Companies understand that their suppliers are critical partners in lowering costs, increasing quality and driving innovation. However, when contract negotiations begin, the parties often default to a conventional transactional approach, which puts the buyer and supplier on opposite sides of the negotiating table, as both seek to negotiate terms and conditions that best protect their organizations from risk. 

Contracting parties agonize over every conceivable scenario, then try to put everything into black and white. A variety of contractual clauses — such as “termination for convenience,” which grants one party total freedom to end the contract after a specified period — are used to try to gain the upper hand. However, such tactics not only confer a false sense of security (because both parties’ switching costs are too high to actually invoke the clauses), but also foster negative behaviors that undermine the relationship and the contract itself.

The solution is a totally different kind of arrangement: a formal relational contract. We define is as “a legally enforceable written contract establishing a commercial partnership within a flexible contractual framework based on social norms and jointly defined objectives, prioritizing a relationship with continuous alignment of interests before the commercial transactions.”

Let’s examine how a formal relational contract is different from conventional transactional contracts, to see how it can offer a significant advantage when contracting in complex and dependent supplier relationships.

It focuses on the “relationship,” not the “deal.” The focus of contracting tends to be “this deal,” “this time,” and under “this set of business and legal terms.” Negotiators and lawyers think, “Get a signature, and you are done.” By contrast, a relational contract puts the relationship front and center, and recognizes that the deal points will change over time as business needs change. In the process, the parties embrace one another in “partnership” spirit.

It adopts a “partnership” versus “arms-length” mindset. A transactional contract establishes an arm’s-length relationship. Procurement professionals are taught to not get too “cozy” with suppliers. Conventional logic is that becoming overly dependent on your supplier is risky, and that buying organizations should avoid “lock-in." Moreover, the organization with the most power typically uses the upper hand to create contractual terms and conditions that shift risk. But power-based strategies don’t work in today’s networked and outsourced world. A relational contract abandons the arm’s-length mentality, choosing instead to use a partnership mentality, which understands that a highly collaborative strategic relationship with a supplier can create far more value. 

It embraces and formally embeds social norms. Social norms have been researched for decades, including by Nobel Prize-winning academics such as Douglas North and Eleanor Ostrom. Almost everyone recognizes when a social norm such as honesty, equity, integrity or autonomy is violated. A plethora of psychological research shows that most people want to treat others fairly and be treated fairly in return. But they’re also willing to punish unfair behavior when there’s a breach in social norms. The simple fact is that violating social norms makes the situation worse. This is why a formal relational contract not only embraces social norms, but also requires contracting parties to formally document and agree on how they will adhere to them.

It encourages risk mitigation through transparency and collaboration. The conventional approach to mitigating contracting risk comes from wielding one’s market power or state power. Market power is the ability to leave the relationship and contract with another player in the market. State power means the power to legally enforce contractual obligations. In reality, neither mechanism does a good job of mitigating risk in complex and dependent relationships.

Here's why. In complex and dependent relationships, market power falls short because invoking a termination for “convenience” isn’t, after all, convenient in complex and dependent relationships. State power also falls short because while you might be able to take the other party to court, this is costly and only happens as a last resort. Both market power and state power create an illusion of safety, when in reality they can be weak in managing known risk, and largely ineffective in dealing with those that are unknown or unanticipated.

A better approach is to establish a highly transparent and collaborative relationship, wherein the parties work together to identify risks and invest in risk-mitigation mechanisms. Embrace the fact that you’re in it together, and work collaboratively to optimize the situation, rather than fighting over who’s to blame and pulling out the force majeure clause.

It recognizes the fact that all complex contracts are incomplete. A contract is first and foremost an economic instrument, with the purpose of supporting the realization of business plans. Conventionally, this is done by allocating control over activities through contractual obligations such as developing a statement of work and price for the work. But in the words of Nobel laureate Oliver Williamson, all complex contracts are incomplete. A relational contract embraces the fact that “business happens,” and creates a flexible contract structure and formal governance mechanisms, whereby the parties work together to keep their interests in continual alignment.

Now more than ever, organizations need to embrace the fact that business is dynamic, and create formal relational contracts that are built on a flexible contract framework that puts the relationship first, and uses a common shared vision and social norms to keep the parties in continual alignment of interest. By developing formal relational contracts, parties can build trust and cooperate efficiently, without resorting to power plays and blame games.

Kate Vitasek is a graduate and executive education faculty member at the University of Tennessee.

Read more of SupplyChainBrain's 2022 Supply Chain ESG Guide here.