On the Meaningless of Contracts and the New Optionality

An old saying is that contracts are only as good as the parties that enter into them. And the evidence is growing that when there is a meaningful power disparity between two parties to an agreement, the odds are high that the bigger player will elect to behave badly. This blog is rife with examples: pervasive contractual and regulatory violations in securitizations and foreclosures, banks exploiting not just ordinary consumers with “tricks and traps” but even billionaire clients; debt collection abuses; routine raiding of employee pensions while CEO pay and perquisites remain sacrosanct; and, of course, the pilfering of customer accounts at MF Global.

And conditions on the ground are even worse. Hoisted from comments:

LAS says:
March 23, 2012 at 10:41 am
I think you are on to something, Yves.
There’s no indication of improvement either.

For an example, our firm completed work for a major corporation last month (successfully) and they will not accept the invoice for our work. While we have had to lay out cash to perform the work, they have not. Although they came to us to do the work for them, they have shut down their procurement/accounts payable dept and they have kept it shut for about 2 months now. This is a major international corporation and I believe they are treating other suppliers like this, trying to make their Q1 performance look better than it is.

I consider this to be theft of service. Until they re-open their procurement/accounts payable system, they are in effect refusing to acknowledge that they owe anything.

Mel says:
March 23, 2012 at 1:38 pm
(Robert Reich wrote another post mentioning the “destruction of meaning”. Why can’t I find these things when I want references?)

Wait till you see their next move. They’re going to run Accounts Payable as a Profit Center. Because they can.

Lidia says:
March 23, 2012 at 7:43 pm
Is (isn’t) that how banks work?

As a small business person, I was shocked at the practices OF MY DEBTORS that pretended to keep me on the skids.

I was expected to be THEIR BANK, me! Someone who pulled in $50k, was fronting money to Siemans, Bard Medical and even larger, more obscure, companies whose names I now forget.

Obscene.

Planck says:
March 24, 2012 at 8:58 am
We saw this recently too…major corporations who don’t think they have to pay suppliers. Also, procurement officers who want 5% off the top of everything to justify their measily paper pushing jobs for profits that roll up to some Family Office somewhere.

Now LAS might have some creative routes for recourse (say drafting a press release from Concerned Big Multinational Suppliers expressing concern that the mysterious shuttering of the purchase department might be a sign that Big Multinational is in very bad financial shape because it is taking such desperate measures, faxing it to the corporate communications office from a Kinkos so as to disguise the source, with a list of financial websites and websites to whom it will be sent if checks are not forthcoming in a week. That might get their attention). But it is grotesque that we are even having to discuss taking extreme measures to get paid. LAS’s company is a victim of theft, period.

Guest blogger and author of On Value and Values Doug Smith took note of the LAS story and e-mailed:

It all reminded me of two things: specifically, the Morgan Stanley guy who is charged with stabbing the cab driver – and more generally a profoundly important shift that is already happening in society/capitalism/markets.

Business used to be based on cultivating critical relationships: with customers, employees, suppliers. Capitalism has not simply abandoned a relationship orientation, but has rapidly moved through “transactions” to “options.”

Today, everything is just an option. As deleterious as transaction orientation is to relationships, at least transactions have the constraints of obligations to follow through. But in our current raging and out of control homo economicus-as-options situation, not even that exists. There are no contractual obligations whatsoever.. there are only new negotiating positions tied to option values.

When the corporation in LAS’s initial comment above refuses to accept the invoice for services, it is merely exercising its option choice — likely under the belief that any cost (whether legal or otherwise) will be less than paying the invoice.

This is the world in which William Bryan Jennings operates. The driver’s account is credible, because it reflects this new business reality. When the cab pulled into the driveway, Jennings — just out of habit, routine and practice — treated the ‘agreed upon transaction amount’ as a mere option to be exercised through a new transaction/renegotiation. What the cabbie recalled as a contract for $204 became, if I remember, an option to pay $50.

