General Contracting Principles
Contracts are used everywhere. A contract is a promise between people to sell goods or perform services. Some basic contractual principles apply to all contracts, no matter what the underlying transaction is. People use contracts to state the rules of their relationship. Contracts determine how parties will act with one another. They recite the promises that each party makes to the other. They also help describe what happens if the parties cannot complete their contract.
A mixture of common law and code law governs contract formation and performance. Many states have enacted statutes that govern certain types of contracts. One law that many states have in common is the law addressing the sale of goods. Laws governing the sale of goods are part of the Uniform Commercial Code (UCC), written by the National Conference of Commissioners on Uniform State Laws (NCCUSL). The NCCUSL works to develop uniform state laws and has been in existence since 1892.1 Each state appoints commissioners to work on draft model laws. It took the NCCUSL 10 years to write the UCC.
The UCC is a model law that states can adopt. Every state has adopted all or parts of the UCC. However, states may amend portions of the UCC when they adopt it. For example, Article 2 of the UCC addresses the sale of goods. A “good” is a movable object such as a computer, desk, or chair. States have enacted similar laws governing the sale of goods so that commerce between the states can be predictable and uniform. This helps encourage even more commerce and business. The UCC does not cover every aspect of contract law, however. Many parts of contract law are left to each state’s common law.2
NOTE
When reviewing contract laws in a particular state, it is important to study both the state’s code law and its common law.
Common law contracting principles also are similar among the states. The Restatement (Second) of the Law of Contracts, a treatise on common law contract rules prepared by the American Law Institute (ALI),3 summarizes the common law rules. The ALI is a group of highly distinguished judges, lawyers, and legal scholars who review cases on a certain type of law, then compile the principles stated in those cases into a series of rules. These rules are not binding authority on a court the way statutes or court rulings are. However, they do offer guidance on identifying the common law.
NOTE
The ALI and the NCCUSL worked together to create the UCC.
This chapter discusses the basic rules that are applicable to all contracts. It also discusses how those rules apply to online or electronic contracts. However, this chapter does not discuss the special rules that apply to certain types of contracts such as real estate or securities transactions.
The general contract law rules are derived from the common law. It is important to keep in mind that the common law traditionally applies to contracts for services, whereas the UCC applies to contracts for goods.
Contract Form
A contract is a legally binding agreement that is enforceable in court. Contracts can be either oral or written. Oral contracts are contracts that parties do not write down, whereas written contracts are contracts that may have been negotiated verbally, but are then written down. An oral contract is just as enforceable as a contract that is written down. However, there are a few reasons why written contracts are best. They include:
NOTE
A lawyer’s favorite line, “An oral contract is not worth the paper it is written on,” is attributed to Samuel Goldwyn. Goldwyn was a Hollywood producer who rose to fame in the 1920s.
- Proof—It is easier for a person to prove the existence of a written contract.
- Terms—It is easier for a person to prove the terms of a written contract.
- Precision—A written contract requires the parties to be more precise in defining their relationship.
- Clarity—A written contract is more likely to have terms that clarify what happens if a contract relationship fails.
Some types of contracts must be written down and the contracting parties must sign them. Otherwise, the contemplated transaction cannot take place. These contracts must be written down to prevent fraud between the contracting parties, according to a rule called the Statute of Frauds. For example, contracts for the sale of land must be written down. Some contracts for goods that are valued over $500 also must be written down.4 The law requires these contracts to be written down and signed to provide proof of their existence. The law does not specify how contracts must be written down. Even exchanged text messages can be sufficient to demonstrate proof of a contract.5
No matter what the form of a contract, all contracts must have certain elements in order to be enforceable. For example, contracts must be made between parties that have the legal ability to enter into them. Parties can contract only for transactions that are legal and that do not violate basic societal principles.
Finally, the parties to the contract must show that they intended to enter into a specific transaction with specific terms, which is called mutual assent. Mutual assent is shown through the “offer” and “acceptance” process.
Capacity to Contract
The law assumes that almost anyone can enter into a contract. There are few exceptions to this rule. People who enter into contracts must be able to understand that they are negotiating for a relationship. They also must be able to understand that each party will have rights and obligations because of the parties’ agreement.
A court will not find a contract enforceable if a person was not able to understand the consequences of entering into the contract at the time that it was formed. A person who is unable to understand the consequences of entering into a contract lacks contractual capacity.
