Professor Oliver Hart, recipient of Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2016, delivered a lecture at the Indian Institute of Technology Bombay on January 14, 2020. The Prize to Prof. Hart was awarded in recognition of his contribution to the contract theory and the topic of his lecture at IIT Bombay was ‘A New Approach to Contracts’.
Prof. Hart started his lecture by citing example of Dell which in 2005 selected FedEx to handle all aspects of its hardware return-and-repair process and the companies drew up a traditional supplier contract. The 100-page-plus document was filled with “supplier shall” statements that detailed FedEx’s obligations and outlined dozens of metrics for how Dell would measure success. Unfortunately, it did not work. By the eighth year, the parties were at the breaking point. Each lacked trust and confidence in the other, yet neither could afford to end the relationship. More importantly, he emphasized that this story is not unique and that the remedy is to adopt a totally different kind of arrangement: a formal relational contract that specifies mutual goals and establishes governance structures to keep the parties’ expectations and interests aligned over the long term. Designed from the outset to foster trust and collaboration, this legally enforceable contract is especially useful for highly complex relationships in which it is impossible to predict every what-if scenario. These include complicated outsourcing and purchasing arrangements, strategic alliances, joint ventures, franchises, public-private partnerships, major construction projects, and collective bargaining agreements. He highlighted that a growing number of large organizations—such as the Canadian government, Dell, Intel, AstraZeneca, and the Swedish telecommunications firm Telia—are successfully using this approach.
In the lecture, Professor Hart stressed on the problem of ‘shading’ (when there are unforeseen changes in circumstances in the period after the contract has been drawn in contracts) and suggested ways to potentially alleviate this problem. Professor Hart opines, the problem of shading particularly in long-run complex deals can be so pervasive that tit-for-tat retaliatory behaviour becomes a death spiral. To solve the problem of shading, Professor Hart explained that a ‘vested methodology’ approach to drawing contracts. This involves a five-step process. (i) to be transparent about the aspirations, goals and concerns; (ii) to have a shared vision of objectives needs to be created by keeping expectations aligned in a complex and changing environment; (iii) need to adopt guiding principles based on which unforeseen contingencies are to be dealt with, and these need to be incorporated in the contract; (iv) align expectations and interests; and, (v) stay aligned. These principles are based on reciprocity, autonomy, honesty, loyalty, equity and integrity and are the basic social norms that may be activated through ex-ante and ex-post communication. In principle, these principles can be legally enforceable in a court of law, and are well-appreciated even when there are cross-cultural differences among the participants.
Though Professor Hart said that the ‘vested methodology’ approach is a relatively new consideration that composers of contracts have only recently started exploring, it has been already practised by fifty-seven companies till date, and they have generally reported raised profits, cost savings, raised profitability, and better services. In general, the approach described may be used in a wide range of partnerships, namely outsourcing and purchasing deals, strategic alliances, joint ventures, franchises, public-private enterprises, and even to social partnerships like marriage.