The Principles of Contract Law and their Application to Businesses

Author- | Posted- | Updated: August 12, 2020 |

Definition of a Contract:

A contract can be defined as an agreement between two or more private parties that creates mutual obligations enforceable by law. The basic compulsory elements that make an agreement a legally enforceable contract include mutual assent or genuine agreement, valid offer and acceptance, adequate consideration, as well as capacity and legality. In some of the US  States, a valid substitute can satisfy the element of consideration. The key to a contract is that there should be an offer and acceptance of the terms of that offer. An offer denotes a proposal that is made to demonstrate an intent to form a contract. Acceptance denotes that the parties to the agreement are ready to be bound by the terms of the agreement.

 Apart from being made with intent, offers need to be definite and certain which implies that the terms of the offer should be clearly expressed in order to make the contract enforceable. The offer should also be communicated to the parties involved (from the offeror to the offeree). Moreover, acceptance of the offer must demonstrate the willingness of the offeree to consent to all terms of the offer.  In terms of a contract, there are at least two parties involved, one of them is an offeror and the other is an offeree. If there is a valid agreement, then there must be at least three things – an offer, an offeror, and an offeree.  The process of making an offer also requires that the terms of the offer are made clear and that the offeree clearly knows what is being proposed.

What factors may lead to the termination of an offer?

There are at least seven reasons that may lead to the termination of an offer. They include revocation, rejection, counteroffer, the lapse of time, intervening illegality, destruction of subject matter, and death or insanity of either party.

Revocation is when the person who has made an offer decides to take his offer back. However, it is possible to revoke an offer only until there has not been an acceptance from the other party. Once the second party or the offeree has accepted your offer, it is not possible to revoke the offer. For example, you made an offer to a person that you will be selling your house for $200K. However, later you realized that the house was worth at least $300K and buy selling it for only $200K you will be incurring heavy losses. So, you decide to revoke the offer. However, you can only revoke your offer until the prospective buyer has not sent his acceptance. If the buyer had given acceptance, the offer could not be revoked.

Offers may also be terminated due to rejection. When the offeree has rejected your offer or said no to it, then in that case too the offer is terminated. Suppose you made an offer to the buyer interested in purchasing a house that you are willing to sell it for $100K. However, the buyer did not like the price and therefore rejected the offer. So, your offer is terminated following the buyer’s rejection. Or in another case, you wanted to sell your used car for $10K. However, the buyer was looking for a car that costs less than $10K and was not driven more than 20K miles. So, he rejects your offer and the offer is terminated.

A counteroffer may also lead to the termination of an offer. In the case of a counteroffer, the offeree makes his own proposal or offer in response to the offer made by the offeror. As a part of the counteroffer, first, the original offer is rejected and then there is the creation of a new offer. So, it would not be wrong to say that due to the counteroffer, the roles of the offeror and the offeree are switched.

Suppose, you own a fashion brand and make an offer to your franchisees that if they can achieve sales higher than $50K individually during a season, they will earn 10% higher than their regular share. The franchisee group makes a counteroffer that they will push to achieve the target but that there share should be increased by no less than 15%. This is a counteroffer that terminates the first offer and then creates a new one.

In another case, suppose you are selling your used car for $15K. However, the buyer instead proposes that he is willing to buy it for $12K and that’s the final price he can offer. So, he makes a counteroffer to your offer. This cancels out the offer you made or the initial offer made by you is terminated.

Lapse of time can also lead to the termination of offers. If it is clearly included with an offer that it will have lapsed by a specific time, then in case, acceptance to the offer is not made by the given deadline then the offer will be terminated. Just like there is an expiration date on several products or coupons, offers can also have an expiry date and in case of no acceptance by that time, they will be terminated.

In case of offers that do not state the time of termination, they will still be terminated by a reasonable time. However, determining a reasonable time when an offer can be considered terminated is actually a complex concept. For example, you made an offer to a person to sell your house to him for $300K. He did not reject your offer but did not show any acceptance either. Six months later, you have invested a large fortune in upgrading the interiors and the person returns asking you to sell the house for the same price you had mentioned six months ago. You are still interested in selling the house but now you want $350K for the same house since you have invested around $50K in improvement. However, the buyer is still adamant at buying it for the price you had proposed earlier. Now, since the buyer did not show his acceptance at that time and several months have passed, your previous offer stands terminated and the buyer will need to accept your new offer in order to enter into a legally enforceable buying contract.

