LEARNING OBJECTIVES

1. Explain what constitutes a contract.
2. Understand how a contract is formed.
3. Know the defenses to performance of a contract.
4. Understand breach of contract and its consequences.
5. Identify remedies for breach of contract.

Although businesses tend to use the terms “agreement” and “contract” interchangeably, legally the terms have very different meanings. An agreement is a mutual understanding between two or more parties about their rights and duties toward each other. A contract is a legally enforceable agreement between two or more parties. All contracts are agreements, but not all agreements are contracts.

When contracts are broken, or breached, the injured party can seek damages. In contracts, this usually means an amount that would make that party whole again.

Generally speaking, contracts are a form of private law, because the terms of the contract are binding on the parties to the contract but not anyone else. Parties may enter into contracts for whatever they wish and under any terms that they agree on. In other words, parties may assent to agreements even if those agreements represent bad bargains.

Contracts may restrict parties’ future activity. For example, a non-compete clause in an employment contract may be enforceable in the future against an employee after termination of employment.

However, contracts that are illegal or against public policy are not enforceable.

Contract law performs three significant economic functions:

1. It helps individuals and businesses exchange goods and services efficiently.
2. It reduces the costs of economic transactions because parties do not need to negotiate a variety of rules and terms with each separate transaction.
3. It alerts the parties to problems that have arisen in the past, making it easier to avoid potential pitfalls.

Offer

All contracts start when an individual or business proposes a deal. It might involve buying or selling goods, performing services, or making an exchange. An offer is a conditional promise to do or refrain from doing something now or in the future. In other words, it is willingness to enter into a contract.

Offers can be formal or informal. In some industries, such as retail and restaurants, offers are often posted on menus, signs, and advertisements. For example, a sign hanging above a cash register listing menu items and their prices is the restaurant’s offer to sell customers those items at those prices.

There are not a lot of legal requirements about what an offer must contain, but there are some things that cannot be a legal offer:

Once made, offers can be terminated in a number of ways. An offer that has been properly communicated continues to exist until it:

1. Is rejected;
2. Is replaced by a counteroffer;
3. Lapses or expires;
4. Is revoked; or
5. Is terminated by operation of law.

Unless it states a specific time, an offer remains open for a reasonable time.  A lapsed offer is an offer that is no longer valid because a reasonable time to accept it has expired. An expired coupon is an example of a lapsed offer.

Acceptance

To constitute an agreement, there must be an acceptance of the offer. Legally, acceptance is an implied or express act that shows willingness to be bound by the terms of an offer. To be effective, both parties must understand and agree to be bound by the contract.

Acceptance can be both express or implied. Express acceptance occurs when a party states that they accept the offer. Acceptance may be implied based on the parties’ conduct. For example, a retailer offers to sell a product to consumers for the price listed on the shelf. A consumer may accept that offer by handing the cashier the item and money to pay for it. The consumer does not need to say anything to complete the transaction. But the consumer must do something to accept. Silence, without more (such as handing over payment), is not acceptance. This is because silence may be evidence that the consumer either does not know about the offer or has rejected it.

A common problem in the business community is knowing what constitutes acceptance and what is negotiation. If an acceptance changes, adds, or modifies terms of the offer, it is a counter-offer and no contract is formed. The original party may decide to accept, reject, or propose another offer as a result. Although this sounds straightforward, with today’s fast-paced communications, parties may respond to part of an offer, negotiate various parts of the contract simultaneously, or agree to terms in installments. As a result, there may be confusion about what the full terms of a contract are.

Offer and acceptance form mutual assent, which is also called “meeting of the minds.” This is the parties’ intention to enter into a binding contract on the terms they agreed upon. If parties do not agree on the essential terms, then there can be no meeting of the minds to enter into a contract. This is the basis for many of the defenses to contract formation.

Consideration

Consideration is the bargained-for exchange of something of value that shows the parties intend to be bound by the contract. There are two elements to consideration:

1. Something of value
2. Is exchanged between the parties.

The “something” that is promised or delivered must be a legal detriment. A legal detriment is giving up a legal or property right.

Consideration may be concurrent or a promise to perform in the future. However, it cannot be “past consideration” based on something that has occurred before the formation of the current contract. In other words, an act or promise made before the current contract is not adequate consideration because it was not given in exchange for the current promise.

When bargained-for consideration is not present, a court may validate a promise based on promissory estoppel. Promissory estoppel is the principle that a promise made without consideration may nonetheless be enforced to prevent injustice if the promisor should have reasonably expected the promisee to rely on the promise, and the promisee actually relied on the promise to his or her detriment. Promissory estoppel is an equitable doctrine used as a substitute for consideration that allows the imposition of contractual liability to prevent unfairness.

