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CHAPTER 10 CONTRACTS

Basic to the law of contracts is the principle that business has the freedom to enter into and create nearly any contract. Freedom of contract a requisite for progress, but limits are imposed by contract law. CONTRACT LAW Contract law is primarily state common law. The Restatement of Contracts, now in its second edition, is an authoritative document that provides an orderly presentation and summary of the common law of contract. Common law principles of contract are significantly influenced by many legislative enactments. Of particular importance are Articles 2 and 9 of the Uniform Commercial Code (UCC), which we see in the next chapters. Definition of a Contract Blackstone: "an agreement, upon sufficient consideration, to do or not to do a particular thing." Restatement: "a promise or a set of promises for the breach of which the law gives a remedy." A contract is the legal relationship that consists of the rights and duties of the contracting parties growing out of promises. Contract law governs the enforceability of that legal relationship. Not all promises are enforceable contracts. (Note: "The duty to keep a contract at common law means a prediction that you must pay damages if you don't keep it,--and nothing else." Oliver Wendell Holmes, The Path of the Law, 10 Harv.L.Rev. 457, 463 (1897).) Sources of Contract Law The law is common law that has evolved over hundreds of years. The basic rules are quite similar to civil codes' contract law rules; both are based on the way business relationships developed in practice. The UCC is a significant addition to (or modification of) common law rules. TYPES OF CONTRACTS Although contracts can be classified by their method of formation or their legal effect. The standard classifications are express and implied contracts; bilateral and unilateral contracts; executory and executed contracts; valid, void, voidable, and unenforceable contracts; and quasi-contracts. These classifications are not mutually exclusive. Express and Implied Contracts An express contract is a contract created by a direct statement by the parties of a promise or promises to each other. Nothing is left to implication. The statement may be 10-1 oral or in writing. In an implied contract, the parties do not state directly the promise or promises to one

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another; the promises are inferred from the behavior of the parties or the circumstances. Words, conduct, gestures, and the like reasonably imply the existence of certain kinds of contracts. Both express and implied contracts are genuine contracts and are equally enforceable at law. Express and implied contracts differ primarily in the manner in which the assent of the parties is manifested. Bilateral and Unilateral Contracts Every contract has an offeror and an offeree. If the offeree accepts an offer by an exchange of a mutual promise, a bilateral contract is formed. If the offeree accepts an offer by an exchange of performance for the offeror's promise, a unilateral contract is formed. The distinction between a bilateral and a unilateral contract has been diminished by a number of authorities, including the UCC and the Restatement 2d of Contracts, and is not recognized in some states. Executory and Executed Contracts Executory contracts have not been fully performed by either party, while executed contracts are those that have been fully performed by both parties. Valid, Void, Voidable, and Unenforceable Contracts A valid contract is one in which all the elements of a contract are present. Such contracts are enforceable at law. A void contract is one that does not exist at law, such as a contract whose subject matter is illegal or a contract made by an individual without capacity to make a contract. Voidable contracts are valid contracts, but one of the parties to the contract has the right to avoid legal obligation without incurring liability. For this reason, the contract is not void but rather is voidable, or capable of becoming void at one party's option. Unenforceable contracts are contracts that once were valid but, because of a subsequent illegality, will not be enforced by the courts. The passing of a statute that makes previously valid contracts illegal creates an unenforceable contract. Quasi-Contracts quasi-contract is not contract. This term is used by the courts to impose obligations on one party to a dispute when to do otherwise would create an injustice to the other party. The courts created the concept of quasi-contract to give relief to innocent parties even though no "true" contract exists. The remedy prevents unjust enrichment International Perspective: Contract Rights in Eastern Europe For contracts to be effective within a society, three things must be present: (1) Contract Law, (2) Private Property Rights, and (3) Freedom to Acquire and Protect Knowledge and Information. Because of prior communist rulers, a pressing problems in Eastern Europe is the lack of contract law and private property rights. The countries are struggling, with varying degrees of success to develop consistent laws that will be respected by citizens and foreigners, to give them confidence in doing business. ELEMENTS OF A CONTRACT The elements include agreement, consideration, legal capacity of the parties to contract, lawful subject matter, and genuine consent to the contract. Compliance with the Statute of Frauds may be necessary. The Agreement An agreement means a mutual understanding between the parties as to the substance of the contract. Agreement is reached through a process of offer and acceptance. The Offer An offer is a promise to do or refrain from doing some specified thing. The party making an offer to another party to enter into an agreement is called the offeror. The offeree is the party to whom the offer is made. To be an effective offer, three requirements must be met: clear manifestation of intent, definite terms and conditions, and communication of the offer. Manifestation of Intent. In making the proposition, the offeror must have the intent to be bound to the contract, and that intent must be clearly manifested. Preliminary negotiations are not an offer. Intent is