Another way in which an offer may be terminated is through intervening illegality. If the substance of the offer becomes illegal after the offer is made but before acceptance is made, the offer becomes voidable due to intervening illegality.

For example, you own a pet of a rare species. However, you have decided to sell it and talk to the local pet store owner. The pet store owner wants a day or two to consider your offer. Two days later the government puts the animal on an endangered species list and then you know it will be illegal to sell the pet. Its being on the endangered species list is the intervening factor that makes the act of selling the animal illegal act. As a result, the offer gets terminated.  

Destruction of subject matter can also cause an offer to be terminated. It means that the thing that was going to be exchanged as a part of the contract has been destroyed and therefore the offer stands terminated. For example, a person plans to sell his house. he had made his offer to a potential buyer. The deal has been nearly sealed when the house gets burned down due to a gas leak. In another case, you have ordered costly home decor material from abroad. However, the seller’s shipment gets destroyed while on the way. In that case, too the offer is terminated, and either you will have the price you paid refunded or you will not have to pay anything if you have not paid yet.

The subsequent death or insanity of either party that is involved in a contract may also terminate the contract. So, in order for a contract to be legally enforceable both the parties need to be competent as well as sane.

For example, you entered into an agreement with Mr. Smith to buy his entire business for $300K. However, before you could make him the final payment and take over his business, you received the news that Mr. Smith died of heart attack and it was his nephew who inherited everything including his house, belongings, and business. Now, you can either form a new agreement with his nephew or just leave it since the offer Mr. Smith made to you stands terminated. In another case, suppose not Mr. Smith but you died of a heart attack before the payment was made and the deal was sealed. In that case, as well, the offer will be terminated. Mr. Smith cannot ask your wife or children to buy his business since the person he made the offer to is no more. Similarly, if two people are planning to enter into a contract and one is selling his business to the other but either the offeror or the offeree is diagnosed with a mental illness subsequently before the deal had been sealed and finalized, then the offer will be terminated.

Other factors required for an agreement to be complete include genuine agreement, consideration, capacity to contract as well as legality. Consideration is also an important part of a contract. However, in some US states, it is also substitutable. Consideration is a thing of value that is promised in exchange for another valuable object.  It is the mutual exchange involved in a contract that binds the two parties together. Capacity to contract is also an important element required for a contract to be valid. According to law, anyone entering into a contract must have the legal capacity to do so. Minors do not have any contractual responsibility and law also excludes the mentally incompetent as well as drugged or drunken individuals from contractual responsibility.

The last important element is legality and the contract should involve a legal business or exchange. If the conduct involved as a part of the contract is not legal then any of the involved parties must not expect any judicial relief if the contract is violated.

Consideration and Promissory Estoppel:

Contract law in the United States uses the principles of Consideration and promissory Estoppel.

Consideration:

Contracts come into formation when a duty exists due to a promise made by one of the parties in the contract. For a contract to be legally binding, a promise must be exchanged for adequate consideration. There are two theories of consideration including Bargain theory of consideration and the Benefit-Detriment theory of consideration.  

Benefit Detriment theory of consideration:

“An adequate consideration exists only when a promise made to the benefit of the promisor or to the detriment of the promisee, which reasonably and fairly induces the promisor to make a promise for something else for the promisee.  For example, promises that are purely gifts are not considered enforceable because the personal satisfaction the grantor of the promise may receive from the act of generosity is normally not considered sufficient detriment to constitute adequate consideration.”   (Benefit Detriment theory)

Bargain for exchange theory of consideration:

Under this theory, adequate consideration exists when a promisor makes a promise in exchange for something else. The important condition in this regard is that the promisor was given something mainly to induce the promise it made. The difference between benefit-detriment theory and bargain for exchange theory is that the focus of bargain for exchange theory is the motive of the parties for making the promises and the subjective mutual assent of the parties. On the other hand, the focus of the benefit-detriment theory is an objective legal detriment or benefit to the parties.

Consideration does not always need to be monetary. It can be either money or property or something else like a promise or a right. Most contracts are legal and enforceable only if each party gets consideration from the promise. For instance, if a company sells electronics products, its product is the consideration for the buyer and the money that the buyer pays in exchange for the electronics is the consideration for the seller.

