978-0078023866 Chapter 6 Lecture Note Part 1

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CHAPTER 6

Contracts

Chapter Goals

Chapter Six sets forth the basic requirements to have a valid contract and then proceeds to discuss the

interpretation and enforcement of contracts. It starts, however, by tying the importance of the law of

contracts to any capitalist free market system, both practically and philosophically. It is new to the text

with this edition.

Chapter Learning Objectives

1. Explain the importance of contracts to a capitalist free market system.

2. Determine whether the Uniform Commercial Code or common law governs a contract dispute.

3. Identify the elements of a legally enforceable contract.

4. Classify a contract as bilateral or unilateral; express or implied; executory or executed.

5. Distinguish between valid, unenforceable, void, and voidable contracts.

6. Describe the elements of a valid offer.

7. Describe the elements of a valid acceptance.

8. Explain the significance of consideration as an element of a legally enforceable contract.

9. Compare and contrast the rights and duties arising in contractual assignment and delegation.

10. Compare and contrast different types of third-party beneficiaries to a contract.

11. Explain how a contract may be discharged.

12. Describe the remedies available for breach of contract.

Chapter Outline

I. Preface: The Role of Contracts in a Complex Society

A capitalist, free-market system cannot operate effectively and fairly without a reliable foundation in

contract law. At the practical level, all buyers and sellers must be confidence that the deal they are about

to make will be completed as specified, or that they will have remedy available if it is not complicated.

Otherwise, the legal risk in making deals would act as a drag on the commercial process, reducing

certainty and depreciating the extraordinary efficiency of the free market. At the philosophical level, the

fundamental point of a contract is personal freedom. To a considerable extent, people define themselves

by the contractual choices they make, and contract law protects those choices.

Sharing Facebook?

This section reveals the indispensable role of contract law with reference to the remarkable Facebook

story. Mark Zuckerberg, Facebook CEO, developed the fabulously successful social network while still a

student at Harvard. In 2011, entrepreneur Paul Ceglia, for whom Zuckerberg apparently agreed to write

computer code while at Harvard, claimed that he and Zuckerberg entered into a contract in 2003 that

entitled Ceglia to a 50 percent share in the company. In 2012, Ceglia pleaded not guilty to federal charges

of mail and wire fraud for forging evidence in his lawsuit.

The twins, Cameron and Tyler Winklevoss, claim Zuckerberg stole their social networking idea.

Zuckerberg denied that accusation, but the parties reached a settlement of about $65 million in 2008. The

twins sued, however, to have the settlement overturned on the grounds that Facebook had not provided

accurate valuation information during the settlement process. A court of appeals panel in 2011 rejected

the twin’s request; the Winkelvoss twins later dropped their U.S. Supreme Court appeal of that decision.

Also in 2011, Boston software developer Wayne Chang sued the Winklevoss twins for breach of contract,

among other claims. Chang believes he is entitled to a share of the Winklevoss–Zuckerberg settlement

(currently valued at around $160 million).

For further information, students could refer to the following websites:

www.businessinsider.com/mark-zuckerbergs-facebook-contract-with-paul-ceglia

[http://www.businessweek.com

http://latimesblogs.latimes.com/technology/2011/05/boston-developer-wants-cut-of-winklevoss-twin

s-65-million-facebook-settlement.html

http://abcnews.go.com

http://www.businessinsider.com

Part One—Building a Binding Contract

I. Introduction

People make promises routinely in their lives. Under what circumstances do promises become

enforceable contracts? State laws and court decisions resulted, to some extent, in a confusing, inefficient

patchwork of laws that didn’t conform to the reality of complex, contemporary business practice. As a

result, the Uniform Commercial Code, a body of rules on commercial law across the United States, was

developed and then adopted by state legislatures.

The Uniform Commercial Code

The Uniform Commercial Code (UCC), is a body of rules designed to render commercial law

consistent across the 50 states. The UCC has been adopted in 49 states, and Louisiana has

adopted portions of it. The UCC is divided into a series of articles addressing the multitude of

potential issues that arise in complex commercial practice. Section 2-105 of the UCC defines goods

as tangible, movable, things. In determining whether the UCC applies, the courts have asked

whether the dominant purpose of the contract is to provide a service or to sell a good.

Characteristically, in determining whether the UCC applies, the courts have asked whether the

dominant purpose of the contract is to provide a service or to sell a good.

II. What is a Contract?

Legally enforceable contracts must exhibit all of the following features:

Agreement: A meeting of the minds of the parties based on an offer by one and an acceptance by

the other. The determination as to whether the parties have actually reached agreement is based

on the objective evidence as a “reasonable person” would interpret it rather than on an effort to

ascertain the subjective or personal intent of the parties.