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Communication of the Offer. An acceptance requires knowledge of the offer by the offeree. Accidental compliance with terms of an unknown offer does not form a contract consistent with the terms of offer. Terminating an Offer Termination of an offer can occur by action of the parties (withdrawal, rejection, counteroffer, lapse of time) or by the operation of law (intervening illegality, destruction of the subject matter of the offer, or death or insanity of the offeror or the offeree). [Note that the UCC provides that a merchant's firm offers cannot be revoked until that stated time period expires. The UCC's firm offer is similar to option contract under the common law.] An option contract requires the offeror to hold open an offer for a specified time. Termination by the Parties. Withdrawal of an offer is a revocation. It must be communicated to the offeree. If the offeree rejects the offer or makes a counteroffer, the offer is terminated. If a reasonable length of time passes (when no time is specified), the offer expires. Termination by the Operation of Law. An offer may terminate by intervening illegality; a court decision or new law that makes the offer illegal. Destruction of the subject matter terminates the offer as does death or insanity of either party. The Acceptance Acceptance is the offeree's expression of assent or agreement to the exact terms of the offer. To be effective, an acceptance must be unconditional, unequivocal, and legally communicated. Must Be Unconditional. Acceptance must be the mirror image of the offer. The common-law rule is that a purported acceptance that adds conditions to the original offer is a counteroffer. [The UCC alleviates the mirror image rule by focusing on the intent of the parties to determine if a contract has been formed.] CASE: Ardente v. Horan Must Be Unequivocal. Acceptance must be unequivocal (definite). "I see" or "What a good idea," fail the unequivocal test and there is no acceptance. As a general rule, silence is not acceptance for the simple reason that it is not unequivocal; it could mean yes or no to the offeree. Must Be Properly Communicated. In general, in communicating an acceptance any reasonable method is adequate. Problems arise when the offeror specifies one mode of communicating acceptance but the offeree uses another. The timeliness of acceptance is important, especially when the distance between the parties creates the potential for long passages of time between the offer and the acceptance. The courts created the general rule that if the method of acceptance is reasonable under the circumstances, the acceptance is effective when sent. The mailbox rule, states that acceptance is effective when it is mailed and revocation is effective when it is received by the offeree. Note about Unilateral Contracts: Special considerations govern acceptance of unilateral contracts. They are accepted by performance. Concerned that an offeror could revoke the offer just before the offeree was to complete the performance, most courts take the view that if performance has started the offeror may lose the right to revoke the offer. Consideration Consideration is something of value or something bargained for in exchange for a promise. It is the element of a contract that keeps it from being gratuitous (a gift). The definition of consideration requires either a legal detriment to the promisee or a legal benefit to the promisor.

