Basic Concepts in the Law of Contracts

LGST 612 Prof. Kevin Werbach BASIC CONCEPTS IN THE LAW OF CONTRACTS Contracts are essential to business. They are a legal mechanism used in every industry and every part of the world to structure relationships among firms, and with customers, partners, and suppliers. Over several centuries, the law governing contracts has developed a large number of doctrines. Most are consistent with common sense, but unless you know what the rules are, you can easily make a mistake. This document introduces the fundamentals of contract law most relevant to businesspeople.

Important legal terms are italicized. What is a Contract? And what is Contract Law? Legally, a contract is a set of promises that the law will enforce. We make promises all the time. Only some of them – the ones that meet the contract formation requirements listed below – are legally enforceable. That means the legal system, in the form of courts, can step in to order some action or payment for violation of the contract. Contracts are therefore private deals with the possibility of public (governmental) enforcement.

Of course, there are many reasons to fulfill promises other than legal obligations. Reneging on promises may be unethical, or may result in a loss of goodwill or reputation as costly or more so than anything a court can impose. The general principles of contract law are fairly universal around the world. However, specific rules vary from country to country. In common law countries such as the United States and Great Britain, most of the legal doctrines governing contracts have been developed by courts over the centuries.

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When parties enter into a contract, therefore, they generally do not expect it to be breached (violated), or to resort to the legal system. However, they recognize that sometimes a partner may make a promise with good intentions, and later fail to fulfill it, or that circumstances may chance in some way. When evaluating contracts, courts will generally not consider whether the deal was a good one for either side. The standard view is that no one forced the parties to enter into the contract; they should be held to the bargain they struck.

Another way to think of a contract is as a legal hedge against uncertainty or risk. The contract gives each party confidence that if the other fails to perform, they can receive compensation through the courts. It also allows parties to specify how specific situations in the future may be addressed. For example, in the software license described above, what happens if the buyer decides to modify some of the software code and resell it? Rather than wait for the confusion if that happens, the parties can specify ahead of time how the situation will be handled, by adding provisions to the contract.

LGST 612 (Prof. Werbach) Page 2 Contemporary legal systems focus on two things in contracts cases: intent and reliance. If the evidence shows that all parties acted as though they intended to be legally bound to a contract, and the plaintiff (the one filing the lawsuit) reasonably relied on the defendant to follow through with the contract, the courts will generally enforce it. To do otherwise would be unfair to the party that was harmed by honoring their commitments. In modern contract law, intent and reasonable reliance often trump formalities.

A contract may generally be enforced even if it not signed, written, or even expressly made. For example, if a fishmonger delivers fresh fish to a restaurant every Monday for a year and receives the same payment each time, there may be an implied contract even if the parties never explicitly spoke about it. The plaintiff still needs to convince the judge or jury in court, which is much harder to do based on oral testimony than documentary evidence. Unwritten contracts also leave significant gaps for courts to fill in.

The implied contract between the restaurant and the fishmonger, for example, could be terminated at any time by the parties, because there is no explicit term guaranteeing how long it will last. Remedies What a court awards to a successful plaintiff for breach of contract is known as the remedy. In contract law, the sole purpose of the remedy is to adequately compensate for the breach. You cannot receive additional “punitive” damages to punish someone for breach of contract, as you might under a tort claim such as products liability. The same facts, however, might give rise to both kinds of claims, as when a party deliberately breaks a contract in order to harm the other party’s business. ) In most contracts cases, the remedy is a payment of money, known as damages. There are three main ways that courts may calculate the level of damages: • Expectation is the preferred formula. Whenever possible, this is what courts will use. Expectation means that the plaintiff (who did not breach the contract) gets the “benefit of the bargain. ” In other words, they receive compensation to put them in the position they would have been in, had the contract been performed.

For example, if an airline enters into a futures contract to purchase jet fuel in one year at $4/gallon, and at the time of performance the fuel company breaches because the spot market price is now $7/gallon, the expectation remedy would be $3/gallon times the number of gallons. In other words, it is the difference between the market and contract price. That way, the airline can buy the fuel from someone else at the market price, and still get the benefit of the contract. Reliance is used when expectation damages cannot be calculated because the amounts are too uncertain, or there is some other reason not to give expectation damages.

