A contract is a legally enforceable promise. Contracts are vital to society because they facilitate cooperation and trust. Rather than relying on fear of reprisal or the hope of reciprocity to get others to meet their obligations, people can enlist other people to pursue common purposes by submitting to contracts that are backed by impartial authority. Without contracts and their supporting institutions, promises would be much more vulnerable to ill will, misunderstanding, forgetfulness, and other human flaws. Indeed, contracts allow people who have never even met to reach agreements, such as lending/borrowing money to buy a house, that they would never consider making outside of a legal framework. Discussed below are characteristics and types of contracts.
As a legally enforceable promise, a contract differs from a simple verbal promise in that either party may ask the state to force the other party to honor its promise. To distinguish contracts from other types of promises and agreements, courts have established basic elements that are necessary for a contract to exist. A contract may be legally defined as a voluntary, legal, written agreement made by persons with the proper capacity. It should include: 1) an offer; 2) an acceptance; and 3) consideration, or an exchange of value. There are legal exceptions to most of these conditions, and all of them are subject to interpretation in the courts. Furthermore, some contracts do not meet these requirements, such as implied contracts and those created under promissory estoppel, both of which are discussed later.
Contracts not entered into voluntarily are voidable. For example, a company might tell a supplier that it was considering ending their business relationship if, within the next ten minutes, the supplier did not sign a contract to provide materials at a certain cost. If the supplier signed the agreement, it might be able to convince the courts that it did so under duress or undue influence, and therefore was not bound by its terms. In general, contracts created under duress, undue influences, fraud, and misrepresentation are voidable by the injured party.
Contracts are also void if they involve a promise that is illegal or violates public policy. For instance, a contract regarding the sale of illegal drugs is unenforceable. Likewise, contracts that are legal but are not in the public interest may be rendered null. For example, a contract in which a company requires a customer to pay an extremely high rate of interest on borrowed funds could be deemed invalid by the courts. Similarly, a retail company that required an employee to sign an agreement that he would never work for another retailer would likely not be able to enforce the contract because it had unreasonable restrictions or imposed undue hardship on the worker.
Contracts do not have to be written to be enforceable in court. In fact, most oral contracts are legally enforceable. However, they are obviously much more difficult to prove. Furthermore, most states have adopted "statutes of frauds" which specify certain types of contracts that must be in writing. Examples of contracts that typically fall under the statues of frauds include agreements related to the sale of real estate, contracts for the sale of goods above $500, and contracts in which one person agrees to perform the obligation of another person. Such contracts need not be overly long or involved. In fact, a simple memo or receipt may satisfy all legal requirements. There are exceptions in this area, however. For instance, when one party will suffer serious losses as a result of reliance on an oral agreement, the statute of frauds may be waived (see promissory estoppel below).
An otherwise acceptable contract may also be voided if one (or both) of the parties making the agreement does not have the mental or legal capacity to do so. Obviously, a mentally retarded individual or a child could not be bound by a contract. But a contract signed by a person exceeding his authority to make an agreement may also be voided.
In addition to being voluntary, legal, written, and made by persons with proper capacity, contracts usually must possess three basic components: an offer, an acceptance, and consideration. An offer is a promise to perform an act conditioned on a return promise of performance by another party. It is recognized by a specific proposal communicated to another party. Once a legal offer has been made, the offering party is bound to its terms if the other party accepts. Therefore, the offering party must clearly indicate whether the proposal is an offer or some other communique, such as an invitation to negotiate. The offering party, however, may stipulate certain terms of acceptance, such as time limits, and even withdraw the offer before the other party accepts.
Acceptance, the second basic requirement for the existence of a contract, is legally defined as "a manifestation of asset to the terms [of the offer] made by the offeree in the manner invited or required by the offer." As with offers and offerors, the courts look for an intent to contract on the part of the acceptor. The difference is that the offeror may stipulate terms of acceptance with which the other party must comply. If the offeree attempts to change the terms of the offer in any way, a rejection is implied and the response is considered a counteroffer, which the original offeror may reject or counter. As with most rules regarding contracts, exceptions exist. For example, the Uniform Commercial Code includes a "Battle of the Forms" provision whereby an offeree may imply acceptance under certain circumstances even if it changes or alters the offer.
Even if an offer is accepted, it must be consummated by consideration for a legally enforceable contract to exist. Consideration entails doing something that you were not previously bound to do outside of the agreement. In other words, promisees must pay the price (consideration) that they agreed to pay the promisor in order to gain the right to enforce the promisor's obligation.