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CASE: Hamer v. Sidway Adequacy of Consideration Courts generally do not like to inquire into the adequacy of consideration given in a contract. In a business transaction, this places the bargaining responsibility on the parties to the contract. Preexisting Duty and Past Consideration Consideration is a present detriment to the promisee and a benefit to the promisor; hence, consideration cannot be based upon past consideration or a duty that already existed before the new agreement was made. An existing contract can be changed so long as there is new consideration to support a new agreement. Enforceable Promises without Consideration There are circumstances where consideration for a promise is not required by the courts for the promise to be enforceable. The doctrine used by the courts is called promissory estoppel or detrimental reliance. CASE: Hoffman v. Red Owl Stores, Inc. Capacity to Contract The term capacity refers to a party's ability to perform legally valid acts, acquire legal rights, and incur legal liabilities. Generally, minors, intoxicated persons, and the insane lack capacity to contract or have partial capacity, which allows them to later disaffirm a contract. A party claiming incapacity has the burden of proof. Minors At common law, the general rule is that a minor may enter into contracts, but those contracts are voidable at the option of the minor (right to disaffirm). There are some contracts that minors may not disaffirm. Enlistment contracts and marriage contracts are classic examples of nonvoidable contracts. After a minor reaches the age of majority, most states provide that the individual may expressly or implicitly ratify contracts. Mentally Impaired and Intoxicated Persons If a person is intoxicated when a contract is made, most courts hold that the contract is voidable. Contract law classifies insane persons as either adjudicated insane or insane in fact. A person is adjudicated insane if a court rules that the person is not competent to carry on contractual activities,contracts are void. A person not adjudicated insane but who nonetheless lacks the capacity to enter into a contract is insane in fact,person has the right to disaffirm a contract. Legality For a contract to be valid, its subject matter must be lawful. The contract will be illegal and unenforceable if its subject matter violates a state or federal statutory law or the common law or is contrary to public policy. Illegal Agreements,Promises that violate statutes, such a deal to sell heroin, are not recognized as enforceable contracts. Contracts Contrary to Public Policy Some contracts are unenforceable because their subject matter is contrary to public policy,they are said to have a negative impact on public welfare. The courts have found some contracts to be illegal on the ground that they are contrary to public policy. Exculpatory Agreements. Releases one party from the consequences brought about by his wrongdoing. Unconscionable Contracts. A contract that is so grossly unfair to one party (normally due to unfair bargaining power), that the courts in equity will not enforce it.

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Reality and Genuineness of Consent A person may enter into an agreement without full knowledge of the consequences. Without full knowledge, there is no reality of consent or genuineness of assent by the parties, and the contract is void or voidable depending upon the circumstances. If the parties enter into a contract by mutual mistake, the contract may be voidable. If a person contracts under fraud, deceit, duress, or undue influence, there is a right to disaffirm the contract. Statutory Exceptions Some statutes deal with high-pressure selling techniques by door-to-door salespeople. These "home solicitation" statutes allow contracts to be rescinded if undue influence or duress can be proved to be the basis for the innocent party's consent to enter into the contract. Under federal law, the Federal Trade Commission's cooling-off rule allows purchasers of door-to-door sales with a value over twenty-five dollars to rescind the contract if the rescission is done in writing within three business day. Fraud and Misrepresentation Contracts may be disaffirmed due to fraud, misrepresentation, duress or undue influence; in which cases there was not genuine consent. Duress and undue influence are not common, but claims of fraud and misrepresentation are. Fraud. Contracts based on fraud may be rescinded. If a case is made for damages then plaintiff must show: 1) misstatement of material fact; 2) scienter (intent to defraud); 3) seller knew or should have known of the false information; 4) justifiable reliance on the information; 5) privity between parties; 6) proximate cause; and 7) damages. When fraud is present there may be damages for breach of contract but also in tort, which allows the possibility of punitive damages. Misrepresentation. Misrepresentation is usually a lesser form of fraud; usually material false statements that affect the making of a contract. If misrepresentation has no impact on the value of a contract, then there are unlikely to be damages. CASE: Johnson v. Davis Cyberlaw: Digital Signatures and Contracts Digital signatures, when properly transmitted, are presumed valid to create contracts. The common law adjusts to allow usage of new modes of communication. The E-Sign Act helped codify and make uniform the legal standards for digital signatures. Contracts in Writing and the Statute of Frauds Some contracts must be in writing and signed to be enforceable. Such contracts are subject to the requirements of the Statute of Frauds. Most states have six types of contracts that are covered by the Statute of Frauds and that must be in writing: 1. Contracts for the sale of land and real property. 2. Contracts that cannot be performed within one year. 3. Promises to pay the debt of another. 4. Promises by an administrator to personally pay the debts of the estate. 5. Promises made in consideration of marriage. Sufficiency of the Writing For a writing to be sufficient under the Statute of Frauds, it must set out all material terms in writing and must be signed by the party against whom its enforcement is sought.