To establish promissory estoppel, a party must show:

1. A definite promise;
2. The party making the promise should have expected that the other party would rely on the promise;
3. A reasonable person would have relied on the promise;
4. The party relied on the promise and it resulted in a substantial detriment; and
5. Basic justice and fairness require that the promise be enforced.

Bilateral and Unilateral Contracts

In a bilateral contract, both parties make a promise of performance. These contracts are also called mutual or reciprocal contracts. Bilateral contracts are the most common form of contracts. They include ordering food in a restaurant, buying gas for vehicles, purchasing goods and services, etc.

A unilateral contract, on the other hand, is a contract where one party makes a promise that the other party can accept only by doing something. For example, a business offers a reward for information leading to the arrest of a thief. A person cannot collect the reward money by promising to give information–he or she must perform under the contract by providing the information.

Express and Implied Contracts

An express contract is a contract in words (orally or in writing) in which the terms are spelled out directly. The parties to an express contract, whether written or oral, clearly intend to make a legally enforceable agreement. For example, an agreement to buy a car for $1,000 and to take title next Monday is an express contract.

An implied contract is a contract that is inferred from the parties’ actions. Although no discussion of terms took place, an implied contract exists if it is clear from the conduct of the parties that they have an agreement. A delicatessen patron who asks for a “turkey sandwich to go” has made a contract and is obligated to pay when the sandwich is made. By ordering the food, the patron is implicitly agreeing to the price, whether posted or not.

Quasi-contract: Contract Implied in Law

Both express and implied contracts embody an actual agreement of the parties. A quasi-contract, by contrast, is an obligation imposed by law to avoid unjust enrichment of one person at the expense of another. In fact, a quasi-contract is not a contract at all. It is a judicial remedy in which the court decides what a contract should look like between the parties to prevent injustice. For example, a carpenter mistakenly believes a homeowner hired him to repair her porch, when it was actually the neighbor who hired him. One morning the carpenter arrives and begins work. Rather than stop him, the homeowner lets him proceed, excited to get her porch fixed for free. Although no contract exists because there was no offer, acceptance or consideration, the law will imply a contract between the carpenter and homeowner for the value of the work.

Enforceability

A contract that is fully enforceable and reflects the parties’ intent is valid. Conversely, an unenforceable contract is a contract where the parties intend to form a valid bargain but the court declares that it cannot be enforced for legal reasons. For example, Ramesh owes Jai money, but Jai has waited too long to collect it and the statute of limitations has run out. The contract for repayment is unenforceable and Jai is out of luck unless Ramesh makes a new promise to pay or actually pays part of the debt.

An agreement that is lacking one of the legal elements of a contract is void because it never was a contract. In other words, it is not legally enforceable because it is not a contract at all. An agreement that is illegal is also void. For example, a promise to commit a crime in return for payment is void because neither side can enforce the agreement in court.

By contrast, a voidable contract is a contract that can be annulled. It is a contract that is unenforceable by one party but enforceable by the other. For example, a minor may “avoid” a contract with an adult; meaning the adult may not enforce the contract against the minor if the minor refuses to carry out the bargain. The adult must comply if the minor wishes the contract to be performed. A contract may be voidable by both parties if they are both minors. Usually, the parties to a voidable contract are entitled to be restored to their original position.

A voidable contract remains a valid contract until it is voided. Thus, a contract with a minor remains in force unless the minor decides he does not wish to be bound by it. When minors become adults, they have two choices:

1. Ratify the contract–that is, agree to be bound by it; or
2. Disaffirm the contract–that is, disavow or avoid it.

Ratification may be explicit or implicit. For example, by continuing to make payments or retaining goods for an unreasonable period of time, a party may ratify the contract. If a party has not disaffirmed the contract while still a minor, she may do so within a reasonable time after becoming an adult.

Degree of Completion

An executory contract is a contract that has yet to be completed. Most executory contracts are enforceable. If some, but not all, of the terms of the contract have been performed, the contract is called partially executed. A contract that has been completed or carried out fully by both parties is called an executed contract.

Conditions

A condition is an act or event (other than the lapse of time) that must occur before performance under a contract becomes due. Conditions determine when a party must perform.

A condition precedent is an act or event that must occur before a duty of immediate performance of a promise arises. For example, an inspection of property is a condition precedent to the sale of a home.

