CHAPTER 7 Basic Contract Law 1-2 Contract Law Contracts evolved from the common law Each state has its own common law precedents Dissatisfaction with differences across state led to the Uniform Commercial Code (UCC) – UCC has been adopted by all 50 states and will be discussed next chapter Currently we are dealing with another watershed event: Ecommerce Lawyers and legislators are scrambling to provide a universally accepted contract law of E-commerce McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-3 Contract Law A contract is: A promise or set of promises, the breach of which the courts will provide a remedy for When the two parties agree to a contract, it creates a legally recognized duty to perform Not all agreements are recognized as legally binding A promise to make a gift is not binding McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-4 Elements of a Contract Valid contracts possess the following: An agreement between the parties: an offer and acceptance Consideration--each party must do something that they were not previously obligated to do Both parties have capacity to contract Formation and performance of the contract are legal and not against public policy McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-5 Contractual Nomenclature Valid, void, voidable and unenforceable – A valid contract is one recognized as binding in law – A void contract is not recognized at all such as a gambling contract – In a voidable contract one of the parties can not perform without liability--a victim of fraud – A contract is unenforceable if there are no legally enforceable remedies--an oral real estate agreement In a bilateral contract, both parties exchange promises In a unilateral contract a promise is made for performance--e.g., reward contracts McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-6 Types of Contracts Executory and executed – A executory promise is a promise for future performance • If the contract has been executed, both parties have performed Express and Implied An express contract can be written or oral – In an express contract the duties of the parties are clearly elucidated An implied contract is implied by conduct – After receiving treatment from a doctor, you will be asked to make arrangements for payment McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-7 Quasi Contracts – The plaintiff is suing for quantum meruit (the fair market value of her services) • The plaintiff performed valuable services • The defendant knowingly received these services • The plaintiff expected to get paid if the services were used by the def. • The def. was unjustly enriched – Quasi contract has been used by writers who claim movies were made based on ideas they told directorsComing to America – Quasi contract is sometimes used by small firms to try to salvage an inadvertent or bungled knowledge transfer to a larger firm McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-8 Elements of a Contract Agreement Offer and Acceptance The offeror must have intent to make an offer – Intent is judged under an objective standard--What would a reasonable person believe under the circumstances? – Most advertisements are an invitation to bargain as are items submitted for auction • If the offer is very specific, then maybe it will be termed an offer – Many advertisements made on the Internet are offers • Customers can make an immediate contract McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-9 Offer and Acceptance The terms of the offer must be clear and definite – Under the common law of contracts, at a minimum the offer must contain Price, Quantity, the Parties and the Subject Matter of the contract. – Must contain all material terms The offer must be communicated to the offeree – and the offeree knows of the offer before performing – If an offer is made to the offeree, a third party cannot accept the offer – Offers can be directed to classes of offerees McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-10 Acceptance Just like an offer, the acceptance must have: – Intent to be bound by the offeree • Again judged by objective standard • In general, silence is not deemed an acceptance unless the parties had prior dealings – Acceptance must be complete and unconditional • An acceptance that contains conditions or additional terms is a counteroffer and thus a rejection of the offer – Acceptance must be communicated to the offeror • Offeree should use the same medium used by the offeror to make the offer if nothing is said in the offer McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-11 Acceptance An acceptance must be timely If the offeror accepts in the manner invited by the offer or uses the same medium if there is no specified method The acceptance is effective upon dispatch by the offeror Mailbox rule has been made irrelevant generally by faxes and E-commerce McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-12 Termination of an offer The offeror can revoke the offer at any time (with some limited exceptions) – Thus an offeror can make an offer that is good for 10 days and then revoke it after 5 days – Revocations must be communicated to the offeree – Offers and revocations are effective when received Among the exceptions to the common law rule that an offeror can revoke an offer at anytime are: – promissory estoppel and the – UCC firm written offer by merchants rule (discussed in next chapter). McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-13 Promissory Estoppel An offer is irrevocable if the conditions for promissory estoppel take place: (1) offeror knows or should know the offeree will rely on the offer made by the offeror (2) the offeree does rely and (3) relies to his detriment and (4) injustice can only be avoided by enforcing the promise Damages under P.E. are based on costs of reliance McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-14 Termination of the offer If the offeree rejects the offer or makes a counteroffer, the offer is terminated Will occur when the offer is deemed lapsed after a reasonable period of time What is reasonable depends upon the industry An offer could expire by operation of law Death or incapacity of offeror or offeree Supervening illegality Destruction of the subject matter McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-15 Consideration Consideration Is the exchange element in a contract In order to support a promise made by the promisor, the other party (the promisee) must do something that constitutes consideration The promisee must incur a legal detriment Examples of consideration: – Make a promise in exchange for a promise – Transfer something of value – Give up something of value such as a legal