Understanding the Basics of a Contract

What is a Contract?

When two or more individuals or groups agree to have an exchange of promises, a contract has been entered into. Though most people are familiar with a contract agreement between commercial entities, like an employment or a sales contract, you have technically entered into a contract when you agree to help your friend move his personal belongings in exchange for pizza and beer. A contractual agreement can be made between a plumber offering free plumbing services in exchange for free package shipping by a freight company. As long as the parties agree to the exchange being made, a contract exists.

A contract is a legally binding, enforceable agreement between two or more parties through which one party offers a value (either in service or through a good) in exchange for the other party's value (which could be in the form of compensation). These values can include a commitment to perform or to forbear, not perform, an act, or to enter into, or to maintain a relationship. For the contract to be enforceable, there has to be a meeting of the minds between the participants; all parties bound by the contract must fully understand and be competent to enter the agreement.

Contracts may be written, oral, or implied by a person's behavior. A written contract is one in which the parties sign an agreement that specifies the terms, conditions, payment, and other provisions that bind the parties together. This is the most easily enforceable contract situation. An oral contract occurs when both parties can be shown to verbally agree on a few fundamental aspects of an exchange of values. The oral contract is difficult to enforce due to the lack of evidence needed to prove wrongdoing or non-performance. An implied contract is an unwritten agreement based on the behavior of one or both parties relative to an exchange. Again, because of a lack of proof, implied contracts are difficult to enforce; although a history of behavior towards fulfilling a contract can show intent to complete the agreement. Some states require written contracts where completion or conditions extend for longer than one year, such as a real estate transaction or commercial construction projects.

The essence of a contract lies in the reciprocal or mutual obligations that each party agrees to when entering the contract. As the old saying goes, "One hand washes the other." Each participant is required, after accepting the agreement, to fulfill its requirements within the terms of the contract. In the U.S., laws mandate that these obligations fundamentally bind the contractors together. There are mechanisms available which can dissolve the agreement once the contract is accepted; however, the parties must complete their commitments or face a potential lawsuit from the party that suffers due to the unfulfilled contract.

The agreement is comprised of two major concepts: offer and acceptance. The offering entity (offeror) extends a promise, and then when the receiving party (offeree) accepts the terms of the agreement, the parties are said to be under contract. The offer is a consideration by the offeror to perform, or not perform, an activity, while the acceptance by the offeree is made by expressing his assent to the contract (typically through signature for written contracts). Simply discussing the offer does not constitute a contract; there must be firm acceptance in order for the contract to be valid.

What factors make a contract valid? A valid contract is one which can show a meeting of the minds and assent by both parties, and establishes an exchange of value. These standards exist for all contractual relationships. For example, if you are shopping for home furnishings and choose to purchase a piece that is out of stock, if the shopkeeper offers to order the item and you instruct him to do so, you have entered into a valid contract. Even if no documentation exists, you are technically obliged to purchase the item when it is delivered. Terms can be challenged, especially if they are proven to be illegal, unethical, or impossible to perform; however, the validity of the contract still stands if the two conditions (assent and value exchange) can be shown.

Contract Types

There are several types of contracts recognized by U.S. law. Valid contracts are generally structured as a combination of express or implied and unilateral or bilateral. The elements of each type breakdown as follows:

Express.

The specifics are stated, either in writing or orally. Both parties agree to the terms and conditions expressed within the agreement. The offer and acceptance requirements are understood by both parties. These contracts are the most easily enforceable because the meeting of the minds is more clearly defined. Express contracts come in three varieties:

By parol. Distinguished as an agreement, not sanctioned by an official seal (such as a notary), that comes between two or more distinct entities capable of entering into the contract without performing activities that violate common laws, public policy, or human morality.

By specialty (under seal). Here the distinguishing characteristics are the seal placed by the offeror embossed onto the original document, and the fact that no consideration is given by the offeree. In other words, it is a contract that is validated by the appearance of the seal. A property deed or an investment bond is an example of this type.

