How Too Many Legal Contracts Are Costing Business

What do work-for-hire contracts, email disclaimers and spam have in common? They are all getting ubiquitous, annoying—and ineffective.

Here’s what I mean.

Trend #1: Business is moving from a vertical management model to a horizontal purchasing model. Consider benefits administration: once a department reporting to the VP HR, now a purchased service, linked to the company by a commercial contract for services.

The Result: more contracts.

Trend #2: Communications and media—like books, records, movies and letters—have been fragmented, even atomized. In their place: email, twitter, web sites, links, sampling, and digitization. Far more opportunities for claims of intellectual property rights.

The Result: more contracts.

Contracts and Costs

Think of contracts as transaction costs. Unlike production costs, contracts add zero value. They are a tax on productivity—necessary for orderliness in a complex society, but a form of overhead nonetheless.

Here’s the problem. Costs of production go down with scale. Transaction costs, however, go up. Often exponentially.

The more commercial contracts, the more detailed the lawyers will want to make those contracts. The more fragmented the bits of sample music are, the more detailed must the IP contracts become to cover all eventualities.

The old response to risk was to create tighter contracts. But as the world becomes more complex, the ever-fertile legal mind will find more and more risk to be mitigated—and will unfortunately default to the only thing it knows—more and more complex contracts.

When quantity of contracts demanded is multiplied by some exponential complexity factor, you’ve got a serious economic issue. It’s hard to nail down the macro-economic costs of complexity, but they are very real. See, for example, Steven Covey’s Speed of Trust or Collaboration Rules by Philip Evans and Bob Wolf.

Still, you can get a visceral example of it by looking at email disclaimers. Spudart offers a tour of 50-plus samples—Great Moments in Email Disclaimers, so to speak—for your reading pleasure.

Or harken back to BusinessWeek’s legal advice to small business owners to use the fine print on sales receipts to protect companies from their customers.

And the Law Offices of Ernest Sasso gives you the downward spiral of logic that leads lawyers to attach such disclaimers to their own email; you can see the slippery slope by which every email by everyone to anyone should—in theory—have disclaimers attached.

It is, of course, ironic that disclaimers usually say "don’t read this if it wasn’t meant for you." Too bad they come at the end, after you’ve read the email.

More significant are increasing clauses in commercial contracts. Five years ago, I wasn’t being asked to certify that my subcontractors on a $50,000 consulting job had automobile insurance. I don’t recall being asked to indemnify huge clients against potential suits by third parties for theft of intellectual property. I don’t recall the ubiquity of IP suits I’m hearing about now.

Only Luddites object to increasing complexity. But only troglodytes insist on pushing the same old tools in changed circumstances, not noticing that the tools are making things worse, rather than better.

Interestingly, parties to contracts are beginning to push back in their own way—through the use of constructive hypocrisy. “Sorry about this, the lawyers are requiring it…you know, this won’t ever really come up…it’s just a technicality, if we ever need to address it we’ve always worked it out before…come on, this doesn’t really have to change things…”

Constructive hypocrisy is often quite preferable to actually trying to live by this contractual spam. Unfortunately, many people insist on actually meaning it. And enforcing it, if only for power plays. And it doesn’t take too many to force the rest to live by it.

Is there an alternative? You betcha. It’s called more trust.

If you think that’s fluffy, read about how one buyer bought an $800 million business in 20 minutes in this Wall Street Journal article.

The buyer? Warren Buffett.


The Cancer of Short-term Thinking

Western capitalism is fighting a form of business cancer. And the most virulent form of it is short-termism.

In physical cancer, some cells go haywire and turn viciously against the body. This is also what happens when certain core beliefs are perverted or taken to extremes. Some examples—the beliefs that:

• greed is good (Hollywood simplification)
• individual pursuit of selfish aims yields public good (mis-translated Adam Smith)
• pursuit of short-term corporate goals ends in long-term social success (what’s good for General Motors hasn’t been good for America for some time now).

