Finance:Proactive contracting

Proactive Contracting is akin to Proactive Law and focuses on the same properties, namely to prevent problems and promote relationships. The legal area of research developed in Scandinavia in the 1990s and has gradually gained attention. Proactive Contracting deals with Contract Management, Relational Management, Risk Management and Business Process Management.

The word proactive is the opposition to reactive and refers to acting in anticipation of future problems, needs, or changes.

A survey conducted by IACCM shows that businesses urge a paradigm shift in contracting, favoring a more relational approach. Thus, the focus of future contracting becomes more relational. Businesses may therefore face increased complexity as trading is done not only across physical boundaries, but also across religious, cultural, and ethical boundaries.

The IACCM survey has underpinned the need for re-thinking contracts and the approach to business relationships, as international, and long relationships, make it hard to draft and agree upon every single event that might occur in the future.

Proactive Contracting is moving away from the path of responding to these complex relationships with complex contracts. However, as it is hard to imagine realistic alternatives to contracts, Proactive Contracting suggest businesses to change perception of contracts to meet the needs of the future. Add to this the increased complexity of products due to technological evolution and it becomes clear that businesses need to actively deal with the danger of increasing complexity and uncertainty. In fact, a survey conducted by IBM Corporation revealed that 79% of Chief Executive Officers (CEOs) see increased global complexity as a major challenge over the coming years.

As the legal framework increases in complexity, it becomes apparent that there is a need for creating certainty in order to support future trading. Businesses need to manage this complexity in order to avoid unnecessary losses, but also in order to exploit all the possibilities deriving from global interaction.

Empirical studies on contracting capabilities and research on dynamic capabilities have shown that promoting proactive behavior in businesses is a key in the quest of future success. As globalization increases, sustainability and certainty become more urgent, resulting in decentralization of the traditional legal environment. The reason for this decentralization is that the traditional legal environment does not fulfill the task of creating the certainty and sustainability that businesses need in order to prosper.

After the launch of the United Nations Decade of Education for Sustainable Development, mechanisms have evolved through which future development is achieved. According to these mechanisms, a sound development must be focusing on ethically acceptable, morally fair and economically sound processes. Management tools for global value chains have already been developed, and focus is especially on self- and private regulation instruments and standards - this is where proactive contracting and proactive law is coming to the fore.

Preventive Law

The proactive law movement has become more visible in recent years, but the idea of an ex ante view is not new. It is generally known that the earlier a dispute or a potential dispute is addressed, the better the chances of a fair and prompt solution. Louis M. Brown was the first to introduce the ex ante view in his ground-laying book “Preventive Law” Although he identified and organized the preventive law into a distinctive way of thinking, he was not the inventor of this approach. It has been, and still is, well known to many legal professionals and every business manager that:

"It usually costs less to avoid getting into trouble than to pay for getting out of trouble."

In order to understand the general principles of proactive law, Edward E. Dauer has identified the core principles of preventive law, as these principles create the foundation on which proactive law and proactive contracting is built. The four core principles of preventive law are:

• Predicting human behavior: A legal solution, which anticipates and takes into account what people will do and by doing so, preventing litigation. This improves personal and business relationships, and constitutes an essential part of the preventive law.
• Conflict management: Preventive law is drawing parallels from the medical context, illustrated by the fact that successful medical treatment is prophylactic.
• Embracement of risks: Instead of focusing solely on reducing one or a few elements of risks to zero, the preventive law approach focuses on the overall sum of risks and strive to reduce the overall risk.
• Preventive legal service: Lawyers and in-house counsels must participate with others in multi-disciplinary teams in the planning of the business’ venture. By bringing in legal expertise earlier, it becomes possible to detect and prevent legal problems from occurring.

The proactive law movement encompasses the basic principles of preventive law stated by Edward E. Dauer, namely preventing what is not desirable, and keeping problems and risks from materializing. Thus, preventive law constitute the foundation of proactive law. To this preventive dimension of law, proactive law adds a second aspect, which is often neglected in traditional law – known as the promotive dimension.

The Promotive Dimension

The nature of the promotive dimension is positive and promotes what is desirable while encouraging good behavior. This is the distinction to preventive law.

In a legal context, proactive law emphasizes the importance of collaboration between legal professionals and other disciplines, in order to achieve the desired goals in circumstances where legal expertise works in collaboration with other professionals involved. In proactive law the need for dialogue between different understandings is thus emphasized. In a medical context the preventive law prevents ill health, while proactive law promotes well-being.

The proactive law approach is based on legal certainty, literacy and cross-professional collaboration in order to “localize the mines and preventing them from exploding.”

Businesses need to manage their compliance with the law and align it to business objectives. In order to do this, not only lawyers, in-house counsels and regulators need to know the law, but also managers and other stakeholders need to have basic knowledge and understanding of the legal mines. When the business have the capability of navigating past the mines through legal literacy and awareness, it has used the law in a proactive manner that in the end may constitute a source of competitive advantage.

