Relational Governance and Contract Damages: Evidence from Franchising

Adam B. Badawi, University of Chicago Law School

Abstract

The literature on contract theory expects parties to use incentive mechanisms that minimize the costs of verifying breach in court if these mechanisms can effectively deter breach. This paper tests this hypothesis about relational governance in the context of franchising, an organizational form that provides parties with a suite of governance choices that span the range from those that require little or no verification to those that entail expensive and uncertain litigation. While relational governance options may be inexpensive, they may not be as effective as using incentives that require enforcement of written contracts, such as the threat of contract damages for breach. Using a newly collected dataset of franchise contracts, this paper documents and quantifies the tradeoffs between relational governance and contract enforcement. The empirical evidence provides support for the theory that when franchisors can use relational governance to police the behavior of franchisees they are willing to forego credible threats of damages, as measured by the presence of liquidated damages terms in contracts.