Contract Violations in Interorganizational Relationships. Drivers, Perceptions and Reactions

Table of Content

1 Introduction
1.1 Methodology

2 Theoretical background
2.1 Contracts
2.2 Trust

3 Contract violation

4 Drivers of contract violations
4.1 Bounded rationality and opportunism
4.2 Uncertainty, asset specificity and complexity
4.3 Misaligned expectations
4.4 Relationship strength
4.5 Trust and distrust
4.6 Contract specificity

5 Perception of the contract violation

6 Reaction following the contract violation
6.1 Modification of the contract
6.2 Trust repair

7 Discussion
7.1 Managerial and theoretical implications
7.2 Limitations and further directions

References

1 Introduction

In the last decades, challenges of globalization like globalized competition, rapid technological change, shorter product life circles and the rising demand of differentiated products by customers have made it difficult for organizations to stay competitive. As a result, cooperation between companies is increasing, because cooperation allows organizations to better focus on their core competencies while staying competitive at the same time. Therefore, the management of business relationships is of growing importance. In fact, the ability to develop and maintain strategic interorganizational relationships has become a critical competence in the last years (Hamel and Prahalad, 1994).

A major method to manage such relationships is through contracting. Contracts govern economic exchanges (Poppo and Zenger, 2002) and help to align the expectations of partners involved in the relationship (Mayer and Argyres, 2004). Existing literature has primarily dealt with how contracts are formed (Macauley, 1963, Reuer and Arino, 2007) and how they are crafted to manage relationships more effectively (Mayer and Argyres, 2004, Ryall and Sampson, 2009). One other main focus has been the examination of non – contractual governance, like interorganizational trust (Macauley, 1963). Trust is essential for establishing and maintaining interorganizational relationships (Davis et al., 2000). Scholars have primarily studied the role of trust in interorganizational relationships and how trust facilitates relationship performance (e.g. Das and Teng, 2002).

Despite all efforts of contracting, contracts that aim to manage interorganizational relationships do not always succeed and are violated (Robinson and Rosseau, 1994). Therefore, it is important to understand how organizations react when contract violations occur in order to secure an effective and long – lasting relationship. Only recently, researchers have begun to develop an understanding of contract violations and their influence on interorganizational relationships. It is apparent though, that existing literature mostly focuses on single aspects. A study about the entire process of contract violations including the factor of trust is yet missing.

Therefore, the objective of this thesis is to show an overview of existing literature about contract violations and trust. The goal is to combine research on different aspects and reveal differences. Lastly, this thesis aims to develop a framework showing the whole process of contract violations and to establish propositions showing the causes and reasoning behind drivers, perceptions and reactions of contract violations.

The remainder of this thesis is organized as follows: First, literature addressing contracts and trust is reviewed in order to build a theoretical foundation. In the following chapter, contract violations are defined, and possible forms of contract violations are portrayed. After that, this thesis will develop factors that facilitate relationships drawing from transaction cost theory and key concepts of contracting literature. In chapter five, existing approaches of how a contract violation can be perceived are analyzed and propositions are established. The next chapter elaborates on possible reactions following a contract violation, including contract modification, trust repair and contract termination. Thereafter, this thesis will discuss the findings and conclude implications for theory and managerial practice. Finally, limitations and possible directions for future research are discussed.

1.1 Methodology

The goal of this thesis is to show an overview of existing literature about contract violations, why and when such violations occur, how the violation is perceived and what kind of reaction follows a contract violation. Moreover, the concept of trust in interorganizational relationships and how it influences the process of contract violations are components of this thesis. Therefore, research publications related to contract design, contract violations and trust had to be identified. This thesis used three steps to gather information about these topics. The first step included reviewing the papers “The many futures of contracts: Moving beyond structure and safeguarding to coordination and adaption” by Schepker et al. (2014), “Restoring interfirm relationships following contract violations: A TCE perspective” by Raj, Mayer and Rich (2017) and “The repair of trust: A dynamic bilateral perspective and multilevel conceptualization” by Kim, Dirks and Cooper (2009). Based on these papers, I was able to define relevant key words and conducted a systematic search in the database Business Source Premier. The keywords “contract*”, “cooperat*”, “coordinat*”, “adapt*”, “control”, “safeguard*”, “contract violation”, “violation*”, “relational capability*”, “trust”, “trust repair”, “interorgani?ational” and “interfirm” were entered in different combinations in the TITLE section of the database search. In the second step, I examined abstracts of articles that cited seminal work in the area of contract violations and trust to ensure I did not miss any key research. Because it became evident in the second step, that relevant literature was mostly written by specific authors, I entered the names of relevant authors, e.g. Lumineau, to find out if other papers by these authors were relevant.

