2.1.1. Economics of contracting

The economical background assumption is that a contracting party will get more benefit from the contractual situation compared to the strains than opting out from the contract (Hemmo 1997, 21). Of course, the best contractual outcome would be that both parties could experience the same situation, i.e. a win-win situation. Contracts free the companies to focus on their core competence and to outsource all other production and service activities needed in business, i.e. the contracts enable the division of labour (Häyhä 1996). The contract is a binding promise to deliver in the future to the other party a service or product against payment or other counter-performance. Thus in this sense contract law is actually based on monetary terms. Häyhä (ibid) further argues that the contract must be understood as a tool that the parties use to divide the future risks. The contract also allows the contracting parties to better anticipate each other’s future behaviour.

According to Klein et al. (1978) long-term contracts give a primary alternative to vertical integration as a solution to the general problem of opportunistic behaviour[1]. To distinguish between a long-term contracting and vertical integration is not always clear. They further argue in favour of a long-term contracting although the contracting partners are not able to include all possible contingencies in the contract, as it would be to resource consuming. They rely on the goodwill of market-enforcement mechanism that supports the realization of the contract as anticipated (ibid). A company that behaves opportunistically and not fulfilling the contract would be driven to a position where they lost future business opportunities as a result of extralegal market sanctions.

Contracting and governance. As Ring and Van de Ven (1992) note the managers must constantly do buy or make decisions as they operate in a dynamically evolving and time constrained business environment. The Transaction cost economics –analysis (TCE) is static and does not take into account history, i.e. the transaction that follows one another does not in any way have an effect on the next one.

The market governance structure is common and applicable to non-specific transactions, independent from the frequency, see Fig. 2. As discussed above the discrete transactions, be they occasional or recurrent in their nature, the markets are in concordance with the classical approach. The customer and supplier in these markets must rely on themselves as the contract is the only safeguard against the usage of opportunism if there was an open possibility for that. No relationship between the parties exists that would prevent parties from resorting to underhand methods. The trilateral governance structure again capitalizes the possibilities drafted in the contracts to use third-party assistance e.g. in the form of arbitration to resolve disputes or evaluating the parties performance during contract fulfilling (Williamson 1985).

The bilateral governance structure is typical for long-term contracting purposes with recurrent contracting utilizing mixed investments in the relationship where the autonomy of the parties is maintained. The transactions have a non-standardized nature and this favours continuity in the trading relationship. Whereas the unified governance structure may be the most suitable in situations where two parties find out that the most profitable mode of cooperation is as close as possible in order to protect the highly specific investments. This development can even end in different forms of alliances via licensing to more systematic and lasting forms of cooperation, mergers and joint ventures where the transactions are removed from the markets inside of the firm (Nooteboom 1999).

But from a modern relationship research perspective it does not pay enough attention to other motivations, e.g. the social elements in the business relationships and equitable outcomes (Ring & Van de Ven 1992). Jones et al. (1997) identify four conditions necessary for network governance to emerge and thrive: (1) demand uncertainty with stable supply, (2) customized exchanges high in human asset specificity, (3) complex tasks under time pressure and (4) frequent exchanges among parties comprising the network.

The main attributes of contracting according to the Williamson’s (1985) TCE-theory are the behavioural assumptions including the bounded rationality[2] and opportunism as well several dimensions that are the asset specificity of companies, uncertainty of the future and frequency of transactions, see also further discussion on bounded rationality and opportunism in (Timonen 1997). These are also the focal issues where the critique of his framework is concentrated as the critics find the theory to have a too unilateral and twofold theoretical perspective. The basic unit of analysis is a transaction. Whereas in this study the salient theory is the relationship development between to firms elaborated by the International Industrial Marketing and Purchasing -group (IMP) and the basic unit of analysis are the activities of process elements (Naudé & Turnbull 1998, ix) and (Håkansson 1982). These are further elaborated in the next sections.

Ring and Van de Ven (1992, 487) have studied the advantages of recurrent and relational contracts in relationship governance. Their analysis of cooperative agreements is based on following assumptions about the partners. First the risk and trust are separable concepts. The risk may have the character of commercial, technological, scientific, engineering and corporate risks. The degree of the risk depends on time, possible unexpected events and information. Trust again can be seen from two perspectives that are: 1) the predictability in one’s expectations and confidence in other’s goodwill, 2) assumption of trustworthiness over opportunism and both parties trust on each other to deal fairly about the uncertain future (ibid).

