“Common sense is not so common.”

Voltaire

In a previous article (see Designing Successful Performance Based Contracts) I highlighted three tests for a highly successful Performance Based Contract (PBC).  These were:

1. Does the PBC drives the right behaviour in the seller?
2. Does the PBC provide adequate commercial protections for the buyer?
3. Does PBC have a usable Commercial Construct?

While you may believe these three tests are basic common sense, unfortunately there are many examples where, despite the best intentions of the drafters, that these arrangements resulted in an unexpected outcome due to perverse incentives.  So what is a perverse incentive?

A perverse incentive is any incentive, both positive or negative, that has an unintended and undesirable result which is contrary to the interests of the buyer.  In the case of PBC, we are specifically looking at whether our contract “drives the right behaviour in the seller”; that is, does the PBC drive the seller to deliver the outcomes desired by the buyer?

There are many examples where this wasn’t the case including my earlier article (see Unintended and Perverse Outcomes).  For example, I recently saw an article which described the commercial arrangements for transporting convicts from England to Australia in the late 18th and 19th centuries.  While this article has been around for over 15 years it is an excellent read on how a simple change in the commercial arrangements can result in extreme, and in this case, dire consequences.  But there are other, less extreme, examples such as:

• Dinosaur Bones – 19^th century palaeontologists travelling to China used to pay locals for each fragment of dinosaur bone that they delivered. However, given locals were paid on the number of bones they delivered, as opposed to the size or completeness of the overall skeleton, the palaeontologists later discovered the locals would break up large bones or complete skeletons into tiny pieces to maximise their payment, but in doing so, greatly reducing their scientific value.
• Rat Reduction – in Hanoi, Vietnam, under French colonial rule, the colonial administration created a bounty program that paid a reward for each rat killed based on each severed rat tail produced.  However, Colonial officials began noticing rats in Hanoi with no tails.  Instead of killing the rats, the local rat catchers would capture rats, chop off their tails, and then release them back into the sewers so that they could procreate and produce more rats, thereby increasing the rat catchers’ revenue.  On noticing this perverse incentive, the Colonial officials ceased the bounty.

While all of you reading this will agree all these examples are deplorable, and in the case of transporting convicts, that is trading life for money, criminal, PBC practitioners must be aware of the potential for perverse incentives in our arrangements and that we take precautions to make sure that they are not accidentally included. So how do we do this?  In the next article we’ll look at how PBC practitioners, both buyers and sellers, can avoid perverse incentives.