In a world of relationships, those relationships had value beyond ‘just one damn transaction after another’…. and this goes missing in a world of transactions… but, in a world where every moment is just that moment’s options … not even previous promises have any stable value, let alone relationships …. and this is the dog now, not the tail.

Now there are settings in which not having a contract can work, but those are where relationships matter. When I worked with in Japan in the 1980s, the entire society was non-contractual. You’d have a vague understanding (Japanese is a vague language, being explicit is seen as tiresome and rude) and the two parties would keep arguing about what the deal was as they worked together. But there was a well understood, well shared set of norms, and it was a shame based culture, so word getting out that one party had been abusive would have led it to be hectored and shunned by others.

With a rise in an options-based view of business, it isn’t hard to see how a pernicious dynamic sets in. It used to be that only occasional scumbags would behave this way, and you’d write it off as bad luck and a reminder to do a decent amount of due diligence on new customers. But when this sort of behavior becomes common, the cost of doing business escalates since no one can trust anyone’s commitments. You can see this now in the way many types of contracts have changed. It used to be possible to do business with a short agreement. In many fields, they’ve now become excruciatingly long, since the odds of them being litigated is correctly seen as higher, so nailing down all sorts of possible outcomes is more important. And longer agreements means more protracted negotiations. It amounts to a tax on commerce.

And this pattern is particularly devastating to small businesses. It’s comical to see the Administration talk up the need to help entrepreneurs yet gut the rule of law to help banks. The last time I had to think about suing someone (more than 10 years ago), the rule of thumb was that it didn’t make sense to litigate unless the matter at hand was at least $300,000, between the hard dollar costs (you can get to $50,000 in legal and not be very far along) as well as the management distraction and emotional toll. Adjusting for inflation alone, the number has to be even higher now.

And the power imbalance does not have to be of the big company versus small one sort. It can be informational. As we wrote in ECONNED:

When the seller knows more than the buyer (or vice versa), commerce in the neoclassical framework becomes costly. One option is dealing only with vendors a buyer has used before successfully. Even then, he runs the risk that the seller pulls a fast one now and again, taking advantage of him in ways he cannot readily detect.

If sellers cannot be presumed to be trustworthy (and the dictates of maximizing self-interest say they in fact won’t be), consumers have to either spend money and effort to validate the quality of their purchase or accept the risk of being cheated.

Consider purchasing a computer in the neoclassical paradigm. The buyer has no way of being certain that the computer lives up to the vendor’s promises. So the consumer will have to bring an expert to test the computer’s functionality at the time of purchase (does it really have the memory and chip speed promised, for instance?). The seller will need to be paid in cash, otherwise the buyer could revoke payment.

And what happens if the computer fails in a few weeks? Assuming the vendor has not fled the jurisdiction, the only remedy is litigation, or an enforcer with brass knuckles.

But even that scenario is too simplistic. It assumes the buyer can evaluate the expert. But in fact, if you aren’t a computer professional, you can’t readily assess the competence of someone who has expertise you lack. And even if the person you hired is competent, he might arrange to get a kickback from the seller for endorsing shoddy goods. The same problem holds true in any area of specialized skills, such as accounting, the law, or finance. Many people judge service quality by bedside manner, which is not necessarily a good proxy for the quality of the substantive advice. And as we will see later, one of the factors that helped create the crisis was the willingness of investors to buy complicated financial products based on the recommendation of a salesman who did not have the buyers’ best interests at heart.

We can see the damage of the breakdown of the norms of commerce. The private label securitization market, which functioned fairly well when originators and servicers acted in accordance with their agreements with investors, is now dead. The securitization market, which was 60% private label prior to the crisis, is now effectively 100% government guaranteed (there was all of one private label deal last year). Various reform proposals have been suggested; some have been well thought out enough that past investors reacted positively. But of course, the sell side nixed anything far-reaching enough to make a real difference. The investors I know say there won’t be a private label securitization market ex root and branch changes for at least ten years.

So it looks like Marx is being proven correct, that capitalism sows the seeds of its own destruction, although not by the route he envisaged, that of a worker revolt. Instead, it comes about via the capitalists turning on each other to try to secure an even better deal.