The requirement of consideration serves an important purpose. It protects the promisor from being liable for granting, or relying on, gratuitous promises. For example, suppose that a person told her roommate that she would always pay the entire rent for their apartment. If she later changed her mind, she could not be held liable for the rent because she had neither asked for, nor received, anything in exchange for the promise. Had the other roommate promised to clean the apartment in exchange for the roommate's promise to pay the rent, an enforceable contract would exist (assuming other requirements were met).
The two primary categories of contracts are "unilateral" and "bilateral." In a unilateral contract only one party promises something. For instance, if a car dealer tells a customer, "I will give you that car if you give me $15,000," he has made an offer for a unilateral contract—the contract will only be created if the customer accepts the offer by paying the $15,000. If the dealer says, "I will promise to give you the car if you promise to pay me $15,000," a bilateral contract has been proposed because both parties must make a promise. The concept of unilateral contracts is important because it has been used by courts to hold a party liable for a promise even when consideration was not given by the other party. For instance, an employer may be liable for providing pension benefits that it promised to an employee, even if the worker gave no promise and did nothing in return.
Contracts may also be classified as "express" or "implied." Express contracts are those in which both parties have explicitly stated the terms of their bargain, either orally or in writing, at the time that the contract was created. In contrast, implied contracts result from surrounding facts and circumstances that suggest an agreement. For instance, when a person takes a car to a repair shop he expects the shop to exercise reasonable care and good faith in fixing the car and charging for repairs. Likewise, the shop expects the customer to pay for its services. Although no formal agreement is created, an implied contract exists.
In addition to express and implied contracts are "quasi-contracts," which arise from unique circumstances. Quasi-contracts are obligations imposed by law to avoid injustice. For instance, suppose that a man hires a woman to paint his house. By accident, she paints the wrong house. The owner of the house knows that she is painting it by mistake but, happy to have a free paint job, says nothing. The painter would likely be able to collect something from the homeowner because he knowingly was "unjustly enriched" at her expense. Had she painted his house while he was on vacation, he would be under no obligation to her.
Contracts may also be categorized as valid, unenforceable, voidable, and void. Valid contracts are simply those that meet all legal requirements. Unenforceable contracts are those that meet the basic requirements but fail to fulfill some other law. For instance, if a state has special requirements for contracts related to lending money, failure to comply could make the contract unenforceable. Voidable contracts occur when one or both parties have a legal right to cancel their obligations. A contract entered into under duress, for example, would be voidable at the request of the injured party. Void contracts are those that fail to meet basic criteria, and are therefore not contracts at all. An illegal contract, for example, is void.
A separate type of contract, and one which overtly exemplifies the trend away from strict interpretation and toward fairness, is created by promissory estoppel. Under the theory of promissory estoppel, a party can rely on a promise made by another party despite the nonexistence of a formal, or even implied, contract. Promissory estoppel can be evoked if allowing a promisor to claim freedom from liability because of a lack of consideration (or some other contractual element) would result in injustice. Suppose that a business owner promised an employee that he would eventually give her the business if she worked there until he (the owner) retired. Then, after 20 years of faithful service by the employee, the owner decides to give the business to his son-in-law. The owner could be "estopped" from claiming in court that a true contract did not exist, because the worker relied on the owner's promise.
"Business relationships are not a matter of trust. People change and circumstances change," attorney Charles Melville wrote in an article for Agency Sales Magazine. "Written agreements, negotiated up front, are really the practical and low cost answer. As people and circumstances change, the agreement should be reevaluated to make sure that it still reflects the intentions of the parties."
Contracts are a necessary part of all sorts of small business transactions—office and equipment leases, bank loan agreements, employment contracts, independent contractor agreements, supplier and customer contracts, agreements for professional services, and product warranties, to name a few. Even the process of writing a contract can be helpful, because it forces the parties to think through contingencies and decide in advance how to handle them.
Small business owners should be careful of the standard legal terminology that appears in some types of contracts. It is important to understand and agree with all aspects of a contract before signing it. "No matter how small the print is, it's still part of the contract," Martin A. Goldberg wrote in an article for Medical Economics. "Understand what you're signing, or don't sign it."
Barrett, E. Thorpe. Write Your Own Business Contracts. PSI Research, 1993.
Goldberg, Martin A. "Watch Out for Traps in That 'Standard' Contract." Medical Economics. August 17, 1992.
Melville, Charles. "It's Not a Matter of Trust…." Agency Sales Magazine. May 1995.
Metzger, Michael B., et al. Business Law and the Regulatory Environment: Concepts and Cases. Irwin, 1992.
Winn, Steven L. "All Contracts Are Not Created Equal." Business Credit. March 1995.