Overcoming Contractual Incompleteness: The Role of Guiding Principles

Companies increasingly choose to outsource key economic activities rather than carrying them out in-house. However, outsourcing poses a challenge. Transactions of any complexity between buyers and sellers are supported by long-term contracts and these contracts are inevitably incomplete. It is simply too hard for the parties to anticipate and incorporate all the contingencies that may occur. The Covid-19 pandemic is just the latest example of an uncontracted-for contingency (for many firms).

The literature has identified several economic costs of contractual incompleteness: ex post adaptation problems, ex ante investment distortions, corner-cutting on quality and shading costs. The literature has also suggested some ways to reduce these inefficiencies: vertical integration, changes in asset ownership, mechanisms to make observable information verifiable, or the use of relational contracts. While some of these approaches are undoubtedly useful, none provides a completely satisfactory solution.

Our paper proposes a different approach for overcoming contractual incompleteness, albeit one that is close in spirit to relational contracting ideas. Our premise is that most people are moral, in the sense that they are inclined to follow widely accepted social norms or moral principles, such as not lying, being fair-minded, acting with integrity. This will lead them to put some weight on the welfare of others with whom they have a contractual (or other) relationship. This tendency is present in all relationships, particularly extended ones. However, and this is the crucial point, we suggest that the tendency can be greatly reinforced if these social norms or moral principles are incorporated into a formal contract in the form of guiding principles. The idea is that these guiding principles will be applied when an uncontracted-for contingency occurs to determine an outcome that both parties find reasonable. This helps to ensure that, even if a major shock hits, frictions can be minimized, and the relationship can be preserved. To use the language of Hadfield and Bozovic, these guiding principles provide the ‘scaffolding’ that can sustain a relationship. Furthermore, given that they rest on strong social norms, it is more accurate to say that the guiding principles are ‘activated’ rather than ‘chosen’.

We develop a model based on Hart and Moore’s idea that disagreement about an appropriate outcome in an uncontracted-for contingency can lead parties to become aggrieved and to shade on performance.  Our supposition is that even without guiding principles each party in a contractual relationship will put some weight on the other party’s payoff to determine an appropriate outcome. However, guiding principles, combined with well-defined, formalized communication processes, increase this weight, narrowing the range of disagreement. This can both reduce aggrievement and shading costs and lead to a more socially efficient outcome. We focus on two guiding principles, equity and loyalty, although we mention others that can also be important. 

After presenting the model, we discuss some cases where the guiding principles approach has been applied in practice. (The first author (David) has been actively involved in developing the approach.) One case concerns Vancouver island Health Authority and South Island Hospitalists, a group of doctors in British Columbia who provide inpatient care for patients in two hospitals on Vancouver Island. Prior to 2016, Island Health Authority and the Hospitalists had a conventional contract, but it was not working well. The service delivery model had been changing whereby more care in Vancouver Island hospitals was done by hospitalists and less by family physicians. Hospitalists were put under a great deal of pressure to increase the number of patients they looked after and became stressed. Matters came to a head in 2009-2010. Although the Hospitalists put in repeated requests for more hours, the Health Authority did not respond. Workloads soared and many hospitalists felt that they could not devote adequate time to patients to provide safe, high-quality care. Some hospitalists eventually refused to accept the responsibility for admitting patients from the emergency room, which was a requirement to facilitate flow into the hospital. This led to a heavy strain on the relationship, and the administration eventually temporarily suspended the privileges of some hospitalists in 2015. The actions of both the Hospitalists and the Health authority led to deadweight losses.

Our model suggests that the use of guiding principles, embodied in a formal contract, can reduce such deadweight losses. In 2016, over two years after their conventional contract had expired and countless hours of contentious negotiations had failed to replace it, the parties decided to explore a ‘formal relational contract’, eventually signing one on July 1, 2018. The parties report a great improvement in their relationship since then.

Our paper also discusses some other cases where the approach has been successfully applied, involving Accenture and ISS,  PwC and ISS , and Telia and Veolia.

Obviously, much more work needs to be done to explore the generality of our ideas. We believe that theory, empirical work, and experiments are all promising directions to pursue to clarify the role of guiding principles in overcoming contractual incompleteness.

David Frydlinger is the Managing Partner of Cirio law firm.

Oliver Hart is Professor in the Department of Economics, Harvard University.