A contract is an agreement among two or more parties. It includes a promise, or mutual set of promises, freely agreed to and in exchange for something of value. Once properly set in place, the agreement will be enforced by the court. We will now take a closer look at how contracts are formed, how contracts are voided and how contracts are enforced by the courts.
What Makes A Contract?
A contract is formed when the two essential contract elements are in place: mutual assent and consideration. Mutual assent refers to an offer made by one party, plus the acceptance of this offer by the other party. Consideration is something of value: Each party must promise to give something of value to the other in order to bind the contract. When mutual assent and consideration come together, the law claims there has been a “meeting of the minds” and a contract is formed. Memorializing it on paper will make it more certain to be enforced in court, but an oral contract is as legally binding as a written one.
When determining if a party has made or accepted an offer, the courts use an objective interpretation of contract formation. The court considers: Would the reasonable person believe she or he had just entered into an agreement? A defense of “but that’s not what I really meant” will not move the court. The court makes no attempt to peer into a person’s mind, it looks only at behavior. If Tom behaves in a way to lead Fred to reasonably conclude that Tom and Fred have a contract, the court will likely honor Fred’s reasonable belief.
The creation of a contract begins with the offer. In order to fulfill the legal definition of an offer, it must convey that the one making the offer (the offeror) has a serious intention to enter a contract; to be bound to the agreement if the offer is accepted. The courts employ their objective standard here: Was it reasonable to believe that the offer was sincere? When Tom says to Fred, “I’m so sick of repairing my house, I’d sell it for a dollar,” Fred has no reasonable expectation that he may now pull four quarters out of his pocket and complete a cash transaction for Tom’s home.
The key characteristic of a legal offer is its completeness: It contains all the essential components of the deal and nothing of substance remains to be negotiated. It should be specific in terms of quantity, price, and description. It should state who may accept and spell out the appropriate manner of acceptance, including the time limit for acceptance. And it must be communicated to the potential buyer (offeree). An offer is not an offer until the potential buyer hears it.
The offeror is the master of the offer: She or he is free to revoke the offer at any time prior to a communication of acceptance, even if the offeror has stated that the offer will remain open. For example, let’s assume you are a musician and you enter negotiations to sell a recording to Bighits Records. You tell Bighits, “I’ll give you the exclusive right to buy my recording for $50,000 at any time in the next 90 days.” Later you change your mind, and send a letter to Bighits revoking the offer. The offer is now null and void, even though we are still within the 90 days.
As is often the case within the law, this general rule is subject to certain limits. The offer may not be revoked if Bighits gave something of value in order to hold the offer open. Assume Bighits responds to your initial offer and gives you $5,000 to keep your offer open for the full 90 days. Now you may no longer revoke your offer to sell the recording. This “option contract” is a contract in and of itself: you offered to sell a right; Bighits accepted. Both parties give something of value to bind the deal: Bighits gave cash; you gave up your right to sell to anyone but Bighits. All the elements of a contract are in place and the courts will enforce it as such. Acceptance of the offer will complete the requirement of mutual assent. Again, the courts employ an objective standard: It is the offeree’s behavior that matters. The court will not be moved by a statement that one did not intend to accept if the offeror was justified in believing the offer had been accepted.
Just as an offer must conform to certain standards to fulfill the legal definition of an offer, an acceptance also must meet certain standards. As the master of the offer, the offeror sets the specifics of most of these standards. The offeror controls when the offer may be accepted. The offer may normally be accepted until the offer is overtly terminated or until the end of the stated life of the offer (i.e., “this offer is good for the next 90 days”).
The offeror also controls how the offer may be accepted, determining what medium should be used to communicate the acceptance, be it fax, mail, or some other means. There is an automatic implication that whatever medium was used to make the offer is an authorized medium. According to the widely adopted “mailbox rule,” if the offer is accepted via an authorized medium, that offer becomes binding the instant it is dispatched. If an unauthorized medium is employed, the acceptance is not binding until it is received. Thus, if the U.S. mail is authorized, an acceptance is binding the second it is dropped into a mailbox, and the offer could not be revoked while the letter was in the mail. However, if U.S. mail was not authorized, the offeror could revoke the offer while the letter was in transit. It was delivered via an unauthorized medium and would not become binding until received.
