Chapter 12
Contract Formation
Chapter Objectives
1. Define the term contract, and discuss the
function of contracts in our society.
2. Identify the types of contracts that are
subject to Article 2 of the Uniform
Commercial Code.
3. Summarize each of the four basic
requirements for a valid contract.
4. Explain the contractual rights and
obligations of minors.
5. Give some examples of how third parties
may acquire rights in contracts.
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The Function of Contracts
Contract law:
 establishes what kinds of promises
will be legally binding
 supplies procedures for enforcing
legally binding promises or
agreements
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4
Quasi Contracts
Quasi contracts, or contracts
implied by the law, are really not
contracts at all. The underlying
theory is that individuals should not
be allowed to be unjustly enriched
at the expense of others.
Why is the term “contract” used in
situations involving quasicontractual recovery, in view of the
fact that no agreement between the
parties exists?
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Employment Manuals and
Implied Contracts
It is common for large companies or other
organizations to distribute an employee manual
or handbook containing the conditions of
employment. Do statements made in an
employee handbook constitute “promises” in an
implied-in-fact employment contract?
Under the employment-at-will doctrine (Chap.
17), employers may hire and fire employees at
will, with or without cause. The at-will doctrine
will not apply, however, if the terms of
employment are subject to a contract between the
employer and the employee.
Why would any person accept employment with a
firm without a written contract?
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Requirements of a Contract
The four requirements that
constitute what are known as
the elements of a contract are:
AGREEMENT
CONSIDERATION
CAPACITY
LEGALITY
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Defenses to Contract
Formation or Enforceability
A contract that is otherwise
valid may be unenforceable if:
 the parties have not genuinely
assented to the terms
 the contract is not in the proper form
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How Intent to Form a Contract Is
Measured in Other Countries
Courts in some nations give more weight
to subjective intentions.
U.S.—routinely adhere to the objective
theory of contracts.
France—French law civil code prefers the
subjective interpretation of contracts.
What problems may arise when a court
attempts to look at the subjective basis of
a contract?
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Agreement
Requirements of the Offer
Termination of the Offer
Acceptance
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Requirements of the Offer
Three elements are necessary
for an offer to be effective:
Intent
There must be a serious,
objective intention by the
offeror to become bound
by the offer. Nonoffer
situations include:
(a) expressions of
opinion; (b) statements of
intention; (c) preliminary
negotiations; and
(d) advertisements,
catalogues, and circulars.
Definiteness
The terms of the
offer must be
sufficiently
definite to be
ascertainable by
the parties or by a
court.
Communication
The offer must be
communicated to
the offeree.
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Case 12.1 Lucy v. Zehmer
Lucy and Zehmer had known each other for 1520 years. Lucy always wanted to buy Zehmer’s
farm, but Zehmer never wanted to sell. One
night they met at a restaurant, and while
consuming alcohol, wrote up an agreement on
the purchase of the farm. Lucy then went to
court to enforce the agreement, but Zehmer
argued he was intoxicated at the time. The
trial ruled in favor of the Zehmers. The
Supreme Court of Virginia reversed the ruling
and the Zehmers were ordered to sell.
How does the court’s decision in this case
relate to the objective theory of contracts?
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Termination of the Offer
An offer can be terminated by:
Action of the Parties
Operation of Law
An offer can be revoked
or rejected at any time
before acceptance without
liability. A counteroffer is
a rejection of the original
offer and the making of a
new offer.
An offer can terminate by
(a) lapse of time, (b)
destruction of the specific
subject matter of the offer,
(c) death or incompetence
of the parties, or (d)
supervening illegality.
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Acceptance
An acceptance can be made
only by the offeree or the
offeree’s agent.
It must be unequivocal. Under
the common law (mirror image
rule), if new terms or
conditions are added to the
acceptance, it will be
considered a counteroffer.
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Mailbox Rule
Also called the “deposited acceptance rule,”
which the majority of courts uphold. Under this
rule, if the authorized mode of communication
is the mail, then the acceptance becomes valid
when it is dispatched—not when it is received
by the offeror.
What happens when offers and acceptances are
sent by FedEx or via fax? How should
traditional legal principles be applied to
transactions over the Internet?
What other types of issues, other than
signature problems, might arise when
transmitting offers and acceptances via the
Internet?
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Consideration
Consideration is broken down
into two parts:
 something of legally sufficient value
must be given in exchange for the
promise
and
 there must be a bargained-for exchange
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Sufficiency of Consideration
To be legally sufficient,
consideration must involve a
legal detriment to the promisee,
a legal benefit to the promisor,
or both.
