Contract optimization is more about business than legal.
In 2019, the world collectively achieved a GDP of $87.5 Trillion. This economic activity results from millions, if not billions, of transactions for the purchase and sale of goods and services, with each transaction being governed by some form of contract. Remarkably, even with minor improvements to our horribly inefficient contracting process, global GDP in 2019 likely would have exceeded $90 Trillion.
Now would be a good time for the world to have access to an additional $2.5 Trillion. And it is fully within the reach of lawyers working with other allied legal professionals. Cf. Post 226 (discussing an expanded legal profession that includes other disciplines). Yet, to get there, we have to become willing to rethink and simplify contracts, which is the basic building block of all other commercial activity.
Post 228 is organized in two parts. Part I begins by examining the two main areas of loss: (1) contract formation and (2) post-execution contract management. Part II then looks at the impact of one key driver of this loss—contract complexity—and concludes by exploring several vehicles to help us solve significant parts of our $2.5 Trillion problem.
I. Contracting and Economic Loss
Economic loss, or value leakage, occurs at every stage of the contracting process. These losses, however, manifest themselves most acutely during two phases of the process: the contract formation phase and the post-execution contract management phase.
A. Losses during contract formation
The contract formation phase begins when the parties start to discuss the possibility of a deal and ends when a contract is signed or accepted. Three types of loss typically occur during this phase.
1. Transaction costs
The cost associated with finalizing a contract varies widely. At their most efficient, business-to-consumer transactions occurring in an app store have virtually zero transaction costs. Business-to-business contracts, however, commonly have significant up-front costs associated with them.
|Cost of Completing Simple Contract||$3,800||$6,900||45% saving|
|Cost of Completing Medium Contract||$14,000||$23,000||39% savings|
|Cost of Completing a Complex Contract||$49,000||$100,000+||50%+ savings|
|Source: Tim Cummins, The Cost of a Contract (IACCM, November 20, 2017).|
Simply bringing average transaction costs down to the level enjoyed by today’s top performers alone would reduce economic loss by at least $3 Billion per million impacted transactions.
2. Cycle times
Transaction cycle times also vary widely. Business-to-consumer transactions in app stores take seconds. Business-to-business transactions commonly take weeks, sometimes even months.
|Transaction Cycle Time||11.5 days||21.2 days||46% savings|
|Source: Bryan Ball, Contract Management: How the Best-in-Class Maximize Their Potential (Aberdeen Group, July 2017)|
There is a clear linkage between negotiation cycle times and cost. Reducing these cycle times down to the level enjoyed by today’s top performers would add roughly 10 days per year of additional economic activity under these contracts. With global daily GDP equaling roughly $250 Billion, the impact of these cycle time savings could be huge.
3. Transaction abandonment
Completing transactions is not easy. At a minimum, the parties must agree on product fit, delivery schedules, pricing, etc. Every additional hurdle, such as agreeing on contract terms, increases the likelihood that a transaction will be abandoned rather than consummated.
According to one recent study, “research showed that 57% of B2B buyers did not complete a purchase for their companies because the vendor checkout process took too long.” See MSTS, “B2B cart abandonment: Hidden problems & possibilities,” Payments Next, Sept 19, 2019 (citing MSTS, More Payment Options Means More Purchases (2019)). With the average business-to-business contract requiring over ten days to complete, it seems inevitable that contracting is one of the largest causes of the abandonment-inducing delay.
If streamlining the contracting process could reduce abandonment rates by even a tenth of the current rate, global GDP could easily increase by as much as one percent or over half a trillion dollars.
Taken together, the three types of losses occurring during the contract formation stage are staggering.
B. Post-execution losses
Contract formation losses pale in comparison to the value leakage that occurs after a contract has been signed. Studies over the past decade consistently show that the average company suffers annual contract value leakage equal to almost ten percent of revenues. See, e.g., Tim Cummins, “Poor Contract Management Costs Companies 9% — Bottom Line,” IACCM, Oct 29, 2012; Supporting Local Public Services Through Change, Contract Optimisation (Ernst & Young 2016) at 2; KPMG LLP Strategic Sourcing Point of View: Shared Services, Outsourcing Contracts Can Hinder Business Plans Without Proper Governance (Feb. 23, 2012).