Under this formula, the plaintiff gets back any costs he or she has expected by relying on the contract, so they are no worse off than before the agreement. Generally, this will be a smaller amount than the expectation remedy. Restitution is used in rare situations where even reliance damages are not feasible to determine. Under this formula, the defendant (who breached the contract) must give back whatever benefit he or she received from the plaintiff, even if this does not fully cover the plaintiff’s reliance.

For example, if the plaintiff paid money to the defendant for some services, the defendant must give it back. • • Courts may also consider awarding incidental and consequential damages. These are other costs the plaintiff can demonstrate, which go beyond his or her expectation under the contract. For example, imagine a factory owner contracts for a $50,000 piece of machinery to power a production line, and LGST 612 (Prof. Werbach) Page 3 the supplier breaches the contract. It takes a month before the factory can obtain an equivalent machine from another supplier (also for $50,000).

As a result, the factory loses one month of production, which produces financial losses of $500,000 and causes its customers to terminate future orders worth several million dollars. All those costs are considered consequential damages. Whether they can be recovered depends on how foreseeable they were, and on the terms of the contract itself. On the one hand, those are actual losses the plaintiff suffered; on the other hand, was it reasonable to think the defendant took on millions of dollars of potential liability when it sold a $50,000 machine?

In limited situations, monetary damages are not sufficient to give the plaintiff an adequate remedy. In such cases, a court may order an injunction (forbidding the defendant from some course of action) or specific performance (affirmatively ordering the defendant to go through with the transaction). Specific performance is only available for unique objects, where the money to purchase a similar object is not considered sufficient. This includes things such as works of art and real estate. Breach Failing to follow through on the legal obligations of a contract is called a breach.

A breach might mean one party totally ignored its contractual obligations, or that it failed to perform some of them (such as completing the contracted-for services within a specified time), or that it did so in an inadequate manner. Whether something constitutes a breach is a factual decision for the court. The decision may be easier if the contract itself specifies conditions for breach, or whether a failure to perform specific responsibilities constitutes a breach of the whole agreement.

As mentioned above, breaching a contract is not the same thing as breaking a promise, because law and ethics are not identical. In particular, sometimes a breach is, economically at least, a good thing. Imagine that an architect contracts with a cabinetmaker for custom-designed built-in furniture in a renovated house. However, the owner of the house changes her mind before finalizing her contract with the architect, and he loses the commission. The cabinetmaker has not yet started to manufacture the furniture.

It would be wasteful to force the architect to go through with the contract, when he knows the cabinets will be useless. It is more efficient for the architect to breach the agreement. So long as the architect pays sufficient compensation to the cabinetmaker (voluntarily or in the form of monetary damages or a voluntary payment), there is nothing unethical in his breach. Contract Formation There are five required elements for a legally binding contract. In other words, a plaintiff suing for breach of contract must first show that all five were met. Then they must show the contract was breached, and they are entitled to a remedy. ) 1. 2. 3. 4. 5. Offer Acceptance Consideration Legality Capacity The first two requirements, offer and acceptance, are sometimes lumped together and called “mutual assent. ” They are typically the most difficult and important elements to establish. LGST 612 (Prof. Werbach) Offer Page 4 An offer is a proposal that manifests intent to enter into a contract. It is distinguished from an invitation, which is merely a proposal to enter into negotiations and therefore not legally binding.

The party that makes an offer is called the offeror and the party that receives it is called the offeree. For the offer to be valid, the offeror must: 1. Manifest the intent to enter into a contract 2. Be definite and certain regarding the essential terms of the proposed contract 3. Communicate the offer to the offeree Suppose you are at a used-car dealer’s lot. You see a care you like with the price listed as $9,995. You ask the salesperson what he’d take for the car; he doesn’t answer you, but responds by asking you what you would offer.

If you then say, “I wouldn’t pay the list price, but I might pay $8,000 if I could finance it,” have you made an offer? In considering questions of this type, courts will look to “objective” manifestations of intent. Would a reasonable (ordinary, average) person, listening to your conversation in context, think that you intended to bound into a contract if the salesperson accepted? Again, reasonable reliance is what the courts look to protect, so your subjective mental state, even if it could be reliably determined, is irrelevant. Courts do, however, consider the context.