2 Theoretical background

2.1 Contracts

To understand why contract violations occur and the reaction following a contract violation, it appears essential to understand why contracts are important and what purpose they serve in interorganizational relationships.

If individuals would faithfully live up to their contractual obligations, there would be no need for a contract. (Ring, 2006). But recognizing that most exchange relationships underlie mixed motives and the coordination of partner’s expectations is integrally difficult (Ring and Van de Ven, 1992), firms rely on contracts. Contracts govern economic exchanges (Poppo and Zenger, 2002) and are attributed to have a significant role in the development of exchange relationships (Macauly, 1963; Williamson, 1979). More detailed, Macneil (2000, p. 877) defines contracts as “relations among people who have exchanged, are exchanging or expect to be exchanging in the future – in other words exchange relations.” Overall, a contract must express the intentions of both parties about what they will provide for each other in the future, how resources are used and exchanged and when and why the relationship will end to serve as an effective governance structure (Ring 2002). The function of a contract is to ensure predictability and security in business transactions (Macauley, 1963). Contracts define roles and responsibilities for the cooperating parties and give both parties involved in the transaction the option for defining possible legal sanctions to either induce performance or compensate for not – performing. (Mayer and Argyres, 2004; Snyder, 1999). The goal of a contract is to align expectations within the relationship and include safeguards to mitigate the possibility of contractual hazards, which often result from asset specificity or complexity. (Raj, Mayer and Rich 2017; Mayer and Argyres, 2004). By defining responsibilities and by agreeing on legal sanctions, the risk of a contract violation can be reduced. Thus, contracts can help the exchange partners to improve the effectiveness and performance of the interorganizational relationship (Ring and Van de Ven, 1992).

Contracts can range from informal promises to formalized agreements; they can be formal, informal, written or oral (Schepker et al., 2014; Ring, 2002). Recent literature (Harmon, Kim and Mayer, 2015) has researched how the nature of an agreement, meaning if an agreement is documented or not, influences the reaction following a contract violation. Though these findings are relevant in contract and contract violation literature, this thesis will only focus on formal, thus written contracts. Formal contracts are legally enforceable documents that lay out the terms and conditions between the exchange partners with the goal to minimize transaction costs that may occur while conducting the exchange (Ryall and Sampson, 2006). For a contract to be legally binding, four essential elements must be established. First, a contract must reflect an agreement between legally competent persons of the parties. Moreover, the contract must be based on consideration and mutual consent. Lastly, a contract must be of valid subject matter, which means the contract cannot violate notions of public policy (Ring, 2002, 2006).

This abstract addresses the theoretical concepts of contracting literature regarding interorganizational relationships. These relationships include high levels of risk and uncertainty, due to diverse economic, social, cultural and legal systems (Seggie, 2012). Most commonly, strategic alliances are designed for a longer time period and therefore entail a great risk of uncertainty. Contracts must take these uncertainties into account (Ring, 2002).

The dominant principle theory underlying contracts is transaction cost economics (TCE). This theory, developed by Oliver Williamson, has received substantial empirical attention and has profoundly influenced the empirical research on contracts. TCE explains how the transaction influences governance decisions (Mayer and Salomon, 2006). The theory views contracts as governance structures for managing relationship structures between parties, with the goal to minimize transaction costs (Williamson 1985, 1991; Schepker et al.,2014). Furthermore, it seeks to explain when and why some institutional structures, other than markets, are a more efficient way of governing interorganizational relationships (Mellewigt, Madhok and Weibel, 2007). The theory rests on the assumption, that both partners have bounded rationality and that a partner has the potential to behave opportunistically (Williamson 1975, 1985; Simon, 1957). TCE underlies four dimensions of transactions, which are asset specificity, behavioral uncertainty, environmental uncertainty and transaction frequency (Williamson, 1979).

Based on TCE, literature has mainly proposed two governance mechanism for contracts and how they function (Lumineau, 2017). One mechanism views contracts as instruments of control. Control problems stem from misaligned incentives (Gulati, 1995). Consequently, contracts serve as safeguards against opportunism and misappropriation by the partner (Lumineau and Quelin, 2012). The controlling party of the contract defines the rights, responsibilities and obligations to minimize idiosyncratic and deviant behavior (Salbu, 1997). Control mechanisms mitigate relational risks, such as self – interested behavior by the other party. TCE states that the adequacy of contracts depends on the possibility of opportunistic behavior and transactions costs. This means simpler contracts are very efficient due to low transaction costs but create space for opportunistic behavior, whereas complex and detailed contracts are very costly but mitigate relational risks quiet well (Mellewigt, Madhok and Weibel, 2007).