Consideration: The bargained-for legal value that one party agrees to pay or provide to secure the

promise of another.

Capacity: The parties must have the legal ability to enter the contract; that is, they must be sane,

sober, and of legal age.

Genuineness of assent: The parties must knowingly agree to the same thing. Their minds must

meet as shown by the objective evidence. If that meeting does not occur because of, for example,

mistake or fraud, or the like, a contract does not exist because the parties’ assent was not real.

Legality of purpose: The object of the contract must not violate the law or public policy.

Contracts embracing these five features are enforceable by law; therefore, they are distinguishable from

unenforceable promises.

III. Classification of Contracts

Contracts fall into a series of sometimes overlapping categories.

A. Contract Formation

Bilateral and unilateral contracts: A bilateral contract emerges from a situation in which both parties

make promises. A unilateral contract ordinarily involves a situation in which one party makes a promise

and the other acts in response to that promise.

Express and implied contracts: When parties overtly and explicitly manifest their intention to enter

an agreement, either in writing or orally the result is an express contract. An implied-in-fact contract is

inferred on the basis of the facts—that is, by the behavior of the parties. The courts construct an

implied-in-law or quasi-contract when it is necessary to prevent unjust enrichment.

B. Contract Performance

Executory contracts: A contract labeled executory until all parties fully perform.

Executed contracts: When all parties have completed their performances, the contract is executed.

C. Contract Enforceability

Valid contracts: A valid contract meets all of the established legal requirements and thus is

enforceable in court.

Unenforceable contracts: An unenforceable contract meets the basic contractual requirements, but

remains faulty because it fails to fulfill some other legal rule.

Void contracts: A void contract is, in fact, no contract at all because a critical legal requirements is

missing; usually it is either an agreement to accomplish an illegal purpose.

Voidable contracts: A voidable contract is enforceable but can be canceled by one or more of the

parties. The most common voidable contracts are those entered by minors who have the option, under

the law, of either disaffirming or fulfilling most contracts.

Can I Change My Mind?

Australian Vin Thomas placed his 1946 World War II Wirraway plane for sale on eBay. The plane

reportedly is one of only five in the world still flying. Peter Smythe, also of Australia, matched the

$128,640 reserve price moments before the online auction ended in 2006. Thomas then declined to

convey the airplane to Smythe apparently because Thomas had already agreed to sell the plane to

another party for $85,800 more than Smythe’s bid. The case involved, among others, a pair of issues

frequently arising in contracts law disputes:

Did the facts (the eBay auction) create a contract?

Can Thomas change his mind about selling the plane to the highest bidder?

IV. The Agreement: Offer

Characteristically, an offer consists of a promise to do something or to refrain from doing something in the

future. A valid offer must include all of these elements:

Present intent to enter a contract.

Reasonably definiteness in terms of the offer.

Communication of the offer to the offeree.

Intent

Intent to enter a contract must be distinguished from preliminary negotiations. Of course, if no offer

exists, one cannot accept, and no contract can emerge absent further negotiation.

Gambling

In 2006, Troy Blackford, a Des Moines, Iowa, truck driver, won $9,387 gambling at Prairie Meadows

casino. Blackford tried to collect the winnings, but his request was denied by the casino. Officials

said that he had been banned from the casino since 1996, and the ban had not been lifted. (In the

1996 episode, Blackford had punched a slot machine and was belligerent with casino security.)

Blackford sued the casino.

Source: Blackford v. Prairie Meadows Racetrack & Casino, 778 N.W. 2d 184 (Ia. S. Ct. 2010).

Advertisements

Ordinarily, ads do not constitute offers but rather are treated by the courts as invitations to deal.

Were an ad actually treated as an offer, it would put the seller in the commercially impracticable

position of being required to provide the advertised product at the advertised price to everyone who

sought one, regardless of available supply. Presumably, that open-ended duty was not the seller’s

intent when issuing the ad. It follows then that the buyer, in responding to an ad, technically making

an offer, with the seller free to accept or decline.

On the other hand, courts have held that some ads do manifest a present intent to make an offer.

The critical terms in those ads must be highly specific and complete, leaving nothing open for

negotiation.

A Jet Fighter from Pepsi?