Of record. This contract is distinguished by the offeror. The agreement is entered into by a public authority, such as a mayor or hospital, which offers a right or responsibility to the offeree(s). It may or may not require direct reciprocal action. Judgments, diplomas, and proclamations are a few examples that are created.

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Implied.

The contract exists based on circumstances, rather than being specified in writing. Certain actions are presumed by U.S. courts to require reciprocal action, for instance, seeing a doctor and being required to pay following the visit. In these cases, one party accepts an offer (such as a new TV) knowing that reciprocation (such as payment) is expected. An implied contract has the same enforceability as express contracts, yet may be more difficult to recover damages if one party is injured or suffers loss. There are two forms of implied contracts:

Implied-in-fact. The parties indicate agreement by their actions, sometimes through a pattern of behavior, and each has the opportunity to remove his- or herself from the contract. Based on a tacit agreement, contract laws recognize that the offer is assumed to be accepted by all those bound by the activity. For example, buying a soda without discussing the purchase with the convenience store clerk infers that both parties understand the exchange without explicit expression. In order to obtain the soda, the purchaser (the offeree) pays the clerk (the offeror) the price posted on the sign. The offeree cannot return and demand a refund after finishing the soda claiming he did not understand, because he accepted the offer thus creating the contract. Though the offer does not have to be clearly defined, an injured party must prove that a reasonable person would not understand the terms of the purchase agreement.

Implied-by-law. The contract is formed because of legal intervention to prevent injustice to a party. Sometimes called a quasi contract, the actions involved may not be agreed to by both parties, but, by not enforcing the implied contract, one party would suffer unreasonably. This form is based on equitable relief, which means both parties should gain equally upon completion of the contract. For example, if a landscaper mowed the lawn of the wrong house while the homeowner sat on the front porch watching and then refused to pay when asked, the landscaper has a defensible position because the law protects him from suffering financially while the homeowner gains.

Unilateral.

A one-sided contract whereby the offeror makes a promise to perform only if the offeree performs the offeror's request. The offeror is the only party making an express consideration; the offeree is not required to reciprocate. An example would be if you offered a relative $500 to quit smoking. If your relative stops smoking you must make the payment, if not, you have no obligation to pay. Many insurance contracts are unilateral, in that the company promises to pay if the insured suffers loss. Competitions and contests also provide unilateral agreements, if you win there is a reward upon completion.

Bilateral.

A mutual agreement whereby parties make promises to each other to perform in the future. Each party is obligated once acceptance is made, and each acts as both the offeror (sometimes called the promisor) and offeree (sometimes called the promisee). This arrangement is what most people understand as a contract. Real estate contracts are prime examples of bilateral agreements. The Buyer promises to pay Seller the agreed-to amount if the property passes inspection and the funds are obtained. There are three categories of this type:

Negotiated contract. A result of bargaining the terms of an agreement. Though rare, these occur during expensive real estate purchases, collective bargaining agreements with labor unions, and corporate acquisitions or mergers.

Contract of Adhesion. The agreement is submitted by the offeror to the offeree on a take it or leave it basis. There is no bargaining, yet if some terms are unfair or unethical, a court may remove the unfair conditions. Most consumer purchases are contracts of adhesion, if you agree to pay for the item, you must accept all the conditions that go with it.

Third-party beneficiary contracts. Though considerations are made by the signatory parties to the contract, another entity receives the benefits of the performance. A clear example is a life insurance contract whereby the policy holder accepts the offer from the insurer to pay the beneficiary in the event of the policy holder's death. The third party can sue the offeror (the insurance company in our example) for nonperformance or breach of contract.

Every day we enter into contracts, even when performing the simplest tasks. Though most contracts are enforceable at some level, many times unfulfilled contracts get dismissed. Busy schedules and a lack of significant damages lead many people to simply abandon challenging a party who has not performed.

