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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.
