The world of contract management got a boost from the Royal Swedish Academy of Sciences on Monday. That morning, the Academy announced the 2016 Nobel Prize in Economics was awarded to Oliver Hart and Bengt Holmström “for their contributions to contract theory”.
We were thrilled to see contracts get such great recognition, and to learn more about the important work of Hart and Holmström. Like many winners of this prestigious award, these two men have seen their theory infuse the basic understanding of their field. Today, we intuitively accept their findings on the principal-agent problem, conflicts of interest, incomplete information, and other critical theories that inform contract design.
How Contract Theory Informs the Optimal Contract
More than ever, every company and every contract author now must acknowledge the importance of contracts on their day-to-day activities. The question turns to how contract theory can inform the process of designing optimal contracts. Here are four practical considerations from this Nobel Prize.
1) Hart and Holmström find that contract design matters in many ways. If you handle contracts in volume, you won’t be able to structure, author, and negotiate the best contracts for your business without a tool that gives you full control and visibility of your contract design. Partial and limited tools won’t do enough for your business.
2) Contract theory highlights the importance of designing proper incentives into your contracts. Many of the professionals involved in contracting are not directly involved in incentives management, so it makes sense to use a contract management provider that also understand and offers incentives tools.
3) Whatever incentives you have in place with your counter-parties, you need excellent reporting capabilities to scorecard their performance. You need to make sure you make the correct payments and follow the terms of your agreements—and also that you can understand the tradeoffs you are making so you can address any issues at renewal time. Contract theory tells us that it’s not possible to observe or control every action of a counterparty, so it’s critical that your contract management tool capture and use all available information. We often see businesses that have underinvested in contract management struggle to measure their obligations, leading to a cascade of poor decisions, missed payments, and expensive manual resolutions
4) Contract theory applies to almost any kind of agreement, so you need the best contract management tools for all contracts—not just sell-side agreements or buy-side agreements. If you use separate and disconnected systems for parts of your business, you are opening yourself up to the risks that Hart and Holmström revealed: improper incentives, poor measurement, and incomplete contracts caused by poor controls on negotiations and legal language.
Apttus is proud to offer the highest-rated and most capable contract management tools, giving you the ability to control your full contract lifecycle. Don’t worry about whether your contract practices fail to capture the key lessons of contract theory. Let us show you a contract management system that you’ll prize.