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Relational contracts certainly are not a new idea. But the coronavirus pandemic and its lasting effects will underscore the importance of implementing “formal” relational contracts as the most effective approach to doing business in the COVID-19 era.
For procurement professionals, the temptation for companies is to use their clout to pressure suppliers to reduce prices. Or when the supplier has the upper hand, it is hard to resist the opportunity to impose price increases. Witness how the shortage of personal protective equipment (PPE), ventilators and even toilet paper led to skyrocketing prices last year — to say nothing of the cold-chain challenge of delivering 300 million vaccines to the population this year. New, cooperative and collaborative relationships will have to be forged: relationships that are transparent, agile and resilient to a degree hereto not seen.
Parties to procurement agreements must make sure their contracts do not become breeding grounds for “shading,” a term coined by Nobel Prize Laureate Oliver Hart and John Moore. Shading happens when one party isn’t getting the outcome it expects and feels the other party has not acted reasonably. The aggrieved party will react by becoming less cooperative and less proactive in meeting the other’s needs — such as helping to meet sudden shifts in demand that would entail actions not directly spelled out in a contract, or imposing higher prices when the business climate shifts.
A better way of contracting in uncertain times is formal relational contracts that are designed to keep the parties’ expectations aligned on an ongoing basis. This kind of agreement is a legally enforceable written contract (hence “formal”) that puts the parties’ relationship above the specific points of the deal. The parties embrace the fact that all contracts are incomplete and can never cover all the contingencies that may occur, for instance, in a pandemic. It will be something else another time.
The contract includes shared goals and objectives, guiding principles and robust relationship management processes, which spell out how the parties will work through issues as they arise. The guiding principles contractually commit the parties to use proven social norms (treating each other with honesty and in an equitable fashion), that ensures they will refrain from short-term opportunism. The formal relational contract is a playbook for working through issues fairly and flexibly in good times and bad.
Given the uncertainty that lies ahead, companies must avoid antagonizing the members of their ecosystems. Formal relational contracts can turn adversarial relationships into mutually beneficial partnerships.
Kate Vitasek is a faculty member at University of Tennessee's Haslam College of Business Administration.
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