The second mechanism views contracts as instruments of coordination. The coordination function is less prominent in the field of contracting literature though (Mayer and Argyres, 2004; Schepker et al., 2014). Contracts as instruments of coordination regulate collaboration and trust within interorganizational relationships (Macneil, 1980). Coordination problems stem from misaligned expectations and behavior (Gulati, 1995). Therefore, especially when tasks of high complexity and uncertainty are completed within interorganizational relationships, they require high levels of coordination (Schepker et al., 2014). To enhance the coordination of the relationship, firms use contracts to define roles and responsibilities and define the rules for monitoring processes (Mayer and Argyres, 2004; Argyres and Mayer, 2007). Contracts used as coordination mechanisms mainly address performance risks. Performance risks include the probability and consequences that the objectives of the alliance are not achieved even if the cooperation among partner firms is adequate (Das and Teng, 1996).

Recently, researchers (Eckhard and Mellewigt, 2005; Mayer and Argyres, 2004; Argyres, Bercovitz, Mayer, 2007; Luo, 2005) have come to the conclusion, that besides fulfilling a control and coordination function, contracts also fulfill an adaptability function. Partners have to react to unforeseen changes to ensure a productive relationship. In order to manage changes and unexpected occasions in the contract environment, contracts need to ensure adaptability. According to Argyres, Bercowitz, and Mayer (2007) firms can learn to use contracts to govern their exchange relationships and react accordingly to high environmental uncertainty.

2.2 Trust

Trust is essential for establishing and maintaining cooperative relationships (Davis et al., 2000; Gambetta, 1988). Trust has a direct effect on the performance of interorganizational relationships (Das and Teng, 2001) and has a crucial impact on value creation (Uzzi, 1997). Therefore, it is important to incorporate the role of trust when analyzing contract violations.

Although there is no universally accepted scholarly definition of trust, a popular definition by Rosseau et al. (1998, p.395) is that trust is a “a psychological state comprising the intention to accept vulnerability based upon positive expectations of the intentions or behaviors of another”. Because personal interactions and the development of trust happen between people, not organizations, their behavior is of high significance to their organizations (Zaheer, McEvily and Perrone, 1998). It is assumed that trust between partners in interorganizational relationships is rather low in the beginning of the relationship but can build over time as parties gain knowledge about the others expectation and competences (Lewicki and Bunker, 1996). Traditional trust literature refers to the term trustor for the party whose trust has been violated, and the term trustee for the mistrusted party (Kim, Dirks, Cooper 2009). Instead, I will use the term non – violating party for the party who has been violated and the term violating party for the partner who either violated the contract or trust in an organizational relationship to avoid confusion down the road.

There are two necessary conditions for trust to arise. The first condition is the existence of risk, because there would be no need for trust if transactions could be conducted with complete certainty (Lewis and Weigert, 1985). The other necessary condition for trust is interdependence, which means the objectives of one party cannot be achieved without the reliance on a partner. Because risk and interdependence are necessary conditions for trust, variations in these factors change the level of trust in a relationship (Rosseau et al., 1998). Furthermore, factors of the perceived trustworthiness are the competence, benevolence and integrity of the partner who is trusted. A partners’ competence is domain specific, for instance the partner is highly competent in one field but has little experience in another field. Benevolence is described as the willingness to do good for the partner. Integrity implies that both partners comply with principles the other partner finds acceptable. (Mayer, Davis and Schoorman, 1995). A trustful relationship between exchange partners has many advantages, for example lower monitoring costs (Barney and Hansen, 1994), the willingness to disclosure truthful information (Ring and Van de Ven, 1992), or reduced transaction costs and value creation for the partnership (Mellewigt, Weller and Zajac, 2017). However, trust is recognized to be violated frequently (Robinson and Rosseau, 1994).

It is also important to observe the relationship between contracts and trust. Researchers distinguish between two perspectives on how formal contracts designed to mitigate relational risks using the mechanism of control interact with trust (Das and Teng, 2001). On the one hand, formal contracts and trust can be seen as substitutes, meaning formal contracts and trust have a negative relationship. (Granovetter, 1985; Dyer and Singh, 1998; Gulati, 1995; Uzzi, 1997). On the other hand, formal contracts and trust can be seen as complements, meaning that formal contracts and trust have a positive relationship. (Mellewigt, Madhok and Weibel, 2007; Poppo and Zenger 2002). Mellewigt, Madhok and Weibel (2007) give two reasons on why formal contracts and trust are substitutes. First, trust is expected to reduce opportunistic behavior and therefore lower the need for the control mechanism of contracts. Therefore, trust seems to make specified contracts unnecessary (Uzzi, 1997). Second, specific contracts can lower the trust in interorganizational relationships. Malhotra and Murningham (2002) argue that formal contracts completely eliminate trust. This is so, because when a partner feels controlled and restricted in its autonomy, formal contracts seed suspicion and can even encourage opportunistic behavior (Macauley, 1963).