Promissory Estoppel:

An exception to the requirement of consideration in contracts is the doctrine of promissory estoppel. When one party acts on the basis of the promise made by another party, it triggers the promissory estoppel. In the cases that trigger promissory estoppel, severe harm or injustice has happened to one party because it acted on the promise made by another party. According to the doctrine of promissory estoppel, the affected party can seek justice or fairness for the performance of a contract in the court, or other remedies, even when there is no consideration involved. While the legal application of the doctrine of promissory estoppel may vary from state to state, but there are still some basic elements of the doctrine that include the following.

– There was a legal relationship between the parties involved.

– A promise was made by one party to another.

– One party relied on the promise made by the other and acted before any real consideration could be exchanged.

– The failure to perform the contract on the part of one party led to a substantial and measurable detriment for the other.

– The breaking of the promise by one party led to an unconscionable result (contrary to good conscience) or gross injustice.

If the court finds that these elements were present and that the doctrine of promissory estoppel applies in a given case then it will issue appropriate damages (reliance damages) to the party that was adversely affected so that it can be restored to the position it was in before the promise was broken.  If promissory estoppel is being claimed by a party then expectation damages are not usually available.

An example:

Suppose Jack has received two job offers. One is from his current employer in his local town and the other is from an employer in a far-away and larger town. The second job is exceptionally good and Jack considers it his dream job and therefore decides to move to the larger town where he can join in his dream role at the soonest possible. However, he has to break his commitment with the current employer and accept a penalty before he can join in his new role. Apart from the penalty, he has to spend a large sum (say $13K) in his travel and moving costs. Since the cost of living is higher in the larger town, he again spends a fortune paying two months’ rent and security deposit. within two days, he receives a call from the new company’s management. The manager tells him the company has changed its mind and closed the job offer. Apart from losing the job in his hometown, Jack has also lost a large amount in the form of rents and moving costs.

In case, Jack decides to bring a Promissory Estoppel suit, he will be entitled to all the costs he has incurred. After he has been reimbursed with all the costs he has incurred, Jack will be in the same position he was in before the new company broke its promise. However, the company will not be likely required by law to reopen the position for him that he has been denied. Apart from that, there will be no damages awarded for the job he turned down with the first company as in such cases, expectation damages are not usually available.

It is important to gain an understanding of the doctrines of consideration and promissory Estoppel in order to understand the application of contract law in the US.

Reliance Damages versus Expectation Damages:

Damages are not available (whether expectation damages or reliance damages) in all cases. If an agreement does not meet all the legal requirements to be considered a legal and valid contract, then it will not be enforceable by law, and the party that has breached the agreement will not be required to compensate the aggrieved party for the breach of the agreement.

So, the plaintiff or the aggrieved party will be able to win expectation damages only if they can show that contractual agreement under consideration really existed and that it was valid as well as enforceable. If the aggrieved party is able to prove all this, it will be rewarded expectation damages or damages that include the entire sum that the aggrieved party would have made if there was no breach in the agreement as well as any reasonably foreseeable consequential damages that the party suffered due to the breach of the contract.  In this condition, expectancy means the monetary value of the contract, if the contract was fully performed. It is also important to note that there are no punitive damages for contractual remedies and the aggrieved party is not awarded more than the expectancy.

However, there are also certain circumstances where agreements that are not considered contracts may still be enforceable to a limited extent. It is applicable in the cases of Promissory Estoppel. Reliance damages are applicable in the case of Promissory Estoppel. If one party has made reasonable reliance to its detriment on the promise made by another party, then the court may apply the doctrine of Promissory Estoppel. It will issue reliance damages to the aggrieved party in order to compensate it for the amount it has suffered as a result of its reasonable reliance on the agreement.  

The courts may also award Unjust Enrichment to a party that confers a benefit on another party but the second party receiving the benefit unjustly keeps the benefit without paying the first party for the benefit it conferred. Unjust enrichment occurs when one party confers a benefit on another party but does not receive proper legal restitution for the benefit. This generally occurs in the case of a contractual agreement when party A fulfills its part of the agreement but party B does not. So, the plaintiff is required to show that the defendant was enriched unjustly at its expense in order to recover a claim. The burden of proof lies on the plaintiff. Generally, this happens when there was no contract between the parties or when the contract was invalid. (Unjust enrichment is different from a gift. A gift is given by one party to another without any expectation of receiving something in return.)