In the case of the markets (Table 1) the discrete contracts, classical contract law and markets provide a sufficient mechanism for governing transactions in the environment in question (ibid).

The hierarchy again is characterized by a high level of risk and economic efficiency and it is typically guarded by hierarchical governance structures. They could even end mergers or joint ventures in order to reduce the prevailing risk factor. The recurrent contracting scheme enables the parties to build trust based on norms of equity and reciprocity. If the partners are given the opportunity they may practice first with the low-risk recurrent transaction in order to establish and build trust for future more demanding joint efforts. Lastly the relational contract describes the case where the risk of the transaction is high and the trust level between the partners is also high, so that it is not only sufficient but is also necessary. According to Ring and Van de Ven the relational contracts require a more complex governance structure than is required in the other modes scrutinized above. However, as the parties see their interest is to converge the authority and other control mechanisms related to performance outcomes can be loosely specified in the contract (ibid). This flexibility allows them to leave gaps in the contract and thus to avoid over-specifying the contract as the partners are able to internally harmonize possible conflicts. They further argue that the emergence of the relational contracts is a dynamic process.

Gaps in contracts. Written contracts are not needed if, there is absolute trust between the contracting parties and both parties understand precisely about what they are making a contract and they agree on the issue. However, as the case is seldom this, binding (usually written) contracts are being used. Still in every case the contracting parties must cover themselves from unforeseen situations that are not under their control. The most important value and reason for contracting is that it makes possible controlled co-operation between totally strange parties. However, in addition to the contracts the co-operation runs considerably more smoothly when trust prevails between the parties. The contracting process is a cost factor. Therefore the costs of drawing up contracts must be smaller than accruing costs from the possible losses of the non-fulfilment of the contract. The necessity to make a contract and minimizing transaction costs of contracts can be examined with the following inequalities (Cooter & Ulen 1999, 200):

Cost of allocating a risk > cost of allocating a loss * probability of a loss ⇒ leave gap.

Cost of allocating a risk < cost of allocating a loss * probability of a loss ⇒ fill gap.

Gaps are elements in the contract that are left from the written agreement. Because of the contract writing costs (endogenous opportunity costs of time), it is meaningful to agree only on those things that really are economically significant even though the contract would perform better if more or even all contingencies could be specified in the contract (Gifford 1999). The parties must weigh the cost of drafting a contract that would foresee all possible situations. As this is not economical the parties must be satisfied with an incomplete contract structure (Hart 1988).

Contracting comes into play, for example, when the customer has decided to outsource part or whole of its application development. This is normally after the customer has compared and analysed the in-house development costs of the application with buying the same software from an outside vendor, cf. (Heiskanen, Newman et al. 2000). During this analysis all the relevant costs, included the transaction costs, are calculated. As the transaction costs are made up from e.g. drafting, negotiating and safeguarding the contract, the cost of formulating the agreement grows depending on how detailed and tight the partners want the contract to be (Williamson 1985). These costs and usage of resources are excess costs and it is in both parties interest to try and keep them as small as possible. For this reason the supplier has to have some advantages compared to the customer to be able to win the contract. This is also true with the competitors. The supplier may own one or several factors that make it more economic than an in-house development project. These elements can be e.g. special know-how, economic development processes, quality standards, etc. On the other hand the partners have to guard themselves against a “lock in” situation and opportunistic behaviour (Hart 1988).

Houtsonen (2000, 235) gives an interesting sociology of law perspective to contracting. He presents the question “What extent do other operations’ models and rules other than formal contractual conditions create relationship activity expectations to be anticipated?”. The answer to the question is in convergence with the business relationship approach discussed in the next section. Houtsonen (ibid) defines the established, common and self-evident contracting practices in focal line of business both to restrict and to make possible the economic exchange between the companies. The model of operations is supported by institutionalised rules that are formal legal norms, informal social norms and cultural categories etc. The cooperation between companies is characterized by the questions, what is the relevance of a formal contract in the relationship and its development, what is the role of the lawyers during the negotiations and the contracting process, what kind of contracts are used in each various situations, who is authorized to sign the contract, when the contract is invoked, i.e. what are the situations when the contract is actually “taken out of the drawer” and what are the regulations and rules on which the contract rests (ibid, 236)? These are among the fundamental questions that this study answers in the specific context of a software developing company. It is also interesting to study how long the line of business must have been developed before it has attained ways of actions that can be considered as institutionalised behaviour amongst the companies. Technological development often breaks old institutions and customs as the cultures encounter, technology creates possibilities that neither the individuals (i.e. companies) nor the legal systems can predict.