A concurrent condition occurs when mutually dependent conditions must be performed at the same time by the parties. For example, delivery of goods and payment in a cash sale are concurrent conditions.

A subsequent condition is an event that discharges a duty of performance that becomes absolute. They are rare and tend to occur in the insurance industry. For example, an insurance company may require notice within thirty days of a claim. The insurance company does not have a duty to pay until the insured gives notice. Notice is the subsequent condition that triggers the insurance company’s performance.

A constructive condition is a condition contained in an essential contractual term that, though omitted by the parties from their agreement, a court has supplied as being reasonable in the circumstances. It is an equitable doctrine that serves to imply conditions to prevent injustice.

Illegality

Illegal contracts are unenforceable because they are void. There are two common types of illegalities: (1) statutory violations, and (2) violations of public policy. An example of a statutory violation is where a company in the US wants to avoid import regulations and quotas by purchasing Cuban cigars through an intermediary in Mexico. If the US buyer pays the Mexican intermediary for the cigars but does not receive them, the buyer cannot sue the intermediary for breach of contract. The law will not provide a remedy to someone who intends to violate the law.

Examples of violations of public policy often occur in an employment context. An employer that tries to bind its employees to unreasonable non-compete agreements violates the public policy of freedom to work. Another common example is contracts with professionals who do not maintain a current license in their field. If they are not legally licensed for the work they perform, they are not entitled to payment for their services. Here, the public policy is that the law does not want to encourage a black market for services outside of government regulation.

Incapacity

If someone lacks mental capacity to understand the terms of the agreement, there cannot be a true meeting of the minds to form a contract. Capacity is the mental state of mind sufficient to understand that a contract is made and its legal consequences.

Incapacity can be permanent, such as from mental illness, physical illness, or insanity. Incapacity may also be temporary, such as being intoxicated, under the influence of drugs, or underage (i.e. under eighteen years old).

Undue Influence

Undue influence occurs when one party overpowers the free will of another by use of superior power or influence. In other words, it is unfair persuasion. Undue influence is not a normal level of persuasion. Rather, it occurs when a party agrees to a contract that they would not have otherwise consented to without the unreasonable pressure of the other party. For example, an elderly person who is isolated from others due to poor health and living conditions may be lonely and eager for company. If a caretaker exerted influence over the elder to the extent that he or she could no longer exercise free will, then undue influence occurs. Contracts and transactions in which elders transfer most or all of their wealth to others are frequently reviewed for undue influence.

Duress

Duress occurs when there is a threat to a person, family or property. Economic pressure may constitute duress if it is wrongful and oppressive. Cases involving duress often occur in emergency situations. For example, when someone is required to sign legal paperwork in an emergency room before receiving medical treatment for themselves or their children.

If a person enters into a contract under duress, he or she is able to get out of the contract after the emergency situation is over. Duress essentially overcomes a person’s free will to voluntarily choose to enter into the contract.

Unconscionability

Unconscionability occurs when the contract contains markedly unfair terms against the party with less bargaining power or sophistication than the party who created the terms and induced the other party to sign it. Common cases involving unconscionability claims occur when one party is an experienced business dealer, while the other party is an average consumer. If the business dealer uses a very small font and inserts terms into the contract in a way that intentionally misleads the consumer into signing on unfair terms, then the contract may be deemed unconscionable.

Statute of Frauds

The Statute of Frauds requires certain contracts to be in writing and signed to be enforceable. The Statute of Frauds originated in England in 1677 to prevent fraud when one party tries to claim a contract existed when it did not. The Statute of Frauds requires a written contract for:

1. Real property interests;
2. Marriage;
3. Payment of another’s debt;
4. Contracts that cannot be completely performed within one year;
5. Contracts for the sale of goods of five hundred dollars or more; and
6. Acting as another’s executor/administrator.

Statute of Limitations

The statute of limitations is an affirmative defense that can be raised by a defendant to argue that a lawsuit is being brought too late. This means that if a dispute arises under a contract, then the plaintiff must bring a lawsuit concerning that dispute within a certain time period. States have different statutes of limitations. If a contract has a choice of law provision, then that state’s statute of limitations will apply to disputes related to the contract.

Mistake

In the context of contracts, a mistake is the situation in which the parties did not mean the same thing or when one or both parties formed untrue conclusions about the subject matter of the contract. In other words, a mistake is an erroneous belief.

Mutual mistake refers to something that is a mistake by both parties that relates to an essential term of the contract. For example, a contract to buy property that is not actually owned by the seller would be a mutual mistake, if the seller believed in good faith that he owned the property. When mutual mistakes occur, either party may rescind the contract.

