Building Trust: Relational Governance in Outsourcing Contracts

Outsourcing contracts are all based on relationships.

You cannot overestimate the value of relationships in outsourcing. 

Since the contracts shape relationships between economic actors, they become the indispensable instrument of mutual trust and commitment building - if used right!   

The definition of a contract

A contract is a legally binding promise to act in the future, e.g., delivering goods or providing services.

It is mainly required for four reasons:

• the geographical distance between parties makes it impossible to coincide the performance and acceptance of obligations by the parties;
• provision of credit by either party;
• risk allocation between parties;
• relationship-specific investments should make the exchange more profitable due to lowered costs or increased benefits.

Economic exchange is a transaction where goods or services are transferred from the provider for a return of relative value (compensation) from the receiver in a manner that advances the economic interests of both parties.

So, a contract projects an economic exchange into the future.

The theory of incomplete contracts.

The theory of incomplete contracts assumes that the parties to a relationship (e.g., outsourcing) will only write a contract that anticipates some possible scenarios of events and their consequences. Instead, they would write an incomplete contract containing gaps and missing provisions.

This failure could be due to bounded rationality or the cost of writing complex contracts (we explained the transactional cost theory earlier.)

In an incomplete contract, the parties in some situations will act differently from what is prescribed in a contract. Consequently, the parties will disagree on what an agreement really means and would want to renegotiate it.

The following assumptions apply then:

• if it is mutually beneficial to renegotiate a contract, then the parties will do so; 
• each party believes that the terms of an agreement would be enforced in the absence of renegotiation. 

Hold-up problem of incomplete contracts

Another result is that pre-contract investments couldn’t be verified, future contingencies could not be foreseen, and post-contract payoffs could not be completely secured. 

Contracting parties may be in a hold-up situation when they under-invest in contractual relationships, fearing losing post-contract payoffs. 

Let's assume your company manufactures nuclear plant equipment, which is concrete in the application and cannot be easily redeployed to another industry.

They may decide to invest heavily in developing a more efficient product.

But what if the nuclear plant's owner wanted to take advantage of the asset specificity and refused to buy the modified product at an agreed-upon price? Your company could not easily find another customer to redeploy these assets. 

In anticipation of such opportunistic behavior and the absence of mutual trust, parties would try to limit their exposure to the deal by limiting their upfront investment. Consequently, the initially planned benefits of cooperation will not be achieved. 

The Hold-Up Problem in Procurement: A Game Theory Perspective

In procurement, the hold-up problem is a classic example of opportunistic behavior, which can be analyzed effectively using game theory. 

The core issue arises when a buyer makes a specialized investment, and the supplier subsequently adjusts prices or terms, leveraging the buyer’s increased dependence. This interaction creates a strategic “game” with multiple possible outcomes, depending on the actions of both parties.

By framing the hold-up problem through game theory, we can better understand how cooperative or adversarial strategies play out in the buyer-supplier dynamic. Here’s a breakdown of the game-theoretic scenarios in this context:

Step 1: Buyer Invests, Supplier Maintains Prices

In this step, the buyer invests in specialized equipment to improve future profits (P), and the supplier chooses not to exploit the situation by raising prices. The supplier's cooperative strategy of maintaining the status quo can be seen.

Buyer Payoff: The buyer receives the profits generated by their investment (P) minus the cost of the investment (V), resulting in a payoff of P - V.

Supplier Payoff: The supplier maintains the business relationship but doesn’t gain additional profit from increasing prices. Their payoff remains neutral at £0.

This cooperative equilibrium benefits the buyer, as they can generate profits that exceed the investment cost (P > V). While not seeing immediate gains, the supplier benefits from a long-term stable relationship. This cooperation leads to a balanced outcome, with no party exploiting the other.

Step 2: Supplier Raises Prices Post-Investment

In this case, the supplier adopts an opportunistic strategy, raising prices (R) after the buyer’s investment has been made, assuming the buyer is now dependent and unable to switch quickly.