Capacity and Legality:

Capacity:

Capacity in the context of contract law denotes the capacity of the individual parties involved to enter into a legally binding contract. legally, there are certain classes of people that are presumed to lack the capacity to enter into a legally binding contract. These classes of people include the minors as well as the mentally handicapped and the intoxicated people.  if people from any of these classes enter into a contract, the contractual agreement would be considered voidable. However, if a contract is voidable then the incapable party that entered into the contract has the choice to continue with the contract or end it.  

Examples:

In case of minors:

In most US states, minors or people under the age of eighteen do not have the capacity to enter into a contract. So, they can either continue with the contract or void the contract. However, there are also certain exceptions to this rule. In most US states, a contract for necessities (like food or clothing) may not be voided. Moreover, in most US states, contracts are not voidable after the minor person has turned eighteen.

for example, Jack who is an athlete entered into a long term contract when he was seventeen and decides to bargain for a better deal when he is nineteen and tries to terminate the agreement on the ground that he entered into the agreement when he lacked the capacity to do so. Now, since Jack has passed the period of incapacity, he will most likely not succeed in getting his agreement voided.

In case of mentally handicapped people:

 In the case of a person lacking the mental capacity to enter into a  contract, the person or his legal guardian may void the contract given the contract does not involve necessities like food or clothing.

In most US states, law measures mental capacity against the cognitive standard of whether the party understood the meaning and effect of the contract.

Example:

Bill contracted to sell a patent. However, he later claimed that he did not have the capacity to enter the contract. So, he sought to have the contract voided. he based his claim on his fact that he was diagnosed as manic depressive and had also received treatment for this condition from several mental hospitals. his doctor also claimed that he lacked the capacity to evaluate the contract due to his condition.   In a similar situation, a California Court of Appeals refused to terminate the contract since even in a manic state the person did not lack the ability to contract but the condition only impaired his judgment and not his understanding of the contract.  A court can also reach a different legal conclusion if the person had a different mental condition.

Voluntary Intoxication: Drugs and Alcohol

In the case of people that are intoxicated voluntarily when entering an agreement, the courts do not find them lacking the capacity to contract generally. the main reason behind this decision is that people cannot shun their contractual obligations on the basis of their self induced states including voluntary intoxication. However, courts also do not want that any sober party takes advantage of another party’s intoxicated state since it can have unfair and undesirable results. So, if an individual is so inebriated that it cannot understand the consequences or the nature of the agreement it is trying to enter, then the contract can be voided by the intoxicated party.

Example:

A person owned a significant amount of stock during the 1900s but he decided to go on a three-month drinking binge. A local bank knew of the individual’s condition. It hired a third party that could persuade the individual to enter into a contract with the bank. The third-party successfully persuaded the individual to sell his stock for just 1.5% of its original value. A month later when the individual ended his binge, he came to realize that he had been duped. When he investigated he found that the third party that had formed the agreement with him had sold the stock to a local bank that was behind the entire deal. So, the individual sued the third party. The case reached the United States Supreme Court. The court declared the agreement voidable because the bank as well as the third-party knew that the individual was ignorant of the thing he was doing when he entered the contract. The court asked the bank to return the shares to the individual apart from the sum he had already been paid.

Legality:

Contracts should not involve the illegal exchange of goods and services. They are created for the exchange of legal goods and services. Contracts that violate the law and public policy are voidable according to law. This rarely happens but still, it is an important requirement for a contract to be legally enforceable. typically, courts arrive at this conclusion only in cases where the potential harm to the public is clear and can be recognized without much effort even if judges have different views of the same violation.

Contracts should not have an immoral purpose. It means that there must not be a criminal intent behind a contract. For example, if a terrorist group enters into a contract to source AK 47s for a massacre, then it is not a legally binding contract. There are many contracts that are formed between criminal groups each year but these contracts are not enforceable by law. if a person contracts another person for committing murder then this is not a legally enforceable contract. So, if the contract demands a party to commit an illegal act or if the formation of the contract will force the parties to commit an illegal act, the contract is not enforceable by law or just as enforceable as a nonexistent contract. So, if any of the parties involved in the contract breaches the contract then the law will not make any relief available to the aggrieved party. In cases, where a party claims that there has been a breach of contract, then the defendant can defend by claiming that the contract itself was illegal.