claim McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-16 Consideration Generally the courts do not consider the adequacy of consideration unless they decide the bargain is unconscionable Consideration does not exist if the other party has a preexisting duty to perform by law or contract – In general past consideration is not consideration Consideration does not exist if the promise made by the promisee is illusory – If the promisee maintains an unlimited right to cancel at any time for any reason, the promise is illusory McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-17 Consideration There are some promises that are enforceable without consideration A promisor is liable under the theory of promissory estoppel (PE) Note with PE it is not a contract and therefore the damages are based on reliance costs of the promisee and are generally less than if the negotiations had resulted in a contract McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-18 Capacity Both parties to a contract must have capacity to contract There are three categories of people who do not have capacity Minors--under 18 Intoxicated people--must not comprehend the transaction Mentally deficient either due to age or disease McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-19 Capacity Minors can enter into a contract but The contract is voidable at the option of the minor When a minor voids a contract it is called disaffirming a contract Upon turning 18 the minor has a limited right to disaffirm or else the contract is deemed ratified – If the minor makes a payment after turning 18 the contract is ratified – A minor cannot ratify a contract while still a minor McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-20 Capacity If a minor disaffirms, the minor must return the consideration if he has it There are an increasing number of contracts that are binding on minors, though these exceptions vary from state to state – Contracts with the army, insurance contracts, educational loans, bank account agreements are examples – A minor is liable for the FMV of necessaries: food clothing and shelter and tools etc for an emancipated minor McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-21 Capacity A contract is voidable if at the time the contract was agreed to, a party was too intoxicated to understand the terms of the contract If a person has been judged incompetent, then all contracts with the person are void If the person is, in fact, insane, the person can claim lack of capacity even though the courts have not ruled the person is incompetent by appointing a guardian McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-22 Legality Contracts can be illegal by statute or by public policy – In either event, the agreement is void – There are a number of agreements that have been ruled illegal by statute in various states: • Gambling, illegal drug sales, usurious loan agreements, contracts with unlicensed professionals • Increasingly, illegal contracts are taking place in cyberspace-e.g., prescriptions drugs sold online. – Under public policy a number of bargains are void • Exculpatory agreements such as agreements not to sue employers under workmen’s compensation • Contracts to excuse intentional actions McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-23 Legality Public policy constraints The contract is unconscionable Look at superior education and legal representation one side and relative ignorance on the other side A contract by a third party to pay a governmental employee is illegal Contracts in restraint of trade – Covenants not to compete agreed to in employment contracts must be reasonable – Must be reasonably limited in time and space – Cyberspace may make spatial obsolete McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-24 Taints on an Agreement: Mistake An agreement is voidable if there is a mutual mistake of a material fact A fact is material if knowledge of the true fact would have changed the decision of the parties to contract If one party knows or should have known the other party was mistaken, then the agreement is voidable Often occurs when bids are submitted and there is a typo McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-25 Taints on an Agreement: Fraud If a contract is fraudulent, it is voidable at the option of the victim Fraud in contract has the same elements as fraud in tort: – – – – – Misrepresentation of an important fact Scienter Intent to defraud Justifiable reliance by the victim Damages are caused by the fraud An innocent misrepresentation of a material fact makes the contract rescindable McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-26 Genuineness of Assent A contract is voidable if It is the product of duress A party signed a contract because of threat of force, criminal prosecution, or blackmail It is the product of undue influence The victim is either in a weakened mental state or the other party has a confidential relationship The bargain is objectively unfair There was no consultation with outside counsel McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-27 Writing requirements Oral contracts in general are enforceable For certain contracts, the contract must be in writing – – – – – – Contracts involving real estate Contracts that cannot be performed within one year Surety contracts Marriage contracts Contracts for the sale of goods where the value exceeds $500 Contracts where an executor is personally liable for the debts of the deceased McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-28 Writing Requirements There are some exceptions to the exceptions Oral promises of sureties to obligors are enforceable by obligees In some states there are part performance exceptions for oral real estate agreements, where the buyer takes possession, makes improvements, and pays some or all of the purchase price Promissory estoppel UCC exceptions--discussed in next chapter McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-29 Writing Contracts Sufficiency of the writing The agreement must have all material terms Must be signed by the defendant Names of the parties, consideration, and the subject matter of the contract are required terms McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-30 Parol Evidence Rule Excludes prior or contemporaneous evidence that conflicts with a written agreement If the written agreement is incomplete, oral evidence may be introduced The corporate party often tries to negate an inference that the agreement is incomplete by putting in an integration clause A party can always introduce evidence of fraud or misrepresentation or mistake McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-31 Performance, Discharge