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Parol Evidence Rule It prohibits the introduction of oral evidence where the evidence presented is contrary to the terms of a written contract. Oral evidence cannot contradict, change, or add terms to a written contract. Oral evidence may be introduced when the written contract is incomplete or ambiguous, when it will prove fraud, mistake, or misrepresentation, or when the parol evidence explains the written instrument via trade usage or course of dealing. PERFORMANCE, DISCHARGE, AND BREACH OF CONTRACTS When the obligations of a contract are satisfied, the contract is terminated or discharged. Assignment and Delegation Transfer of contract rights to a third party is assignment; transfer of duties is a delegation. Contracts for personal services generally cannot be assigned or delegated, but for ordinary goods, there is no public police reason against assignment or delegation. Third-Party Beneficiaries Third-party beneficiaries of a contract to which they were not an original party may sue to force performance of the contract, or for damages, if the party to the original contract fails to performs. Performance Most contracts end by performance. Performance terminates the contract, no further obligations exist. Substantial Performance If a contract is substantially performed only a small part was not that does not impair the whole matter then there are not grounds for terminating the contract. Parties are obligated to act in good faith to get along as well as possible+such as subtract for what was not delivered, but not sue for damages for the value of the contract. Discharge by Breach When parties do not perform their obligations there is a breach and a remedy may be available. Material Breach Performance fails to meet the terms of the contract. The wronged party has a cause of action against the breaching party for damages and is discharged from the performance promised under the contract. Anticipatory Breach Before the performance of the contract is to take place, an anticipatory breach (or repudiation) occurs if one party expresses inability or lack of desire to perform the contract. The nonbreaching party's duties are discharged and that party may sue for damages incurred from the repudiation. Until the nonbreaching party treats the expression not to perform as a repudiation, the breaching party may retract the repudiation, and the duties of the contract will be reinstated. Discharge by Agreement of the Parties The parties to a contract have the freedom to agree to modify or to terminate their obligations under the contracts. Discharge by agreement between the parties include rescission, novation, and accord and satisfaction. Rescission occurs when both parties agree that their contractual relationship should be terminated without performance. A rescission discharges completely the obligations of both parties under the contract. Novation In a novation the parties agree to discharge one party from the contract and create a new contract with another party who is to become responsible for the discharged party's performance.

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Accord and Satisfaction Another way parties may agree to discharge their duties to one another under a contract is through accord and satisfaction. An accord is an agreement by the parties to give and accept some performance different from that originally bargained for. Satisfaction is the actual performance of substituted obligation. Discharge of the original obligation occurs when the performance of the substituted obligation takes place. Discharge by Operations of Law The occurrence of certain legal events will sometimes terminate the obligations of the parties to a contract. Examples include (1) the material alteration of the contract by one of the parties, (2) the running of the statute of limitations after a contract has been breached, or (3) the bankruptcy of one of the parties to a contract. Discharge by Condition A party's duty to perform under a contract can be conditioned on the occurrence or nonoccurrence of some event. The condition is often stated expressly in the contract. The parties may specify that their contract will terminate upon the occurrence of some specified event (an express condition subsequent). For example, the parties may provide that the outbreak of a war or other military action in the area in which one party's duties are going to be performed expressly terminate the duties of the parties to the contract. The parties may provide that their duties under the contract are to occur simultaneously (condition concurrent). If either party fails to perform, the duties of the other party does not arise. Most common is condition precedent. Failure of a Condition Precedent Where some stated event must take place before the promises of the parties become operative. Failure of the condition precedent discharges the contract. Discharge by Impossibility Legal impossibility is used to discharge the obligations of the parties to a contract when some event occurs that makes performance impossible by one or both parties. Objective impossibility occurs when a party to a contract dies or is incapacitated, a law is passed making performance of the contract illegal, there is complete destruction of the subject matter of the contract, or the performance contemplated by the contract turns out to be massively more expensive or difficult than anticipated. It discharges the obligations of the parties to the contract. Subjective impossibility includes such events as strikes by workers, shortages in raw materials or other supplies, and an anticipated loss of profits in the performance of the contract. Subjective impossibility does not discharge the obligations of the parties under the contract. The business assumes the risk of certain occurrences. CASE: F. J. Busse v. Dept. of General Impracticability The more modern view of impossibility, in the UCC and in some common law states, is impracticability. It refers to "extreme or unreasonable difficulty, expense, injury or loss." The Busse case may well have gone the other way under this rule. International Perspective: Contracting With the Japanese The attitude of Japanese businesses toward contracts is often different from that of US businesses. The typical US view is that a contract defines the rights and responsibilities of the parties and seeks to cover all possible contingencies. The traditional Japanese view is that a contract is secondary in a business transactions. The parties should do business is an ongoing relationship, with both parties committed to the pursuit of similar objectives. Relationships, not contracts, are negotiated in Japan. Legal documents are often brief and flexible to accommodate the evolving relationship between the parties. Contracts are viewed as tentative agreements that may be redefined as circumstances change. Long legal contracts specifying the relationship,particularly if written by a foreign firm,are viewed with