Contracts and contracting processes are complex and often involve cross-professional collaboration. The different stakeholders to a contract each represent their respective area of responsibility, e.g. technical, financial, legal area, etc. A successfully executed contract is thus dependent on the stakeholder’s ability to communicate and collaborate. In order to promote successful contracting, the stakeholders to a contract thus need mutual understanding in order to collaborate efficiently.

How to Apply Proactive Contracting

The quest is thus to go from theoretically to practically applicable solutions, in order to obtain a competitive advantage. One big leap in this process is recognition of the benefits that proactive law brings into contracting.

It all starts with the managers. If they are not confident that the proactive approach is beneficial, then the implementation has no foundation. It is crucial that the managers are convinced that this new approach maximizes the business opportunities while minimizing the risk. Just as important, the managers need tools in order to be able to see that implementation of the proactive approach in business processes is within reach.

In order to achieve a sustainable competitive advantage through proactive contracting, there is a strong consensus that the following points need to be integrated in the business overall strategy and business processes. When the manager knows about the following contracting elements, she/he has the prerequisite to take an informed decision about going the proactive way.

Alternative Dispute Resolution

It is obvious that the earlier a potential dispute is addressed, the better the chance of a prompt and fair solution. However, even the most proactive manager may face difficulties in ADR as a dispute involves at least two parties, and their mutual willingness to follow the proactive approach.

This implies that even in situations where the parties have applied the best thinkable proactive approach to their contract, not all disputes can be avoided. If the parties lack common understanding of what they have agreed upon, this will trigger disputes.

The proactive law approach to contracting tells us that the essential thing is to anticipate human behavior, thus being prepared to take control of situations that the parties in their agreement did not predict.

The parties should take control of contingencies by considering the best method to resolve a dispute. The aim in ADR is to avoid unnecessary escalation of problems, as value is protected through proper dispute resolution. The most successful approach in solving disputes is based on preventing them from occurring by promoting a mutually healthy relationship.

By handling problems early, businesses might prevent time consuming resolutions from evolving and thereby save costs and promote value. This requires proper understanding of the mutual goals of the relationship through disclosure of procedures that aim at identifying possible sources of disagreements before they arise. Therefore, a clear dispute resolution policy provides an important strategic advantage in identifying the source of disagreement and deals with them before they develop into severe disputes. Besides avoiding costs from occurring, an ADR strategy limits the time spent by management on litigation. Thus, the costly disruption of litigation and the opportunity cost are limited.

Besides preventing escalation of the dispute, the parties are able to anticipate the next step of the resolution process, as the procedure has been contractually agreed. The parties’ incentives to incorporate an ADR clause in their contract is both economically, but also legally grounded. The optimal resolution for the parties is not reached through traditional litigation, by referring to their rights and obligations. Instead the parties should be more proactive and find a solution that is in the best interest of both parties in order to minimize losses derived from their disagreement. This enhances the chances that their relationship will continue in the future. A recent survey shows that the most favored ADR in international contracts is, arbitration. Arbitration is considered the last resort in the escalation, along with court litigation. This indeed shows that businesses miss the opportunities provided by avoiding immediate escalation.

Visualization

The proactive approach to law suggests that contracts are more than just a legal insurance policy that handles the case that one party does not perform. Contracts should be considered as a management tool that visualizes the goals to reach and how to reach them. Thus, it is not enough that the legal department and the in-house counsels read and understand the business’ contracts, and furthermore these legal professionals should not craft contracts alone as contractual literacy is required by every user of the contract.

One of these processes concerns the issue of making all the business’ contracts accessible and easily understandable to all the users. The quest is thus to change the way contracts are communicated, perceived and taught. A promising new direction for contracting practice is developing though the use of non-textual communication, which deals with visualization of legal information combined with strategy visualization. In order to facilitate a meeting of the parties' mind, visual techniques is considered a proactive contracting-resource. The idea of using visuals in contracting processes has evolved in Europe and especially Germany . This field of research is also known as - Rechtsvisualisierung.

A survey conducted by IACCM suggests that the majority of businesses expect that there will be greater use of visual techniques in contracting, and that visualization will play a main role in achieving better and more successful contracts in the coming years.

In general, visualization is understood as a graphic presentation that depicts information in a way that is conductive to acquiring insight, developing and elaborating understanding, or communicating experience. In this context, the idea of visualization is to communicate through visual legal tools in order to convey information in a way that makes it easily understandable by the users of the contract. The need for visual communication is reflected in the growing use of visual tools in businesses to explain legal concepts in legal education. However, most contracts still lack visualization, and instead use text in black and white. Businesses that take this traditional approach face huge opportunities for improvements. The research field of visual contracts is quite new, and lack solutions.

The Holistic View of Business Managers

In addition to visual contracts, managers need to avoid focusing on single objectives. Instead emphasis should be on the duration of their customer relationship, the innovation that have resulted from their interactions, and the referral business that can be traced to those customers. As stated by George J. Siedel: “Rather than focusing on whether they achieved price discounts, purchasers should emphasize a full cost approach that considers matters such as the operating efficiencies gained through using the supplier, the reductions in defects achieved by the supplier, and even the supplier’s role in developing products or service innovations.”