NOTE
A person who lacks “contractual capacity” is not bound by his or her contracts. Courts will not enforce contracts against a person who lacks contractual capacity.
The law recognizes that the following classes of people may lack contractual capacity:
- Children under the age of 18
- People who are mentally incompetent
- People who are intoxicated by drugs or alcohol
In most cases, courts will not enforce contracts against people in these classes. However, there are special rules for contracts for necessary items such as medical care. People who lack contractual capacity can be held responsible for contracts that they enter into for necessary items. These rules are applied subjectively. Courts look at the facts and circumstances of each case. The legal representatives for both children and mentally incompetent people may approve certain types of contracts on behalf of the people that they represent.
The contractual capacity of an intoxicated person requires special review. To avoid a contract based on intoxication, a person must be so intoxicated that his or her mental capacity is limited. Courts will look at objective measures of intoxication and the actions of the party. An intoxicated person’s deliberate actions, such as writing contract terms on a napkin, might be used to show that a valid contract existed.
NOTE
An intoxicated person can lack the capacity to contract through drug or alcohol use. A court can find contractual incapacity even if a person’s drug or alcohol use was voluntary. It depends on the facts of the case.
A person who is trying to avoid a contract may claim that he or she lacked the capacity to enter into the contract. If a person raises this defense, then he or she bears the burden of proving the lack of contractual capacity.
Contract Legality
Some types of contracts simply are not enforceable because they are against public policy. Public policy refers to the principles that form the beliefs of a society. A contract that is contrary to those principles is not enforceable.
NOTE
Courts will not enforce illegal contracts. An illegal contract is formed when parties try to enter into an agreement to commit a crime or other wrongdoing.
An example of an unenforceable contract is a contract for murder. It is against the law, and public policy, to murder another person. Therefore, a court will not enforce a contract where one party agreed to kill another party for a sum of money. This type of contract is called an illegal contract.
Contracts that are not enforceable because of public policy reasons include:
- Contracts that reduce commercial competition
- Contracts to commit a crime or other wrongdoing
- Contracts that are unfairly burdensome to one party
- Contracts that discriminate based on unchangeable characteristics such as race, color, religion, or disability
NOTE
Contracts that are unfairly burdensome are called unconscionable. Unconscionable contracts are not enforceable.
Form of Offer
An offer is an invitation to enter into a relationship or transaction of some kind.6 The person who makes an offer, called an offeror, must put enough detail into the offer so that the other party knows what he or she is agreeing to. The other party is called an offeree.
The offer must contain enough terms and detail to describe the underlying transaction. In a transaction for the sale of goods, an offer typically would include terms describing the goods, the quantity of goods available, and their price. That way, the offeree would know what and how much he or she gets for the contract price. These are material terms of the transaction. An offer has enough detail when the offeree knows what is part of the bargain.
To be valid, an offer must be communicated to the other person. For example, an offeror selling a couch must communicate the item to be sold, when the item is available, and the price for the item. He or she must communicate all of these terms in order to make a sufficient offer. An offer is valid as soon as the offeree receives it.
NOTE
In contracts for the sale of goods, the offeror is called the seller. The offeree is the buyer.
An offeree must take action once an offer is communicated. An offer remains open until it is accepted, rejected, or retracted. An offer also can expire if too much time passes before an offeree accepts it. Sometimes offers say that they are valid only for a certain period. When that period ends, the offer expires. If an offer does not include a time period, then it expires after a reasonable period of time.
NOTE
Offers expire after a reasonable period of time. Courts determine what a reasonable period of time is by looking at the facts and circumstances surrounding a case.
If an offeree does not agree to the terms of the offer, then it is rejected. An offeree also rejects an offer if he or she proposes terms that are different from the original offer. This is called a counteroffer. In this situation, the original offer is rejected when the counteroffer is proposed. The original offeror then has to decide whether to accept or reject the counteroffer. The parties cannot go back to the original offer unless one of them proposes it again.7
NOTE
Usually offers and counteroffers are made during the negotiation process. Verbal negotiations are very normal. Parties do not always write down the offers and counteroffers that they make during this process. Sometimes the only offers that are written down are the final, accepted offers. These end up becoming the contractual terms.
An original offeror also can revoke an initial offer. This means that the offer is no longer available. If an offer is to be cancelled, this must be done before an offeree accepts it.