2.1.2. Types of Contracts

Grönfors (1989) describes a general model for gradual bonding of negotiation positions. The complicated contract structures are built during a longer time period. First during the contemplation or study phase the negotiating partners seek contact and in general explore the future contractual cooperation possibilities. When the partners have found enough possibilities for sound common business opportunities they usually sign a letter of intent. The letter of intent is a document where the partners write down their purpose of entering into a contractual partnership. The purpose of the document is to express the consensus that prevails between the partners of the contract that will be drafted and signed in the future in a situation where the precise and central issues of the contract are better known. The letter of intent does not bind the partners, as does the preliminary contract (binder) to make a contract in the future (Nurmi 1997). After this the partners enter into the negotiations phase during which the specific conditions are drafted in more detail. However, some academics argue that even though the letter of intent is not as binding as a preliminary contract it restricts the partners not to negotiate about the same project with a third party. The legal situation in Finland is though unclear. Warberg (1997) describes several generic contract types as depicted in Table 2.

The above-described contractual forms increase in the level of integration and complexity, moving down the table. However, Warberg (ibid) argues that this perspective is only one of many possible, as contracts in the business environment are so manifold they can be viewed and characterized from different angles.

Contract templates. Above transaction costs were defined to be excess costs that in a sense do not add any special value for the rendered service or delivered product they should be as low as possible. One way to lower these costs is making good use of the standard contracts and other methods to standardize the exchange processes (Hemmo 1997). To these methods also belongs the aptitude for settling disputes preferably by arbitration than in court that judges on the basis of the presumed intention, where the result may not reflect the view the parties had in mind when drafting the initial contract (Bainbridge 2000). Template contracts (standard contract, boiler plate contract) mean contracts that use at least to some extent general ready-made conditions. The standard conditions are used to make the contracting procedures more efficient. The company can clarify and specify the non-mandatory terms that may be confusing. Wilhelmsson (1995) characterizes this contract type as follows:

1. They are drafted to be used in several individual contracts.

2. They are drafted to be used also in later partnerships. They are not drafted just for one relationship or for the needs of one concrete contractual need.

3. They are meant to be used for several different contractual relationships.

Saarnilehto (1996, 46) gives further categorizations for contracts from which bilaterally binding contracts and the norm contract are interesting ones from the point of view of this study. A bilateral contract binds and creates according to its name obligations to both parties. This is typical in a business environment between the customer and supplier. A norm contract again defines in advance the general content of the contract to be negotiated. This contract can be typified by framework and standard contracts. The standard contracts are typically printed or otherwise duplicated, but they can also be included directly in the written contract using a word-processor’s capabilities.

Wilhelmsson (1995) argues for the perspective to see the contracts and the contracting as dynamically changing and forming compromises that emphasize the cooperation between the parties rather than a confrontation between the parties. This change of the natures of contracting is reinforced with the companies’ efforts to establish long-standing relationships. Further Wilhelmsson discusses the question of how conclusive standard contracts are concerning the other party who has not drafted these contract texts. According to Wilhelmsson the opinions are mixed and the issues must be judged case-wise. As the contents of these template contracts and in them included conditions can be unbalanced. As he argues it is simpler to accept the view that the parties are bound to the agreed documents than to standard contracts that are made by either one side (ibid). The situation is also different if the company is conducting business in an international environment and how binding are the conditions if they are written in foreign language. Also the conclusiveness depends on who is the adverse party, should he/she know and understand the conditions and are they the conventional to the focal line of business as well as how long-standing the business relationship between the partners is? One of the central issues in evaluation of the status of the standard contracts is how explicitly the reference to the standard forms must be done in the individual contract so that the templates become part of the individual contract? According to Nurmi (1997) the general contract law norms on standard contracts contain lines of argumentations in these issues.

