Think before you tear up an unwritten contract

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The substitution of transaction-oriented dealings for relationship contracting added to profitability in the short run; but in the long run it eroded relationships that had been the underlying source of much of that profitability.

The chief of Clan MacNeil owned much of the Isle of Barra, the most southerly of the principal islands of the Outer Hebrides. Barra is famous for its beach airstrip, which disappears at high tide. The island is also noted for its role in Whisky Galore, the more or less true story of how its inhabitants drank the cargo of a wrecked ship carrying export whisky. In 2003 the MacNeil gave the estate to the Scottish government for the benefit of Barra’s people, having previously donated his castle to Historic Scotland for posterity.

I.R. Macneil was an American law professor. His most important contribution to scholarship was the concept of relational contracting, explained in an extended article in the Southern California Law Review in 1974 and subsequently developed into a book entitled The New Social Contract. I discovered Macneil’s work 20 years ago in the course of research into the competitive advantage of companies. The modern business is often described as a nexus of contracts. But the meaning of a contract frequently depends on the social context in which it is made and implemented.

The importance of context to business performance was first elaborated by a sociologist, Stuart Macaulay, who emphasised how trust relationships underpin business behaviour. Using the label relational contract, Macneil introduced a similar idea to legal theory. Economists talked of implicit contracts as a means of dealing with imperfect information in a changing world. Similar strands of thought had been developed simultaneously and independently, by legal, theorists, sociologists and economists.

The economic perspective emphasised that, in most commercial situations, it was impossible to specify all the contingencies that might arise. The formal contract was necessarily incomplete. Enforcement by reference to the explicit terms of the contract was therefore uncertain, expensive and largely irrelevant. The effective mechanism of enforcement was the need of the parties to go on doing business with each other.

Lawyers for American companies spent hundreds of billable hours drawing up contracts to which no one ever referred. Their Japanese counterparts engaged in complex business relationships with no formal agreements at all, or ones that covered a single sheet of paper. But the commercial relationships that emerged in Japan’s car industry were more successful in securing component reliability and managing just-in-time inventory than those hammered out by the hard-nosed negotiators of Detroit.

In my own work, I used the term architecture to describe competitive advantages derived from structures of implicit contracts with suppliers, employees and customers. Marks and Spencer exemplified the use of such relational contracts.

I had barely formulated this thesis, however, when the company began to put strain on these relationships, in the interests of shareholder value. If the success of M & S demonstrated the power of relational contracting, the company’s decline illustrated a process that swept across business – and above all the financial sector – from the 1980s. The substitution of transaction-oriented dealings for relationship contracting added to profitability in the short run; but in the long run it eroded relationships that had been the underlying source of much of that profitability.

I might have drawn that lesson from the courses in Scottish history to which I had been subjected years earlier. The traditional relationship between the chieftain and his clan, now much romanticised, imposed an implicit structure of mutual obligation, which could not, and did not, survive into modernity. As the feudal commitment was replaced by an economic relationship, some Scottish landowners (not the lairds of Barra) became very rich. But the Highland Clearances provoked a resentment that persists to this day, and the long-term economic decline of the rural economy was relentless.

It was only upon reading the obituaries of a man who died last month that I discovered that the MacNeil of Barra was also Professor I.R. Macneil, author of that article in the Southern California Law Review.

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