Form of Acceptance
An offer is accepted when the offeree agrees to the terms of the offeror’s bargain. Traditionally, an acceptance had to have exactly the same words and terms as the original offer. This was called the mirror image rule. The mirror image rule meant that even a small change in terms or language between the offer and an acceptance served as a rejection of the original offer. The new terms in the acceptance then became a counteroffer. Parties had to be very careful in their negotiations to use the same terminology all the time to avoid the rule.
Today there is less emphasis on the mirror image rule. An acceptance does not have to be identical to an offer to be enforceable. Under the more relaxed rule, an acceptance is viewed as a counteroffer only if the terms of the acceptance change a material term in the offer. If the acceptance does not alter material terms, then it is enforceable. The UCC follows the relaxed mirror image rule.10
The offeree must clearly communicate acceptance back to the offeror. This includes the use of words such as “Yes” or “I accept.” Acceptance of an offer also can be communicated through actions. One action that clearly communicates acceptance is paying money.
The timing of the acceptance is an important consideration under the common law of contracts. When parties are in the presence of one another, acceptance is communicated instantaneously. A contract is automatically formed when the offeror receives the acceptance; the parties are clear on the terms of the offer and of the acceptance because they are in each other’s presence. There is no break in communication that might indicate that the offer has been revoked.11
What Communications Constitute an Offer?
Courts frequently encounter questions about the types of communications that constitute an offer. The general rule is that a communication is considered an offer if an objective, reasonable person would consider it an offer.
Courts have long held that an advertisement can constitute a valid offer. The Carlill v. Carbolic Smoke Ball Company (1892) case is one of the oldest and most cited cases in this respect.8 It is an old English contract law case. The Carbolic Smoke Ball was a flu and illness remedy. The manufacturer advertised in newspapers that it would pay Smoke Ball users a “reward” if they caught the flu after using the product.
The plaintiff in the case used the product and caught the flu. She asked the manufacturer to pay the “reward.” The manufacturer declined to pay the reward. Eventually the case went to court. The English Court of Appeal held that the advertisement did indeed constitute a valid offer. It said that the plaintiff’s actions in using the Carbolic Smoke Ball were a valid acceptance of that offer. The court found that the plaintiff acted reasonably in relying on the terms in the advertisement. The manufacturer needed to pay the reward that had been advertised.
However, not all advertisements constitute a valid offer. In Leonard v. Pepsico, Inc. (S.D.N.Y. 1999), the plaintiff claimed that a Pepsi television advertisement showing that “Pepsi points” could be redeemed to claim a Harrier jet was a valid contractual offer.9 The plaintiff claimed he accepted the offer when he submitted Pepsi points, cash, and a claim form for the jet to Pepsi. You can see the commercial at http://www.youtube.com/watch?v=ZdackF2H7Qc.
The court held that it was clear that Pepsi’s “offer” of the Harrier jet was a joke. It said that an objective, reasonable person would not believe that the television advertisement constituted a real offer.
The best part about this case is the court’s opinion. It is clear from the opinion that the judge had a sense of humor and dramatic flair. In discussing the commercial, the judge wrote, “Plaintiff’s insistence that the commercial appears to be a serious offer requires the Court to explain why the commercial is funny. Explaining why a joke is funny is a daunting task. . . . ” You can read the opinion at https://law.justia.com/cases/federal/district-courts/FSupp2/88/116/2579076/.
NOTE
A material term in a contract is one that is necessary to understanding the underlying transaction. Material terms include item, price, quantity, and time when the item is available for delivery.
The situation is different for delayed communications. For those communications, courts developed the mailbox rule. The mailbox rule means that an offer is deemed accepted for legal purposes as soon as an offeree puts a written acceptance into the mailbox. The mailbox rule developed because there was often a time lag in postal communications that could cause the parties to doubt whether a contract existed. The relationship between the parties is clear if a contract forms upon mailing the acceptance. Under the mailbox rule, an acceptance is valid as soon as it is dispatched or sent. The mailbox rule also applies to electronic communications such as email.
NOTE
An offeree’s silence is not acceptance of a contract. An offeree usually has no legal obligation to respond to an offer.
If an offeror specifies that an offer must be accepted in a certain way, then the mailbox rule will not apply. The mailbox rule also does not apply if an offeror states that a contract does not form until he or she receives the acceptance. Today, many offers specifically require receipt of the acceptance before a contract is formed to avoid the application of the mailbox rule.
