Understanding Mutual Co-operation as the Ultimate Contractual Remedy in Commercial Contracts through Game Theory and Network Effects

Ramya Singh*

Introduction

Contracts are legally enforceable promises with considerations of efficiency in the commercial realm, and disputes arise when such promises are breached. In the event of a contractual breach, contractual remedies are viewed as static entitlements to ensure protection of rights and become the final trade-offs for dispute resolution in commercial contracts. However, while enforcing such contractual remedies, parties often lose sight of the primary objective of the contract and engage in futile ego-battles and bleed through heavy litigation costs, business losses, delays, and strained relationships.

Therefore, parties must consciously engage in interest-based analysis to ascertain their priorities which go beyond mere enforcement of legal rights. Parties must exercise contractual remedies as strategic play-offs and not only as static entitlements, especially, in transactions involving multiple interdependent stakeholders. Mathematical and economic theories such as game theory and network effects provide valuable insights and frameworks for analysing strategic interactions where each party’s optimal decision depends on the anticipated choices of the other parties, and the valuation of any strategic interaction based on the number of stakeholders who leverage it.

Analysing Strategic Interactions to Understand the Benefit of Mutual Co-operation

These theories are particularly effective in ecosystems (networks) which rarely involve isolated bilateral relationships such as construction and procurement contracts, where each stakeholder (player) is making strategic calculations (playing a game) within community which further influences the reliability of a particular strategy.

By Modelling Contracts As Games

The strategic landscape of construction and procurement contracts resembles what game theorists call an “iterated game”. In an iterated game, parties interact repeatedly over the project lifecycle, hence, exercising a remedy carries future implications on bargaining powers of the parties. For instance, a judicial order for specific performance helps gain immediate benefits, at the cost of stifled performance (the non-performing party might take strict enforcement as a deterrent) and costs, generating further disputes. This dynamic suggests that parties should discount aggressive remedy strategies, accounting for the hidden costs of “winning” in legal enforcement. Hence, parties should particularly consider how their remedy strategy affects their position in potential future disputes on the same project, as disputes once arisen legally rarely resolve all outstanding issues definitively.

Game theories provide insights to understand and predict stakeholder positions and fundamentally shape remedy selection. An event of breach, calls for a strategic choice, which determines the fate of the transaction. For instance, upon occurrence of breach of a bilateral contract, consequences are shared mutually either through co-operation for performance or non-performance. However, if one party cooperates while the other raises claims, (for instance the contractor continues work in good faith while the subcontractor raises claims) the party which raises claims gains strategic advantage at the cost of disrupting not only the performance of the contract but also the contractual relationship. Thus, in any situation of breach net losses are inevitable. However, mutual co-operation allows the possibility for parties to overcome the net losses in the future.

Even though, commercial projects offer individualistic economic opportunities with gaining higher bargaining power, they only thrive on mutual co-operation of all the stakeholders involved. Co-operative game theory provides models to sustain co-operation taking into account individual and group incentives. Moreover, other game theories such as ‘prisoner’s dilemma’ and ‘stag-hunt game’ also illustrate that self-interest lead to worse outcomes than co-operation, as individual risk-aversion may lead a stakeholder to choose safer but less rewarding outcomes, even though, parties achieve the highest payoff only through mutual cooperation. For instance, in a EPC contract upon occurrence of floods on a construction site, parties prefer raising claims to ensure payment of the work done instead of invoking the force majeure mechanism to account for losses caused due to floods, even though, invocation of the force majeure clause will absolve the parties of their liabilities through mutual co-operation.

By Understanding Decisions As Network Externalities

While game theory examines strategic interactions between specific parties, network effects theory considers how the value of decisions increases or decreases based on how many others make similar choices. Network effects occur when the utility that a user derives from a good or service depends on the number of other users, similar to telephone networks, social media platforms, or operating systems.

In commercial relationships, equity is maintained through transparency, as it ensures effective performance of the contract. Transparency generates reputational capital for all stakeholders involved in the transaction and promotes fair play creating network effects by value creation dependent on coordination among multiple parties. The choice of remedy by one party can create cascading effects i.e., network externalities throughout this network. The choice of aggressive remedies by a party often create negative externalities for other actors in the industry network. Inversely, parties who prefer collaborative remedy approaches such as dispute review boards or structured negotiation protocols, generate positive network externalities by demonstrating alternative paths to dispute resolution.

Even arbitrators, while granting remedies, should consider whether their decisions will generate positive or negative network externalities, as their remedy determinations create network effects beyond the immediate disputing parties. However, it must be considered that, the accuracy of the information available to the arbitrator is a key dimension of this hypothesis. The access to precise information affects the arbitrator’s decision to implement a contract in which the cost of production reflects its updated value whereas the absence of such information, would lead to the seller incurring additional risk of a surge in production costs that would slash profits. Hence, remedies should be designed to reduce perceived uncertainty, promote the payoff-dominant cooperative equilibrium, as risks are shared fairly through transparent contracts.

Conclusion

A functioning contractual relationship is the life of every commercial transaction. In the Asia-Pacific businesses thrive on effective communication and on-going relationships rather than out of purely commercial interests governed by strict contracts. Parties exercise contractual remedies not in isolation, but within complex strategic environments where each decision has a ripple effect through multiple layers of networks. Thus, it becomes highly important to strategize actions which are of utility, to remedy breaches which work around legal rights without being aggressive. Parties can benefit from accumulated interpretive precedent and reduce transaction costs, by adopting industry-standard forms which create self-enforcing standards as they emerge from the study of remedy structures trusted by parties.

Contract drafters should recognize that remedy provisions are not merely legal terms but strategic game elements that shape party behaviour throughout project performance and designed clauses which facilitate cooperative equilibria by creating remedy structures that reward co-operation through alternate dispute resolution. For every transaction, a state-x can be designed which demonstrates a perfect state of equilibria, where no party has an incentive to unilaterally change their strategy and all the stakeholders abide by the contract to achieve the objective. In an event of breach, stakeholders can analyse their position with respect to the state-x and plan their action accordingly.

Therefore, practitioners should develop practical tools for conducting strategic remedy analysis understand coordination games and empirically test game-theoretic predictions within complex commercial networks against stringent dispute resolution outcomes, to make more sophisticated strategic choices through alternate dispute mechanisms.

*The author is an Associate at ANR Law LLP. She expresses profound gratitude to Dr. Ajar Rab and Mr. Ankit Singh for their invaluable review, suggestions and support.