Buyer Payoff: The investment cost and the supplier’s price increase reduce the buyer's profits, resulting in a payoff of P—V—R.

Supplier Payoff: The supplier gains the additional profit from the price increase, making their payoff R.

This is a non-cooperative equilibrium in which the supplier’s short-term gains come at the buyer’s expense. The buyer may tolerate the price increase as long as they are still left with a net positive outcome (P—V—R > 0), but this reduces trust and the likelihood of future cooperation.

Step 3: Buyer Switches Suppliers After Price Increase

When the supplier pushes too far by increasing prices (R), the buyer might leave and find another supplier. However, this comes with significant switching costs (setup, delays, etc.), which leads to a loss-lose situation for both parties.

Buyer Payoff: After absorbing both the price increase and the switching costs, the buyer’s payoff becomes P-V-R-(P-R) = -V (a net loss.)

Supplier Payoff: The supplier loses the buyer’s business and suffers not only from lost revenue (R) but also reputational damage and potential penalties (B). The supplier’s payoff is R-R-B (R from Step 2, loss of R and B in Step 3) or -B (another net loss.) 

In step 3, R can be the subset of B, and the payoff is R-B (likely negative.)

Game-Theoretic Outcome

This scenario results in a Pareto-inefficient outcome, where both parties are worse off. 

The buyer loses their investment and incurs switching costs, while the supplier loses the business and suffers further damage. 

This breakdown in cooperation underscores the importance of balanced contract terms and managing opportunistic behavior.

Conclusion: Game Theory as a Tool to Mitigate the Hold-Up Problem

The outcome of the above steps is determined by the buyer's and supplier's strategic choices. Game theory helps us understand the incentives that drive these decisions and highlights the potential for cooperation or conflict.

To mitigate the hold-up problem, procurement professionals can leverage long-term contracts with fixed terms for critical investments, implement revenue-sharing models to align incentives, or even pursue vertical integration to reduce dependency on opportunistic suppliers. Each solution shifts the game towards a cooperative outcome, minimizing the risks associated with the hold-up problem and fostering more sustainable supplier relationships.

The social side of outsourcing contracts: trust and commitment. 

Professor Ian Macneil published "The New Social Contract: An Inquiry into Modern Contractual Relations" in 1980.

Macneil defined the contract as "the relations among parties in the process of projecting exchange into the future." The exchange happens along the spectrum of transactional and relational behavior. 

On one end of that spectrum, there are discrete transactions characterized by careful measurement of what's being exchanged, specification of time and manner of performance, comprehensive planning, and little expectation of cooperation outside the scope of exchange.

Conversely, contractual relations involve continuous exchange and interaction between parties. The open-ended nature of contractual relations restricts detailed planning and requires cooperation and compromise regarding contract conditions.

Macneil assumed that contracting is never completely discrete and includes relational elements, specifically trust and commitment.

He identified ten standard contract norms (behaviors) variably applied, whether formally or relationally:

• contractual solidarity, 
• effectuation of consent, 
• power creation, 
• propriety of means, 
• reciprocity, 
• role integrity, 
• flexibility, 
• harmonization, 
• implementation of planning 
• cohesive norms 
• restitution, 
• reliance, 
• expectation.

A psychological contract in outsourcing

Outsourcing is based on a social exchange relationship involving the parties' cooperation for mutual benefits. 

Mutual obligations are the essence of the outsourcing contract: the vendor agrees to make specific investments to the client for certain benefits. 

Such obligations form the psychological contract, the parties' beliefs and perceptions of their mutual commitments in contractual relationships.

There are particular client and vendor expectations of each other's obligations under the psychological contract.

If either party to a contract perceives that these obligations have not been adequately fulfilled, a psychological contract breach occurs. 

The definition of relational governance.

Relational governance occurs in commercial relationships between firms and involves the trust-based development of relationship-specific assets.  

