Forming a Contract

In order to adequately understand how a contract is formed, defining what a contract is will be helpful. There are many definitions of a contract but a simple definition sufficient for this chapter is an enforceable agreement reflecting terms of an exchange of value. Thus, a contract is formed when there is (1) an agreement; (2) for exchange of value; and (3) sufficient terms. It is important to note that a contract doesn’t have to be in writing to be enforceable. That said, getting terms in writing is vital to the success of a transaction, and getting the terms in sufficient detail will often save a lot of time and money that would otherwise later be spent in confusion, damaged relationships, and/or litigation. Like a good fence can make good neighbors, a good contract can make or preserve good business relationships. The more clearly the parties can anticipate and define obligations, the less time and money that will be wasted in litigation (and the more time that can be spent making money).

Exchange of Value.
The exchange of value in a contract is most often referred to as consideration. An agreement is not enforceable without consideration. In other words, one party is not obligated to give another something if they did not give some value in return. Whether the exchange is a fair exchange is not usually the concern of the courts, unless the disparity in the value exchanged is outrageous or unconscionable, and usually only when the disparity is perceived to be a result of one party’s limited bargaining power or sophistication. Beyond a minimal level, however, courts will not be concerned about whether it was a fair deal.

The existence of consideration, not the amount, is the focus. Thus, it is important to set forth the consideration in the contract– or at least that there was consideration. For example, it isn’t uncommon to see in a deed conveying real property a statement that the property is conveyed for “ten dollars and other valuable consideration.” This doesn’t mean that the property was actually sold for ten dollars but rather, it is just an indication that there was consideration without going into the specifics. In fact, in the not so distant past, a peppercorn was commonly used to signify consideration.2 At any rate, courts typically hold that the inadequacy of consideration is not, by itself, a bar to enforcement of a contract.

Practical Tip: In drafting a contract, always set forth the consideration of both parties or recite that adequate consideration was exchanged:

“WHEREFORE, in consideration of the mutual covenants and agreements set forth below, and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the Parties agree as follows: . . .”

Consideration can come in many forms, including cash, credit, services, a promise to do something, and even a promise not to do something (often referred to as forbearance). Without consideration exchanged by both parties, there is no enforceable contract.3

A promise to give a gift is not usually enforceable because gifts are, by definition, generally given without consideration. For example, if a woman promises to give her mother $1 million if she wins the lottery (without receiving anything in return) and then happens to win the lottery, that promise is not enforceable because there was no consideration. The mother’s attorney might argue that her tireless service and nurturing is more than adequate consideration, but the daughter’s attorney might respond that the mother would have given that service (and in fact had already provided that service) with or without the promise of the lottery winnings. If the mother could argue that she did add additional services in exchange for and in reliance on her daughter’s promise (thereby adding consideration), the mother would have a better case. Without that additional service, however, the daughter’s only obligation to pay lottery winnings to her mother is a moral one.

Sufficient Terms.
An enforceable contract also needs terms. If a contract doesn’t have enough detail, it cannot be enforced. For example if there was an agreement to sell 10,000 widgets by Friday, but the parties had never settled on a price, a court would have a hard time enforcing that agreement, even if it was clear that both parties agreed to it. It may seem like a silly example, but it has real-world application. If the two parties have had a long-standing relationship in which widgets were bought and sold, and the seller was confident that the price was understood or that it would be agreed upon (because, for example, they had done so in the past), the seller may start production of the widgets. What if in the meantime, however, the price of the raw resources necessary to build your widgets increased suddenly? Could the seller pass the increased costs along to the buyer in the form of a higher price? Conversely, what if the price of the resource dropped? Would the buyer expect a discount? Courts would have a hard time enforcing that agreement.

That said, faced with a contract lacking some terms, a court will try to fill in the gaps left by the parties with terms that are reasonable in the industry or based upon the parties’ past relationship. In our example above, if the parties had consistently used the same price and had ignored the cost fluctuations, then a court might feel comfortable inserting a similar set price if one was not specifically agreed to by the parties. Where sufficient evidence is available, courts will try to use terms that can be inferred from the parties’ actions. Courts will work to identify the parties’ intentions and what they reasonably understood to be the terms of the agreement.3 However, courts are not comfortable doing this and will, at some point, decide that the contract is not sufficiently formed to be enforceable.