By going to the balcony - symbolizing the holistic view - managers become proactive as they view contracts in a big picture perspective. The focus on contracts is thus changed from a legal tool to the broader view of contracts as a management tool. Managers, who want to become proactive, need to challenge the conventional wisdom that contracts are legal documents and instead adopting a view of contracts as a source of innovation through collaboration.

The fundamental components that managers need to adapt into contracting processes, in order to become proactive, are centralized around leadership. Proactive leadership facilitates the environment needed for supporting an organization that enables high performance and good behavior that encourages collaborative contracting. The balcony view provides managers with a holistic mindset that facilitates the foundation for proactive leadership. With this revised focus, the parties can attempt to establish procedures for more open information flows and greater transparency in order to signalize their intentions to collaborate and work together to manage risks and optimize results. Thus, contracts are no longer a necessary evil, but rather an instrument that, when handled proactively, facilitates a competitive advantage.

Coase Theorem and Proactive Contracting

As trading becomes more relational, the traditional role of contracts is changing, favoring the informality of traditional sales and business development. However, this seems somewhat unlikely considering the pressure for regulatory compliance on the one hand, and the demand for better management of risk and delivery of financial return on the other hand. This leads to an overwhelming view that the result of growing complexity will be a different form of contract, adjusted to the needs of the market. Ways that this will be achieved include a growth in industry standards and in some cases increased use of private law. There will also be a continued drive towards international standards that enable agreement through reference, rather than requiring case-by-case negotiation. This view is also reflected by an IACCM survey, which shows that businesses expect international standard terms in contracting to prevail in the future. A response to this anticipated change in contracting could be based on the CISG. It is shown how the CISG can fulfill the need of standard terms in international contracting, in accordance with the proactive philosophy.

Since Ronald Coase in 1960 stated that when moving from an economic regime supposing zero transaction costs to an economic regime of positive transaction costs, the legal system becomes crucially important.

The insight of the Coase theorem is in short that if transaction costs are higher than the gains from trade, then the initial assignment of property rights determines how resources are ultimately allocated.

In the slipstream of the Coase theorem, professionals increasingly focused on understanding the roles of transaction costs and the legal system in the economy. In particular, the focus was on institutions that could enable a reduction of transaction costs called New Institutional Economics.

A great deal of the research has been based on the assumption that economic growth is reflected in the ease of doing business. Accordingly, a key recommendation is to develop institutions that reduce transaction costs and facilitate trade.

In the traditional legal framework, some managers derogate from or opt out of the CISG. In general, this is not in accordance with the mutual economic incentives that derive through the use of the CISG. Instead the proactive manager bears in mind the CISG benefits on macro level, and recognizes this as an opportunity to limit transaction costs on a micro level between businesses. The proactive characteristics support the use of tools that enable a maximization of the value in each business relationship. Thus, the CISG is truly a proactive tool that should be seen as kind of an agreed document between the contracting parties on sales of goods. This implies that rights and obligations to a large extent are subject to CISG regulation.

By using the CISG as an agreed document, the parties’ rights and obligations are distributed in a fair and balanced way that is widely recognized as promoting international trade.

Of course the CISG does not fit completely to specific transactions, thus the parties need to negotiate provisions that are dealing with the transaction, e.g. delivery, payment, price, ADR, etc. In addition to transactional terms, the parties need to negotiate a limitation of liability, as the CISG does not govern this issue. Further, there is a need to emphasize that the use of the CISG in commodity sales is often not suitable because of string trading and the lack of strict avoidance provisions in the CISG.

However, with these constraints, the proactive manager should emphasize the CISG as an agreed document, as the default rules roughly reflect the same result, which the parties would have bargained. This implies that the parties reach agreement in less time and with less effort, in accordance with the proactive philosophy. The use of and need for international legal standard terms will increase in the future, and as a response to this need, the CISG provides a framework that can easily be adopted into contracting.

Another fact that speaks pro the use of Proactive Contracting, is decisions of the German Supreme Court in cases on interpretation of the CISG. It seems that even in transactions leading to dispute, judgments seem to favor the most economic solution, supporting economic cost considerations and bargaining-for-risk theories.

Proactive Contracting as a Competitive Advantage

To transform the traditional legal approach to contracting into a proactive approach to contracting, businesses must strive to maximize the value of their business relationships through a change in mindset towards relational contracting. This view is no longer disputed as IACCM has valid measuring showing this fact.

The paradigm shift that businesses urge, which IACCM has identified, must be supported by an ex ante view on contracting that emphasizes the need for preventing problems from materializing, when possible, and resolving unavoidable disputes early using the most appropriate methods. Further, businesses are encouraged to promote procedures that can help identify opportunities before they pass in order to maximize value, strengthen business relationships and manage risk. Managing the desired goals and securing the most appropriate mix of means to achieve them require early involvement of stakeholders, alignment of objectives, creation of a shared vision, and development of support and guidance for successful implementation. By adopting a proactive view on contracting, businesses may be able to turn the view on future contracting from uncertain threat into a proactive resource of value.