One incurs a legal detriment by
doing something that one had no
prior legal duty to do.
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Adequacy of Consideration
Adequacy of consideration relates
to “how much” consideration is
given and whether a fair bargain
was reached.
The general rule is that courts will
NOT inquire into the adequacy of
the consideration.
 Courts will inquire into the adequacy of
consideration only when fraud, undue
influence, duress, a gift, or
unconscionability may be involved.
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Hamer v. Sidway (1891)
Was there a valid contract where the uncle
promises his nephew $5000 if he refrains
from drinking, smoking, and gambling?
In refusing to pay, the executor of the
estate argued that the promise resulted in
neither a benefit to the uncle nor a
detriment to the nephew (since it was
good for him). What did the court rule?
How might one argue that this contract
also benefited the promisor (Story, Sr.)?
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Contracts Lacking
Consideration
A number of so-called contracts
may lack the necessary
consideration to make them legally
binding.
These include:
 Contracts to perform a Preexisting Duty
 Contracts based on Past Consideration
 Contracts containing Illusory Promises
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Promissory Estoppel
When a promisor reasonably
expects a promise to induce
definite and substantial action or
forbearance by the promisee, and
the promisee does act in reliance
on the promise, the promise is
binding if injustice can be avoided
only by enforcement of the
promise.
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Promissory Estoppel
Promissory estoppel allows a variety of
promises to be enforced despite the fact
that they lack what is formally regarded
as consideration.
Can you name some common examples
from the business world?
Can you think of any other contract
doctrine under which, to ensure justice,
courts will allow a party to recover based
on detrimental reliance?
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Should Social Promises be
Enforced under the Doctrine of
Promissory Estoppel?
Recently, a college freshmen whose boyfriend
broke their prom date sued the boyfriend for
the cost of her unused prom dress. A
Minnesota state court dismissed the case,
suggesting that “[w]hether the defendant
has a social or moral duty to help the plaintiff
with her prom costs is a question for the likes
of Emily Post or Miss Manners, not for courts
of this state.”
Contract law reflects society’s decisions on
what promises will be enforced and what
promises will not.
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Case 12.2 Goff-Hamel v. Obstetricians
& Gynecologists, P.C.
Julie Goff-Hamel worked for Hastings Family
Planning for 11 years. In 1993, representatives of
Obstetricians & Gynecologists, P.C. asked GoffHamel to work for Obstetricians full time. GoffHamel agreed and gave notice to Hastings. She was
given uniforms and a copy of her work schedule.
The day before she was to start her new job, she
was told not to report because the wife of one of the
owners opposed her hiring. The Nebraska state
court ruled in favor of Obstetricians, which was later
reversed by the Nebraska Supreme Court.
If you were a judge in the trial court to which this
case was remanded, what factors would you
consider in determining the amount of damages that
should be awarded to Goff-Hamel?
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Capacity
The third element required for the
formation of a contract is contractual
capacity, the legal ability to enter into a
contractual relationship.
Three types of people who do not have
the capacity to enter a contract are:
Minors
Intoxicated
Persons
Mentally
Incompetent
Persons
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Minors
Contracts with minors are
voidable at the option of the
minor.
When disaffirming executed
contracts, the minor has a duty
to return received goods if they
are still in the minor’s control
or (in some states) to pay their
reasonable value.
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Intoxicated Persons
A contract entered into by an intoxicated
person is voidable at the option of the
intoxicated person if the person was
sufficiently intoxicated to lack mental
capacity, even if the intoxication was
voluntary.
A contract with an intoxicated person is
enforceable if, despite being intoxicated,
the person understood the legal
consequences of entering into the
contract.
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Mentally Incompetent
Persons
A contract made by a person
adjudged by a court to be
mentally incompetent is void.
A contract made by a mentally
incompetent person not
adjudged by a court to be
mentally incompetent is
voidable at the option of the
mentally incompetent person.
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Legality
For a contract to be valid and
enforceable, it must be formed for a legal
purpose.
A contract to do something that is
prohibited by federal or state statutory
law is illegal and void from the outset and
thus unenforceable.
A contract to commit a tortious act or to
commit an action that is contrary to
public policy is illegal and unenforceable.
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Contracts Contrary to Statute
USURY
Occurs when a lender makes a
loan at an interest rate above the
lawful maximum. The maximum
rate of interest varies from state
to state.
GAMBLING
Gambling contracts that
contravene (go against) state
statutes are deemed illegal and
thus void.
SABBATH LAWS
Laws prohibiting the formation
or the performance of certain
contracts on Sunday. Such laws
vary widely from state to state,
and many states do not enforce
them.
