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Explore Rice 2/15/2006
There's no such thing as a risk-free contract, but it is worth shooting for Rice University's Shannon Anderson, who recently analyzed hundreds of transactions, found that even contracts containing mutually agreeable provisions don't eliminate all risks. Still, the least-risky contracts are those designed to cover the most likely hazards related to that particular transaction and the parties involved. They may be more costly to write, but the company should have fewer problems in the long run. ------------ In business, as with many things, even the best-laid plans can fail. Case in point: What appeared to be a win-win opportunity between Toys "R" Us and Amazon.com turned into a major contractual failure and costly lawsuit. In a comprehensive study that examines the actual details of hundreds of information technology contracts, university researchers found that contractual agreements which try to cover all potential risks may be costly up front, but result in fewer problems down the road. Those who don't make an effort to include all major contingencies are more likely to encounter problems, and these problems are often more costly in the long run. "Preparing contracts takes time and money, and even the most extensive contracts don't always cover all the potential risks involved in transactions," said Shannon Anderson, associate professor of management at Rice's Jesse H. Jones Graduate School of Management. "Certain factors, however, help to reduce the likelihood of those risks, the most important being the degree to which a contract's provisions are aligned with the particular circumstances and the specific characteristics of the transaction partner." According to Anderson, most contracts contain some or all of four areas of provisions, including rights assignments, which define each firm's respective areas of responsibilities and rights, their legal recourse, descriptions of the products and services being provided and their costs, and after-sales service, including the supplier's liability and the length of the maintenance contract. The larger the transaction, the more provisions tend to be included in the contractual agreement. "Larger transactions often require the most extensive -- and therefore more costly -- contracts since they potentially pose the most risks," said Anderson. When putting together contracts, firms also take into account how competitive the market is for the service or product they plan to purchase, as well as each firm's relative size or influence. Either the amount of competition in the seller's market or the power of either party can have an impact on provisions of a contractual agreement. "For example, if there's a lot of competition for the service or product one company is purchasing from another firm, that buyer can expect the seller to be more forthcoming because it can go to other suppliers if necessary," explained Anderson. The more competitive the seller's market, said Anderson, the less effort is made to define each party's responsibilities and rights. Instead, more effort is put into defining the specifications and pricing of the product or service; as a result, the firms experience fewer problems. However, when the supplier has more power and market influence than the buyer at the start of the transaction, provisions of the contract place greater emphasis on the specific terms of after-sales service and each party's legal recourse, should there be problems during the transaction. In another circumstance -- when the buyer believes there is a risk that the supplier might fail to provide the product or service -- the buyer will want the contract to include more details covering the rights and responsibilities of the seller and buyer as well as their legal recourse if the supplier is unable to fulfill the agreement. "In that particular situation," said Anderson, "the buyer and seller will want a contract that makes sure each party knows who's doing what, and their legal recourse if one or the other isn't fulfilling their responsibilities." In the feature article of the December 2005 issue of Management Science entitled "Management Control for Market Transactions," Anderson and accounting professor Henri C. Dekker from the Free University of Amsterdam analyze 858 transactions between small-to-medium-sized Dutch firms and suppliers of information technology products and services. Overall, the researchers found a strong relationship between the way these firms designed contracts and the risks they perceived at the outset. "Overall, contracts that experienced subsequent problems were mainly responsive to financial risks arising from the size and specificity of the transaction," said Anderson. "Companies that had few problems tended to also address the risks involved in technical challenges which reflected the uncertainty and complexity of the transaction." While prior research has shown the relationship between risks and contracts or contracts and costs, no other study also had information on the outcome of individual transactions and whether problems arose after the fact. "The key as a manager is to know what sorts of hazards the company can accept and what formal provisions are needed to ensure that the great opportunity they see at the outset comes to fruition," concluded Anderson. Prior to joining the Jones School faculty in 2001, Anderson taught for nine years at the University of Michigan Business School. She earned a master's degree and a doctorate in business economics at Harvard University and a bachelor of science and engineering degree in operations research at Princeton University. For more information on this research, contact Anderson at swa@rice.edu or Debra Thomas in the Jones School at dthomas@rice.edu. |
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