Contract Elements and U.S. Law

Elements of a Contract

As you know, a valid contract needs only evidence of voluntary agreement, assent from all parties, and an exchange of value between parties to be considered enforceable. However, there can be several elements, features, and concepts of a contract that can be challenged by either party. Though the fundamentals of a contract's makeup are widely accepted as legally understood, more complex agreements contain specifics that can be challenged and constitute the bulk of disputes between contracted parties. At times, issues of contention between parties develop out of a misunderstanding about what entering a contract means. Let's examine the typical elements that are included in nearly every contract:

Parties. Those who have the legal right and capacity to act on their own behalf or on behalf of others are called signatories. There can be an unlimited number of signatory parties to a contract, but each party is responsible for abiding by all of the stated or implied terms and conditions that are contained within the agreement. Third parties (non-signatory) can also be involved, as in the case of a life insurance beneficiary, but their only legal recourse is to recover a benefit bestowed because of the agreement between the original parties; a third party cannot sue a signatory party over the terms within the contract. Non-signatory parties must show that they are intended to be included by one of the signatories, as opposed to a party that benefits because of an incidental relationship with one of the original parties.
Offer. For an offer to be legally binding, it must be made clearly to the offeree. The offer must show the expression of the offeror's willingness to perform. This can be done through writing, orally, or through behavior that would lead a reasonable person to understand what was being offered, how it was being offered, and when the offer was to be performed. Intention is a critical point that, if not clearly defined, can be challenged. An offering party must show that he intends to complete the offer in order for the offer to be valid. If an offeror promises to contribute $50 towards the purchase of lottery tickets for an office pool but does not immediately pay, and another worker covers her share, she could still likely be required to contribute her money if the covering worker demands the money, because the offeror showed intent to perform by promising to contribute the money. Another issue where intent must be proven is an invitation to treat, that is, a preliminary willingness to negotiate a contract that is not considered an official offer.
Acceptance. Acceptance is evidenced by a promise to the offeror by the offeree to provide reciprocal action to the offer as it exists. This can be done through written or verbal communication but, by law, must clearly communicate assent in order for the contract to be enforceable. Any change or modification to the original offer is considered a counteroffer, not an acceptance. Although acceptance can be implied through actions or behavior, the test of validity requires that a reasonable person would determine that the offeree accepted the offer.
Privity. Privity legally means the close, mutual, or successive relationship to the same rights over the promises made within the contract. Each party has the power to enforce the promises, and only parties with privity can be compensated in the event of wrongdoing, nonperformance, or breach. Horizontal privity occurs when the benefits from a contract are bestowed upon a third party. Vertical privity arises from a contract between two parties whereby an independent contract between one of the signatories and another entity is in place and can affect the original contract.
Terms. Contracts can be designed to cover a variety of unique situations, and each agreement is judged on its own merits. However, there are several standard terms that are used on a boilerplate contract form that many business agreements are based on. Generally called clauses, these obligations must be adhered to even if one or more parties have not read the entire contract. They include:
Limitations, Restrictions, and Exclusions. Reduces the rights, obligations, liabilities, and duties of either party during the course of fulfilling the contract.
Claims and Representations. A statement of fact about offerings or conditions to which the parties are agreeing.
Default. Defines the conditions and timing of actions which could place either party in default and subject to litigation.
Warranties. Explains that one or more parties are obligated to perform to a specific standard that, if not reached, allows the damaged party to recover remedies.
Disclaimers. An acknowledgement that a party is not responsible for certain obligations, outcomes, or situations arising from the performance of the contract.
Severability. Points out that, in the event one clause is found to be invalid, the entire contract remains in force.
Dispute Resolution. Determines how conflicts will be settled in the event one party disputes the completion of the contract, or the terms within it, or suffers injury or loss.
Liquidated Damages. Describes how a loss due to nonperformance or breach will be remedied.
Entire Agreement. Explains that the contract is made up of all the terms and conditions explained within the agreement, and each party must abide by its provisions.
Forum Selection. Describes where disputes shall be decided upon.
Waivers. Explains under what circumstances a party gives up its rights.