Example:

Gambling is illegal in a state and two parties enter into a contract in the state to hire a blackjack dealer. This contract would not be legal since the employee will be required to get involved in illegal activities as gambling is illegal in the state. So, if anything happens during the course of his employment, the courts would not be able to offer any legal help since the contract will be voidable. The courts will treat the contract as just a nonexistent contract. However, if two parties enter into a contract in the same state for the sale of dice to a known dealer, then that will not be illegal. The contract will be considered legal since while gambling is illegal in the state, the act of selling dice is not a crime.

There are several such examples where entering a contract will not be considered legal. For example, a  contract for the sale of drugs, or for the sale of illegal weapons or even loansharking and for hiring undocumented workers illegally are all cases where the contract would be considered voidable.

Once two or more parties have legally entered into a contract, it is expected of each party to perform its duty according to the contract. A breach of contract claim can arise in certain situations when one party or both parties claim that part or all the promises included in the contract were not fulfilled.

When a breach of contract claim is made, it triggers several question:

The first important question is that if a contract really existed. if it is found that a contract existed then more questions need to be addressed.

What did the terms require the parties to do? Were the terms of the contract modified at any point? Did a breach of the contract really occur? Was the claimed breach material to the contract?

Is there a legal defense to the enforcement of the contract available? What are the damages the breach has caused?

Material breach versus minor breach:

Whether the breach is material or minor affects the obligations of the involved parties and remedies for the breach of contract.

If the result of the contract is substantially different from the expectations set out under the terms of the contract, then it will be considered a material breach. For example, if the contract was for the delivery of jewelry and instead the person received a box of candies, it will be considered a material breach. if there has been a material breach, then the aggrieved party has the right to all remedies for breach of the contract. It is no longer expected to perform all its obligations that were a part of the contract.

There are several factors that the courts will determine when considering if the breach was material or minor:  

– If the aggrieved party still received a benefit (and how much).

– What will be adequate compensation for damages?

– the extent to which the breaching party performed its duty under the terms of the contract.

– hardships faced by the party that breached the contract.

– negligence or intent behind the behavior of the breaching party.

– If the breaching party will perform the remaining part of the contract and if so what is its likelihood?

Minor Contract:

However, if the breaching party fails to perform only a small part of the contract then it will be considered a minor breach. for example, if the breaching party has carried out a substantial part of the contract, or the non-breaching party has received a large part of the goods and services included in the contract then it will be only a minor breach. For example, a contract does not specify a firm deadline for the delivery of goods and services or does not clearly state that time is of the essence for the contract to be fulfilled. So, a short delay in the delivery of products and services laid out in the terms of the contract will be considered a minor breach. While damages will be available to the aggrieved party if it has suffered any harm due to the breach of contract, it will still be required to perform as pursuant to the contract.   

Remedies for the breach of contract:

Generally, the remedies available for breach of contract include monetary damages, restitution, rescission, reformation, and specific performance.

Monetary damages include compensation for the financial losses that the breach has caused.

Restitution damages restore the aggrieved party to the position it was in prior to the breach of the contract or status quo. Restitution restores the money or property given as a part of the contract to the plaintiff.  Generally, restitution is sought when courts declare a contract voidable because of the fact that the defendant lacked capacity or was incompetent.

Rescission or reformation damages are available mainly in cases where a party has entered into a contract by mistake, fraud, duress, or undue influence.  The duties of both parties are terminated under rescission. Courts equitably change the contract’s substance under reformation.

Specific performance: Specific performance compels the breaching party to perform the duties outlined in the contract as much as is possible for the party. When monetary damages cannot adequately compensate for the breach of a contract, specific performance is mandated. However, courts do not use personal service to compel specific performance since it constitutes slavery and that is illegal as per the US constitution.

State common law generally governs the contract law. While the general overall contract law is common throughout the United States, some specific court interpretations of a specific element of the contract may vary from state to state.

Abhijeet Pratap

Abhijeet has been blogging on educational topics and business research since 2016. He graduated with a Hons. in English literature from BRABU and an MBA from the Asia-Pacific Institute of Management, New Delhi. He likes to blog and share his knowledge and research in business management, marketing, literature and other areas with his readers.