What is the point of a contract?

16 October, 2013

This final article in the Back to Basics series looks at the reasons for having a contract. The previous articles have outlined the requirements for a legally binding contract (offer, acceptance, consideration and an intention to create legal relations), looked at some key contract clauses, and identified the issues associated with terminating a contract. This article steps away from the contract itself and asks the question, what is the point of a contract?

 

There are many differing views on what the ‘purpose’ of a contract is and these views can often influence how the contract is expressed and presented and the approach which is taken when negotiating the contract (if negotiation is considered at all). This article identifies some of the key benefits of putting in place a written contract.

 

 

ENFORCING PERFORMANCE

When businesses are asked why it is important to have a written contract, the answer is often “To enable us to sue the other party in court if they do something wrong”.

 

It is true that having a written contract can greatly improve the chances of a successful action for breach of that contract, and can certainly help to reduce the costs of litigation by avoiding protracted arguments about what was said, by whom and when. However, even when the terms of a contract have been breached, the wronged party can often decide that bringing a claim for breach of contract could actually be detrimental to their business. For example, if a supplier had not been paid by a customer but was aware that the customer was a local sole trader who was facing bankruptcy, even if there was a high likelihood of “success” in court, heading to the courtroom or threatening to do so could have a damaging effect on the supplier’s reputation in the local community and could result in the supplier losing a potentially valuable customer. Even if the supplier was “successful” in court, there would be no guarantee that they would actually receive payment if the customer was declared bankrupt. In these circumstances, agreeing a deferred payment arrangement with the customer may be the more successful option for the supplier, even if there was a watertight claim under the contract.

 

 

PROVIDING CERTAINTY

As identified in the first article in this series, a contract can be made orally without anything having to be put in writing or signed by the parties. However, the purpose of a written contract is to provide certainty as to what has been agreed and the process of writing and negotiating the contract can be invaluable in drawing out each party’s motivations and requirements. 

 
A contract does not have to be complicated. It is substantially a letter between two (or more) people doing business with each other. The purpose of the letter is to establish who does what, what restrictions there are on the two parties and what happens if a party fails to do what was agreed.

 

A perfect contract would result in no surprises for either party. The customer’s requirements and the supplier’s commitments would be clearly recorded in writing and the parties would have one (and the same) expectation of what the successful fulfilment of the contract looks like. Each party’s outcomes and deliverables from the contract would be objective and measurable with no grey areas or issues to be decided at a later time. Whilst in reality this can be difficult (or impossible) to achieve, one of the key purposes of a contract is to provide certainty for the parties and they should strive to achieve this level of certainty as far as possible.

 

 

IDENTIFYING DIFFERENCES AT THE OUTSET

One of the benefits of recording the terms of a contract in writing (and striving to achieve certainty) is that it can help to identify the differences between each party’s intentions and requirements for the contract. The contracting process (rather than the contract itself) can be one of the most important elements as it is the process of negotiating and recording the agreement in writing which helps to establish each party’s understanding of the key issues.

 

A common scenario involves a customer and a supplier spending several weeks discussing, e-mailing and meeting to agree the terms of a deal. The discussions end and the parties walk away, both thinking they have an understanding, only to discover many months down the line when an issue arises that there are differences in their views about the terms of that understanding. One party thinks they have agreed X while the other thinks it was Y. This can be avoided by putting a detailed written contract in place.

 

 

HELPING TO ACHIEVE A WIN-WIN

When approaching a new contractual relationship, a party can often seek to ensure that their form of contract is used with absolutely no modifications by the other party being permitted. As identified in the first article in this series, this can lead to a ‘battle of the forms’ situation with neither party being clear whose terms won. Even if it is clear which contract applies, by taking a strict ‘no negations’ approach, the parties could be missing out on one of the most important elements of the contracting process, agreeing a balanced deal.

 

Where long-term contractual relationships are required, a win-lose negotiation style is likely to be counterproductive. If one party feels like they have a bad deal, they will either try to find ways of bringing the deal back in their favour (for example, by not complying with their obligations) or will lose interest in the relationship. The win-win negotiation style is far more successful in building long-term relationships where mutual trust and commitments are essential to doing business.

 

By identifying each party’s objectives and concerns and balancing the risks and rewards, each party can feel that their interests were met and be satisfied with the outcome.

How to negotiate a win-win deal

One of the most successful ways of negotiating a win-win deal is to identify each party’s interests and then to essentially trade concessions.

 

The early discussions will help to draw out from the parties what their interests are. These interests can then be ranked according to their importance and value to both parties. An unskilled negotiator can often make the assumption that the issues of importance to them must be of equal importance to the other party, but the reality is often the opposite. 

 

Taking the example of a purchaser and vendor of IT services, the key interests of the purchaser are likely to include price, quality and delivery. These are not equally valuable to the vendor who is more concerned with quantity, contract duration and ability to sell additional products/services. By trading off the vendor’s interests in trying to gain a new or bigger account and to establish a long-term relationship, against the purchaser’s interests in terms of price and delivery, it is easy to see how a win-win deal could be reached.

 

Another skill that effective negotiators use is the conditional offer. Generally, a party will not want to grant a concession unless an equivalent concession is received (having regard to their differing value to each party). This is when a conditional offer can be useful: “If you reduce the price by X, then we will increase the quantity purchased to Y”.

 

 

PROVIDING A MECHANISM FOR CHANGE AND RESOLVING DISPUTES

There is a view that once a contract has been signed, it should be put in a draw, never to be looked at again. However, often the most successful contracts act as living, breathing expressions of the commitments and obligations between the parties and are subject to on-going review and management to respond to changes which occur during the life of the contract.

 

In addition to recording the obligations of the parties, a contract can also be used to lay down a “relationship infrastructure” which includes change control provisions, escalation and dispute resolution.

 

As noted in one of the earlier articles, like any long term relationship, it is not unusual for disputes or grievances to arise during the life of a contract. But this does not have to mean the end of the contract. The chance of the parties being able to resolve a dispute and being able to maintain the relationship is significantly increased if the contract contains a clear process for escalating and dealing with issues as they arise.

 

 

CONCLUSION

There is greater value in a well drafted contract than simply being a weapon which can be used to punish a wayward party. The key purpose of a contract is to act as a tool for structuring the relationship and recording what the parties have agreed to do for and with each other. The contracting process itself, during which the parties identify each of the issues which are important to them and negotiate to agree a mutually acceptable balance of risks and responsibilities, can be just as useful as the contract itself in building a foundation for a successful lasting relationship.

 

Reviewed in 2015