NOTE
The mailbox rule says that an acceptance is valid as soon as an offeree sends it. It applies only to acceptances. It does not apply to situations where the offeror revokes his offer. A revocation of an offer is valid once the offeree actually receives it.
Meeting of the Minds
It is a basic rule of contract law that the parties to a contract must agree to its terms. To determine whether the parties really did make a contract, courts look to see if there is mutual agreement. A court studies the parties’ words and actions to look for evidence that both parties acted as if they had entered into a contract with one another.
The idea that contracts form when there is a meeting of the minds is a long-standing feature of American law. The United States Supreme Court held in Baltimore & Ohio Railroad Co. v. United States (1923) that a contract can be inferred from the conduct of the parties.12 This is true even if no written contract exists.
Meeting of the minds is evidenced through words, such as saying “I accept” in response to an offer. It also can be shown through the actions of a party. If the parties behave in a way that suggests there is a contract, then courts likely will enforce some sort of agreement.
NOTE
Mutual agreement is a contract law principle that is used to describe how the parties intend to act with respect to a contract. It is also called mutual assent or meeting of the minds. The case study at the end of this chapter includes a mutual assent issue.
Consideration
In forming a contract, the parties must bargain for something of value. This is called consideration. Consideration is an essential contract element that means the parties have negotiated for, and are exchanging, something of value. Every contract must be supported by consideration. If there is no consideration, the contract is not enforceable.
Consideration is reciprocal. It means that both parties are promising to do something. For example, the offeror offers to develop a web page for $50 and the offeree accepts the offer. The offeror’s consideration is developing the web page, whereas the offeree’s consideration is paying $50 for the developed web page.
In the United States, courts do not usually review the value of the consideration that the parties exchange. They leave it to the parties to determine the sufficiency of their own deals. As long as a party has the capacity to contract, he or she is free to bargain and enter into contracts. This is true even if the individual enters into contracts with terms that might seem unwise. Courts generally only review whether the consideration was truly bargained for and whether there was a mutual exchange of promises.
NOTE
Consideration is an exchange of money, goods, or a promise to perform a certain action.
Some transactions do not have consideration. If there is no consideration, there can be no contract. For example, gifts do not involve consideration. In addition, there is no consideration when value is given for a service that a person has already performed. This is called prior consideration. Prior consideration cannot be used to form a new contract.
In addition, there is no consideration when a person is already required to do something because of a preexisting obligation. For instance, you cannot enter into a contract with a firefighter to save your burning home because the firefighter already has an obligation to fight the fire.
Performance and Breach of Contract
A contract must be performed in order to be complete. This means that each party must fulfill his or her promises to one another. If the parties complete all of their promises to one another, then they are discharged from any further obligation. Discharged means that each party is freed from his or her contractual requirements.
NOTE
In the law, a party is discharged when he or she no longer has any responsibilities or obligations toward the other party.
There are three general types of contractual performance:
- Complete performance—When a party performs all of his or her contract promises, this is called complete performance.
- Substantial performance—A party’s performance of all material contract promises is known as substantial performance. Nonperformance of some terms results in a minor breach of contract.
- Incomplete performance—A party’s failure to perform his or her contract promises constitutes incomplete performance. This kind of nonperformance results in a material breach of contract.
If one party does not fulfill all of his or her promises, then the other party may sue that party for breach of contract. The non-breaching party may sue for both a minor breach of contract and a material breach of contract. Once a lawsuit is filed, a court reviews the parties’ contractual performance. It then determines what remedies are available to the non-breaching party.
In contract law, a court may order a variety of legal remedies. It awards remedies depending upon the facts of the case. The available legal remedies in a contract law case include money damages, specific performance, contract rescission, and contract reformation.
NOTE
A remedy also is called legal relief. Courts grant remedies in order to enforce the rights of the parties that appear before it. A winning party is usually the party that receives a remedy.
The most common type of remedy in a breach of contract dispute is an award of damages. Damages refers to money that the court awards to the party that did not breach the contract. For the most part, damages are used to make a non-breaching party whole. They try to compensate a party and put him or her in the same position as if the breach never occurred. Under the law, a non-breaching party has a duty to avoid or reduce the total damages caused by the other party’s breach of contract.
There are four types of money damages that can be awarded in a contract case:
NOTE
A duty to mitigate is the non-breaching party’s obligation not to aggravate the harm caused by a breach. A person may not allow the damages to rise if it is possible to keep the damages low. He or she must take reasonable actions to limit the amount of harm caused by the breaching party.
