Are Longer (More Detailed) Contracts Better? [Gaille Energy Blog Issue 80]
- Posted by scottgaille
- On January 13, 2020
- 0 Comments
- "longer contracts" "contract completeness"
Over my 25 years as an energy transactions lawyer, I have watched as agreements of all kinds have become longer and more detailed. Last week, I was in Canada (-21 degrees) helping a client develop a new agreement. The precedent previously used by the client for the same type of contract ranged from a dozen pages to ninety pages, which inevitably led to the question:
Are longer (more detailed) contracts better than shorter (less detailed) contracts?
We had a wide-ranging discussion of why energy companies have increasingly migrated to longer and more detailed agreements—and whether that was a good or bad development for the industry.
Adopting longer agreements certainly comes at a price. Someone has to draft them. Many others have to review and understand their voluminous provisions. Negotiations take longer for the same reason, as parties need more time to turn drafts, and when they do, there are more changes that must be discussed.
This front-end investment often does generate long-term value, though. Consider the following:
- Meeting of the Minds. Detailed agreements are longer for a reason. They usually address more risks, leading to discussion about which parties should be allocated which risks—and what the compensation should be for bearing them. Negotiation of detailed agreements prevents issues from being swept under the rug.
- Predictability. Managers must live within their budgets, and one’s career (or at least one’s annual bonus) can be in trouble if a project incurs costs that were not built into the project’s original economic model and budget. It is better to, for example, pay a counterparty to accept a risk at the outset than it is to lose a dispute and have to ask for more funds from one’s investors or board of directors.
- Better Relationships. The energy industry is one in which companies often engage in long-term relationships—whether manifested by a single, long-term contract or a series of repetitive, short-term contracts. Clarity on the front end therefore pays ongoing dividends to the relationship. When an issue arises that the agreement failed to address, feelings of surprise and unfairness can undermine the relationship.
- Ease of Renegotiation. Detailed contracts clearly allocate rights and obligations among the parties. This means that each party to the contract knows what it owes and is entitled to. This clarity of ownership facilitates renegotiation because trades can more easily be orchestrated. Where contracts have not allocated all possible rights and obligations, there are fewer possible trade combinations, making renegotiation harder.
- Less Litigation. The more risks that are clearly allocated by an agreement, the less likely that litigation is. Litigators cannot do much with a clear contract because courts are very likely to enforce it according to its terms.
Perhaps the key question is whether the front-end costs of negotiating more detailed agreements are less than the longer-term (often contingent) benefits that arise from clarity. When transactions go smoothly, the investment in a detailed agreement may seem like a waste. After all, a handshake would have probably sufficed. The same is true of insurance, though—and investing in more detailed agreements may be viewed as a form of insurance. If so, the drift toward more complete contracts may be efficient because it is reducing (more expensive) disputes.
There is one very interesting study of loan agreements that supports this theory. In Measuring Contract Completeness: A Text Based Analysis of Loan Agreements, Bernhard Ganglmair (University of Texas at Dallas) and Malcolm Wardlaw (University of Georgia) analyze more than 3,000 loan agreements from public companies. They used “several measures of contractual detail” to compare the performance of the banks based on how detailed their loan agreements were:
Consistent with the idea that more complete contracts create less holdup and therefore allow for greater investment efficiency, we find that subsequent annual return on assets and sales growth are higher for firms which sign more detailed loan contracts, conditional on other contractual features such as loan size and covenant makeup. The overall evidence suggests that firms which are able to sign more complete loan contracts are better able to exercise their growth opportunities. Id.at 4.
There is no reason to believe that similar benefits do not exist for energy companies using more complete agreements. Energy projects, like loan agreements, often play out over the course of many months or years. Clarity and completeness matter even more in such longer-term arrangements because the magnitude of loss from a dispute is likely to be greater.
In any event, transactional lawyers should consider contractual completeness at the outset of each deal. Like the fable, The Three Little Pigs, one can build a contract of straw, sticks, or bricks. All work fine until the Big Bad Wolf arrives. The more valuable the deal—and the longer the warranties, indemnities, and other contractual provisions will survive—the more detailed and complete the contract should be. Short and simple agreements should be left for low-cost, short-duration matters.
About the Gaille Energy Blog. The Gaille Energy Blog (view counter = 119,974) discusses issuesin the field of energy law, with periodic posts at www.gaillelaw.com. Scott Gaille is a Lecturer in Law at the University of Chicago Law School, an Adjunct Professor in Management at Rice University’s Graduate School of Business, and the author of three books on energy law (Construction Energy Development, Shale Energy Development,and International Energy Development), and the co-author of Strange Tales of World Travel.
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