Another example of a missing term might be terms of delivery or payment. Is payment due immediately? Upon invoice? 30 days after invoice? or in installment payments? Failure to agree on terms of payment would not, in itself, defeat an otherwise valid agreement. The Uniform Commercial Code (the “UCC”)5 holds that even if one or more terms are left open, the contract does not fail for indefiniteness if the parties have intended to make a contract and there is a reasonably certain basis for giving an appropriate remedy. In other words, the more that terms are left open, the less likely the court will decide that the parties intended to have a binding agreement.6

An enforceable contract must contain sufficiently definite terms and conditions regarding the essential terms of the contract. Courts do not require all of the terms of the contract to be set forth in the agreement, but the major aspects must be addressed. When only incidental details are left out, the contract may still be enforced.7 For example, in a lease agreement, the essential elements include: the identity of the property, the agreed duration, and the rental amount.8 Contracts that are found to be too indefinite will be unenforceable. A contract is too indefinite if its terms are so incomplete or uncertain that it is clear that the parties did not regard themselves as having completed the contract.9

Disputes often arise because an agreement was not reached in sufficient detail. Often parties agree on central terms, but don’t always discuss, much less agree on the details. If sufficient terms are not reached, the court may determine that a legal and binding agreement was never reached. There must be, as it is often put, a meeting of the minds. Courts have refined that standard to simply require enough evidence that the parties did agree.

There can, of course, be an agreement on some terms but not on others. Whether there was agreement on a sufficient number of terms is the question at the heart of whether a contract has been formed. And, whether a contract has been formed is the threshold question for any attempt to enforce a contract. Whether a contract is enforceable simply refers to whether the court will force the other party to perform the contract, or, more likely, pay damages for its failure to perform the contract.

Courts are much more willing to order a party to pay damages than force it to perform the contract (which is called “specific performance”).10 Specific performance, which is when the court requires the party to perform the contractual obligations that it originally agreed (and then later failed) to perform, is not seen by the courts as an effective and efficient remedy for at least two reasons: (1) the courts do not want to be in the business of monitoring and assessing job performance and completion (nor does it have the physical resources to do so); and (2) it may not be practical to force a party to do something that it was unable or unwilling to do (causing the breach of the contract in the first place). The exception to the doctrine favoring money damages over specific performance is when money damages will not adequately compensate the party. A contract for the sale of real property is one such instance in which the courts often recognize that some parcels of real property are unique and that no remedy other than the conveyance of that real property is adequate. Otherwise, courts are much more inclined to award money damages because getting paid is generally thought of as the ultimate business objective.

Agreement.
At the risk of stating the obvious, there must be an agreement before a contract is formed (and is enforceable). An agreement can be reached in writing (like a signed written contract, or an invoice, or even an email exchange), in conversation, in actions or even in acquiescence.

Thus, one must be careful about what is said and done and not just about what is written. While it is certainly easier to enforce a written contract, there are many cases in which a court has enforced a contract that was not in writing. For example, in Murray v. State,11 the Court enforced a settlement despite the fact that there was neither a written agreement nor the parties’ signatures. In Martin v. Scholl,12 the Court held that an oral agreement to convey land was enforceable because one party had already partially performed—where the party had changed its position, relying in good faith on the existence of the agreement.

There are even instances in which a party’s actions or spoken words have superseded written terms. Such surprises can usually be avoided by specifically prohibiting oral terms and amendments in the contract. These provisions are often referred to as integration clauses.

Practical Tip: When drafting a contract, you can avoid surprise terms and amendments by including specific prohibitions of the same in the contract.

This Agreement supersedes all prior agreements, understandings, and representations between the Parties with regard to the subject matter hereof and there are no other understandings or agreements between them except as expressly stated herein. This Agreement shall not be modified or amended unless such is in writing and executed by the Parties.

