The Hidden Costs of Contract Complexity

In 2019, the GDP of the world was $87.5 trillion. This is the result of millions, if not billions, of transactions for the purchase and sale of goods and services, with each transaction regulated by some form of contract. Even with minor improvements to our horribly inefficient contracting process, the global GDP in 2019 would have surpassed $90 Trillion.

It’s about time we have access to an extra $2.5 trillion. Luckily, lawyers and other allied legal professionals can make this happen. However, to get there, we have willingly rethink and simplify contracts, since they are the basic building block of all commercial activity.

We’ll be organising articles into two parts. The first begins at Value Leakage by looking at the areas where this occurs most acutely: 

a)     When the contract is formed.

b)    Post-execution contract management.

Then, we’ll look at the key catalyst which causes these problems to happen: Contract Complexity. Finally, we’ll finish by exploring tools to help us get back that $2.5 trillion and more.

1)     Contracting and Value Leakage

A. Contract Formation Losses

When parties start to discuss the possibility of a deal and it ends when a contract is signed or accepted is called the contraction formation phase.

These are the three losses which occur:

1. Transaction costs

The costs of finalising a contract varies vastly. B2C transactions at their most efficient, have zero contraction costs in an app store or on an online checkout service. B2B contracts are a different story. Top performers spend $49,000 on a complex contract while others will spend more than $100,000 per contract.

By democratizing the contract costs enjoyed by the top performers of today would reduce the economic loss by at least $3 Billion per million impacted transactions.

2. Cycle times

Transaction cycles are as varied as transaction costs. B2C transactions often take seconds – think of the time it takes for you to install an app on your phone for example. However, B2B transactions commonly take weeks, or even months. For example, most companies take on average, 21.5 days for a transaction while top performers spend 11.5 days.

The link between negotiation cycle times and cost are clear. Bringing cycle times to the same level enjoyed by today’s top performers adds roughly 10 extra days of economic activity per year under these contracts. With the global daily GDP being roughly $250 Billion, you can imagine the significant impact the time saved would have.

3. Abandoning Transactions

It’s not easy to complete a transaction. At the bare minimum, parties must agree on product fit, delivery schedules, pricing, etc. Hurdles such as agreeing on contract terms increases the likeliness a buyer will give up on a transaction. 

One recent study showed, “57% of B2B buyers did not complete a purchase for their companies because the vendor checkout process took too long.” With the average B2B contract requiring over ten days to complete, it is clear contracting is one of the largest catalysts of abandonment-inducing delay.

Streamlining the contracting process by even one-tenth of the current rate would raise the global GDP by as much as 1%, translating to over half a trillion dollars.

Together, the three types of losses during the contract formation stage are staggering.

B. Losses Post-Execution

If you thought the contract formation leakages were staggering, wait until you see the value leakage once the contract has been signed. Studies consistently show the average company suffers equal to almost 10% of revenues in annual contract value leakage.

This comes from the result of non-compliant goods or services, billing errors, etc. Including consequential losses (e.g. lost sales due to an inability to perform, etc.) raises the value leakage numbers drastically. 

While the formation and post-execution phases differ in nature, they share the same problem of contract complexity which we shall delve into down below.

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

There’s a reason we scroll to the “I accept” button without double-checking during consumer purchases. Trying to waft through multiple pages of legalese and numerous embedded policies, secondary agreements, etc. is overwhelming. Luckily for these sorts of transactions, the risks of blind acceptance are often miniscule. 

A. B2B contracting

The complexity is magnified in the B2B space. The dollar amounts at stake are significant, requiring businesses to conduct meaningful assessment of risk. This makes the resulting contract analysis and negotiations lengthy which are made more complex by the contracts lawyers make and only they can understand. 

As mentioned earlier, the more complex the contract, the longer the negotiation cycle times. Worse still, the likelihood each party will draw a different conclusion due to personal interpretation is proportionate to the complexity of individual contract provisions increases.

The presence of complex legal provisions shifts the focus away from the business issues that ultimately determine the value of a contract. Members of WorldCC (World Commerce & Contracting) observed the reduced focus on business issues during contract negotiations disengages key businesses leads at the contract formation stage, leading to significant value leakage during post-execution. Therefore, it’s not surprising that sub-optimal delivery occurs when the businesspeople in charge for performing under a contract don’t understand the key provisions in a contract properly. 

