Are Formal Contracts Necessary in Long-Term Relationships? Professor Albert Choi Examines Their Role

Albert Choi

Albert Choi is an expert in contract law who teaches courses on corporations, as well as mergers and acquisitions.

July 13, 2015

If long-term relationships already come with strong relational penalties when the understood boundaries of the relationship are violated, why are formal contracts needed at all?

University of Virginia School of Law professor and contracts expert Albert Choi argues in a new paper that formal sanctions have advantages that informal sanctions often lack. They deter violations while controlling costs if enforcement is required. They also uncover, through the formal adjudication process, evidence that parties and other market actors can use to better tailor relational sanctions.

Choi's article, "Contract's Role in Relational Contract," was co-authored with Scott Baker of Washington University in St. Louis and appeared in the Virginia Law Review in May.

Can you explain relational contracts, and give an example?

In a relational contract, parties rely on informal mechanisms — such as the threat of termination — to ensure that promises are kept. Imagine an at-will saleswoman. Suppose the employer promises her an end-of-the-year bonus if her performance is determined to be "excellent." The end of the year arrives and both parties agree that she has done an "excellent" job. But will the employer pay the bonus? What keeps the employer in line? In case the employer reneges, one possibility is for the salesperson to bring a breach of contract lawsuit against the employer, but that could be difficult and costly when she has to prove to the court that her performance was indeed "excellent." Further, a court may not even recognize the employer's bonus promise as a contract for being too illusory. Instead of a legal action, another, potentially more powerful, mechanism is for her to quit her position or only perform the minimal amount of tasks going forward. Especially if she is a valuable employee, the employer would want to keep her on the job and would not want to go to the trouble of finding a new person for the position. When the relationship (in this case, employment) is valuable, the threat of termination induces the employer to keep the promise. We can think of the employer's promise to pay a bonus conditional on "excellent" performance, backed by and combined with the threat of termination, as constituting a relational contract.

Why do business parties write contracts if both sides already have something to lose?

Given the widespread use of relational sanctions, it is curious why parties, including commercially sophisticated entities, go to the trouble and expense of writing detailed formal contracts. Our analysis suggests that formal sanctions will often be used in combination with relational sanctions. Both formal sanctions and informal sanctions are costly to impose. Relational sanctions require, among other actions, terminating or suspending an otherwise viable relationship. Formal sanctions require parties to spend money on dispute resolution. But — and here is the important difference — the parties often have better control over the cost and benefit of formal sanctions and, with that control, can decouple the size of deterrence from the cost of deterrence. For example, they can opt for low-cost dispute resolution systems (such as arbitration) and, at the same time, improve deterrence by liquidating damages. By doing so, they can generate deterrence that is larger than the cost of dispute resolution. If they liquidate their damages at $100 and impose limitations on dispute resolution so that the cost is $50, for instance, they have created a deterrence-to-cost ratio of 2 to 1.

By contrast, the cost and the benefit of relational sanctions tend to be quite closely linked with each other. The more valuable the relationship, the larger the deterrence from imposing relational sanctions, but also the bigger the cost of imposing such sanctions. Coming back to the bonus example, if the salesperson's staying on her job would have produced $100 of value for the employer-employee pair, by quitting her position, she would have imposed (the maximum of) $100 in deterrence. At the same time, though, the parties are losing $100 of surplus that they could have gotten in the future. The deterrence-to-cost ratio, in this example, is 1 to 1. Parties in a long-term relationship will prefer to choose a deterrence mechanism that produces the most bang for the buck, and the flexibility in the design of the formal sanctions can produce that desirable result. This provides one explanation for why even sophisticated commercial parties in long-term relationships still draft and rely on formal contracts.

Are there other reasons why parties might want to use both legal and relational sanctions?

Another benefit of using formal sanctions is informational. Especially in settings where multiple parties can transact with one another, effective communication amongst the parties plays an important role. If a supplier cheats on a buyer, community-based, relational punishment may require other buyers to stop transacting with that supplier. But how will other buyers find out about the supplier's misbehavior? There are, of course, many different modes of communication, some formal and others informal, but one particular mode we emphasize is judgment from a formal dispute resolution system. For example, when a court finds that the supplier has reneged on her promise to deliver conforming goods or acted in "bad faith," when such judgment becomes public information, this allows the other buyers to coordinate their actions against the misbehaving supplier. In that sense, using formal sanctions facilitates more effective relational sanctions.

By the way, the informational role goes both ways. For instance, in determining whether a defendant breached the contract, courts will often look at the parties' prior relationships ("prior dealings"), and the information from past relationships can help produce better judgment.

How do such concepts as acting in "good faith" or "bad faith" play into the discussion?

Courts have trouble identifying what conduct amounts to acting in "bad faith." This is not surprising, not only because the concept of "good faith" is ill-defined, but also because whether a particular party did or did not act in "good faith" is highly contextual and industry or market-specific. Consistent with the idea that formal sanctions can play a useful informational role, we suggest that the court's determination of "bad faith" is not just about getting the judgment right in the case at hand. In doing a careful good-faith analysis, the court also provides information to future contracting parties. If future buyers learn that a seller has delivered a faulty product because she rushed production, even if the court determines that the seller's conduct did not amount to acting in "bad faith," the buyers, who are better informed than the court, will become more hesitant in transacting with the seller. Particularly in the context where relational sanctions play an important role, uncovering and making public the evidence of "bad faith" by a court plays a useful role in inducing better-tailored relational sanctions.

What does your work say in general about the relationship between these two types of enforcement mechanisms?

There is an ongoing debate within the legal academia about whether formal and informal sanctions function as substitutes or complements. Many influential scholars have shown or argued that imposing legal sanctions tends to "crowd out" informal sanctions: They are substitutes. At the same time, there is substantial evidence, mostly empirical, that formal sanctions can induce informal sanctions. Consumers' ceasing to purchase a manufacturer's product after a products liability judgment against the manufacturer is one example. We argue that legal and relational sanctions will often function as both substitutes and complements. On being substitutes, contracting parties will attempt to provide the necessary deterrence at the best cost-benefit ratio and will often prefer one type of sanction over the other. In this way, the two types of sanctions function as substitutes. On the other hand, it will often be the case that neither mechanism will strictly dominate the other, and the parties will employ both types of sanctions in solving their enforcement problem. Further, once we take the informational role into account, one type of sanction will often facilitate the other: They act as complements.

What are you working on next?

I'm currently working on several new projects. Let me mention just two. The first project is on the role of controlling shareholders and private benefits of control. The project attempts to analyze more closely the costs and benefits of having a controlling shareholder and allowing certain private benefits of control. One argument that comes from the analysis is that private benefits of control will often enhance a controlling shareholder's long-term commitment to the firm and this can generally increase the overall firm value when such long-term commitment is important. The second project is on post-closing adjustment clauses , such as earnouts and purchase price adjustments, in mergers and acquisitions contracts. With an earnout, for instance, the seller doesn't get the entire consideration at the time of closing. Rather some portion of the payment is tied to certain post-closing measures (such as earnings). The goal of the project is to better understand how such mechanisms can allow the parties to overcome various transactional challenges.

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