This leakage often occurs as a result of non-compliant goods or services, billing errors, etc. If consequential losses (e.g., lost sales due to an inability to perform, etc.) are included the value leakage number increases dramatically.
While the losses occurring at the formation phase and the post-execution phase differ in nature, they share at least one common root cause: contract complexity. The remainder of this post explores the impact of contract complexity and steps that can be taken to drive improvement through simplification.
II. Contract Complexity
Contracts can be complex. There is a reason that we all throw up our hands and just click “I accept” with no analysis whatsoever when making simple consumer purchases. The alternative of trying to wade through multiple pages of legalese and numerous embedded policies, secondary agreements, etc. is simply overwhelming, and the risks associated with blind acceptance are often insignificant.
A. B2B contracting
In the B2B space, the complexity is often magnified. Likewise, the dollar amounts at stake are often significant, thus requiring businesses to conduct a meaningful assessment of risk. The resulting contract analysis and negotiations can be lengthy, made more complex by contracts that only lawyers, paid by the hour, can understand.
As noted above, the more complex the contract the longer the negotiation cycle. Even worse, as the complexity of individual contract provisions increases, so too does the likelihood that each party will draw a different conclusion as to the provision’s interpretation.
The presence of complex legal provisions in a contract has another highly pernicious impact: they shift focus away from the business issues that ultimately determine the value of a contract.
Members of World Commerce and Contracting (WorldCC) (formerly known as the International Association for Contract & Commercial Management, or IACCM), an industry association of over 70,000 contracting specialists working for more than 20,000 companies around the globe, have observed that a reduced focus on business issues during contract negotiations often causes key business protagonists to disengage at the contract formation stage, which can result in significant value leakage during post-execution. Thus, it is hardly surprising that sub-optimal delivery occurs when the business people responsible for performing under a contract do not properly understand key provisions in the contract such as obligations, milestones, etc.
B. Types of Contract Complexity
Contract complexity exists in at least two flavors: qualitative complexity and quantitative complexity. Any attempt at contract simplification requires focus on each of these areas.
1. Qualitative Complexity
A contract is qualitatively complex when it is drafted in a way that makes it hard to understand. The relevant lens here is not what a seasoned lawyer might find intuitive but what the average business person who is responsible for negotiating the business transaction and/or managing the contract post-execution finds intuitive.
Unfortunately, many contracts fail abysmally at this hurdle for several reasons.
First, the contract may simply fail to address a salient point in the formation of the business relationship, forcing the parties to rely on extracontractual measures to make sense of what they are trying to achieve. Economists generally agree that the more complete a contract is, the higher the level of economic performance it will generate. The problem can be challenging to solve since contracting parties simply cannot foresee every eventuality in a prospective relationship (especially one of long duration and/or wide scope).
Second, clauses within contracts may be drafted in an ambiguous manner, rendering them impossible for even a seasoned attorney to interpret in a definitive manner. This problem is more widespread than you might think. A recent TermScout analysis reviewed 327 standard, click-accept agreements used by a wide range of IT vendors and found that roughly one quarter failed to achieve high levels of clarity. This number is remarkable given that the agreements reviewed were all based on standard contract templates that (a) get used hundreds, if not thousands, of times, (b) are drafted without time pressure, and (c) can justify a significant investment of legal resources to get them right. Negotiated agreements, which are one-offs created under extreme time pressures, likely suffer from substantially higher levels of ambiguity.
Finally, even when a contract addresses a point in a manner that is clear to a highly skilled attorney, it may do so using legalese that is at best partially intelligible to the businessperson who is responsible for the business deal or managing the contract post-execution. Increasingly organizations are making efforts to write their contracts in plain English, but these contracts often are still insufficiently user-centered and difficult for non-lawyers to understand.
As shown in a survey of 475 organizations conducted by WorldCC in October 2020, uncertainty about the meaning of key provisions is the single biggest threat to realizing contract value. At the root of this uncertainty is a lack of clarity, which commonly stems from the factors discussed above.
2. Quantitative complexity
A contract is quantitatively complex when its length, including all referenced or nested documents, exceeds that which a user can efficiently process.
