Hot on the heels of our recent post announcing the “World’s First ‘IoT-Enabled Legal Contract’, we wanted to dive a bit deeper into why dynamic and real-time state is important for contracting.
At Clause we are building the future of legal contracting: an architecture that enables contracts to be driven by and connected to real-time data, and able to manage themselves. Essential to our vision is that contracts should be dynamic — their terms and conditions should adjust over time by responding to the state of the physical world they aim to govern. Contracts should be living, breathing parts of digital ecosystems, not a roadblock to business automation.
Companies want dynamism in their contractual relationships yet today contracts remain generally static — a problem that Clause is fixing. To the extent companies bring dynamism into their contracts right now, they do so by pre-specifying the ways terms change and leaving room for clarification or renegotiation. While these low-tech methods are useful, they are fundamentally limited, resource intensive, costly, and expose parties to unnecessary risk.
Prespecified Contract Dynamism
Contracts are dynamic when prices, interest rates, and other terms are drafted to change in prespecified ways in response to the state of the parties’ relationship, the condition of a party, or the physical world. For example, in this metal can supply agreement, the price for any particular purchase is based on the volume of goods ordered and the supplier’s own costs (e.g., the costs of ingot). And in this Intel supply agreement, the price owed is reduced if the goods are delivered late or the seller charges the buyer more than it is charging its other customers (known as a “most favored nation” clause).
Most corporate loan agreements have “performance pricing,” meaning that the interest rate charged varies depending on some measure of the borrower’s financial performance, such as their credit rating or debt-to-equity ratio. Likewise, the amount of credit available to a borrower under an asset-based loan typically changes monthly, if not more often, based upon the value of the borrower’s inventory and accounts receivable.
Of course, a wide variety of commonplace contract terms have some kind of built-in dynamism, such as credit cards interest rates that increase if a borrower misses payments. This kind of built-in dynamism is also becoming more prevalent and being driven by data. As recently noted by Insurance Networking News, “[c]onstant data from IoT devices mean that insurers can update prices accordingly — both up and down — as risk is better quantified. Seventy-seven percent of auto insurers surveyed expect policies to be priced dynamically in five years.” At Clause, we’re making the contracting infrastructure for these types of dynamic relationships available for the first time.
Dynamism Through Clarification and Renegotiation
Dynamic contracts also come about when the actual terms or specifications of the contract are later clarified or renegotiated. As noted in a 1992 Columbia Law Review article, parties often form contracts with open terms that are later clarified to preserve flexibility over the course of their relationship. Oliver Hart and Bengt Holmström won the 2016 Nobel prize in economics for helping us understand these “incomplete contracts.”
Contracts may also expressly permit their terms to change. Many freelance agreements, for example, permit the client to request new services with the compensation and delivery schedule to be redetermined accordingly. Contracts may also reserve the right to renegotiate on-the-spot if product specifications are not met or a force majeure event takes place. Long-term supply agreements often contain “price reopenor” clauses that allow either party to renegotiate the price every several years or if a reference price changes. Likewise, contracts to develop a new product are fraught with uncertainty, and parties are well-advised to “reserve the right to renegotiate price, timing, and warranty and indemnification terms.”
Dynamic contracting through renegotiation also takes place even if the contract does not expressly reserve the right to renegotiate. For example, one study found that 76 percent of public companies’ loans were renegotiated before maturity. Indeed, contract researchers have noted for decades that renegotiation often plays an important role in unlocking value for both sides by better aligning the parties’ relationship to new circumstances.
As the foregoing shows, companies already yearn for dynamism in their contracts and commercial relationships. That’s why at Clause we are meeting that desire and amplifying it with a new paradigm that automates and broadens the dynamics of contracts and commercial relationships far beyond what is currently possible. Our technology enables legal contracts to dynamically change their state in response to changes in the physical world (ranging from machine health to weather patterns) and business analytics such as industry benchmarks and spending projections. Doing so allows parties to bring flexibility and real-world-connectivity to a far greater range of contractual terms and relationships. Dynamic contracts also reduce the need for parties to have renegotiate in the first place, and thereby reduce the associated risk and costs.