From Nobel Prizes to the real world: The importance of contracts

When the Royal Swedish Academy of Sciences announced last week that the 2016 Nobel Memorial Prize in Economic Sciences went to two theorists whose work focused on contract theory, they had some good things to say about our corner of the business world.

“Modern economies are held together by innumerable contracts,” the committee wrote.

It’s a statement that validates the importance of investment into modern contract lifecycle management (CLM) technology. In fact, contract theory has been the subject of two other Nobels.

Insights from the 2016 winners’ theories are baked into Revitas’s CLM solutions, and have enabled companies in the most challenging, complex industries to optimize their performance. Companies that use CLM solutions often cut contract process cycles in half, reduce contract administration costs, improve contract compliance by 50 to 55 percent, diminish high contract risks, and increase both revenue and profits by enforcing systematic and efficient procedures for creating, executing, and managing contracts.

The works of Nobel winners Oliver Hart and Bengt Holstrom have become central to how lawyers, executives, and even public policy makers think about contracting and economic relationships today. This article from Business Insider has a very good rundown of Hart’s and Holstrom’s work.

Professor Holstrom’s areas of study deal with how workers and business partnerships such as channel partners, alliances, and suppliers, respond to incentives spelled out in contracts. If a channel partner is incented based on sales volumes tied to a particular price or pricing tier, and if those terms are edited or have changed, the contract is at risk. This could adversely affect the profitability of both the manufacturer and channel partner.

Extrapolate that scenario to that of the CEO. CEOs are often motivated by the financial incentives of stock-based compensation. But stock prices can also rise – or fall – in relation to factors outside the CEO’s control. High oil prices, for example, might cause shares in an oil company to rise, not because of any underlying genius of the executive, but because revenue is likely to increase. Holstrom’s work suggests that CEOs and business partners should be rewarded when share prices rise in relation to other firms in their industries.

Professor Hart’s work centers on the idea that no contract can foresee every possible contingency. When unforeseen problems arise, Hart says that decision-making authority should be invested in specified executives in one firm, because if roles are not clearly defined, one firm may be able to extract economic concessions from the others by holding up progress.

So what are the real-world applications?

Holstrom’s work in particular can be seen as emphasizing measurable outcomes and analytics. That’s something Revitas’s CLM solutions have long done, offering robust reporting, analytics, and dashboard intelligence capabilities. Real-time analytics measure and improve contract processes as well as contract performance to improve clarity and alignment in overall compatible business outcomes for all parties involved in the contracts.

Hart’s theories ask the question of how firms manage decision-making and collaboration around complex contracts, and in which circumstances. Who, in other words, has control over which business process or term? Revitas’s contract management solutions simplify that question using comprehensive clause libraries to ensure best practices, and they set a negotiation path in which contracts are routed to appropriate stakeholders and the executive tasked with reviewing and approving deals. That ensures the authority is vested in the right decision-maker.

One common theme in both Holstrom’s and Hart’s scholarship is the importance of contract design and the cooperative nature of contracts – of keeping lines of communication open and of recognizing that economic arrangements should be mutually beneficial. Contracts should be clearly designed and structured and offer motivators to drive business performance, providing mutually beneficial outcomes and trust for all parties. Good commercial relationships, and good contracts, should emphasize risk allocation and joint risk management, joint problem-solving, mutual objectives, and the sharing of pains and gains alike.

It’s in everybody’s interest to do so.

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