- Compensatory damages—A money award that compensates a non-breaching party for the other party’s breach is called compensatory damages. These damages place the non-breaching party in the same position he or she would have been in had the contract been fully performed. This is the most common type of damages that courts award.
- Consequential damages—A money award that compensates the non-breaching party for foreseeable damages that arise from circumstances outside of the contract. The non-breaching party cannot mitigate these consequential damages.
- Liquidated damages—A contractual grant of money damages. The parties predetermine the amount of damages before entering into the contract. The contract specifically states the amount of damages that a non-breaching party is entitled to. Courts will approve liquidated damages as long as they are reasonable.
- Nominal damages—A money award to the non-breaching party even though he or she has not suffered any financial loss because of a breach of contract. An award of nominal damages recognizes that a breach occurred, but nothing more.
NOTE
Punitive damages are damages that punish a party for bad or wrongful behavior. Although punitive damages are usually available in tort law, they are generally not allowed in breach of contract cases.
NOTE
Specific performance is an equitable remedy. An equitable remedy forces a person to do (or not do) some act. Equitable remedies usually are awarded by courts only if legal remedies are inadequate. Legal remedies are requests for money damages.
Another remedy that courts can award is specific performance. Specific performance is a legal term that refers to situations where a court orders a party to complete his or her contractual duties. Courts do not usually award specific performance unless the underlying contractual transaction is unique. It is harder for courts to determine the damages amount when the underlying transaction is unique. If it is hard to determine damages, then it is more likely that a court will award specific performance.
Non-breaching parties usually do not ask for specific performance as a remedy. This is because if people are forced to perform their contractual duties, they sometimes perform those duties poorly. In addition, courts do not want to have to supervise performance to ensure that a party is performing properly. Courts award specific performance only when no other remedy will compensate the non-breaching party.
Courts also can rescind a contract. This remedy undoes the contract and puts the parties in the same position that they would have been in if there had been no contract at all. This remedy is often available if there has been a material breach of contract. In order to rescind a contract, the parties must return any consideration that they each received. For example, they must return the goods and money that they exchanged under the contract.
FYI
Sometimes a contracting party might sense that the other party has cold feet about a contract. This might lead the first party to worry about an eventual breach even if repudiation has not yet occurred. Under the UCC, a party concerned about repudiation can demand that the other party provide adequate assurance that he or she is not going to repudiate the contract.13 If the other party fails to provide adequate assurance, then the first party can sue for breach of contract.
Finally, courts can reform a contract. In contract reformation, a court rewrites the contract to express the true intent of the parties to a contract. The parties are then expected to perform the contract as rewritten. Courts often use reformation to fix contracts that have obvious clerical errors. Contract reformation is an equitable remedy.
Contract Repudiation
Repudiation is a refusal to perform a contract duty. It occurs when one party either denies the existence of a contract or refuses to perform his or her contractual obligations. Repudiation also is called anticipatory breach of contract. Repudiation occurs when one party clearly communicates that he or she will not perform his or her contractual duties.
Under the common law, a nonrepudiating party can react in three ways to repudiation:
- Immediately consider the contract terminated; that is, the party does not have to perform any of his or her own contractual obligations.
- Wait and see if the other party decides to perform his or her obligations after all.
- Immediately sue the repudiating party for breach of contract.
If one party repudiates a contract, the party who is relying on the contract bears the burden of proving that the contract is indeed valid and enforceable. Usually this is the person who files a breach of contract action. The filer must prove that there was a legitimate contract between the parties using the elements already discussed in this chapter.
Another aspect of repudiation has to do with how a contract is signed. This distinction becomes important later in this chapter. Under traditional legal principles, a party to a contract can always repudiate a contract on the basis that another person forged his or her signature on the contract.
If one party claims that the signature is not authentic, then the other party has the burden of proving that the signature is authentic. He or she has to present evidence that prevents the other party from repudiating the signature. The party presents this evidence because he or she wants a court to enforce the contract.
NOTE
Nonrepudiation becomes an important issue in online contracts. Cryptography can be used to make sure that parties cannot repudiate the contracts that they enter into.
In traditional contract law, contracts are negotiated face-to-face. The parties know one another and would know if a signature was forged. Sometimes contracts are signed in front of witnesses. If witnesses watch the parties signing a contract, it is harder for one party to repudiate a signature. This is a way of assuring that a party cannot repudiate a signature in traditional, paper-based contracts.