Living Agreements for a Risky World

Contracts are meant to enshrine agreements in something like stone. But contracts covering long-term infrastructure investments in emerging markets are written in something closer to sand. As more companies invest in these markets—building roads, bridges, utilities, and telecom systems—contracts must become flexible enough to account for the changes that political and economic instability create. In case after case, investors have seen agreements brokered with foreign governments change—suddenly and rarely to their benefit. One World Bank study of more than 1,000 long-term investments in Latin American infrastructure concluded that 30% of the underlying contracts were ultimately renegotiated. In the 1990s, two-thirds of the agreements that supported 33 investments in independent power projects in developing countries were similarly revised, a Stanford study showed. One explanation for the changes is what Harvard economist Raymond Vernon called the “obsolescing bargain”: Over the long life cycle of an infrastructure project, negotiating power shifts from the private investor to the government customer. Initially, the customer offers attractive terms because it needs private investment, technology, or management expertise; when the customer has what it desires, it unilaterally changes the terms. Frequently, government takings are triggered by unpredictable events such as economic crises, coups, assassinations, or wars. Such big, destabilizing changes expose issues not covered in the initial agreement and alter both parties’ attitudes about suitable risks and rewards. In other cases, government insistence on contract changes is not the product of an external crisis but of changing political circumstances, public opposition to a project, or opposition within the bureaucracy itself. Recently, a group of senior lawyers and business executives gathered for the General Counsels’ Roundtable at Stanford University under the aegis of the Collaboratory for Research on Global Projects to analyze the legal issues raised by a decade’s worth of failed and distressed projects in emerging markets. One outcome of that meeting was the promising, although still not widely accepted, idea that contracts can be redesigned as “living, breathing” frameworks for ongoing negotiation, yet still fix terms solidly enough that parties can obtain necessary financing and operate with acceptable levels of certainty. As one general counsel noted, “Businesspeople want to know: If this thing goes all screwy, what’s my safety net? What guarantees do I have? What is the very worst it can be?” To address conflicting needs for flexibility and predictability, the group proposed two alternatives for improving project outcomes. The first involves the creation of a “governance model” to better align the economic interests of public and private parties through co-ownership and cogovernance of the project company, as is now popular in so-called public-private partnerships. With a shared economic destiny, there may be more incentive for parties to resolve the kinds of disputes that historically have contributed to project failure. The second alternative involves the use of a number of types of contractual tools. “Shock-absorber clauses” are designed to facilitate low-cost, amicable renegotiation. “Safety-net clauses” satisfy the need for security and provide protections in the event that renegotiations fail. Versions of both appear in many traditional business contracts—although they have not previously been sorted into these categories—and could be combined in contracts that are threatened by political instability. Shock-absorber clauses take various forms in the business world. In construction contracts, change clauses allow the customer to make unilateral adjustments to the agreement during a project and let the contractor recover costs associated with those changes. The customer benefits because construction continues even when disputes arise. In the pharmaceutical industry, “development and license agreements” allow small research labs to work with global drug development companies under terms that may shift if, for example, a promising product fails clinical trials or an apparently trivial technology turns out to be exceedingly valuable. In international trade, negotiators from different nations may arrange to periodically divide financial rewards that were not anticipated in the original treaty. Safety-net clauses, also common in many industries, generally state that faltering renegotiations will move to litigation or arbitration. Adopting such clauses for the international arbitration of large projects requires very detailed provisions for variables such as governing law, supervisory agency, language, location, and types of damages. Companies can use existing legal mechanisms to enforce judgments against a contracting government outside its home country in cases where local courts have frustrated attempts to collect arbitral awards. Firms can also state that obtaining political-risk insurance or other types of insurance is a condition for proceeding with a contract. When changed circumstances or attitudes destabilize long-term agreements, companies have two choices: renegotiation or formal dispute resolution. Contracts that combine shock-absorber and safety-net clauses can guarantee a better outcome in either case. For companies looking at the high-risk, high-reward prospect of taking on major projects abroad, these types of contracts provide the starting point for a trust-based partnership—and an ending point should trust ultimately fail.

Living Agreements for a Risky World

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