alt.legal: The (Nobel-Winning) Theory Of Contracts
Efficient contracts are complicated business; can technology help?
I am neither a transactional attorney nor an economist, although contract lifecycle management is a central offering of my business. But I can appreciate other people appreciating the importance of contracts.
Earlier this week, the 2016 Nobel Prize for Economics was awarded to Oliver Hart and Bengt Holmström for their research in contract theory. Many of their contributions have been canonized through a lens on contracts in academic economics and in law. (Remember first-year contracts in law school? Efficient contracts as a balancing of market interests? That’s these guys.) Specifically, they’ve dug into where there are conflicts of interests. The first sentence of their work: “an eternal obstacle to human cooperation is that people have different interests.”
I won’t get into the nuances of their work, partly because it spans decades and partly because it’s over my head. But topics they are cited for by the Royal Academy include:
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- the tension between insurance and incentives: pooling risk is a great idea, but full insurance on a certain outcome invites increased carelessness (moral hazard), which would then have an impact on the pool;
- paying for performance: similar to the insurance example, an employee may be less incentivized if the employer bears more risk, which can be mitigated by tying more pay to performance in employment agreements;
- imprecise observation or measurement: compounding all of these problems is limited visibility to the factors; and
- incomplete contracts: where future outcomes are unknown, the party granted the most decision rights will have more bargaining power when unknown future events transpire (for instance, more rights go to entrepreneurs as long as performance is good, but more rights go to investors when performance deteriorates).
Again, my summary of these theories is rudimentary at best. But they return to basic principles of contract and are well-reflected in our policy-making and contract negotiation today. As an example, consider the Great Recession. Many have criticized the bailout of the banks (including the Nobel Laureates honored for the above theories of contract) because the bailouts worked more or less like an ultimate insurance policy, the impervious safety net, encouraging future morally hazardous behavior. On a smaller, more contractual scale, one could say that credit default swaps, as hedge instruments, similarly invite moral hazard. Imprecise observation or measurement is at the heart of good due diligence practices, especially on complicated transactions. And for anyone that gets a bonus or is paid on commission, pay-for-performance and incomplete contract principles are at the heart of the agreement.
At minimum, efficient contracts are complicated business, and the financial burden of well-negotiated contracts is high. Whether we’re talking about hidden covenants sneakily obscured in bond indentures or whether we’re looking at bad commercial leases that cripple a small business’s ability to grow, a fair and efficient economy requires fair and efficient contracts. To get there, we need more visibility and fairer incentives.
It would make sense to provide a lower-cost, objective analysis for contracts on well-established lenses for contracts. And indeed, this is the existential question for transactional attorneys. Are there alt.legal solutions in this world?
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Yes, there are.
Managed Services Solutions
The advent of legal managed services and globalization have enabled new magnitudes of scale, especially in the area of contract management. Contracts lend themselves more naturally to non-local expertise compared to complex jurisdictional-specific litigation practice. Companies like mine offer scalable legal solutions to help parties enter into fair and efficient contracts.
Contracts are also frequently handled by non-legal managed services, including those offered by business process outsourcers and the Big Four. More frequently, these services focus on process, speed, and volume, and less on negotiating efficient contracts.
Technology Solutions
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Like many of the managed services, most of the contract-based technology solutions are also focused on scale, volume, or convenience. Blockchain technology promises self-execution, self-enforcement, and reduced transaction costs. Document automation tools help with abstracting key terms and contract clauses. Automated review, drafting, and negotiation products help standardize contracts and keep terms in compliance with company policies. E-signature tools help reduce administrative costs and ensure defensibility of execution.
The list goes on—obligations management, analytics. But are there tools that can evaluate a contract’s fairness? Compare it to market practice? Yes, there are a few heading that direction, and there’s room for much more.
Most importantly, how can the tech solutions cure asymmetry in the consumer marketplace? What are the use cases for this technology in policymaking?
We are looking at transactional tools as a category in our alt.legal innovation awards, and I am excited to learn more. Drop me a line and tell me about new influences that can achieve a balanced contract ecosystem that the newly-minted Nobel laureates would be proud of.
Ed Sohn is VP, Product Management and Partnerships, for Thomson Reuters Legal Managed Services. After more than five years as a Biglaw litigation associate, Ed spent two years in New Delhi, India, overseeing and innovating legal process outsourcing services in litigation. Ed now focuses on delivering new e-discovery solutions with technology managed services. You can contact Ed about ediscovery, legal managed services, expat living in India, theology, chess, ST:TNG, or the Chicago Bulls at edward.sohn@thomsonreuters.com. (The views expressed in his columns are his own and do not reflect those of his employer, Thomson Reuters.)
