Formal Relational Contract: What Is It and Why Is It Important?

When big players like Toyota, Dell, and FedEx see the merits of a relational contract, it’s no surprise that the concept is gaining traction. This type of contract allows you to go beyond the black-and-white terms of your agreement. It promotes goodwill and guiding principles that ensure all parties gain what they expect from the relationship.

Yes, the concept is rather complex. But we tried hard to break it down. Keep reading to have a deeper understanding of this legal concept and how it can benefit your business relationships.

What is a relational contract?

A relational contract is built on a relationship of trust between the parties. It does not cover all the issues that might crop up during the collaboration. But it establishes a partnership mentality and sets mutually beneficial goals. Relational contracts are great tools to foster long-term business relationships.

Why go for the formal relational contracts

Contractual agreements, particularly complex ones, have an inherent level of uncertainty. The signing parties can’t lay down specific responses to events or circumstances that may not even be apparent at the time of contracting. Relational agreements prepare for these unforeseen eventualities with intentionally vague language.

For instance, many business contracts were unprepared for the challenges that came with the COVID-19 pandemic, particularly those relating to supply chain agreements. Quite a few companies could no longer deliver on their obligations, so their contracts had to be revised or terminated. This put a spotlight on the merits of relational contracts, which put more weight on good-faith duties than specific terms of delivery. 

Here are the benefits of using relational contracts to address uncertainty:

  • The long-term agreement cuts transaction costs. The contract does not require overly detailed terms, so contracting costs go down. A vaguely worded contract does not have to keep up with changing markets, either. So, modification costs get lower, too.
  • The emphasis on building a relationship of trust limits or prevents opportunistic behaviors. Relational contracts require the contracting parties to work toward mutually beneficial outcomes. They must keep communication lines open and rely on each other’s expertise. They shoulder the risks and reap the benefits equally.  

Case in point, bilateral supply contracts tend to result in one party trying to get the upper hand. Large companies may pressure suppliers to reduce their prices. The suppliers, in turn, may charge them more once they gain leverage. Relational contracts can prevent these opportunistic behaviors by putting the parties’ relationship first. 

The agreement guides the parties’ responses to disruptions in their contractual relations with the following core components:

  • Common goals
  • Guiding principles 
  • Relationship management processes

So, how do you know you’re dealing with a relational contract? Let’s discuss the main characteristics that define this type of agreement.

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Key characteristics of relational contracts

Good faith is implicit in relational contracts. Hence, the contracting parties must maintain transparency, trust, and cooperation. They also commit to engaging in honest dealings and avoiding commercially unacceptable behavior.

You’ll know a contract is relational if it has the following characteristics:

  • No terms expressly remove any implication of good faith
  • A mutual intention between the parties to stay in a long-term relationship
  • The signing parties intend to perform their roles to keep up with their end of the bargain
  • A commitment to maintaining a collaborative relationship
  • The venture’s substance and objectives are impossible to fix in writing in the entirety
  • The contracting parties trust each other
  • A high level of cooperation, open communication, and predictable performance 
  • Substantial financial investment by one or more parties
  • An exclusive relationship between the parties

Now that you have a better picture of relational contracts, let’s delve into the implementation process behind them.

The five-step process of relational contracting

So, how do you put the concept into practice? Here are the five steps to get you through the process.

Set a strong foundation

First, the contracting parties must build a foundation based on a partnership mentality. This means consciously engendering trust and openly communicating their expectations and concerns. 

Establish a shared vision

To ensure they’re all working toward the same goals, the parties need a shared vision to steer them along. Common goals and vision help keep expectations aligned in a constantly shifting environment.

Adopt guiding principles

Even with a shared vision in place, misalignments can still happen. Be ready to confront them with a framework of the guiding principles of reciprocity, autonomy, honesty, loyalty, equity, and integrity. By sustaining these virtues, you will prevent opportunistic reactions to unexpected events.