and Breach of Contracts Most contractual obligations are discharged by performance If performance fails in its essential purpose, it is material breach A material breach relieves the non-breaching party from the obligation to pay the breaching party By inserting a time is of the essence clause, late performance becomes a breach McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-32 Delegations of Duties If the promisor is a company, it may delegate responsibility for performance to employees – If the contract performance is inadequate, the business, not the employee, is liable for breach of contract – Most contracts can be delegated except if the personality or talents of the promisor are unique • In some cases there are statutory or public policy constraints on delegations • Delegations are a very common event McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-33 Assignments Many contracts can be assigned Once the assignment takes place the assignee can enforce the contract against the obligee – The assignee takes the benefits of the contract subject to the defenses the obligor has against the assignor – Assignments are common in car loans. The car dealer is the assignor, the customer is the obligor and the bank is the assignee In general, contracts can be assigned unless the assignment or delegation would make performance by the third party more difficult or disagreeable McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-34 Third Party Beneficiaries If your parents pay a soccer camp to provide soccer training for you You are the 3rd party beneficiary – The purpose of the contract is to benefit you If the soccer camp did not perform, you or your parents could sue If you are an incidental beneficiary, you have no right to sue if the promisor breaches – A garden store has no right to sue if a supplier of a beekeeper fails to deliver McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-35 Material Breach and Obligation to Perform If a promisor materially breaches a contract, the promisee is absolved of her obligation to perform – Same is true if there is an anticipatory breach-• contractual obligations of the non-breaching party are eliminated, but – If a party announces it will not be able to perform, • the other contracting partner need not pursue legal action immediately, • but instead could continue performing in hopes that the anticipatory breacher will in fact perform McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-36 Discharge by Agreement The parties can decide to rescind the contract Each party agrees not to perform and neither party is liable A novation occurs when a new party is substituted – If A and B have a contract, and A agrees that C can fulfill B’s obligations under the contract, a novation takes place Satisfaction and Accord – The same parties change the agreement – The accord is the new agreement and the satisfaction occurs when the new consideration is received McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-37 Discharge Due to Impossibility Impossibility If performance is objectively impossible due to war or embargoes, the promisor is discharged without liability If there is a subjective impossibility due to events that are foreseeable, the obligation to perform is not discharged If the promisor made a bad bid, he cannot claim he cannot perform because he is not making any money McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-38 Discharge Due to Operation of Law and Conditions By Operation of Law Bankruptcy, death of a party, destruction of the subject matter Discharge by condition – Condition precedent--if the condition does not take place the promisor does not have to perform – Condition subsequent--if the condition takes place the obligation to perform ceases – Most executory bilateral contracts have concurrent conditions • If one party does not perform, the other party’s obligation to perform ceases McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-39 Impracticability and Compensatory Damages The UCC equivalent of impossibility It is more liberal and allows for more excuses for nonperformance – Strikes and bad weather may qualify Remedies Generally the remedy in contract law is money damages The theory of compensatory damages is to put the nonbreaching party in the position he would have occupied if the contract had been performed McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-40 Remedies Damages: Compensatory – In sale of goods contracts, damages are often calculated as the difference between the market price and the contract price time quantity: • Damages = (Pm - Pk)Qk in this case, the seller is likely to be the defaulting party In addition reliance and restitution costs are sometimes recoverable – Reliance: Costs associated with relying on promises of the promisor – Restitution: Recovering consideration McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-41 Consequential Damages Consequential damages Damages that are the result of the contract breach but are unusual in some way – Lost profits are an example of consequential damages – The non-breaching party must apprise the breaching party of the consequential damages in order to recover – In some cases there is an obligation to notify the breaching party before the breach of the possibility of consequential or unusual damages McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-42 Liquidated Damages Liquidated Damages – In many contracts damages are difficult to calculate so the parties agree in advance what damages are • If the parties provide a reasonable estimate of damages, liquidated damages clauses are enforceable • If the liquidated damages clause is judged excessive it will not be enforced as a penalty McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-43 Remedies Punitive damages in contracts are very rare The nonbreaching party is expected to mitigate damages Landlords whose lease has been breached cannot refuse to lease to another tenant Wrongfully discharged employees cannot turn down comparable job offers from 3rd parties McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-44 Equitable Remedies Specific Performance The remedy is appropriate if the promisee attaches great value to the consideration – The consideration must be unique – Jewelry, works of art, real estate, family heirlooms Injunctions – The courts will freeze the action if irreversible damage may occur with a continued breach – The plaintiff generally has to demonstrate that he will likely prevail in trial that the defendant is breaching the contract McGraw-Hill/Irwin Legal Environment of Business in the Information Age © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.