Contract Drafting Fundamentals – Be Careful What You Incentivize

The reward of performing is rewarding and being in an orchestra or chamber group also can provide a social outlet for a young musician. But to get to that point, the student must engage in hundreds of hours of focused, independent practice. That practice is solitary and devoid of social interaction. Musicians practice because they want to play well. Few find practice fun.

Older students may be motivated by long-term incentives. The possibility of playing well enough in an audition to be accepted into an orchestra or not playing poorly in a recital that’s weeks away can be incentive enough for them. However, younger students (and some older ones) need more immediate incentives to encourage regular practice.

When my son was young, I combined incentives and learning music notation in a single exercise. For each successful practice session, he received a music note, which I wrote on a stave used to track his progress. After I wrote the new note on the stave, he had to learn what note it was. Once he reached defined benchmarks, he received a prize. His prizes were usually a small Lego set or educational toy.

Most music teachers' incentive programs are less elaborate than the one I used. Stickers are a popular incentive, as is play money, which students later can use to “buy” treats or small toys at the teacher’s “store.” The student might receive these incentives for completing a piece or obtaining specific results in a lesson.

In another incentive program, students track the number of hours they practice. Either they receive prizes when their total practice reaches a target number of hours, or they compete to see who can practice the most.

The problem with using the number of hours practiced is that it doesn't require quality practice. Since it can be difficult for students to focus for a long time, as they increase their practice hours, they are incentivized to reduce their focus -- because that's the only way they can practice longer. And reduced focus results in slower progress. So, the teacher's end goal is thwarted--the student who practices the most and wins a prize might progress the least because their practice lacks quality.

One of my mantras when preparing contracts and company policies is “to be careful what you incentivize. This article discusses the "cobra effect" and why it's critical when preparing legal documents to consider what behavior contract terms might incentivize.

What is the “Cobra Effect”

German economist Horst Siebert created the term "cobra effect" to describe unintended consequences that occur when people exploit a policy that hasn't been well thought out.

In colonial India, the British governor was concerned about the number of wild cobras. To incentivize people to kill cobras, the government paid a bounty for cobra skins.

The plan appeared to work fabulously. The government had thousands of cobra skins, and officials observed a reduction in wild cobras. Yet, people kept delivering cobra skins for the bounty. By placing a bounty on cobra skins, the governor incentivized local farmers to breed cobras. Instead of reducing the number of cobras, there likely were even more of them. But these cobras were specially bred and maintained on farms until their skins could be presented for a bounty.

When the governor called an end to the bounty, the farmers were no longer incentivized to keep and raise cobras, so they released all the cobras they had raised. When the farmers sent those additional, farm-bred cobras into the countryside,  there were more wild cobras than existed before the bounty.

There is debate about whether the cobra incident ever occurred. However, a similar incident occurred in colonial Vietnam.

In 1902, rats were taking over the Hanoi sewer system. Therefore, the French colonial leaders put a bounty on rats. People were required to deliver the rat's tail to city hall to receive the bounty.

Tens of thousands of rat tails were delivered, as many as twenty thousand in a single day, and many bounties were paid. Yet it seemed like the number of rats was increasing.

Then, one of the health officials noticed many tailless rats in the sewer system. After cutting off the rats' tails to get the bounty, they were released back into the Hanoi sewer system, where they continued to breed. As with the cobra skin bounty, the rat tail bounty incentivized behavior that didn't help the rat problem.

The Cobra Effect and a Real Estate Purchase Agreement

One of my client's experiences with a real estate purchase agreement illustrates why, when negotiating contracts, it's important to consider what behavior is being incentivized.

This client was buying an apartment building. They were concerned that the seller might not continue to work hard to obtain and keep tenants during the contract period. So, when my client negotiated the letter of intent (LOI), they added a contract provision requiring that the apartment building retain its current percentage of occupied rental units. If occupancy went down, my client could cancel the purchase.

My client carefully watched occupancy percentages, even visiting individual apartments to ensure that tenants still lived there. After confirming that the building's high occupancy had been maintained, my client closed on the purchase.

A week after the closing, I received a desperate call from my client. Upon reviewing the apartment building’s rent records, the client noticed that although occupancy remained high, many tenants had not paid rent.

The seller, incentivized only to keep tenants in apartments, had stopped evicting tenants who did not pay their rent. As a result, my client ended up with lower revenue than expected and the unenviable task of evicting many tenants.

Had my client consulted me before signing the contract, I would have asked them to consider their goal. Was it to have tenants living in the units? Or was it to have revenue from rental units? My client’s goal was to have revenue. Yet, they negotiated a contract that incentivized the seller only to keep tenants in units without regard to whether they paid rent.

The Cobra Effect and a Property Management Agreement

Another client, who owned an apartment building, experienced the COBRA effect when dealing with a property manager. My client was in a hurry, so instead of hiring me to negotiate the property management agreement, they signed the property manager's "standard agreement."

The agreement said the property manager would receive a monthly fee based on a percentage of the stated rents in the tenant leases. Plus, the agreement said the property manager could pay itself out of tenant rent revenue before paying other expenses. The building had more than enough revenue to cover expenses, so my client saw no reason to negotiate this provision.

After several months, my client received a notice of default from its mortgage lender. Since the property manager’s fee was the same regardless of collections, the property manager had no incentivize to pursue tenants who didn't pay. Eventually, what had been a well-performing building didn't have enough revenue to pay its expenses. Since the property manager got paid before any creditors – including the mortgage lender – the manager had no incentive to worry about unpaid bills.

Failure to pay the mortgage breached the property management agreement, but my client's only remedy was to terminate the contract. My client prevented foreclosure but was left paying late payment penalties and additional interest. Plus, the client paid me far more in attorney fees to work out the delinquent mortgage situation than it would have cost to hire me to negotiate the property management agreement upfront.

Part of the issue was a neglectful property manager. But my client could have incentivized better behavior by requiring that the mortgage loan be paid before the property manager’s fees.

Another issue was that the property manager only had to provide accrual financial statements. My client could have seen the property's declining finances sooner if the property manager had also been required to provide aged payables reports or bank records. And knowing the owner would see that information might have incentivized the property manager to improve collections so the aged payables report didn’t look bad.

Contract Negotiation Tips

Contracts that incentivize undesirable behavior often contain gaps in contract covenants. One party either isn’t obligated to do something they should do. Or, the obligation isn't spelled out in sufficient detail. Often the gaps exist because the other party expects the other party to act in a particular way or to continue past behavior.

In the first example, my client assumed the seller would continue collections and evictions as in the past. So, my client didn't think it was necessary to state in the contract that the seller wasn't to change their behavior.

With the property manager example, my client considered the mortgage payment the top priority. My client mistakenly assumed the property manager felt the same. My client didn’t imagine that the property manager would be comfortable paying itself instead of the mortgage lender. And it was incomprehensible that the manager would risk the property going into foreclosure rather than informing the owner that revenues weren’t covering expenses.

In both instances, my client negotiated the contract solely from its point of view. Of course, a party needs to look out for itself. However, it’s beneficial to step into the other party's shoes at least once during negotiations.

By walking through contract performance from the other party’s viewpoint, a party can better see where the contract might incentivize undesired behavior. By taking the time to view the agreement from the other party's perspective, parties also can develop a better understanding of the other party's needs. Parties that consider each other’s needs can negotiate a stronger contract and avoid misunderstandings that can cause their relationship to fall apart.

© 2022 by Elizabeth A. Whitman

Any references clients and their legal situations have been modified to protect client confidentiality

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