A 1995 Pepsico promotion offered merchandise in exchange for points earned by buying

Pepsi-Cola. The television ad showed a teenager modeling some of the available merchandise. A

Pepsi T-shirt was displayed for 75 points and a leather jacket for 1450 points. At the end of the ad,

a U.S. Marine Corps Harrier “jump jet” landed outside a school, and the boy said, “Sure beats the

bus.” The ad said the jet was redeemable for 7 million points. John D. R. Leonard, at the time a

21-year-old business student in Seattle, Washington, joined five investors in writing a check to

Pepsi for $700,008.50 and demanded the 7 million Pepsi points. Pepsi returned the check and said

it had no intention of giving Leonard the $24 million jet. Leonard sued.

Source: John D.R. Leonard v. Pepsico, 210 F.3d 88 (2d Cir. Ct. App. 2000).

Definiteness

One of the requirements of a binding offer is that all of its critical terms must be sufficiently clear

that a court can determine both the intentions of the parties and their duties. In a contract for the

sale of goods, UCC 2-204 relaxes the definiteness standard by providing that “one or more terms”

may be missing but the court can find a contract, nonetheless, where:

“The parties have intended to make a contract”

“There is a reasonably certain basis for giving an appropriate remedy.”

Under the UCC, the courts can actually fill in missing terms such as specifying a reasonable price

where the contract had omitted a stipulation.

Legal Briefcase: Vian v. Carey 1993 U.S. Dist. Lexis 5460 (U.S. Dist. Ct. S.D.N.Y. 1993)

Communication

An effective offer must be the product of a present intent, it must be definite, and it must be

communicated to the offeree. Communication of an offer expresses the offeror’s intent to make that

offer.

Duration of an Offer

Communication of an offer affords the offeree the opportunity to create a contract by accepting that

offer, but how long does that opportunity last? Here are some general rules:

The offeror may revoke the offer any time prior to acceptance. Normally, revocation is

effective on receipt by the offeree.

The offer may specify that it is open for an express period.

Where a time limit is not specified in the offer it will be presumed to be open for a reasonable

period.

An offer expires if rejected or on receipt a counteroffer.

Irrevocable Offers

Some kinds of offers may not be revoked. These include:

Option contracts: Where an offeror promises to keep an offer open for a specified period

and, in return, the offeree pays consideration (usually money), the parties have created an

option contract which is a separate agreement and is enforceable by its terms.

Firm offers: Under the UCC, if the merchant has made a written, signed offer to sell a good,

indicating that the offer would remain open for a specific time period, the merchant is bound

to that promise whether the buyer paid consideration for it or not. That situation is labeled a

firm offer as specified in UCC 2-205, which also provides that such offers will be kept open

for a reasonable period if the agreement does not mention a time, but that period cannot

exceed three months,

Offers for unilateral contracts: A problem sometimes arises when the offeror attempts to

revoke a unilateral offer after the offeree has begun to perform.

V. The Agreement: Acceptance

The general rule is that an effective acceptance must be a mirror image of the offer, that is, ordinarily its

terms must be the same as those in the offer. If the offeree attempts to change the terms of the offer and

in so doing has issued a counteroffer, they would in turn extinguish the original offer.

Communication of Acceptance

An offer may be accepted only by the offeree—that is, the person to whom the offer was

directed.Because unilateral offers are accepted by performance, no communication of acceptance

beyond that performance ordinarily is necessary. In the case of a bilateral contract (a promise for a

promise), acceptance is not effective until communicated. Acceptance can be accomplished by a

“yes” communicated face-to-face, by a nod of the head or some other appropriate signal, by phone,

or by other unwritten means, unless the law of the state requires writing in that particular kind of

transaction.

Mailbox

Acceptance is effective upon dispatch by whatever mode of communication has been explicitly or

implicitly authorized by the offeror. This well-settled position is labeled the mailbox rule and means,

among other things, that an acceptance is effective when sent even if never received. [For one

professor’s review of the mailbox rule and related rules, see

http://www.tomwbell.com/teaching/KMailbox.pdf]

Authorization

The offeror controls the acceptance process and may specify an exclusive manner in which an

acceptance must be communicated. If so, a contract is not created if the acceptance is

communicated in anything other than the stipulated fashion. Traditionally, if the offeror did not give

an express authorization to a means of communication,, an acceptance by the same or faster

means than that used by the offeror was implied. Implied authorization might also arise from such

factors as prior dealings between the parties and custom in their industry.

Modern View

Under the UCC, if no specific instructions for acceptance are included in the offer, the offeree is

free to accept in any reasonable manner within a reasonable period, and acceptance is effective on

upon dispatch. Even when the means chosen are “unreasonable,” acceptance is effective on

dispatch if it is actually received in a timely manner.