LICENSING STATUTES
Contracts entered into by
persons who do not have a
license, when one is required by
statute, will not be enforceable
unless the underlying purpose of
the statute is to raise government
revenues.
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Contracts Contrary to Public Policy
Contracts in Restraint of Trade
 Contracts to reduce or restrain free competition are illegal.
An exception is a covenant not to compete. It is usually
enforced by the courts if the terms are ancillary to a contract
and are reasonable as to time and area of restraint.
Unconscionable Contracts and Clauses
 When a contract or contract clause is so unfair that it is
oppressive to one party, it can be deemed unconscionable;
as such, it is illegal and cannot be enforced.
Exculpatory Clauses
 An exculpatory clause is a clause that releases a party from
liability in the event of monetary or physical injury, no matter
who is at fault. In certain situations, exculpatory clauses may
be contrary to public policy and thus unenforceable.
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Case 12.3 Brunswick Floors
v. Guest
Brian Guest was a floor covering installer for
Brunswick Floors, Inc. Guest signed a covenant
not to compete that prohibited him for two years
after termination of employment from engaging
in the floor business in virtually any way, within
an eighty-mile radius of the Brunswick location.
After quitting Brunswick, Guest went to work as
an independent flooring contractor. Brunswick
filed a suit against Guest based on the covenant
not to compete. The court ruled in part that the
covenant unduly restricted Guest’s right to earn a
living. The Court of Appeals agreed with the
decision.
Should these same limits apply to employers who
do business only on the Internet?
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Third Party Rights
There are two important
exceptions to the rule of privity
of contract:
 A party to a contract may transfer the rights
arising from the contract to another or to
free himself or herself from the duties by
having another person perform them. The
first of these actions is referred to as an
assignment of rights and the second,
delegation of duties.
 Where a contract involves a third party
beneficiary contract.
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Assignments
An assignment is the transfer of
rights under a contract to a third
party. The party assigning the
rights is the assignor, and the party
to whom the rights are assigned is
the assignee.
The assignee has a right to demand
performance from the other original
party to the contract.
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Assignments
Generally, all rights can be
assigned, except in the following
circumstances:
 When assignment is expressly prohibited by
statute (for example, worker’s compensation
benefits).
 When a contract is personal in nature (unless all
that remains is a money payment).
 Where the assignment will materially increase
or alter the risk or duties of the obligor.
 If a contract stipulates the right cannot be
assigned, then ordinarily it cannot be assigned.
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Case 12.4 Reynolds and
Reynolds Co. v. Hardee
Thomas Hardee worked for Jordan Graphics, Inc.,
as a sales representative under an employment
contract that included a covenant not to compete.
Reynolds and Reynolds Co. contracted to buy
most of Jordan’s assets. On the day of the sale,
Jordan terminated Hardee’s employment.
Reynolds offered Hardee a new contract with a
more restrictive covenant not to compete. Hardee
declined and began selling in competition with
Reynolds. Reynolds filed a suit against Hardee to
enforce the contract between Hardee and Jordan.
The court dismissed Reynolds’ claim.
What interests must a court balance when
deciding whether a covenant not to compete is
assignable?
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Delegation
A delegation is the transfer of duties
under a contract to a third party (the
delgatee), who then assumes the
obligation of performing the
contractual duties previously held by
the one making the delegation (the
delegator).
A valid delegation of duties does not
relieve the delegator of obligations
under the contract.
 If the delegatee fails to perform, the
delegator is still liable to the obligee.
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Third Party Beneficiaries
A third party beneficiary
contract is one made for the
purpose of benefiting a third
party.
Third party beneficiaries can be
categorized into:
 Intended beneficiaries
 Incidental beneficiaries
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Third Party Beneficiaries
Intended
beneficiary
Incidental
beneficiary
One for whose benefit
a contract is created.
When the promisor
fails to perform as
promised, the third
party can sue the
promisor directly.
Examples of third
party beneficiaries are
creditor beneficiaries
and donee
beneficiaries.
A third party who
indirectly benefits from
a contract but for whose
benefit the contract was
not specifically intended.
Incidental beneficiaries
have no rights to the
benefits received and
cannot sue to have the
contract enforced.
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For Review
1. What is the difference between a void
contract and a voidable contract?
2. What are the four basic elements necessary
to the formation of a valid contract?
3. What elements are necessary for an
effective offer? What are some examples of
nonoffers?
4. What is consideration? What is required for
consideration to be legally sufficient?
5. Generally, a minor can disaffirm any
contract. What are some exceptions to this
rule?
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