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suspicion. Because Japanese managers place a high value on compromise and accommodation, contracts often contain a "good-faith" clause. The clause states that the parties are to negotiate in good faith if a dispute arises. Japanese negotiation teams are normally larger than American teams. During the process, the Japanese work to gain a consensus among themselves. As a consequence, negotiations often precede at a slower pace. REMEDIES There is a basic premise in contract law that after a breach, innocent parties should be placed in the same economic position they would have been had the contract been fully performed. Under normal business circumstances, a monetary judgment for damages will place the injured party in such a position. If, however, the circumstances are such that the legal remedy of monetary damages is inadequate, the court may grant the injured party an appropriate equitable remedy. Damages The remedy usually granted for breach of contract is the legal remedy of monetary damages. A variety of damage awards are available to the courts, including compensatory, expectancy, liquidated, nominal, punitive, and special damages. In general, damages should return the injured party to the same economic position if the contract had been performed. There is restitution interest the recovery of value given; reliance interest costs incurred depending on the contract to be fulfilled; and expectation interest lost profits that would have been earned had the contract been fulfilled. Calculating Damages Firms may sue to recover actual (or estimaed) losses for the various interests just mentioned. Different states have different rules about damage measurement. At times, it is efficient for a firm to breach a contract because the damages from breach are less than the cost of fulfilling the contract. Liquidated Damages Liquidated damages are damages specified in the contract to be paid in the event of breach by either party. They serve as a deterrent to both parties from taking actions that will result in a breach of contract. Liquidated damages will not be allowed if the court finds they are so excessive that in actuality they impose a penalty. Nominal Damages When a plaintiff has suffered a technical injury in contract law but has not suffered an actual loss, the courts will sometimes award nominal damages. The amount of recovery to the injured party will often be as little as a dollar plus the court costs. These awards are important because courts are able to establish a precedent that effectively states that even technical wrongs will be recognized at law, thereby upholding the importance of contractual obligations. Punitive Damages Punitive or exemplary damages are usually awarded when the wrongdoer's conduct has been willful or malicious. They punish the wrongdoer by allowing the plaintiff to receive relief beyond compensatory or expectancy damages. Punitive damages are not awarded for breach of contract unless there is also a tort involved, such as fraud or interference with contractual relations. Mitigation of Damages When a breach of contract does occur, the injured party is required to undertake reasonable efforts to mitigate or lessen the losses that may be sustained. The injured party may not recover for losses that could have been avoided without undue risk, burden, or humiliation. In addition, if a buyer does not receive goods ordered under contract, the buyer is required to mitigate damages by making a reasonable efforts to secure substitutes. CASE: Copenhaver v. Berryman Equitable Remedies If money damages are inadequate to redress the injury caused by the breach of

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contract, equitable remedies such as specific performance or an injunction are available. These remedies are not available to injured parties as a matter of right but rather are available at the discretion of the courts. Specific Performance Specific performance is an order by the court requiring the party who created the wrong to perform the obligations contracted for. Injunction An injunction is an order by the court that requires one of the parties to do or to refrain from doing certain acts. Reformation A remedy not often granted; it means the court rewrites the contract in case of obvious mistake. Restitution A remedy to prevent unjust enrichment; not much different in practice from the notion of quasi-contract.

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