Trakti Smart "Legal" Contracts Blog

Trakti hold-up problem in contracts Photo by Kai Pilger on Unsplash

Can automation solve the hold-up problem in contracts?

on July 20, 2021

Photo by Kai Pilger on Unsplash.

A hold-up problem in contracts is the situation where after one party has made some relationship-specific investment, the counterparty refuses to fulfil the original terms of the contract asking for better conditions. 

Making an investment that has a low value outside of the relationship can put the investor in a vulnerable position: the party may be “held up” for the value of that relationship-specific investment. 

In this scenario, the counterparty tries to expropriate the returns from the investment made by the other company.   

This basic problem in contracting shows how the difficulty in drafting complete contracts and the need to renegotiate drive to underinvestment and transaction cost that reduce gains from trade. The hold-up problem has to be considered as one of the major pitfalls in supply chain management. 

How can technology solve the hold-up problem in contracts? 

Slater (Jack Welch on Leadership. New York, NY: McGraw-Hill 2004) affirms that technology has become a critical measure of organizational effectiveness, efficiency and performance; any organization that does not match with the emerging trends, therefore, risks being phased out by the competitor firms. 

According to us, companies should focus on technologies capable of smoothing processes, eliminating inefficiencies and arbitrary behaviours, introducing cost-efficient mechanisms while at the same time enhancing relationships with partners: smart contracts are one of these mechanisms. But not the only one. 

Tokens can help us select the right partner by basing our decision on the company’s reputation profile. 

In “Relationship-specific investment and hold-up problems in supply chains: theory and experiments”, the authors highlight how to provide to the supplier (investor) basic reputation information about the buyers’ past actions. They found that reputation information mitigates the hold-up problem. Moreover, they suggest testing more sophisticated reputation system designs. For example, systems that track not just average performance, but also provide information about recent versus past actions. 

And it is at this point that tokens or balanced scorecards can play a fundamental role. 

As already written here and here by using a decentralised approach and an immutable audit trail built on the blockchain you can assign a score/rating to the supplier during the validation stage of their onboarding. 

The tokenisation of the process has a direct impact on the supplier`s reputation inside the network and creates along with an alternative profile risk a reputation profile. 

The implementation of the smart contracts puts every detail of the contract into light and permits the automatic execution of the terms, making the original contract promises unable to be renegotiated. 

Smart contracts reduce in this way the uncertainty about the promises and give investors’ confidence that the original price will be paid. 

We can dramatically drive down transaction/negotiation costs

Furthermore, increasing the certainty of the payments, insurance costs against unfulfillment risk can be reduced and the money saved can be spent on investments. 

To discourage the hold-up problem smart contracts can be used to trigger a penalty that prevents any deviation from the original contract. 

Someone can point out the rigidity of the mechanism, the absence of flexibility.  

But flexibility is not always an advantage. We talked about the flexibility in semantic contracts and how to introduce it in smart legal contracts here

Of course, the hold-up problem can be caused not just by arbitrary behaviour but by new and unforeseeable circumstances: in this case, the review of the original contract is necessary and fair.  With the right implementation and architecture, the smart contract can trigger the penalty only, for instance, if the new asking price jeopardizes the cost of the party`s investment. 

To dive into it get in touch with us

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