While it seems like a simple analysis to determine whether an agreement has been reached, that is not always the case. Sometimes, there can be a significant dispute as to whether an agreement was reached at all or whether there was an agreement on sufficient detail to constitute a contract (and to be enforceable by the courts).

Just because terms have been negotiated in writing, it isn’t necessarily an agreement, and therefore is not enforceable. Letters of Intent (sometimes referred to as an “LOI”) can be such a document. A Letter of Intent can be a useful document that facilitates discussion of

major terms without getting mired down in the details. Often, parties will memorialize the major terms and leave the details and the actual language of a contract for their attorneys to draft. That being said, LOIs can be a trap for the unwary. The parties to a LOI must be clear as to whether the LOI is binding or whether it is just used for discussion. It is even possible to establish that some sections/terms of the LOI that are binding and some that are not. Regardless, it is crucial to clearly define whether the LOI or other term sheet that is negotiated is intended to be binding or not.

Practical Tip: Whenever negotiating and drafting a Letter of Intent (or similar document reflecting agreed upon terms), be clear as to whether it is binding, non-binding or which section is binding and which section is not:

Except where specifically noted otherwise, this is a non- binding letter of intent and does not constitute a binding agreement. Purchaser and Seller shall use diligent efforts to enter into the Agreement within thirty (30) days of execution hereof. If the Agreement is not executed by said date, this letter of intent shall be null and void.

 

#. Binding Effect. This letter agreement is not intended to be a binding agreement between the Parties hereto but only as an expression of their mutual intent and understanding, except for Sections [for example, confidentiality, non-competition,

exclusivity] and this Section, which Sections shall be

binding upon and inure to the benefit of the Parties hereto and their respective successors and permitted assigns.

A topic should be covered that is just outside of traditional contract formation. It is the concept of a “quasi-contract.” Sometimes these can be referred to as “unjust enrichment” or “quantum meruit” claims. The theory behind quasi contract is that the courts will treat a transaction as though it were an enforceable contract even though a contract has not been technically formed. These are contracts that are implied in-fact or implied in-law. Without going into too much detail, a court will order a party to pay damages if (1) a benefit was conferred on it, (2) it was aware of the benefit, and (3) it retained the benefit under circumstances in which it would be unjust if it did not pay for the same (the contract is implied in-law). Similarly, a court will require a party to pay another if

(1) the party requested the goods/services, (2) the provider of the services expected compensation for those good/services, and (3) the party knew or should have known that the provider was expecting compensation (the contract is implied in-fact). In short, courts will use these theories to treat the parties as if there was a contract when it would be clearly unfair not to do so. Although these quasi-contract claims are quite common, they are often asserted as an alternative to the more straight-forward contract claims, in the event that the court is unable to find the elements of an enforceable contract.

Offer and Acceptance.
The mechanics of contract formation is also important to think through. Simply put, if an offer is made, a contract can be formed upon the acceptance of that offer by its recipient. This, of course, assumes that that the necessary elements discussed above are present.

An offer is valid until it is accepted, expires or is revoked. This is important because an offerer might forget about an earlier offer or casually assume that it is no longer valid (because, for example, of the passage of time or a change in circumstances). For this reason it is prudent to place crucial conditions and a definite expiration date on any offer.

Practical Tip: In any offer, always include crucial terms and a deadline. Consider conditioning any deal on the parties agreeing to a fully drafted contract reflecting those terms (and other details). This will give you some control over the formation of the contract, after the offer is accepted.

Be sure to revoke all outstanding offers that are no longer acceptable.

An offerer can usually revoke an offer at any time prior to acceptance. An exception to this rule is when a party may have a contractual right to accept the offer under certain conditions (e.g., price and time– like an option). Otherwise, until an offer is unconditionally accepted, the offerer controls the validity of the offer. Once the recipient accepts the offer, the offerer is likely contractually bound to the terms of that offer. If, however, the recipient alters the terms of the offer in any material way, it is not a contract, but a counter offer (whereby the offer/ acceptance process repeats). This is true even if the recipient states that the offer is “accepted.” In some instances, a recipient may choose to concede on some otherwise objectionable terms in order to lock in other

favorable terms by accepting an offer before the offer is withdrawn.