One may not accept an offer while simultaneously attempting to alter the terms of the offer. The “mirror image rule” requires that an acceptance be unequivocal. Any attempt at alteration converts the acceptance into a counteroffer. So, Sam Seller offers to sell four tires to Dave Driver for the sum of $500. Dave replies by stating, “I accept your offer, but I want the tires mounted with no change in price.” Legally, Dave has rejected the offer, then made a counteroffer. Sam is now the recipient of an offer that he is free to accept or reject. If Sam rejects, Dave cannot attempt to back up and say, “I now accept your original offer.” Sam’s original offer disappeared the instant Dave countered.
An acceptance need not be a completely mechanical “I accept” in order to furnish mutual assent. For example, Dave could express dissatisfaction with the deal and it would still be an acceptance. (“I think that is highway robbery, but I accept anyway.”) Dave could make an implicit term explicit. (“I accept, assuming that the tires meet U.S. government safety guidelines.”) And the inclusion of a request within Dave’s acceptance does not automatically convert it to a counteroffer. (“I accept, but I would like you to consider mounting the tires for no additional charge.”)
What Is Consideration?
The sine quo non of any contract is consideration. It is the glue that holds the contract together. Consideration is something that is (a) a detriment to the one accepting, (b) induced by the one offering, and (c) given in exchange—it is a promise for a promise. When a court decides if something does or does not act as consideration, the key is the detriment to the one giving the consideration, not the benefit to the one receiving. An example will clarify why the law looks at it this way. August Uncle makes an offer to Neal Nephew: “If you don’t drink alcohol until your 25th birthday, I’ll give you $10,000.” Neal accepts in an unequivocal fashion and follows through on his promise. On Neal’s 25th birthday, August states, “I’m not going to give you the $10,000. After all, I derived no benefit from your behavior. Therefore I owe you nothing.”
A court will not allow August to weasel out of his obligation because he did not benefit. August was the master of this offer. The law will not allow him to rewrite the terms when the moment comes for him to perform. August also loses if he argues that Neal suffered no loss by abstaining. Neal sacrificed a clear legal right—the right to consume alcohol. Giving up this right is a legal detriment to Neal. Neal’s adherence to this obligation and acceptance of this detriment is the glue that holds this entire agreement together. That is the consideration he offered in exchange for $10,000. That consideration makes the entire contract binding on both parties.
What Breaks A Contract?
The issues here fall into two categories. The first deals with the parties involved. The law recognizes that certain people may not form a contract: they lack “contract capacity.” The second category deals with the facts involved. The basic suppositions of fact that support the contract may have been misunderstood or may change through no fault of the parties.
As politically incorrect as it may be, every law student is taught to remember that people who may not form a contract are described by the “three i’s”: infants, idiots, and the intoxicated. The legal adage is that one contracts with an infant (person below the age of 18) at one’s own peril. An adult contracting with a child will be held to his promises. Yet the child may disaffirm the same contract at any time prior to his/her 18th birthday and even for a “reasonable period” thereafter.
If you form a contract with one who is mentally incapacitated—either by level of IQ or level of intoxication—the law is not so clear. Generally speaking, if you were reasonable in assuming that the other party had the capacity to contract, the contract will be enforced. But if you knew or should have known that the other party may be compromised, that other party will be able to void the contract. The reasoning is fairly straightforward. The law expects a certain amount of prudence on the part of one forming a contract. For example, it is a simple matter to ensure that you are not forming a contract with a child: You insist on seeing a birth certificate or other proof of age. Not so with mental capacity. It is possible for one who is incapacitated to appear within the bounds of “normal” on some occasions and to some observers. If you formed a contract with the reasonable expectation that the other party had the capacity to contract, the court will support that reasonable expectation.
Mistakes concerning, or alterations in, the basic facts surrounding a contract may void that contract. For a mistake of fact to void a contract, that mistake must demonstrate three qualities: the mistake must be mutual, the mistake must have a material effect on the agreement, and the risk of the mistake must not have been assumed by the one attempting to void the contract. For example, let’s assume Ben Buyer agrees to purchase a cow from Dan Dairyman. Dan and Ben negotiate a price based on the number of calves the cow is expected to produce over her lifespan. After the agreement is made, it is discovered that the cow is sterile and incapable of producing offspring. Here, the mistake is mutual: Neither Ben nor Dan had an accurate understanding. The impact is material: A cow capable of breeding is worth several times more than a one that is not. And Ben did not agree to the risk. He did not negotiate to buy an animal “as is,” but negotiated specifically to buy breed stock. Under these circumstances, Ben may rescind this contract for “mutual mistake.”