Unilateral mistake occurs when only one party is laboring under a mistake. Mistake does not mean bad bargaining. Courts will not step in to save parties from bad bargaining absent evidence of undue influence or unconscionability. In general, parties cannot rescind the contract when unilateral mistakes occur except when the mistake makes the contract unconscionable, the error is apparent to the other party, or when significant mathematical errors occur.

Figure 10.1 Types of Mistakes Affecting Contracts and Their Remedies

Misrepresentation and Fraud

Misrepresentation and fraud are also defenses to contract. Misrepresentation is when a party makes a false statement that induces the other party to enter into the contract. Fraud is a closely related concept, and it simply means that one party has used deception to acquire money or property. Fraud may also be a basis for criminal charges, depending on the circumstances leading to the contract.

Commercial impracticability

Commercial impracticability is a defense that can be used when fulfilling a contract has become extraordinarily difficult or unfair for one party. For example, a sales contract relating to the sale of goods destroyed by a natural disaster would fall under this defense. It becomes impossible for the seller to deliver goods that no longer exist, and would be unfair to enforce damages against the seller for breach of contract. This is also called frustration of purpose or impossibility in some jurisdictions.

Bankruptcy

Sometimes a party to a contract files for bankruptcy protection. The bankruptcy court will determine which debts the bankrupt party must pay and which are dischargeable. Contract obligations are suspended temporarily through the bankruptcy court’s automatic stay. In other words, the debt does not have to be paid during the course of the bankruptcy. At the conclusion of the bankruptcy, if the contract obligation is determined to be a dischargeable debt, then the debt will not have to be paid.

Third Party Beneficiaries

Assignment and delegation under a contract should not be confused with rights of third party beneficiaries. A third party beneficiary is someone who is not a party to the contract but stands to benefit from it. Life insurance policies are a classic example of contracts with third party beneficiaries. The insurance company and the insured are parties to the contract. But the person who receives payment upon the death of the insured is the third party beneficiary.

Third party beneficiaries can either be intended or incidental. An intended beneficiary is someone who the parties intend to receive the benefit of the contract. For example, the named beneficiary of a life insurance policy. The beneficiary does not need to know about the contract to have his or her rights vest.

An incidental beneficiary is someone who benefits from a contract but was not intended by the parties to benefit. For example, if a business pays for a professional to landscape its property, the neighbors are incidental beneficiaries to the landscaping contract. They benefit from the improved appearance and property values, but the business did not enter the contract with an intent to benefit them. Incidental beneficiaries do not have a legally enforceable interest in the contract.

Damages

Damages are the money paid by one party to another to discharge a legal liability.

Equitable Remedies for Breach of Contract

Equitable remedies involve a request for relief that does not include money damages. Equitable remedies are useful for when money does not provide adequate relief to the non-breaching party.

Specific Performance

Specific performance is a judicial order directing a party to deliver the exact property (real or personal) under the terms of a contract. Specific performance is an alternative remedy to damages and may be issued at the discretion of the court. Specific performance is granted when money damages are not an adequate remedy. For example, sale of specific real property (real estate is always unique), artwork, antiques, and heirlooms.

To warrant specific performance, a contract must be clear, definite, complete, and free from fraud and duress.

Specific performance is generally not available for service contracts. This is because ordering someone to perform a contract against their will is a type of involuntary servitude banned by the Thirteenth Amendment of the US Constitution. However, courts have occasionally entered injunctions prohibiting entertainers from performing at alternative venues until they perform at the venue under their original contract. These cases are in response to unethical forum shopping in the entertainment industry, and are very limited in nature.

Rescission

Rescission occurs when one party seeks to undo a contract and return to the position it was in before the contract was made. Rescission often occurs when fraud and mutual mistake occur and enforcing the contract would be unjust. Rescission may also be available when one party materially breaches the contract to such an extent that requiring the other party to perform would be unjust.

A party seeking rescission must notify the other party within a reasonable time after discovery of the facts that are the basis for rescission. The reason is that restoring the parties to their pre-contractual positions is easiest before too much time and performance has passed. Failure to rescind a contract in a timely manner may be held to affirm the contract or waive a breach of contract.

Restitution

Restitution is restoring property to the original owners. In other words, parties must return any benefit received under the contract. Therefore, only to the extent that the injured party conferred a benefit on the other party may the injured party be awarded restitution. Restitution often follows rescission of a contract. The purpose of restitution is to prevent a party from being unjustly enriched when a contract has been legally annulled.