One good example of this is the AWS Customer Agreement which, at first sight, is approximately 14 pages in length. This seems reasonable until the reader discovers that it contains no fewer than 14 different sets of nested or referenced terms. One of these sets of nested terms alone, the Amazon Service Terms, has 82 different clauses that are augmented by other sets of referenced terms. The sheer volume of these agreements, coupled with the difficulty in locating and assembling all of them into a coherent body, is simply overwhelming for the user.
This type of structure and volume of contract terms is hardly unique to Amazon. Many companies, especially large ones, have extremely diverse product lines and, for logical reasons, want to use one agreement for as much business as possible. In many cases, this often converges with customer needs and wants. After all, most customers don’t want to have to renegotiate terms every time they do business with a supplier.
C. Addressing Contract Complexity
No single silver bullet exists for addressing contract complexity. There are, however, at least three things that can help companies make meaningful improvements in this area.
AI tools have made remarkable strides over recent years. A number of these tools are focused on contract analysis and allow a meaningful portion of the work in analyzing a contract to be offloaded to the machine. For example, consider the LawGeex’s AI Legal Landscape from 2018.
Three years later, the market is both more crowded and more advanced. In terms of sheer usability, the quality of output from these tools–indeed, virtually all legaltech tools–still has a way to go. But, over time, it seems reasonable to expect that AI tools can assist materially with the issue of contract length and complexity. They also have the potential to translate complex legalese into plain English, which would also help us here.
As discussed in Post 225, however, the cost of using these tools remains high and their effectiveness depends upon the data sets provided (e.g., main contract and all nested documents) for the machine to work with.
We recently have seen the emergence of multiple contract review services such as Knowable, Contract Standards, and TermScout. These services offload the challenge of assembling and analyzing contracts for companies.
[Editor’s note: Regular contributor Bill Mooz is Chief Product Officer for TermScout. He is also co-founder and Board Member of the Institute for Future of Law Practice. wdh]
Most of this analysis, however, focuses primarily on the legal terms in the agreement, and not the business terms. That said, these services stand to assist with the complexity problem in multiple ways.
First, they relieve the companies of the burden of assembling the data set—at least where standard contracts are involved, and of the burden of analyzing that data. They also can translate legalese into plain English. Below is an example of explanatory data from Termscout:
These capabilities should allow companies to efficiently handle larger document sets, even when they are not written in plain English.
Second, they can provide broad transparency into issues with a vendor’s contract, such as unclear drafting, unfavorable provisions, noticeable gaps, etc. It seems reasonable to expect that this transparency will help drive standardization within vendor agreements which, as discussed below, stands to significantly ameliorate the complexity problem.
Leaving aside the not-insignificant issue of poor drafting, contracts tend to be complex for a reason. The business relationships they cover are complex and may be wide-reaching and/or of long duration. Covering the nuances of such a relationship, especially as it evolves over time, is not an easy task. Doing so in a small number of pages, in terms that everyone can understand, is even more difficult.
Basing contracts on standards, however, can make this challenge more manageable in at least several very significant ways.
- Independent standards administered by a trusted third party can evolve naturally over time, greatly reducing the need for the parties to attempt to foresee the future and address all possible contingencies.
- Standards that get used on a repeated basis become familiar to people in the relevant industry, making them easy for those administering a contract to understand and work under. When a standard achieves sufficient adoption, companies can even align their business systems and practices to it.
- Incorporating standards by reference allows contracts to be shorter and can significantly reduce negotiation times, without compromising breadth. This is analogous to the way that nested terms work today, but unlike bespoke nested terms that are drafted by parties with vested interests, independent standards come with a level of trust and consistency that can make the process easier on all parties.
D. Sources of much-needed standards
The incorporation of different types of standards could have a very positive impact on contracts. Unfortunately, not all the required standards exist today. Some of the potentially more promising areas for further development appear below.
A significant component of contract complexity stems from differing laws and regulations across jurisdictions. For example, roughly one-third of the 14 sets of nested terms in the AWS Customer Agreement referenced above stem, at least in part, from differences in laws.
Expecting a single global set of laws regulating all aspects of commerce is unrealistic. But examples exist showing that some improvement may be possible.