Some researchers assume that relational governance results from enforcing economic levers, e.g., mutual dependency or credible commitments. 

Others believe it follows social norms of cooperation, flexibility, and information exchange. 

In social conceptualization, relational governance increases the chances that trust and cooperation will protect parties against disputes arising from incomplete contracts.

It is suggested that relational governance complements formal contracts. There are many reasons for that, i.e., 

• the contract drafting and negotiations motivate joint problem-solving and search for a compromise,
• well-drafted contract provisions mitigate risks of the breach of relationships,
• the better the contracts are, the longer and more constructive the relationship should be,
• the long-term and productive cooperation results in contract modifications based on lessons learned, improving the contract quality even further.  

Five Rules of Relational Contracting

1. Focus on outcomes, not transactions; (parties create a formal "Statement of Intent" that establishes their shared vision and guiding principles for the relationship and include this in the relational contract.)
2. Focus on the what, not the how; (parties document the Desired Outcomes, the Statement of Objectives, and a workload allocation.)
3. Defined and measurable desired outcomes (parties define critical few metrics linked to achieving the mutually defined Desired Outcomes.)
4. Pricing model with incentives that optimize cost/service tradeoffs (usually, parties select the cost-based pricing model.) 
5. A governance structure with insight rather than oversight. (A typical mistake would be not establishing a dedicated transformation team but a standard governance committee with people obsessed with their routine tasks.)

Outsourcing SLAs and relational governance.

Outsourcing relationships largely depend on Service Level Agreements (SLAs) - an effective mechanism to safeguard the service customer from the risks associated with suboptimal service quality, completeness, timeliness, etc. 

However, SLAs' main emphasis tends to be on governance and enforcement of service credits - pre-specified monetary amounts that the customer becomes entitled to whenever a service level is not achieved. The links between SLAs and relational governance and eventual dependencies and outcomes may become omitted or not sufficiently considered.

The following scheme represents the linkage between formal contract elements and relational governance and synergetic effects establishing trust and commitment between contracting parties. 

Outsourcing SLAs must stimulate relationships.

Relational norms, mutual dependence, and trust are significantly related to commitment in outsourcing relations.

Outsourcing engagements employ excellent relational governance when using well-structured and comprehensive SLAs. 

There may be nothing new in these observations, but the problem persists - the stick dominates over the carrot. SLAs are getting more sophisticated in suppressing providers and enforcing service credits. 

Parties to outsourcing relationships need to understand the simple logical sequence - our bounded rationality inevitably leads to incomplete contracts. SLAs need help to resolve this problem. 

To overcome that, we need to use formal contracts as relational governance. Otherwise, the broken connection between SLAs and trust and commitment is unavoidable.

Relational contracts in English law

English High Court representatives have given detailed consideration to the issue of relational contracts in English law.

They provided the list of characteristics found in relational contracts:

• The relational contract will involve a high degree of communication, cooperation, and predictable performance based on mutual trust and confidence and expectations of loyalty;
• the mutual intention of the parties that there will be a long-term relationship;
• integrity and fidelity of contracting parties’ roles;
• commitment to collaboration in the performance of the contract;
• the spirit and objectives of the venture may not be capable of being expressed exhaustively;
• parties will each repose trust and confidence in one another;
• there may be a degree of significant investment (or financial commitment) by one party (or both) in the venture. 
• exclusivity of the relationship may also be present.

The duty of good faith in relational contracts

A-priori, relational contracts must imply the duty of good faith, while long-term contracts are likely to be described as relational contracts. 

Such duty requires that neither party will do anything that will destroy or injure the other party's right to receive the contract's benefits during a contract.

In other words, if one party asks another for help and doesn’t receive it, there could be an unintentional breach of the agreement.

Therefore, some contractors appealed to the court for, e.g., the lack of service acceptance, referring to the duty of good faith. Hence, the termination of a relational contract may become very complicated unless the duty of good faith has been explicitly excluded in the stage of contract negotiations. 

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