where they’ve decided all your contract should include is what are the goods and services that are being sold and what’s their price. The do have a clause covering intellectual property rights, but the rest of the contract includes in terms that are implied by law. We mentioned earlier, that the law over the centuries has developed certain implied terms that are a part of a contract.
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And these have been tested in court. They make good sense. So why renegotiate terms that are already implied by the law? So here’s a clause from the Scottish contract. We have agreed on the essential elements of the contract. Rather then incur time and expense negotiating and recording, in writing, other non-essential terms and conditions. We have agreed to allow the general law to regulate such matters, implying such terms as it may. And then, another clause from the contract. There is no minimum duration for this agreement. We’ll simply continue to do business with each other for so long as it remains mutually beneficial to do so.
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In other words, why treat the contract as a club, a legal club to force the other side to do something they don’t want to? Why not use this free market economics approach? If it doesn’t make sense to continue doing business together, then walk away. So let’s compare their approach with the approach that’s used elsewhere in the world. Here’s another beer contract that I pulled off the Internet. This is a contract between Coors Brewing Company and one of its bottle suppliers. This contract, which I would say is fairly typical, 23 pages long with another around 8 pages of exhibits. So compare that to the Scottish contract with one of its suppliers. One page contract, one page attachment.
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Now, does this mean contracting approach makes sense in every scenario? No, I don’t think so. In fact, even with a supply contract, this might be too minimalist. So I think what you have to decide is, if you’re in a business to business kind of situation, are you in a situation involving a snapshot transaction? A one-time transaction, let’s say a loan agreement, shared transaction, you’re selling some real estate. In which case, you probably do want a more detailed contract as opposed to a long-term relationship, where you have a certain trust in the other party.
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In that case you can minimize your legal terms, and you can rely on what the Scottish lawyers call commercial affinity, which means staying together for as long as it makes sense. In the long-term relationship, then you can rely more heavily on trusting the other side. When I present these concepts to lawyers as you might expect, many lawyers are upset. They say, well, you need page upon page of legal protection. We need these protections for our client. We need a legally perfect contract. We need contracts that are 40, 50, 200 pages. But then I ask the attorneys, when you enter into a contract with your clients, how long are those contracts?
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Usually, there is a long pause, because when they enter into contracts with their clients, often they don’t even put the contract in writing. Often it’s a handshake agreement, or at most a one page agreement that specifies what they’re going to do for the client and what the client is going to pay. So in other words, many attorneys do not practice what they preach. And bottom line, if you are in these long-term relationships, trust can go a long way toward focusing on the business deal. Earlier in this course, we mentioned this example of Warren Buffett deciding to buy a $23 million company from Wal-Mart.
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Usually this kind of transaction requires millions of dollars and would be delayed for months for legal and accounting due diligence. But here because there is trust, even with a snapshot transaction like this, because there was trust, there was a two hour meeting and a handshake. According to Buffett, we did no due diligence. We knew everything would be exactly as Wal-Mart said it would be, and it was. So when you’re dealing with somebody you trust, then I think the lean contracting approach can be beneficial and can also be very economical.
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So let’s now turn to our second question.
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Again, we’re looking at the tension between the legally perfect contract and a contract that makes sense from a business perspective. And this question is how can we make the legal terms more understandable? And the answer that question is developing as a result of research done by people in Europe and the US and elsewhere. There’s a movement called visualization, which basically means, how can we visualize these complex legal terms? I’ve written a couple of books with a co-author, Helena Haapio, who is one of the leaders of the visualization movement. She’s a contracts expert based in Finland. So here’s an example. This is what a typical contract clause might look like.
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The agreement shall be valid for an initial period of three years from the date of signing. Unless either Party gives notice of termination at least six months before the expiry of the three-month period, it shall remain in force until further notice, with a notice period of at least three months. Notice shall be given in writing. Now when you look at that, that causes a bit of head scratching as you try to absorb what these words mean. The alternative is to try to visualize it. If you press pause and try to visualize it, you could probably come up with some interesting possibilities. Here’s one possibility, where you have a timeline that shows the date of the signing on the left.
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It shows the date of termination and the requirement for six months between the two red arrows. And if the contract is not terminated, then the second two red arrows indicate that can be terminated at any time on three months’ notice. So, I apologize this is so small, but basically with one line, you’ve captured visually what all those words intended to say. My co-author got me involved in a visualization effort recently in San Francisco. There was what we called a legal design jam, which brought together a small group of attorneys with a group of designers. And this was at the invitation of Wikipedia.
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Wikipedia wanted us to look at their trademark policy, to determine whether it could be improved as a result of visualization. So this is what their trademark policy looked before we began work on it. As you can see, it’s very densely worded, it would take a lot of time to read and absorb and try to understand what that means. As a result of our design effort, we came up with a much simpler policy that is color coded in greens, yellows, and reds. The greens basically means you have free use of Wikipedia, the reds mean you cannot use Wikipedia, and the yellow says you can use Wikipedia content with permission. So it simplifies your use of the trademark policy.
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It’s very clear what you can do, what you can’t do, and where permission is required. And we also developed this in a variety of languages. And in early 2014, Wikipedia adopted this visualized approach as their trademark policy. So that concludes our look at this tension between legal and business objectives. And it also concludes our look at the unit on creating a contract.
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