VI. Consideration

Consideration is used by the courts to distinguish a contract (enforceable) from a gratuitous promise

(unenforceable). The promisee must suffer a legal detriment; that is, the promisee must give up

something of value (an act or a promise) or must refrain from doing something that she or he has a legal

right to do in order to enforce the promise offered by the promisor. Each party, then, must pay a “price” for

a contract to be enforceable. In sum, consideration consists of a detriment to the promisee that is

bargained for by the promisor.

Legal Briefcase: Hamer v. Sidway 27 N.E. 256 (N.Y. 1891)

For a detailed analysis of Hamer v. Sidway, see http://www.law.smu.edu/firstday/contracts/case.htm

Adequacy of Consideration

With certain exceptions, the courts do not, as Judge Parker indicated in the Hamer case, inquire

into the economic value of the consideration in question. Legal sufficiency depends not on the

value of the consideration but on whether the promisee suffered a detriment in some way. To hold

otherwise would put the courts in the place of the market in deciding the value of transactions.

People are free to make both good and bad bargains.

On the other hand, the courts will rule that consideration is found wanting in situations of pretense

or sham where the parties have clearly agreed on token or nominal consideration in an effort to

present the transaction as a contract rather than a gift. Likewise, an extreme inadequacy of

consideration will sometimes cause the court to question a contract on the grounds of fraud, duress

or unconscionability. These cases are uncommon, however, and the courts rarely inquire into the

adequacy of consideration.

Appearance of Consideration

Some agreements appear to be accompanied by consideration, but in fact, that appearance turns

out to be an illusion. Hence, if one agrees to perform a preexisting duty, consideration would be

found wanting. Performance of a preexisting legal duty does not constitute consideration because

no legal detriment or benefit has arisen. Similarly, preexisting duties sometimes arise from

contracts.

Substitutes for Consideration

When necessary to achieve justice, the courts sometimes conclude that a contract exists even

though consideration is clearly lacking. The most prominent of these substitutes for consideration is

the doctrine of promissory estoppel, in which the promisor is “stopped” from denying the existence

of a contract where the promisee has detrimentally relied on that promise. Promissory estoppel

requires the following:

A promise on which the promisor should expect the promisee to rely

The promisee did justifiably rely on the promise

Injustice can be avoided by enforcing the promise

VII. Capacity

To enter a binding agreement, one must have the legal ability to do so; that is, one’s mental condition and

maturity must be such that the agreement was entered with understanding and in recognition of one’s

own interests. The three primary areas of concern are intoxication, mental impairment, and minority

(infancy/youthfulness), with minority being much the more common area of dispute.

Intoxication

Whether a court will nullify a contract on the grounds of intoxication depends on whether the person

was sufficiently intoxicated to not understand the nature and purpose of the contract. If the

objective evidence suggests that the person did not understand the transaction, the contract would

be considered voidable and could be disaffirmed by the person.

Mental Incompetence

In most cases an agreement involving a mentally incompetent person is either void or voidable.

The transaction would be void—that is, no contract would exist—where the impaired party had

been adjudged insane. If the impaired party was unable to understand the purpose and effect of the

contract but had not been legally adjudged insane, the contract would be voidable (void in some

states) at the option of the impaired party.

Minority

Minors may complete their contracts if they wish, but they also have an absolute right to rescind

most of those contracts. They may rescind until they reach adulthood and for a reasonable time

thereafter. (Many states have enacted statutes forbidding minors from disaffirming some classes of

contracts, such as those for marriage, student loans, and life insurance). The minor has a right of

recovery for everything given up in meeting the terms of the contract. Similarly, the minor must

return everything that remains in her or his possession that was received from the contract. In

many states, if nothing of the bargained-for consideration remains or if its value has been

depreciated the minor has no duty to replace it but can still recover whatever she or he put into the

contract. The minor is also liable for the reasonable value (not necessarily the contract price) of

necessaries purchased from an adult. That is, a minor must pay the adult the reasonable value of

contracted-for items such as food, clothing, shelter, medical care, basic education, and tools of the

minor’s trade.

Despite the flexibility accorded to minors entering contracts, the adults who are parties to those

contracts are bound to them and do not have the power to disaffirm. Hence, adults put themselves

at risk when they choose to bargain with minors.

Legal Briefcase: Dodson v. Shrader 824 S.W.2d 545 (Tenn. S. Ct. 1992)

VIII. Genuineness of Assent

Sometimes parties appear to have concluded a binding contract, but the courts will allow

them to escape that obligation because they had not, in fact, achieved an agreement. The

situation arises when the contract is the product of misrepresentation, fraud, duress, undue influence, or

mistake. Such agreements are voidable and may be rescinded by the innocent party because of the

absence of genuine assent.

