When Contracts Destroy Trust

Contracts are designed to reinforce trust and reduce risk. Unfortunately, when they’re too detailed or rigid, or when they send mixed signals, they can exacerbate the very problems they’re supposed to prevent. At a time when trust is already in short supply, managers can’t afford to make these mistakes. Trust requires that parties see each other as ethical and well-intentioned. Overly detailed contracts that codify every potential interaction can undermine trust by preventing spontaneous displays of good intentions. That’s a lesson one financial services firm recently learned. Its relationship managers would complain when corporate clients asked them to instantly remedy the client’s own mistakes. The managers would inform the client that, as explained in the contract, such problems take three business days to address. Inevitably, the client would plead for a quicker solution. Seeing an opportunity to increase revenues and discourage mistakes, a VP suggested that the firm offer expedited solutions for a sizable fee and put that arrangement in the contract. To his surprise, the relationship managers unanimously opposed this idea. Why? As one manager explained: “Do you know how little relationship managing we actually do? Everything is mandated by contract! But when the contract is up for renewal, the only day the client remembers is the one when we went beyond the contract to help them.” By giving managers room for such volition, he reasoned, the company would more than offset the short-term inconvenience and lost revenue with greater goodwill and loyalty. Contracts that are too rigid can also be problematic if they lock parties into arrangements that seem like a good idea in the moment but don’t allow for important adjustments as circumstances change. For example, three Harvard Business School students recently cofounded a social-networking website. At the time, they crafted a contract indicating that the equity would be split almost equally, with slightly more going to Michael, since the venture had originally been his idea. Problems surfaced when Michael started to feel that he was doing more work than his partners and asked for a renegotiation. His cofounders didn’t agree with Michael’s assessment and felt that he was reneging on their contract. Was the conflict inevitable? Not if the initial agreement had been less rigid. Parties to a contract often overestimate the level of certainty in the environment and underestimate the likelihood of a future divergence in perspectives. As a result, they include fewer contingencies than they should and are eager to finalize terms even when it would be wiser to postpone settling some matters. In this case, the partners should have waited to assign at least a portion of the equity until after their roles and contributions were clarified. Instead, even as the company’s strategy evolved and the value each brought to the venture changed, the contract provided no scope for a smooth adjustment of equity—eroding trust and goodwill. Wisely structured contracts postpone agreement on terms that would be more effectively handled after more information is available, and they include contingencies commensurate with the current level of uncertainty. Many contracts include incentives such as performance pay, earn-outs, and vesting schedules. Unfortunately, in some contexts such incentives can signal mistrust. Look at what happened when, after 12 years as manager of the New York Yankees—a period in which the team made the play-offs each year and won the World Series four times—Joe Torre was offered a one-year renewal. The contract lowered Torre’s base pay but included a large incentive for reaching the play-offs and winning the World Series. Torre was insulted, saying the deal implied he couldn’t be trusted to deliver his best effort without an incentive. He rejected the offer and joined the Los Angeles Dodgers, where he was paid less in total compensation than the Yankees had proposed as a base salary! One way to avoid outcomes like that is to limit the use or scope of contractual incentives, especially when the target is already a very high performer or when noncontractual inducements are available (such as social or competitive pressure). Alternatively, parties can reframe an incentive as a way to “share in the value we all create when good things happen.”

When Contracts Destroy Trust

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