Nystén-Haarala (1998, 27) explicates the difference in the way of thinking between the long-term contracting and contract law. Contract law holds to the available and drafted documents whereas the long-term contracting according to its name is a process that establishes a working relationship between the negotiating parties. This contractual relationship is intended to work also during the inevitable changes in the environment that also affect the cooperation. As the contract law approach conveys the decisions strictly from the contracts it treats for example, the divergences from the original contract as breaches. Whereas, from the perspective of the long-term contracting they are only obstacles to be negotiated. Thus one important and central aspect of long-term contracting is the possibility left in the contracts that they are acknowledged already from the start as being incomplete, as the contracts are not able to be prepared for all imaginable future events and changes. They can be adjusted and renegotiated.

According to Nystén-Haarala the Nordic contract law development has two topics under discussion. They are the questions of the possibility of gradual contract formation and the role of loyalty in contractual relations (ibid). This is in concordance with emphasizing the business relationship research that examines social, psychological and economical aspects of the relationship development processes, i.e. the IMP-approach that is predominant in Nordic countries (Håkansson 1982). This is also the basic theory applied in this study, cf. Chapter 3.

It may happen that the partners already start the production phase even though no binding contract exists. In some cases the partners may sign a contract and start to implement it with reservations that “minor details to be finally agreed upon”. This behaviour does not, according to Grönfors (1989), in any way mean that all the conditions are unsteady, but the binding of the negotiation positions proceeds gradually. The partners first agree on the core of the contract, i.e. main terms that includes a general description of the performance, the time scope when it is done and where it is done among other things. Subsequently the partners agree on a set of details, e.g. change management, indemnification issues, etc.

In Table 3 the main arguments for and against licensing are depicted. With a careful selection process the licensor may also benefit from spreading the fixed cost, i.e. the R&D activities, development work and risks by expanding the scale or scope of production. But in any case the choice of the partner (licensee) should be carefully screened to match their own strategic objectives (Nooteboom 1999).

The license has three main manifestations, non-exclusive, where the licensor has the rights to also nominate other licensees as well as to use the license itself. In the case of a sole license the licensor guarantees not to give a license to any other firm, but the licensor is still able to use the object of license itself. The exclusive license gives all the rights to the licensee and the licensor guarantees not to use the object of the license.

As the relationship is based on several different contracts there are twofold problems in interpreting the contracts. First, what is the order of the source documents when interpreting the contents of a single contract? Saarnilehto (1996, 110) gives the following: 1) peremptory norms in legislation or general doctrines of contract law, 2) the contract itself and that what has to be seen as agreed upon, 3) the customs of the trade and similar conventions and possible trading customs emerged between partners and 4) discretionary legal provisions, i.e. the commercial law (Sale of Goods Act) or some of the provisions in copyright law. The second problem deals again with the fact of how to order the different contracts in the contractual network? This problem grows all the time as the company enters into new contractual relationships with its customers, suppliers, subcontractors, employees, etc. All these contracts must form a stable and clear structure. For example, if the company is licensing for its use some components and uses them in the application it develops and delivers (licenses) further to its customer. Then these both licenses must be drafted so that they allow the end-user to use the product as agreed with the focal company.

2.1.3. Procurement and contract negotiations

Hemmo (1997) draws attention to the question of obligation to inform. This is relevant as in many situations the information is not equally shared by the negotiating parties. Also the parties need to know whether the party that holds more information about the object under negotiations is obliged to share this with the other party or not. This is also a common situation in the software business as the supplier can have more specific information about the issues related to the application development and the technology included in it. Hemmo further states that there is no clear answer to the question as there are pros and cons to support either view. In the long run the responsibility set on each individual firm to search for information turns out to benefit society as a whole (ibid).

The main value and reason for contracting is that the contract makes a controlled cooperation between totally unfamiliar parties possible. Besides the written contract cooperation flows notably easier when trust between the parties prevails. The information asymmetry may have an effect on future cooperation as the parties are differently bound in the relationship. As this binding is usually done with something other than legal methods it makes it difficult to judge from a juridical perspective (Nystén-Haarala 1998).