B. Types of Contract Complexity

There are two characteristics which contribute to contract complexity:

a)     Qualitive Complexity

b)    Quantitative Complexity

We most focus on these areas to simply contracts effectively.

1. Qualitative Complexity

To put it plainly, qualitative complexity is when a contract is drafted in a way which is hard to understand. The key point here is not what a seasoned lawyer may find intuitive, but what the average businessperson who is going to negotiate the business transaction and/or managing the contract post-execution understands.

Unfortunately, many contracts fail at this hurdle for several reasons:

a.     The contract fails to address the crux in the formation of the business relationship, forcing parties to rely on sources beyond the contract to make sense of what they are trying to achieve. It is generally agreed amongst economists that the more complete a contract, the higher the economic performance it shall generate. This problem can be difficult to resolve since contracting parties can’t foresee every eventuality in a prospective relationship, particularly those of a long duration and/or an expansive scope.

b.     Clauses within contracts can be drafted in an ambiguous manner, making them impossible for even seasoned attorneys to interpret definitively. TermScout recently reviewed 327 standard, click-accept agreements used by a wide range of IT vendors and found that roughly 25% failed to achieve high levels of clarity. It’s a staggering number given the agreements reviewed were all based on standard contract contracts which get used hundred, if not thousands of times. On top of that, they were drafted without time limits and can justify an enormous investment of legal resources to ensure they are primed for use. Negotiated agreements (one-offs created under extreme time pressures), suffer substantially higher levels of ambiguity.

c.     Finally, even if a contract addresses a point 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.

In October 2020, the WorldCC conducted a survey of over 475 organisations which showed the uncertainty about the meaning of key provisions is the biggest threat to realizing a contract value. The root of this uncertainty is a lack of clarity which comes from the aforementioned factors. 

2. Quantitative complexity

Quantitatively complex contracts are when its length, including all referenced or nested documents, exceeds what a user can efficiently process.

A great example is the AWS Customer Agreement which, at first sight, is approximately 14 pages in length. This may not be bad for page count, until the reader discovers 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. One nest leads to dozens which coupled with the difficulty of locating them all into a coherent body is a colossal task for the reader.

This type of structure and volume of contract terms is not unique to Amazon. Companies, particularly large ones, have extremely diverse product lines and logically, want to use one agreement to cover as much business as possible. In many cases, this converges with the needs and wants of consumers. After all, who would want to renegotiate terms every time they do business with a supplier?

C. How to Address Contract Complexity?

There is no one-for-all antidote for addressing contract complexity. However, there are at least three things we can do to make meaningful improvements to contracting processes.

There are multiple contract review services such as KnowableContract Standards, and TermScout. These services mitigate the challenge of assembling and analyzing contracts for companies.

Most of this analysis, however, focuses on the legal terms in the agreement, and not the business terms. Despite this, these assist with the complex contracts in multiple ways.

First, they relieve the companies of the burden of assembling the data set—at least where standard contracts are involved, alongside the trouble of analyzing that data. They also can translate legalese into plain English. 

Second, they can provide better transparency into issues with a vendor’s contract, by highlighting unclear drafting, unfavorable provisions, noticeable gaps, etc. This transparency will help drive standardization within vendor agreements which, as discussed below, stands to significantly resolve the complexity problem.

1. Standards

Contracts are complex since the business relationships they cover are multifaceted and may be wide-reaching and/or of long duration. Covering the nuances of such, especially as it evolves over time, is challenging. Doing so in a small number of pages, in terms that everyone can understand, is a colossal task.

Using standards for contracting, however, can make this challenge more manageable in at least several very significant ways.

a)     Independent standards administered by a trusted third party evolve naturally over time, reducing the need for the parties to foresee the future and address all possible contingencies themselves.

b)    Standards used on a repeated basis become familiar to people in the relevant industry. This makes them easy for those administering a contract to understand and work under. When a standard attains sufficient adoption, companies can align their business systems and practices to it.

c)     Incorporating standards by reference shortens contracts and significantly reduce negotiation times without compromising breadth. This is like how nested terms work today, but unlike tailored nested terms 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 for Standards

While the use of different types of standards could have a very positive impact on contracts, all the required standards do not exist yet. Some of the potentially more promising areas for further development are as such:

D1. Laws

A significant proportion 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 come form, in part, differences in laws.

While expecting a single global set of laws which regulate all aspects of commerce is unrealistic, examples that exist show that some enhancements may be possible.