You might offer to purchase a candy bar simply by holding out a dollar bill to a cashier, but an offer to enter into a multi-million dollar merger agreement might require significantly greater formalities. Similarly, if it would be clear to a reasonable observer that a statement was made as a joke, or in a social setting that does not involve contractual obligations, such as a wedding invitation, there is no binding offer. All these, however, are factual questions that courts might assess by hearing witnesses, looking at evidence, and listening to experts.

Acceptance An acceptance is the mirror of an offer. If the offeree (the one receiving the offer) objectively manifests intent to be bound, the other elements below are met, and the offer is still valid, a contract comes into being at that moment. Intent is evaluated the same way for acceptance as for the offer. For the acceptance, however, courts are more sensitive to situations where someone takes actions that indicate acceptance (such as signing a document), but does not in fact understand the obligations they are undertaking.

In such cases, courts generally look to whether this is the sort of contract that is typically accepted in that manner, and whether the offeree had a reasonable opportunity to analyze the contract but chose not to. Many business-to-consumer agreements are so-called contracts of adhesion or form contracts, where the consumer has no real opportunity to negotiate the specific terms – think of a rental-car agreement – but acceptance is still generally considered valid because there are other means to protect the consumers and the alternative would be extremely inefficient and cumbersome.

There are four ways that an offer may no longer be valid: 1. The offeror may generally revoke the offer by communicating that to the other party at any moment before acceptance. 2. If the one receiving the offer rejects it, which includes making a counter-offer, the original offer is considered no longer binding. 3. After some reasonable period of time, determined by the court based on the context, offers lapse. You cannot walk into a used-car dealer and say you are accepting the list price of a car advertised two years before. 4. Death or incapacitation of an offeror generally cancels an offer.

One exception to the rule about revocation of offers is the option contract. This is essentially a contract that binds only one party. For example, a property owner might grant a real estate investor LGST 612 (Prof. Werbach) Page 5 an option to purchase a building for $15 million within a period of 90 days. If the investor comes forward with the $15 million, the owner must sell the building. The investor, however, is under no obligation to do anything. (Options on stocks operate the same way; the price for the put or call is the payment for the option. ) Under U. S. aw, there must be a separate payment for holding open the option, even if it is specified in the same document as the purchase terms. In other words, in the real estate example, if the building owner promised to keep the offer open for 90 days, but received no compensation for that promise, it would technically be free to sell to someone else. In many other countries, a party that promises an option must keep it open for a reasonable period of time, even without payment. The acceptance must mirror the offer. That means the offeree must comply with any conditions the offeror placed on the offer.

If, for example, the offer states that payment must be made in cash, or that those wishing to accept the offer must show up in person at a certain location, those conditions must be met for a valid acceptance. If the offeror does not specify, the offeree may use any reasonable means. This may even include actions rather than words. If I ask a friend to bring me a sandwich from the cafe downstairs, which I’ll pay for, and she immediately goes to purchase it without saying a word, her actions would likely be a sufficient manifestation of intent.

As always, context matters. In a complex commercial negotiation, it may be reasonable to exchange numerous very specific drafts, which are not formally accepted until the final version is signed off on by senior executives. Consideration Consideration means that each party has committed to giving up something of value to induce the promise or action of the other party. It is the way the law distinguishes an enforceable contractual bargain from a gift. If someone promises to give you a gift, and then reneges on the promise, you cannot sue them for breach of contract.

There was no contract to begin with, because you did not have to give anything up in return for the gift. In most contracts, consideration will be money in exchange for some goods or services. However, it can be anything of legal value, including property or voluntarily giving up a legal right to act in a certain way. In a famous case, a court held that an uncle’s promise to pay money to his nephew if the nephew gave up smoking and drinking was enforceable, because the nephew stopped doing something he was legally entitled to do. The consideration must, however, be needed to induce the promise.

If your action or inaction wasn’t what motivated the other party, there is no consideration. The amount of consideration need not match the value of what the party receives in return. A contract to pay $100 for a computer worth $1,000 may be a bad deal, but it has sufficient consideration. The main question is whether there is something of value exchanged to demonstrate the agreement is not a gift. In business agreements, this sometimes means a recital (a contractual provision that simply states a fact) along the lines of, “in exchange for good and valuable onsideration of one dollar…” to ensure consideration is found. Legality Contracts that are made for an illegal purpose will not be enforceable in a court of law. An agreement with a hit man to kill a disfavored relative may meet all of the formalities of a contract, but it should be obvious that you could not sue him for failing to go through with it. More realistically, an agreement to engage in bribery or to restrain market competition in violation of antitrust laws would be unenforceable.

