How to Build Trust with Formal Governance Mechanisms Part A – Hierarchy, Monitoring & Contracts – Week 6 of Twelve Weeks to Trust

There are two undeniable facts in inter-organizational relations:

1. All inter-organizational relationships are linked by a governance framework. Partners agree on structure (alliance, equity partnership, joint venture, etc.) and negotiate how it will be managed with contracts, hierarchy, reporting mechanisms and specific investments.

 “The choice of the form of governance …is the inter-organizational strategy of the firm” (Zaheer & Venkantraman, 1995, p. 375).

If you have a partnership between two organizations, you have a strategy. If you have a strategy, you have a governance mechanism.

2. The role of that governance structure is to “mitigate the risk of opportunistic behavior in the alliance and to foster inter-partner trust” (Rivera-Santos & Rufin, 2010, p. 55).

So, your intent and your approach when you establish this governance structure is critical to building trust.

So much so that Ranjay Gulati of Northwestern University (1995) found that if high trust exists prior to the establishment of a governance structure, less formal governance is required because the perception of opportunism, or the fear of being taken advantage of, is low. This means the costs of governance are lower too.

Trust can influence choice of governance, governance can build trust, and in some cases, trust can be a form of governance – think of a handshake that replaces a contract.

Since inter-organizational governance is part formal structure i.e., hierarchies, contracts, etc. and part informal process i.e., norms, practices, etc. we’ll separate our look at formal governance this week into two parts  and cover informal governance in Week 7 … probably in a few parts as well. (Feedback on post length received!) So let’s look at hierarchy and monitoring today and tackle Contracts and Transaction Specific Investments (TSIs) later this week.

Formal Governance Mechanisms & Trust

First, let’s be very clear that your intent has to be to build trust.If you are focused on imposing power and control, any mechanisms that you put in place will erode trust (Kumar, 1996). Conversely, if they are intended and seen as formal mechanisms to support a collaborative relationship, then they will build trust.

Bart Noteboom put it best:  “Adversarial strategies jeopardize value, and cooperative strategies build value.” (1996, p.985).

Hierarchy & Monitoring

In the economics and business literature in particular, externally enforced safeguards such as hierarchy and monitoring are considered important mechanisms to regulate and monitor activities to reduce the risk of opportunism. They provide access to fiat (authority, sanctions, ability to provide directives), better information disclosure, and incentive and punitive mechanisms to solve problems without the cost of resorting to the courts. In a more positive light, hierarchy and monitoring can also

• Create role clarity and enhanced information sharing (Kabadayi & Ryu, 2007); and,
• Boost inter-organizational trust surrounding resource investment where low trust exists but the need for investment is high (Fang et al., 2008, p.94). Basically, tight rules and monitoring create calculative trust (Week 2).

Intent is critical because if the intent is to control and centralize, impose and punish, then parties are acting more out of power and coercion than trust. This leads to conflict and distrust (Ring & Van de Ven, 1994) and less creativity and collaboration (Kumar, 1996). As you can imagine, these have a negative effect on the performance of the alliance (Kabadayi & Ryu, 2007). Ironically, Sako & Helper (1998) also showed that hierarchy does not have a significant effect on attenuating [buyer] opportunism which is its principal objective!

For best results: When mapping out the hierarchy and monitoring mechanisms in your inter-organizational alliance, stress the intent to provide clarity and go lightly on hierarchy, monitoring and control.

Contracts

The intent and approach to contracts and the contracting process can, again, either enhance or erode inter-organizational trust. They build trust when they:

• Act as a coordinating device for activities (Nooteboom, 1999; Williamson, 1993) and resources (Girmscheid & Brockmann, 2010; Mellewigt et al., 2007)
• Align interests (Bhattacharya et al., 1998)
• Provide role clarity and define expectations (Bachmann & Inkpen, 2011; Das & Teng, 2001; Dyer & Chu, 2003; Poppo & Zenger, 2002)
• Provide ‘institution-based’ or ‘thin trust’ where trust is low by controlling opportunity which can be an important starting point for some relationships. (Woolthuis et al., 2005, p.815)
• Provide a formal framework for beneficial adjustments to the partnership (Poppo & Zenger, 2002)
• Provide formal documentation and standardization to informal understandings so that the relationship can be recognized beyond the timespan of the people who initially negotiated it (Ring & Van de Ven, 1994). Like a will.
• Act as a sign of commitment (Woolthuis et al., 2005). Like a marriage contract.

Bart Nooteboom, Professor of Innovation Policy, observed that sufficient trust has to exist before  a contract is drafted because it “constitutes a relation-specific investment, which one does not want to engage in until sufficient trust has developed to make it likely to be worthwhile” (2006, p.275). Essentially, why invest the time and resources to negotiate a contract with someone you don’t trust?

However, if you have no choice but to work with a partner – freedom, a required element for trust, is missing – then you’re talking about cooperation, maybe coercion, not trust. In this case, Rosalinde Klein Woolthuis’ 2005 longitudinal case study on trust and contract complexity found that “contracts may not work when they are needed most, i.e. in the case of asymmetric dependence” (p.825). They conclude that :

“intentions with which contracts are drawn up and used determine whether contracts and trust are complements or substitutes” (Woolthuis et al., 2005, p. 834).

So again, intent is critical. Notice a theme here?

Contracts that are seen as punitive and controlling, may decrease compliance and impede trust building (Kumar, 1996; Mayer et al., 1995; Morgan & Hunt, 1994). Longer and more complex contracts can create distrust because they “sow the seeds of suspicion” (Mellewigt et al.’s, 2007, p.837) and are actually correlated with greater opportunism (Sako & Helper,1998). Attempts to protect confidential information may also backfire because they “may raise suspicions in the counterpart regarding what else is being withheld” and impede information sharing (Currall & Inkpen, 2006, p.246). And, highly specific contracts can limit partners’ ability to make adjustments that could be beneficial (Gulati & Nickerson, 2008).

More importantly, very detailed contracts can erode goodwill trust and competence trust because they imply that a firm doesn’t fully trust its partner to decide what’s best for the alliance (Das& Teng,2001).

Most compellingly, complex contracts cannot anticipate all forms of cheating that may occur and they increase transaction costs due to the costs of drafting and recontracting.

For best results: Approach contracting as a process to get to know the other organization and its representatives, to outline a common vision, to provide role clarity, to define expectations. At the same time, leave enough space in the contract for innovation and autonomy.

More on Transaction Specific Investments in a few days. Until then, what have your experiences been with hierarchy and monitoring or contracts with a partner organization? What type of case studies have you seen that support or dispute these recommendations?

PS. Full references available in my trust bibliography.