For example, the EU uses the GDPR and other laws and regulations to standardize at least certain governing rules across its members. Various countries have come together to adopt conventions relating to various aspects of commerce. The United Nations Convention on Contracts for the International Sale of Goods, routinely get disclaimed and are of relatively limited impact as an example. Others, such as the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (aka The New York Convention), get used quite broadly. Theoretically, it is possible additional conventions could get adopted across jurisdictions, reducing international business complexity.

The U.S. has great potential for further amalgamation of standards. As of now, the U.S. federal government has shown little inclination to exercise its authority over interstate commerce to set out a single set of regulations, even in such areas as telecommunications where the benefits of creating a single federal framework are indisputable by logic. This, however, doesn’t disregard the authority exists and could be used more.

D2. Policies/agreements

Building upon the greater standardization of laws, room exists for standardization of the policies and agreements mandated by various laws such as HIPAA and the GDPR.

These could be administered by independent third parties to assist up-take. For example, WorldCC developed a set of balanced contracting principles which can apply to a multitude of contract types. The economic benefits of using standard contracts within industries are significant. In many cases, industries have proactively driven this transition on their own, e.g., residential home sales, ISDA agreements, etc. These cases involve high volumes of repeatable transactions, parties having similar levels of bargaining power, and/or strong time pressures for conducting the agreement. Where these pressures are not present, inertia and the set ways of buyers and sellers impede this shift.

D3. Operating practices

Contracts layout the ground rules a party will follow in a particular area, with data security as a prime example. Data holders have plenty of obligations (under contract, regulation, and/or common law) to ensure their vendors protect a gamut of information. The appropriate measures for protection continuously transform as hackers become increasingly skilled.

To an extent, vendors have attempted to standardize their approach to data protection by agreeing to submit to periodic audits conducted by third parties and some defined standard (e.g., System and Organization Control (SOC) audits). More room exists for these standards and audits to become more prevalent.

2. Contract Terms and Structure

Contracts in their many forms are business tools which define what parties plan to do together. They are ultimately about communication and to do this, should be written as plainly as possible to be comprehensible for all stakeholders. The likelihood increases when contracts standardize the terms and structures, they employ in comparison to being largely bespoke documents. Several groups, including the WorldCC have made advances in developing standard contract terms and structures which are both balanced and intuitive. 

This is not to diminish the commendable work lawyers put in to construct a contract since their contributions are critical for assessing and quantifying risk. On top of that, they ensure contracts are enforceable. Rather, we suggest lawyers can become better business partners by recognising the costs of complexity their contract drafting creates and placing greater emphasis on creating business-friendly agreements.

User research conducted by WorldCC reveals plainer, more user-centered contracts reduce sales and negotiation cycles, sometimes by as much as 50%. This research further highlights contract users have a stronger opinion towards companies with contracts that are understandable and easy to navigate. These benefits branding recognition and generates greater collaboration among internal and external stakeholders. The combination of these factors have a noteworthy impact on the value companies obtain from their contracts.

3. Tools

Naturally, this doesn’t quite resolve the use of nested terms which means contract users need a quicker way to access information without triggering multiple windows. To do this, companies need more flexibility in their data structures. With this at the fore, Unwynd.io provides a fully customisable setting to edit, create and organise information to the requirements of every user whether as an individual or a corporate business. Through a feature called syntax highlighting, users can associate each color with a specific group of key terms to allow readers to intuitively understand the clauses references within a sentence and its source at a first glance. For greater clarity, these can be paired with special meanings based on certain grammatical rules which helps cross-reference information between one or more documents.

Unwynd.io also assists whenever a clause or a term needs to be updated through its version control system. As discussed in a previous article, Git provides a full edit history which means every update in a project is tracked. This allows for greater standardisation as a full copy of a contract can be accessed and updated by parties connected to a project as they see fit. This keeps contracts compliant to rulings while ensuring the agreed terms evolve with the project. All information required thus comes together into a dedicated project environment which interconnects documentation into one place for those who need to access the contract. 

Conclusion

The world’s economy and its participants suffer from inefficiencies in the contracting process. Most of this inefficiency stems from the qualitative and quantitative complexity of contracts. While simplifying contracts cannot happen overnight, new tools are being developed which can allow companies to start making significant process. As this happens, we should expect to see gains in both the contract formation process and in post-execution contract management.

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