Capacity All parties to a contract must have the legal capacity to enter into a binding agreement. In other words, they must have what the law considers sufficient mental fortitude to understand and commit to LGST 612 (Prof. Werbach) Page 6 the obligations involved. Two main classes of people who do not have capacity are children and those under significant mental disability or impairment. Children are generally not allowed to become legally bound by contracts. (The specific age cutoff and other considerations vary from jurisdiction to jurisdiction. If an adult contracts with a child, the child can void the contract at will, but the adult is still bound if the child wishes to enforce the agreement. The other situations in which capacity becomes an issue are when a party either has a significant disability that prevents them from understanding contractual obligations, or they are too severely impaired by drugs, alcohol, or another factor. Capacity is judged objectively: would a reasonable observer think the party was in a state that made it impossible to express intent to contract?

If so, the party at that moment lacks the legal capacity. It is important to note that capacity is not the same thing as capability or authority. A bank may not actually have the financial wherewithal to provide the financing that it contracts for, but this does not mean it is incapable of entering into any contract. If it fails to provide the financing that the other party reasonably relied on, it is in breach of contract, whether or not it actually has the resources needed to perform. Similarly, an agent may or may not have the legal authority to speak for a firm.

If a sales representative (or someone claiming to be a sales representative) commits a company to an agreement with a customer that the company does not in fact wish to honor, that has no bearing on the legal capacity to contract. In that situation, the court must determine whether it is appropriate to bind the company. If the salesperson did not in fact have actual authority to sign off on such contracts, courts would look to whether it was reasonable for the customer to think that they did, especially without communicating with corporate headquarters.

Whether a Contract Must be in Writing (“Statute of Frauds”) As mentioned above, there is no general requirement that contracts be in writing. It is generally a good idea to write contracts down, because that provides clear evidence of their existence and terms if they are ever breached. Fundamentally, though, an oral agreement, or an unsigned written agreement, is a valid contract, except in two broad cases. The first is when there is a statutory or regulatory requirement to put a certain agreement in writing. This is often the case, for example, with financial and healthcare agreements.

The second is if the contract is under the statute of frauds. The Statute of Frauds was a 17th century English law that required some contracts to be in writing, because otherwise there would be too much risk of witnesses lying (the “fraud”) in their oral testimony in court. Today, the term refers mostly to common law principles that impose a writing requirement, plus provisions of certain modern statutes (such as the Uniform Commercial Code) that impose similar obligations. Saying that a contract is “under the statute of frauds” means that it has to be in writing.

There are several categories of contracts that fall under the statute of frauds, including suretyship (promising to pay someone else’s debts) and contracts in consideration of marriage (such as prenuptial agreements). The three categories most likely to arise in a business context are: • • Sale of land. This also includes interests in land, such as a mortgage. Sales of goods worth $500 or more. Note that contracts for services, such as consulting or financial advice, are not covered under this provision. The $500 figure comes from the Uniform Commercial Code, and is an arbitrary figure, not pegged to inflation.

LGST 612 (Prof. Werbach) Page 7 • Promises not performable in one year. In other words, there is no way the contract could be successfully performed within a year. If the contract does not specify a term of longer than a year, and there is come conceivable scenario in which both parties would discharge their responsibilities before the end of the year, it need not be in writing. If a contract falls under the statute of frauds, a sufficient “writing” is a document that identifies the parties, describes the basic obligations of the contract, and is signed by the party to be charged.

As with any written contract, if there are specific details not set out in the document, the court can interpret the language or fill in reasonable terms as necessary to enforce it. If, however, the writing is missing a material term – for example, the price in most sales contracts – it is not enforceable. Basically, the court needs enough information to determine a remedy. If the contract is not under the statute of frauds, the courts can look to other written evidence or oral testimony to find a material term. However, if the parties simply failed to agree on such an essential point, the contract is unenforceable.

Note that when the statute of frauds applies, only one party is required to sign the agreement: the party who is being sued to enforce it (the defendant). The signature of the other party may still be useful to prove there was intent to enter into a binding agreement. Excuses to Performance In some circumstances, a party will not be held to an agreement, even when it met all the legal requirements for a valid contract. The most common excuses to performance are: Fraud. If one party induces a contract by lying to the other party, it is not enforceable even when the form of the contract is perfectly good.

