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ANALYSIS: Can Relational Contracts Remove Supply Chain Rigidity?

Nov. 1, 2021, 7:01 AM

The pandemic has exposed the fragility of the global supply system. As links in the supply chain shut down to contain the coronavirus, shortages are being felt up and down the line. The easing of pandemic restrictions in 2021 has yet to bring relief, and the forecast for 2022 is for more of the same. Can a different contracting approach by supply-chain participants help lessen the current rigidity and alleviate bottlenecks? Perhaps it’s time to refocus on the relationship rather than the deal.

When I started practicing years ago, one of the elders in my firm told me that the best contract is the one you put in a drawer after signing and never look at again. He described such a deal as “self-executing,” by which he meant that when changes occur or problems arise, and amendments would normally be needed, the parties instead find practical, mutually acceptable, and equitable solutions—often without the help of lawyers or even fidelity to the language of the agreement.

For certain types of contractual relationships, that observation still holds a lot of truth. Long-term contracts involving parties who rely on one another to succeed tend to follow the spirit of the contract and the objectives of the relationship, rather than a strict interpretation of the agreement’s words. The parties know each other and have long institutional memories. Their relationship resembles a partnership or joint venture. But how can practitioners who may not have a long-existing relationship engineer this type of agreement from the outset? Answer: relational contracts.

Relational Contracts Defined

A relational contract has been defined 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.” The concept is not new, but, with the enhanced need for supply chain flexibility, there is a renewed interest in recognizing the benefits of relational contracts in strategic relationships, such as the supply chain.

Contrast the relational contract to the more prevalent transactional contract, in which the exchange itself—not the long-term relationship of the parties—is paramount. Transactional contracts tend to be very detailed, lengthy, arms’-length, and adversarial in nature. They employ market power for competitive advantage and allocate maximum risk and responsibility for performance to the other party. Companies use transactional supply contracts to protect themselves against unilateral, opportunistic behavior by one of the parties. Most supply arrangements are of the transactional kind. Even when repetitive, each delivery is a separate and complete transaction; if a party breaches, the cost and time to find a substitute are typically not extensive.

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What’s in It for We?

The importance of special strategic relationships with a critical supplier transcends the importance of individual deliveries. Likewise, a major customer cannot be replaced without considerable disruption, loss, and expense. These types of transactions do not end when a delivery is made. They depend on continuous improvement, problem solving, collaboration, communication, and trust. They exemplify a “What’s in it for We?” partnership attitude.

Dealing With Change

Despite the transactional lawyer’s best efforts to cover every contingency in the supply-chain contract, the future is unpredictable, and change will occur. In a relational contract, the change process is not only anticipated, but it also is designed into the framework of the agreement for flexibility and resilience.

How? Modern relational contracts are more than a “handshake” deal. They are formal, written agreements recognizing a highly collaborative relationship in which the parties choose to make social norms guide their behavior. They are based on trust, mutual dependency, and aligned interests. The overarching guiding principles or social norms that shape the negotiation, drafting, interpretation, and change mechanisms (governance) of the agreement are reciprocity, autonomy, honesty, loyalty, equity, and integrity. The relationship is continually adapting within the framework established by the agreement.

When change occurs, relational parties problem-solve instead of finger-point. They communicate in a no-blame fashion to address the new risks and work jointly to share the pain and gain presented by the new environment. Undoubtedly, many strategic partners are reacting in a problem-solving way in the face of recent and current supply-chain disruptions. An adversarial posture with clear winners and losers is out of place in a strategic partnership relationship.

Starting the Process

Relational contracts are not fanciful or altruistic. They are practical and real. They exist where a party’s success is highly dependent upon performance by others, which is the very definition of modern supply-chain networks. This does not mean that relational parties don’t clearly allocate risks of non-performance, indemnity, or liability limitation. They do so, however, by recognizing equity, flexibility, and fairness, with responsibility for performance allocated to the party that is better able to ensure compliance effectively and economically.

So, how do you start the process? Attorney David Frydlinger and academics Oliver Hart and Kate Vitasek have endorsed a five-step process that starts by establishing a partnership mentality in an environment of trust. Then, the parties “co-create” a common statement of purpose or shared vision. The third step is to adopt a set of guiding principles as set forth above (reciprocity, autonomy, etc.) as contractual obligations that will serve as a touchstone for the parties’ decision-making and performance under the agreement. A critical step is to align the terms and conditions of the agreement with these guiding principles. Finally, and perhaps most importantly, the parties implement a governance structure to sustain the relationship, continually align interests, and resolve issues consistent with the shared vision and guiding principles. To be avoided are non-reciprocal and inequitable indemnification, audit rights, or liability limitation provisions that fail to maintain the risks of the relationship as a whole in a balanced and fair fashion.

Attaining Supply-Chain Management Goals

In 2020, Bloomberg Law conducted a survey of transactional lawyers on supply-chain issues. Most respondents indicated that the principal goals in supply-chain management are efficiency, risk management, and cost reduction, with flexibility as the No. 1 concern. In strategic relationships, these goals are closely aligned with relational contracting’s tenets of communication, problem-solving, risk allocation, and continuous improvement.

As 2022 approaches, the headlines continue to highlight supply-chain problems. These supply-chain challenges will require a cooperative, problem-solving approach where parties make mutually beneficial decisions. Relational contracts are certainly not the complete answer, but they may be a start.

Access additional analyses from our Bloomberg Law 2022 series here, including pieces covering trends in Litigation, Regulatory & Compliance, Transactions & Contracts, and the Future of the Legal Industry.

Bloomberg Law subscribers can find related content on our In Focus: Contract Drafting resource.

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