Consideration. The value a party commits to offering in exchange for another party's value. Consideration can be in the form of compensation, tangible property, or reciprocal behavior. Simply abiding by a legal or contractual standard doesn't constitute consideration; the value has to be made voluntarily and with effort. In the United States., the standard to be met is that the consideration must be sufficient not adequate. In other words, offering a consideration that has very little value (such as a bubble gum wrapper) is still a valid offer if it meets the criteria demanded by the offeror. The consideration is the aspect of a contract that is most often bargained for between parties.
Time of Performance. The stated dates during which the contract is to be completed. Typically includes date of entry and date of completion, and may include progress dates that are times when the completion has reached certain points. The term time is of the essence is often used to indicate that the parties agree to perform the actions as quickly as possible.
Exhibits or Attachments. Many business contracts include descriptions, drawings, appendices, and other additional data pertinent to the offer. For instance, a lawnmower manufacturing agreement will have scale drawings, measurement specifications, and assembly instructions when defining the product to be constructed. Exhibits can also describe physical conditions, historical data, or performance standards that relate to the contract. Attachments explain in more detail the expectations, so that each party clearly understands the outcome of the contract.

Contracts and U.S. Law

In the United States, contracts are generally governed by the state in which the agreement is made. In cases where one or more parties are based in a different state, the contract is enforced by the courts in the state where the parties had the meeting of the minds. Contract enforcement falls under one of two U.S. legal standards: common law or the Uniform Commercial Code (UCC).

Common Law. Examples include business agreements, service agreements, real estate transactions, and employment contracts. The majority of contracts are enforced under this category. Common law is based on traditional court actions issued typically by judges, rather than legislative statutes or executive regulations. Issues are resolved according to precedent decisions, unless there is no previous case, whereby a judge has the right to determine the appropriate course of action. In first time cases, the judge will issue a matter of first impression which will therefore become the precedent upon which to base future cases. Precedent decisions have the same legal weight as statutes enacted by governments, though verdicts may change from time to time. Different jurisdictions may have different outcomes, so before entering into a complicated agreement, experts advise contractors to review the laws governing the agreement site regarding contract enforcement.
Uniform Commercial Code. Contracts involving transactions (sale or lease) of moveable goods or financial instruments are governed by these legal standards. These contracts involve a buyer and a seller. Each state enforces contracts under this uniform act that was introduced by a national panel of law professionals in 1952 and enacted by state legislatures in all 50 states. The need to develop a cohesive set of rules for these types of contracts arose because of the ease of transfer of such items across state lines. Federal and state statutes supersede or overrule the UCC in the event a transaction or activity violates those laws. Merchants, consumers, financing agencies, shipping companies, and other commercial entities must abide by the UCC.

Contract disputes are judged under a jurisdiction, a realm of legal authority. This legal authority is bestowed upon an individual or group that has the power to create, modify, alter, pronounce, or administer justice upon others. Congress, federal and state courts, and the President of the United States are all granted judicial jurisdiction within their area of responsibility. In the U.S., there are three types of judicial jurisdiction: personal, territory, and subject matter.

Personal Jurisdiction. Authority over a person or being, no matter the location.
Territory Jurisdiction. Authority over all parties and events present within a boundary, such as a state.
Subject Matter Jurisdiction. Authority over a particular subject matter, particularly the legal consequences involved in an activity, regardless of location.

Because of the flexibility in the design of a contract, the multitude of potential offers, and the separate, yet collective, interests of parties to a contract, disputes can arise over a variety of issues. Unmet expectations, delays, postponement and cancellations of delivery, and non-specific terminology can all lead to misunderstanding and disagreement. When a dispute arises under U.S. law, where do the parties turn to in order to settle the disagreement? Parties who enter into a contract typically desire a positive outcome that benefits all involved. But when a contract is contested, an enforcement process takes place.