Duress. If a party felt it was forced to enter into a contract against its will, it can claim the contract is unenforceable due to duress. This means something more than a difficult situation or a tough negotiating partner on the other side. For example, if there is only one supplier for an important input with sufficient production capacity, buying from that supplier is not duress. There must generally be some misconduct, involving threats to engage in illegal conduct or breach other obligations, which convinces the other party it has no choice. Unconscionability.

As noted above, a contract will not be considered unenforceable because it is unfair, or because there is unequal bargaining power (as is typically the case in business-to-consumer interactions). However, if one party has no reasonable opportunity to understand the obligations they are undertaking, or there are terms in the agreement so manifestly unfair that they “shock the conscience,” courts can declare specific provisions or whole contracts as unconscionable. This doctrine is successfully invoked infrequently, and then typically when there is unfairness in the process, rather than the substantive terms.

Mutual mistake. If both parties were mistaken about the fundamental subject matter of the contract, such that they never truly had an agreement, the contract can be declared unenforceable. If the mistake is simply a bad business decision, such as an assumption that the price of a good will not increase substantially, it will not excuse performance. Impossibility/frustration of purpose. If circumstances change so dramatically that either a contract is effectively impossible to perform, or it would be pointless to complete it, courts can excuse performance.

As with the other doctrines, courts will not release parties from their obligations if performance is merely more difficult or costly than they expected. – – – – LGST 612 (Prof. Werbach) Page 8 These excuses are considered by courts after the fact. In such situations, there is a contract, but there is no legal remedy for a breach. Sometimes, the result is merely to sever a problematic provision of the contract. For example, a contract may be enforceable minus the specific term the court considered unconscionable.

Recovery Outside of Contract (“Promissory Estoppel”) Modern contract law makes it relatively easy for parties to enter into contracts, to specify the terms of those contracts, and to be excused from contractual obligations when fundamental fairness dictates. Consequently, the legal system generally focuses on whether the procedural obligations of contract law described above have been met, rather than on whether the outcome is just. After all, the parties were free to act differently, yet chose to structure their agreement in a certain way.

Why should the courts interfere with their decisions? In a host of cases, this freedom-based view of contracts fails to account for reality. Inequalities in access to information or bargaining power may so warp the relationship between parties that the formal structure of an agreement may not actually reflect the intent of at least one of them. Or there may be significant public policy concerns, such as avoiding mistreatment of patients or retail investors, which counsel for heightened obligations beyond those of common-law contract doctrines.

Another category cuts in the opposite direction. Sometimes the un-enforceability of an agreement is unfair. If one party reasonably relies on the other party, yet has no remedy because the agreement is unenforceable, it can create a situation in which the courts view themselves as parties to an injustice. The legal doctrine known as promissory estoppel arose to allow for recovery of damages in court, even when there is no enforceable contract between the parties.

The Restatement (Second) of Contracts, a collection of “best practices” in contract law written by leading legal experts in the field, describes promissory estoppel as follows: “A promise which the promisor should reasonably expect to induce action or forbearance on the part of the promisee or a third person and which does induce such action or forbearance is binding if injustice can be avoided only by enforcement of the promise. The remedy granted for breach may be limited as justice requires. ” Most commonly this doctrine is invoked for charitable gifts.

For example, imagine that a donor to Wharton promises the school $100 million for a new building bearing her name, the school builds the building in reliance on the gift, and the donor then reneges on the promise. There is no enforceable contract, because there is no consideration. (The school’s expenditure in building the building was a response to the promised gift; it is not what induced the promise, as required for consideration. ) In such a situation, if a court feels it would be an “injustice” that Wharton receives no compensation, it can award damages on a promissory estoppel theory.

Courts have applied promissory estoppel in other situations where, because of some legal quirk, a party reasonably relies on a contract and yet has no adequate remedy. Note that promissory estoppel is a distinct legal claim, not a lawsuit based on a valid contract. One consequence is that damages are generally limited to reliance. In the donation example in the previous paragraph, this means that Wharton might recover the amount it spent on constructing the building, but not the full $100 million that was promised. And remember that the court can decline to award anything if it does not feel that an injustice has occurred.

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