When viewing formal contracts and trust as complements, it is assumed that well specified contracts can promote a cooperative, long – term and trusting relationship, because formal contracts lower the risks involved in interorganizational relationships. The cooperation encouraged by trust can even generate contractual refinements that further support cooperation (Poppo and Zenger, 2002). Here, formal contracts augment transparency in the relationship and facilitate learning processes (Mellewigt, Madhok and Weibel, 2007).

3 Contract violation

Despite the efforts of contracting, contracts are often violated (Robinson and Rosseau, 1994). A contract violation is an unfulfilled obligation that was agreed upon prior the violation (Robinson and Rosseau, 1994). Because contracts are based on good faith and fair dealing (Macneil, 1980) and the parties involved rely on each other, violations can entail serious consequences. Contract violations and relationship performance are negatively correlated, meaning a contract violation can harm the exchange relationship severely (Griffith and Zhao, 2015).

Only few researchers have tried to define different types of contract violations. Contract violations can either be intentional or unintentional (Raj, Mayer and Rich, 2017). But critical for the reaction to a contract violation is how the non - violating party perceives and interprets the violation. This thesis will elaborate on perceptions of a contract violation including a psychological perspective later on. Harmon, Kim and Mayer (2015) differentiate types of contract violations based on if an expectation is documented or not. The paper defines “letter violations as the failure to fulfill a clear, documented expectation expressed in a contract” and spirit violations as “the failure to fulfill an undocumented, yet still presumably tacitly agreed upon, violation” (Harmon, Kim and Mayer, 2015, p.498). Spirit violations are further split into oral violations, which refer to verbally made agreements, and tacit violations, which are expectations that are not expressed in words, but evolve from industry norms, assumptions and values.

Because the concepts of contracts and trust are so closely intertwined, trust violations should also be included when analyzing violations. People can often behave in ways that violate trust, such as by exploiting dependencies or by neglecting to fulfill expectations. (Kim, Dirks and Cooper 2009). Trust violations concern incidents that both lower the trusting beliefs in the violating party (trust relevant competences such as competence and integrity) and trusting intentions toward the violating party (the willingness to be vulnerable to another) (Kim, Dirks and Cooper, 2009).

In the following chapters this thesis will develop propositions about factors that facilitate the likelihood of a contract violation to occur and how the intent behind contract violations are interpreted by the non - violating party. On this basis possible reactions to contract violations are proposed, which include trust repair, the modification or the termination of a contract. The self – developed framework illustrating the coherences of the drivers, perceptions and reactions to contract violations is pictured below:

Abbildung in dieser Leseprobe nicht enthalten

Figure 1: Process Framework of Contract Violations (self- developed)

4 Drivers of contract violations

To understand the perception and reaction of a contract violation, it is important to determine the factors that facilitate contract violations. Researchers have devoted limited attention to which factors make contract violations more likely to occur or mainly researched single aspects, an overview of drivers of contract violations is yet missing.

In order to detect possible causes or drivers of contract violations, this thesis will predominantly examine the TCE literature regarding contracts and key concepts in contracting literature gathered by Schepker et al. (2014). These include behavioral assumptions (bounded rationality and opportunism), transactional attributes (asset specificity, uncertainty, complexity and bilateral interdependence) and relational characteristics (relational strength and trust and distrust in a relationship). I also use some aspects of the framework developed by Morrison and Robinson (1997) as a template, which shows the development of a violation between an employee and an organization. This framework was built on the basis of psychological contract violations and therefore views an interpersonal level. But contract violations often occur because individuals have different opinions. It is not necessarily the company as a whole, but individuals who mistrust each other or have different expectations. Therefore, the reasoning can easily be transferred to an organizational level. In this chapter, propositions on what aspects drive contract violations are developed. Possible coherences between single factors are also incorporated.

4.1 Bounded rationality and opportunism

Based on Williamson (1975, 1985) opportunistic behavior and bounded rationality are the two primary causes of contract violations. TCE assumes that all people are constrained by bounded rationality. Simon (1957) defines bounded rationality as a behavior that is intendedly rational, but only limited so because of cognitive limitations and information overload. Therefore, contracts are unavoidably incomplete (Williamson, 1996). Contract violations resulting from bounded rationality are likely to occur because of incomplete contracting and the misinterpretation of contract terms (Weber and Mayer, 2014).