Align the terms and conditions with the guiding principles

The first three steps set the stage for the contracting phase. The fourth step is where you lay down the contractual details. Since you’re working on a relational contract, you must keep all the terms and conditions aligned with the guiding principles. 

Establish governance mechanisms

The final step is to set up governance teams to ensure the parties uphold the guiding principles. You need the following teams.

  • A relationship team to ensure the relationship stays healthy
  • An excellence team to promote continuous improvement and quality control
  • A sustainability team to take charge of scheduling, work assignments, recruitment, and retention
  • A best-value team to focus on operational efficiencies and cost-effectiveness

The teams must meet regularly to ensure all parties stay aligned with the shared vision and goals. 

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Examples of relational contracts

The following use cases will help you better understand the concept of relational contracts.

Dell and FedEx

Dell and FedEx were in a long-term relationship. The former relied on the latter to handle its hardware return-and-repair processes. Although FedEx was meeting its contractual obligations, neither party was satisfied with the relationship. Dell felt FedEx took little initiative in driving growth and innovation. And FedEx was wary of Dell’s burdensome and costly requirements. 

Although both parties were unhappy with the relationship, they couldn’t just end it. Switching to a new supplier would be too costly for Dell. Meanwhile, FedEx needed the revenue the former was bringing in. Both companies eventually agreed to replace their existing agreement with a formal relational contract. It fixed the outcomes they wanted and defined their ideal relationship-management processes.

The switch paid off, as the companies cut costs by 42% in the first two years. Today, Dell and FedEx strongly believe in the merits of relational contracting. So much so that they’ve started using it for their other business relationships.

Toyota vs. General Motors

Toyota is famous for its relational contracts with its suppliers. The agreements assert that as long as their suppliers stay true to their good-faith duties, Toyota will ensure they get contract continuity and a reasonable return on their investment.

General Motors, meanwhile, prefers short-term contracts with its suppliers focusing on immediate results. They tried to replicate Toyota’s methods but failed. Business experts and academics point to the American managers’ lack of long-term orientation (as opposed to their Japanese counterparts) as the main reason for this failure.

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Conclusion

Traditional contracts don’t always result in the partner-like relationships that businesses seek. Iron-clad terms sometimes cause misalignments that work against the interests of the contracting parties. Relational contracts fill the gap with their flexible framework. It fosters collaboration, transparency, and matching expectations and interests. It does so by establishing mutually beneficial goals and governance structures.  

Going through the lifecycle of complex relational contracts can be challenging. Allow us to help you with our all-in-one contract management platform. You can learn more by booking an AXDRAFT demo.  

FAQ
What are the four types of contracts?

There are four types of business contracts: leases (real property or equipment leases), sales-related contracts (bill of sale, purchase order, warranties, security agreement), employment-related contracts (employment agreement, noncompete agreement, separation agreement), and general business contracts (franchise agreement, joint-venture agreement, indemnity agreement).

Is a relational contract a legal concept?

The concept of a relational contract, as well as its implied duty of good faith, is acknowledged by English law. The contracting parties are legally obliged to uphold trust, cooperation, confidence, and transparency.

What is a relational contract?

A relational contract relies on a foundation of trust and an implication of goodwill. They guide the contracting parties’ behavior. Instead of specifying terms for all eventualities, it lays down a shared vision, mutually beneficial goals, and governance structures.

What is a relational approach in contract law?

Relational contracts are considered the mirror image of classical contract law. The latter is self-evident, deductive, standardized, and static. The former is open, inductive, individualized, and dynamic

How are relational contracts enforced?

Contracting parties have every intention to work together for their mutual benefit. But still, they can get tempted to work primarily for their own interests. Relational contracts prevent this using a combination of self-enforcement and external enforcement.

Self-enforcement refers to the parties’ self-regulating tendencies to reward and punish each other. External enforcement entails the formal involvement of the courts and the legal system. 

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