Contract negotiations. When the companies have established their objectives and strategies to conduct the business negotiations the subsequent discussions can be examined from contractual and technical perspectives. Here the technical perspective stands for negotiations techniques used during the discussions. All these aspects must be carefully planned before the start of the negotiations in order to achieve the results wanted of the future cooperation, especially if there is purpose for a long-standing relationship. For more about the technical side of negotiations see e.g. (Holmes & Glaser 1991, Brandenburger & Nalebuff 1996).

From the legal point of view the interesting question is when and how the negotiating parties become bounded to the contract that is under negotiation. This is drawing the line between the contract negotiations and the contract itself (Hertzen von 1983). Also the above-mentioned different legal systems function and define the process differently. He argues further that the purpose of the contract negotiations is to find out if the parties are mutually willing to commit themselves to the arrangement that is the focus of the negotiations (ibid). This is important to know in both cases; first, ending up in contract signing and the performance as agreed or second, in a situation where the contract negotiations are broken up. The broken negotiations may cause demands for compensations from either party. The possibility of indemnification may rise if the other party takes part in the negotiations without any real purpose of contracting (Saarnilehto 1996). If there emerges a need to interpret the agreed contract the declarations of intent expressed during the negotiations can elucidate unclear expressions and clarify oral agreements (ibid). The common custom pursued in the line of business should be taken into consideration. Hemmo (1997) emphasizes the general rule that contract negotiations do not bind the parties, but he indicates some reservations of this, too. This depends on the bona fides[3] of the parties.

The discussions in Nordic contract law have two main lines: a) can the contract be formed gradually and b) loyalty in contractual relations. This has been described as: shift into a contract, dynamic contracts as living like organisms and the gradual developing of the binding force as well. Grönfors (1989) describes the conventional contracting phase model, Fig. 3. In the first phase the parties find each other and start evaluating the general possibilities for collaboration. The first phase ends with a letter of intent, where “The Letter of Intent usually contains contractual duties without an obligation to fulfil the contract”, (Nystén-Haarala 1998, 97). The next phase is the making up of the contract itself with all its details. The second phase ends with the main contract document. During the final phase the contract is fulfilled (Grönfors 1989).

During the Intention and Negotiation phase the contract develops through a so-called “ping-pong” game (Nystén-Haarala 1998). An offer-and-acceptance process polishes the prospective contract in its desired form from the viewpoint of business and software development.

Nystén-Haarala also discusses the second variant of the generic contracting process model according to the traditional German doctrine, Fig. 4. The contracting process splits up into two main parts: unbinding and binding. During the unbinding phase there can be several unbinding contracts (UB) and written memoranda (WM) where there are some conditions agreed upon but also open ones. Nystén-Haarala (ibid, 96) states: ”…A binding preliminary contract contains liability to conclude the final contract and the final contract makes the parties liable to perform.” During the whole negotiations process a relationship of mutual reliance should exist.

As can be seen from the two contracting models they describe the general expression of contracting. They do not in any way take into consideration a particular line of business, in this case the software industry. Also they mainly describe the negotiation and contract writing phase.

Jeffries and Reed (2000, footnote) briefly define the contracting process to consist of contract formation, agreement and award, execution and closeout stages. They have derived this structure and sequence from empirical material they had collected during the interviews with contract managers.

Lampola (1998) writes that the contract is a competitive advantage that enables cooperation building and makes it possible to take an active role in a contract negotiation situation. The usual things to contract upon are the targets of the agreement, the rights and duties of parties, royalties and other compensations. In a good negotiation strategy the business and legal skills are combined – in this order. With a contracting culture is meant the legislative framework, contracting practice, negotiation practice, terminology and juridical concepts that are typical to this business (ibid). Kontio et al. (1998, 1) discusses the problem thorough commitment specifications and commitment management. In this context they introduce a framework for commitment specifications. They see the contract as “the set of agreed commitments regardless of whether there exists a legal, written contract between parties, or the contract is an informal – even verbal – agreement on the commitments”. The so-called underlying motives (i.e. answers to the questions why, what, how and what if) explain why the project is executed. Subsequently they discuss the commitment specification topics, from which they focus on those that are the most relevant and can be specified (ibid).