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Contract Law: Know the Fundamentals

Women studying contract law

Contract law is one of the most important legal concepts in the business world. Contracts determine everything from how employees are hired to how companies work together to how sales are made.

The problem is that while contract law is dense, it’s also fundamental to contract management. Here’s a quick refresher on the fundamentals of contract law to help you successfully navigate contractual relationships.

What is a contract?

A contract is a legally binding agreement between parties to create mutual obligations that businesses and individuals use to protect their interests. Contracts outline the specific terms of engagement for a transaction. They can also dictate legal consequences if a party tries to break the agreement.

Contracts can be written or verbal. Most businesses tend to use written contracts because they are easier to reference later. Written agreements are also less ambiguous, so they are more straightforward to enforce.

What is Contract Law?

Contract law, meanwhile, is the subset of laws specifically regulating how contracts are created and enforced. These laws cover things like:

  • How contracts are formed
  • What a document must contain to be considered a contract
  • Who is eligible to enter a contract
  • What consequences exist for violating contracts
  • What a contract can require of signatories

Essentially, contract law explains when contracts exist, when they’re enforceable, and what the wronged party can do if the other signatory ignores the terms of the agreement.

Essential components of a contract

There are three essential components of any contract: the offer, the acceptance, and the consideration. If all three of these characteristics aren’t present, a document is not considered a contract.

1. Offer

The offer is a clear, specific, and voluntary opportunity provided by one party to another party. The offering party, or offeror, will present particular terms to the offeree. These terms should include:

  • A clear declaration of intent to enter a contract.
  • The offeree’s information indicating who is eligible to accept this contract.
  • What the offeror intends to provide in the contract, such as goods or services.
  • The terms of the agreement, such as what the offeree will provide in return and how the exchange will take place.

2. Acceptance

Next, contacts must include a clear acceptance of the offer. Acceptance can take three forms:

  • Words: Most contracts are accepted through verbal or written statements that the offeree agrees to enter the contract and abide by its terms.
  • Actions: Contracts can also be accepted by taking action(s). For instance, suppose a contract states that taking an action like clicking a link or using a website constitutes acceptance. After reading the contract, people who perform those actions agree to the terms by default.
  • Performance: Even if a contract doesn’t designate a specific action as constituting acceptance, it’s possible to accept a contract without words. If a restaurant receives a food shipment from a supplier and uses it to make food, the restaurant has entered an implied contract. By using the goods in its normal course of business, the restaurant and supplier can assume a contract was created, and the restaurant owes the supplier payment for that food.

3. Consideration

The consideration of a contract is the value that is being provided. This value can be:

  • Financial, such as a loan
  • Property, such as goods delivered
  • Services, such as maintenance or protection from harm

A contract does not need to include a specific type of consideration—there’s no need for money to be involved at all. As long as the document dictates that one party will provide something of an agreed-upon value to another party, consideration exists, and the contractual form is complete.

What makes contracts valid?

There’s more to contracts than the basic structure, though. It’s perfectly possible to create a contract that meets the definition but is not legally binding. A contract is valid if it both follows the appropriate structure and meets the following requirements:

Doesn’t violate public policy

Legal agreements are only valid if they conform to the law. A contract that violates public policy or requires one party to do something illegal is automatically non-binding. For instance, if a contract requires one party to ignore local tax laws, that contract violates public policy and won’t hold up in court.

An unenforceable clause can render part or all of an agreement invalid. Some agreements have provisions stating that any terms that violate local law will be ignored, but the rest of the contract will remain standing. Still, if the violation is a fundamental part of the agreement, then the entire contract will usually be considered unenforceable.

All parties are able to consent

A fundamental part of the contracting process is confirming that all parties involved are eligible to consent. This is known as having the “capacity” to enter the contract. Certain groups are never assumed to have the capacity, including minors or adults with mental limitations.

Other parties may only have the capacity in certain circumstances. A company can enter a contract if it can prove that it’s a genuine legal entity and the person who will sign the contract is the company’s authorized signatory. Without these elements, an agreement may be considered void or voidable.

All parties understand and agree on the terms

A contract is considered binding when all parties give genuine consent to the terms. It’s only possible to provide genuine consent if the parties involved understand what the agreement means, including what they will receive and need to do.

Mistakes or misrepresentations in the contract prevent parties from giving genuine consent. Whether an error in the contract is an accidental mistake or a purposeful misrepresentation, it still means that the misled party can sue to have the contract nullified. The contract’s nullification would occur because the misled party did not understand the agreement’s actual terms and therefore could not consent to them.

When contracts require legal enforcement

Once an enforceable contract is signed, all signatories are bound to the terms of the agreement. If one party fails to live up to the terms without a valid legal defense, they have breached the contract.

There are two main ways to be in breach of contract:

  1. Failure to perform as promised: If a signatory has agreed to deliver payment by a specific date and doesn’t, they have failed to fulfill their contractual obligations. This is a material breach or a failure to accomplish a core element of the contract.
  2. Acting to prevent the other party from performing as promised: Suppose the offeree has agreed to deliver goods to a specific location, but the offeror refuses to let the delivery vehicles onto the property. In that case, the offeror prevents the offeree from fulfilling their obligations and is in breach of contract.

When someone breaches a contract, the other party can sue them for compensatory damages. The wronged party has usually lost something of value because of the other signatory’s actions. Contract law allows them to tally up the value of what they’ve lost and sue to have the breaching party compensate them for those losses.

Principles of contract interpretation

The legal principles that govern contract interpretation can vary depending on the specific jurisdiction and the type of contract in question. However, some common legal principles that are often used to interpret contracts include:

  • Plain meaning rule: This principle states that contract terms should be given their ordinary and plain meaning, as understood by a reasonable person in the context of the contract.
  • Parol evidence rule: This principle restricts the use of evidence outside of the written contract to interpret its terms. Generally, courts will not consider evidence of prior negotiations, oral agreements, or other extrinsic evidence if the written contract is clear and unambiguous.
  • Contra proferentem rule: This principle is applied when a contract term is ambiguous or unclear. It provides that any ambiguities should be resolved against the party that drafted the contract.
  • Course of performance, course of dealing, and usage of trade: These principles may be used to interpret ambiguous contract terms by looking at how the parties have performed under the contract in the past, how they have dealt with each other in the past, and the trade customs or practices that are commonly used in the relevant industry.
  • Implied terms: In some cases, courts may imply terms into a contract to give effect to the parties’ intentions or to fill gaps in the contract where terms are missing.

Overall, contract interpretation is a complex and often fact-specific process within contract law that requires a careful analysis of the contract language, the surrounding circumstances, and the applicable legal principles.

Contract law is critical to modern business

Contract law is a fundamental element of maintaining business relationships and protecting your organization. Understanding what makes a contract valid and the consequences of violating an agreement can help keep your company on track and prevent legal conflict. Well-written contracts support better partnerships and mitigate risk both inside and outside your organization.

Implementing contract law can be complicated, especially if your organization manages many agreements. A functional contract lifecycle management solution can help you stay on top of different elements of contract law and ensure that you don’t accidentally breach agreements.

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