Those and other beliefs have resulted in rampant short-termism. A few examples, “ripped from the headlines:”

1. The trend in private equity toward front-end deal fees. Gretchen Morgensen’s NYTimes article quotes Michael Jensen, emeritus of Harvard Business School and the “father of private equity:”
“…these fees are going to end up reducing the productivity of the model… People are doing this out of some short-run focus on increasing revenues."
In other words, private equity is good when it subjects bureaucratic managers to the pressure of markets, with say a 3-5 year timeframe. But when the privateers themselves succumb to the lure of instant front-end fees, the greed snake is eating its own tail.

2. The trend in the mortgage industry to convert relationships to transactions—from integrated loan-making and loan-holding, to separating the entire process into various stakeholders—most of whom get their money up front, now. Short term.

3. The IBGYBG mentality in investment banking during several market crashes detailed by Richard Bookstaber in his book A Demon of Our Own Design, that resulted in people making fast deals that would explode on investors down the road, but that paid off nicely up front for the dealmakers, who said not to worry, because—"I’ll be gone, you’ll be gone," it’ll be someone else’s problem then.

4. Young financiers opting out of an MBA because the opportunity exists to make so much more money in the short term:
“With the growth of hedge funds, you’re getting a lot of really smart people who are getting paid a lot very young,” says Arjuna Rajasingham, 29, an analyst and a trader at a hedge fund in London. “I know it’s a bit of a short-term view, but it’s hard to walk away from something that’s going really well.” Yup on both counts.

5. The current residential real estate recession, driven heavily by speculative buyers betting well beyond their means on continued high prices—“I’ll pay off the loan when I flip it.”

6. The longer term trend in business toward “alignment” of processes—which often assumes the only way to long-term profit is to ensure that every short-term measure is itself profitable.

7. Quarterly earnings pressure, which was one of the original drivers of private equity, back when PE was doing some good.

8. Private equity firms selling equity to the public: “a non sequitur in both language and economics,” according to Gretchen Morgensen’s paraphrase of Michael Jensen .
The private equity movement initially shook up stodgy companies that were permanently-funded by stock, where inefficient managers could hang out draining away value for decades. Private equity would buy them and insist on returns in 3-5 years; it left managers no place to hide, and produced real value returns. But when the 3-5 year people themselves start selling permanent stock to investors, they have become what they started out to fight. Which means they’re either stupid or venal. And while I usually opt for stupidity in explaining conspiracy cases, in this one I’d put money on venal.

Is there any relief? Or is this just another case of cheap hustlers exploiting weak human nature that goes with every business cycle?

Three antidotes can work against short-termism. One is pain. Suffering may not be a sufficient condition for social change, but it’s usually a necessary one.

Second is education. Awareness creation can help.

The third is leading thinkers, and there are some hopeful signs. Martha Rogers has begun talking about a lifetime financial perspective on customers:

"Creating maximum value from your customers involves optimization — balancing current-period profits against decreases or increases in customer lifetime values, to maximize your “Return on Customer.”

This isn’t new in finance, accustomed to present-value thinking in pricing financial assets. But it’s new to management thinking, accustomed to quarterly EPS. Robbing future customers robs enterprise value, says Martha. And she’s right.

The aforementioned Michael Jensen announced last month a paper he wrote with Werner Erhard (the controversial founding father of EST training, and more recently of Landmark Forum) on the subject of—get this—integrity.

Here’s a tasty quote from the abstract:

We demonstrate that the application of cost-benefit analysis to one’s integrity guarantees you will not be a trustworthy person (thereby reducing the workability of relationships), and with the exception of some minor qualifications ensures also that you will not be a person of integrity (thereby reducing the workability of your life). Therefore your performance will suffer. The virtually automatic application of cost-benefit analysis to honoring one’s word (an inherent tendency in most of us) lies at the heart of much out-of-integrity and untrustworthy behavior in modern life.

They are right too. You can’t fake trust; trust is a paradox; motives matter. The act of justifying trust by its economic value destroys not only trust, but its economic value. The best economic results come as byproducts, not goals.

Can clearer business thinking beat short-termism? It can’t hurt.