Contracts may also be rescinded if a change in the basic facts makes performance of the contract impossible or if the change frustrates the contract’s basic purpose. “Impossibility” is exactly what it sounds like: it becomes impossible for one party to perform. Two people contract for the rental of a hall for a gathering. Prior to the day of the gathering, the hall burns down. Performance has become impossible and the contract is rescinded as a matter of law.
“Frustration of essential purpose” refers to a change in basic facts causing the entire agreement to become irrelevant. To use a classic case from England: A royal coronation was scheduled and a parade route established. Many people with homes along the route offered their houses for rent. These rentals were for just a single day—the day of the coronation. When the coronation was postponed, the original purpose for the rental contracts disappeared. The courts voided the contracts using a line of reasoning we have seen before: The renters did not contract to assume this risk. In such a set of circumstances, the court will often void a contract.
Is A Written Contract Required?
The general rule is that an oral agreement is as much a contract as a written agreement. However, the Statute of Frauds, first enacted in England in 1677, requires that certain agreements must be evidenced by writing in order to be enforceable. Every state in the United States has enacted some form of this statute. While the coverage alters from jurisdiction to jurisdiction, common provisions include the following:
- Sale of an interest in land (not only a transfer of ownership of real property, but also leases of over a year; mineral rights; easements; etc.)
- Promises to pay the debts of another; promise by an executor to pay the debts of an estate
- Promises in consideration of marriage
- A promise that cannot be performed within one year
- Sale of goods at a price of $500 or more
It is important to note that courts may be fairly expansive in what is termed “written evidence.” A single, formal document labeled “contract” is not required. If one can piece together a paper trail of letters, e-mails, checks, and the like that demonstrate that an agreement was in place, this may fulfill the requirement of written evidence.
How Are Contracts Enforced?
If one party to the contract does not live up to a promise, that party is said to have breached and will likely owe damages to the disappointed party. What the disappointed party often wants—but rarely receives—is specific performance: An order from the court that the breaching party must deliver on the promise. Specific performance is usually reserved for situations where what is bargained for is unique; the classic example is real estate. As each parcel of land is unique, a court will often order specific performance to transfer ownership of a contracted-for piece of real property.
But in most cases the court will order only money damages, which is seen as a replacement for performance. The most common way of calculating damages is “expectation” or benefit-of-the-bargain damages. Herb Homeowner contracts with Bob Builder to build a new home on Herb’s lot. Just as Bob is about to begin work, Herb announces that he does not want a house on the lot and will not pay Bob to build one. Clearly, an order of specific performance makes no sense: Bob has little interest in building a home no one wants. What Bob wants is the benefit of the bargain. He wants money damages equivalent to the profit he would have made by completing the home and being paid according to the terms of the contract. The court will subtract Bob’s construction costs from the contracted home price to determine
Bob’s profit and order Herb to pay that amount. Bob has now received the expectation of profits he had when he formed the contract.
Courts will sometimes use an alternative method called “reliance” damages. The goal here is to place the injured party in the same position he or she would be in had the contract never been formed. This is usually done if any estimate of expectation damages would be too speculative for the court to rely upon. In the example above, let’s assume that Herb’s lot is partially covered with quicksand and many builders feel that it would not be possible to place a stable building on the property. Here, it is impossible to estimate Bob’s building costs, thus it is impossible to estimate his profits or even to determine if there would be any profits. So the court will unwind the contract and compensate Bob for any work he may have done or expenses he may have incurred prior to Herb’s cancellation.
Bibliography:
- A. Blum, Contracts: Examples and Explanations, 2nd ed. (Aspen, 2001);
- W. Clarkson, R. L. Miller, G. A. Jentz, and F. B. Cross, Business Law: Text and Cases (South Western, 2009);
- J. Consiver, ed., Barbri Bar Review: Multistate (Thompson, 2006);
- McGovern, L. Lawrence, and B. D. Hull, Contracts and Sales: Conterporary Cases and Problems, 2nd ed. (LexisNexis, 2002).
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