For example, the EU has adopted the GDPR and other laws and regulations that standardize at least certain governing rules across its members. Even broader sets of countries have come together to adopt conventions relating to various aspects of commerce. Some, such as the United Nations Convention on Contracts for the International Sale of Goods, routinely get disclaimed and are of relatively limited impact. Others, such as the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (a/k/a The New York Convention), get used quite broadly. It is at least theoretically possible that additional conventions could get adopted across jurisdictions, reducing international business complexity.
The U.S. offers great potential for further amalgamation of standards. To date, the U.S. federal government has shown little inclination to exercise its authority over interstate commerce and set out a single set of regulations, even in such areas as telecommunications where the benefits of creating a single federal framework are logically indisputable. Still, the authority exists and could be used more.
Building upon the greater standardization of laws, ample room exists for standardization of the policies and agreements that are mandated by various laws such as HIPAA and the GDPR.
These could be administered by independent third parties to help with up-take. World Commerce & Contracting has developed a set of balanced contracting principles that apply across multiple contract types Why do companies burn time and costs reinventing the wheel every time only to arrive at similar positions, much of which are largely mandated by law?
The economic benefits of using standard contracts within industries are significant. In a number of cases industries have proactively driven this transition on their own, e.g., residential home sales, ISDA agreements, etc. These cases tend to involve high volumes of repeatable transactions, parties having similar levels of bargaining power, and/or strong time pressures for executing the agreement. Where these pressures are not present, inertia and the set ways of buyers and sellers have impeded this shift.
Outside forces, however, may cause change to accelerate. As discussed, contract rating companies like TermScout are lifting the veil of secrecy around what is in a particular vendor’s contract and how those provisions compare to market. Below is sample market data on one provision, which was generated by Termscout:
It seems logical that this sort of transparency will cause vendors to consolidate around a set of provisions that reflect the realities of their marketplace.
3. Operating practices
Contracts often seek to specify the operating practices that a party will follow in a particular area, with data security being the prime example. Holders of data have multiple obligations (under contract, regulation, and/or common law) to ensure that their vendors protect a wide variety of information appropriately. What constitutes appropriate levels of protection changes constantly as hackers continuously up their game.
To some extent, vendors have attempted to standardize their approach to data protection by agreeing to submit to periodic audits based conducted by a third party and based upon some defined standard (e.g., System and Organization Control (SOC) audits). Significant room exists for these standards and audits to become more prevalent.
4. Contract Terms and Structure
We know that most contracts are drafted by lawyers for lawyers. But why?
Contracts, in their various guises, are first and foremost business instruments that define what the parties are planning to do together. They are ultimately about communication and should be written as plainly as possible to make them understandable for all stakeholders. This is more likely to happen when contracts become more standard in the terms they use and the structure that they employ, as opposed to being largely bespoke documents. A number of groups, including WorldCC, have made significant strides in developing standard contract terms and structures that are balanced and straightforward.
We are not diminishing the important role that lawyers still play. Their input is a critical component for assessing and quantifying risk and for ensuring that the contract will be enforceable. What we are suggesting is that lawyers could become better business partners by understanding the costs of the complexity that they often create and placing a greater emphasis on creating business-friendly agreements, even when that means tempering their creative instincts and drive for perfection.
User research conducted by WorldCC clearly shows that plainer, more user-centered contracts reduce sales and negotiation cycles, sometimes by as much as 50%. This research further reveals that contract users feel better about organizations that make their contracts easier to understand and navigate. It speaks to their brand and aids greater collaboration among internal and external stakeholders. These combined factors have a significant positive impact on the value that companies derive from their contracts.
Inefficiencies in the contracting process costs the world’s economy and each of its participants dearly every year. Much of this inefficiency stems from the qualitative and quantitative complexity of contracts. Reducing complexity will not happen overnight, but companies have a growing number of tools at their disposal to start making real progress today.
Achieving true gains likely will require a far greater use of standards than occurs today. The high costs of not standardizing and the transparency being provided by AI tools and contract rating services make it likely that the pace of standardization is on the cusp of rapid acceleration. As this happens, we should expect to see gains in both the contract formation process and in post-execution contract management.