Proposition Nr. 1: Bounded rationality stimulates contract violations.

Furthermore, TCE assumes that contractual parties act opportunistically. This means they pursue their own interest when given the chance (Raj, Mayer and Rich, 2017). The risk of opportunism is an inherent feature in interorganizational relationships (Lumineau and Quelin, 2012). There are several transactional attributes that make it easier for an organization to behave opportunistically. These transactional attributes (asset specificity, uncertainty and complexity) will be explained and linked to opportunistic behavior in the following abstract.

Proposition Nr. 2: Opportunistic behavior stimulates contract violations.

4.2 Uncertainty, asset specificity and complexity

Interorganizational relationships include high levels of uncertainty, because they often involve companies with diverse economic, social, cultural and legal systems (Seggie, 2012). Uncertainties are unanticipated and unpredictable changes in circumstances surrounding the exchange (Zhou, Poppo and Yang, 2008). These circumstances can be environmental or behavioral. High differences in the characteristics of exchange partners (e.g. technology or industry standards) lead to higher uncertainty in a transaction. Especially complex transactions entail a high level of uncertainty (Ring, 2006). Williamson (1996) states, that opportunistic behavior increases with uncertainty, therefore:

Proposition Nr. 3: A high level of uncertainty in interorganizational relationships stimulates contract violations.

Asset specificity describes the degree to which investments are specialized to a particular transaction. If firms make specific investments, they put themselves at risk of value appropriation by their potentially opportunistic partner since the specific asset is not very useful outside of the partnership (Mellewigt, Madhok and Weibel, 2007; Williamson, 1991). To control the risk of opportunism resulting from asset specificity, safeguards are included in a contract (Mellewigt, Madhok and Weibel, 2007). Therefore, the complexity of a contract increases as asset specificity increases (Poppo and Zenger, 2002). Mellewigt, Madhok and Weibel (2007) also state, that trust moderates the relationship of asset specificity and contract complexity.

Proposition Nr. 4: An increase in asset specificity puts one party at higher risk when the other party acts opportunistically.

Contracts are only complete in theory (Williamson, 1985, 1996). But due to bounded rationality (Simon, 1957), contracts are unavoidably incomplete (Raj, Mayer and Rich, 2017). As the environment surrounding an interorganizational relationship becomes more complex, problems arise because of this reason (Reuer and Arino, 2007). (Zhou, Poppo, Yang, 2008) state, that complex transactions are characterized by high levels of uncertainty and asset specificity. Because not every single detail can be integrated in a contract, complex environments make it easier for one party to behave opportunistically.

Proposition Nr. 5: High complexity in the environment and transactions stimulate contract violations.

4.3 Misaligned expectations

When expectations of exchange partners are aligned, the partners have agreed to cooperate in a way that is beneficial for both parties (Rosseau et al., 1998). However, expectations of the relationship partners can never be perfectly aligned, because like mentioned in the abstract about bounded rationality, contracts are unavoidably incomplete (Williamson, 1996). Especially highly complex interactions are difficult to specify fully. Different expectations can arise from different organizational cultures or industry norms (Raj, Mayer and Rich, 2017). When the differences in expectations are not recognized before crafting the contract, the parties are likely to misinterpret the contract. (Weber and Mayer, 2014). This means, communication before contracting is very important, because communication minimizes incongruence (Morrison and Robinson, 1998). If expectations are not aligned a priori, it can lead to problems during the execution.

Proposition 6: Misaligned expectations stimulate contract violations.

4.4 Relationship strength

Relationship strength is determined by both the duration and the intensity of the exchange relationship. Gulati (1995) states that high regularity and frequency of prior interactions between the two exchange partners lead to increased familiarity between the parties. This creates a perception of unity among the employees of the firms (Waugh & Fredrickson, 2006). As the number of interactions within the interorganizational relationship increases, the parties are able to learn from each other. The firms develop a better understanding of the partners expectations and processes. When disagreements or problems occur during an interaction, the contract can be adjusted, or solutions can be incorporated into later contracts. Consequently, misaligned expectations decrease over time. Thus, as time progresses contracting can be seen as a repository of knowledge of how to efficiently work with each other (Mayer and Argyres, 2004). In contrast, low relationship strength is characterized by very few conducted transactions and impersonal negotiations. Therefore, I propose the following:

Proposition Nr. 7: Low relationship strength stimulates contract violations.

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