Effects of Contract Ambiguity in Interorganizational Governance
Xu Zheng, David A. Griffith, Ling Ge, Uri Benoliel
Published in Journal of Marketing, March 2020
No one wants to be sued. There was no positive for 7-Eleven on 12 February 2020 when Mitoshi Matsumoto, who owned a 7-Eleven outlet in the Osaka Prefecture city of Higashiosaka, western Japan, made international press by filing suit against the chain. Nor was there any joy at Domino's Pizza Australia in January 2020, when Australian fast-food veteran Frederick Aloysius Mario White filed suit against the chain. Franchisors want to minimize litigation in business relationships. So, what steps can be taken to further the minimization of litigation?
When writing contracts, every word matters. While best practice suggests business contracts should be written to be clear so that there are no misunderstandings (which could lead to contract disputes and litigation), Dr Zheng Xu, Associate Professor in the Department of Marketing found that franchise contracts are often written with terms that are ambiguous. For example, these contracts frequently use terms such as “good faith effort,” “reasonable costs,” etc. The fact that terms such as “good faith effort” are open to multiple interpretations might be cause for concern. Not necessarily so:
“We find that contract terms that are ambiguous in relation to the franchisor’s obligations, enhance collaboration, minimize franchisee-initiated litigation, and enhance franchisor financial performance,” Xu says.
Specifically, Xu and her co-authors writing in the Journal of Marketing, find that in a franchise setting, where the franchise agreement is written by the franchisor, contract ambiguity of franchisor obligations is used as a strategic tool deployed to enhance joint problem solving and collaboration with franchisees, as well as to deter franchisee-initiated litigation. The ultimate outcome for the franchisor is enhanced financial performance of the franchise system. For instance, their findings indicate that a one-unit increase in franchisee-initiated litigation leads to a 7% decrease in franchisor net income. They also note that these findings extend beyond franchise systems, as contracts predominate in interorganizational governance, often with similar power differences, where one party is the contract drafter and the other is the contract taker, such as a powerful manufacturer writing contracts which are offered to less powerful suppliers.
With that said, Xu and her co-authors note that the written contract is only one aspect of interorganizational governance, and there are two significant aspects that managers should consider. First, that franchisor training programmes, when combined with contract ambiguity of franchisor obligations, serve as a buffer against franchisee-initiated litigation. Second, they caution franchisors as to the potential negative consequences related to franchisee associations, and the importance of carefully managing relations with an association for the betterment of the franchise system.