Misrepresentation and Fraud

An innocent untruth is a misrepresentation. Intentional untruths constitute fraud. In either case, a

party to a contract who has been deceived may rescind the deal, and restitution may be secured if

benefits were extended to the party issuing the untruth. The test for fraud is as follows:

Misrepresentation of a material fact

The misrepresentation was intentional

The injured party justifiably relied on the misrepresentation

Injury resulted

In general, misrepresented opinions are not grounds for action, but many courts are now

recognizing exceptions to that rule, especially when the innocent party has relied on opinion

coming from an expert.

Legal Briefcase: Stambovsky v. Ackley 169 A.D.2d 254 (S.Ct. N.Y., App. Div., 1st Dept. 1991)

Toy Yoda

Manager in the Florida Hooters told the waitresses that the server selling the most beer would be

entered in a drawing (involving other Hooters locations) with the winner receiving a new Toyota. At

the end of the contest, the winner did not get the car she expected, but a doll based on the

character Yoda in the Star Wars movie.

Duress

Sometimes genuine assent is not secured and a contract may be rescinded because one of the

parties is forced to agree. Fear lies at the heart of a duress claim. The party seeking to escape the

contract must establish that a wrongful act was threatened or had occurred, causing the party to

enter the contract out of fear of harm such that free will was precluded. Increasingly, courts are also

setting aside contracts on the grounds of economic duress.

Undue Influence

Under some circumstances, the first party to an apparent contract can escape its terms by

demonstrating that the second party so dominated her/his will that she/he (the first party) did not

act independently.

Mistake

In some cases mistakes involving critical facts can be grounds for rescinding contracts. A mutual

mistake is one in which both parties to the contract are in error about some critical fact. With

exceptions, either party can rescind those contracts because genuine assent was not achieved.

However, in unilateral mistakes, that is only one party to the contract makes an error, the general

rule is that those contracts cannot be rescisnded. In cases where an error is made in drafting a

contract, and both parties are unaware of the error (a mutual mistake), the court will reform the

contract rather than void it. That is, the contract will be rewritten to reflect what the parties actually

intended.

$4,934 Discount on Alitalia?

The Italian national airline, Alitalia, was charging more than $5,000 for trans-Atlantic, round-trip,

business class airfares in 2006, but by mistake a fare was briefly listed online at $66.00. About the

same time, Marriott was offering rooms at a New York City hotel for $24.90 when the intended price

was $249.00. Alitalia honored 509 reservations at an expected cost of about $2.6 million. Marriott,

however, raised the $24.90 rate to the intended $249.00. Errors of this kind happen with some

frequency in the travel industry.

Source: Scott McCartney, “When a Fare Is Too Good to Be True,” The Wall Street Journal, April

25, 2006, p. D5.

IX. Legality of Purpose

Illegality refers to bargains to commit a crime or a tort (such as a deal with a coworker to embezzle

funds from one’s employer); but more broadly, illegality involves bargains that are forbidden by

statute or violate public policy. Three general categories of illegal agreements: (1) contracts that

violate statutes, (2) contracts that are unconscionable, and (3) contracts that violate public policy. In

general, the effect of an illegal contract is that it cannot be enforced, and the courts will not provide

a remedy if its terms are unfulfilled.

Contracts Violating Statutes

A contracts to commit a crime or a tort is illegal and unenforceable. The states have also

specified certain other agreements that are illegal. Those provisions vary from state to state, but

they commonly include antigambling laws, laws forbidding the conduct of certain kinds of

business on Sundays (blue laws), laws forbidding usury, and laws forbidding the practice of

certain professions (law, real estate, hair care) without a license.

Modern Family Contract Feud

On July 24, 2012, cast members of the popular and Emmy Award–winning television comedy

Modern Family filed a breach of contract lawsuit against producer 20th Century Fox, seeking to

have their current contracts declared null and void under California law prohibiting enforcement

of a personal service contract after seven years. Shortly after the lawsuit was filed, Fox agreed

to enter into new agreements with the cast members, who then dropped the lawsuit.

Unconscionable Contracts

Certain agreements are so thoroughly one-sided that fairness precludes enforcing them.

Problems of unconscionability often arise in situations in which the bargaining power of one of

the parties is much superior to the other—where one can, in effect, “twist the arm” or otherwise

take advantage of the other. Both the common law of contracts and UCC 2-302 give the courts

the power to modify or refuse to enforce such deals.