Contract Basics

Essentially, a contract is an agreement between two or more parties that the law will enforce. Generally speaking, damages (that is, compensation) are payable for loss suffered by one party due to the non-performance (or poor performance) by the other party to the contract. Moreover, a party may (in appropriate circumstances) request a civil court to order performance by the other party in default.

The law relating contract in India is contained in the Indian contract Act, which came in to force on the first day of Sept 1872. The act is extended to the whole of India except the state of Jammu and Kashmir. The act as it now stands contains the general principles of contract, contract of indemnity, surety ship, Bailment, and Agency. The law of contract deals with those transactions or promises which create legal rights and obligations. In case of non-performance of the promise by one party, it also provides legal remedies to an aggrieved party.

Contract Definition

Generally contract may be defined as an agreement which creates rights and obligations between the parties. These obligations and right s must be of such a nature that these can be claimed in the court of law. According to Salmond, “A contract is an agreement creating and defining obligation between the parties.” Section 8(h) of the Indian Contract Act defines contract as an agreement which is enforceable by law.

From the above definitions of contract it is clear that a contract essentially consists of three elements:

An agreement
Obligation, and
Enforceability

An agreement involves a valid offer by one party a valid acceptance by the other party. Enforceability means contract must be legal in nature and which can be claimed in the court of law.

For example, X invites Y to a party and Y accepts the invitation, then it is only a social agreement and not a contract. On the other hand A agrees to sell his house to B for Rs. 5, 00,000. This is a contract.

Contract Elements

An agreement to be enforced in the court has to satisfy certain conditions. On satisfying these, the agreements become a contract, and those conditions become essentials of a valid contract. The essential elements of a contract are contained in the definition of contract given in sec. 10 of the contract Act. According to this Act, “all agreements are contracts if they are made by free consent of parties competent to contract for a lawful consideration and with a lawful object and are not hereby expressly declared to be void.” The essential elements of a contract include:

Agreement: – There must be an agreement between the parties of a contract. It involves a valid offer by one party and a valid acceptance by the other party. Agreement is created by offer and acceptance. Therefore an agreement is = offer +acceptance. It is only by an agreement a contractual relation is established between the parties. For example, A sends a proposal to B to purchase a property for Rs. 10 lakhs and B accept the same, then this result into an agreement.
Lawful consideration: Consideration means something in return. An agreement is legally enforceable only when each of the parties to it give something and gets something. It may be past, present or future and must be real and lawful. A contract without consideration is not a contract at all. The consideration must be legal, moral and not against public policy.
Capacity of parties: The parties to an agreement must be capable of entering into a valid contract. According to sec. 11, the following persons are not competent to enter in to a contract.
Persons of unsound mind (Idiots, lunatic person etc.)
Persons disqualified by law to which they are subject.
Minors (Not completed the age of 18)
Free consent: For the formation of a contract one person must give his consent to another person. The consent thus obtained must be a free consent. A consent is said to be free if it is not caused by coercion, undue influence, fraud, misrepresentation or mistake. If the consent is obtained by unfair means, the contract would be voidable.
Consensus ad idem: It means the two parties of the contract must agree upon the subject matter of the contract in the same manner and in the same sense. That is there must be identity of minds among the parties regarding the subject matter of the contract. For example, A has two houses one at Calicut and another at Palakkad. He has offered To sell one house to B. B accepts the offer thinking to purchase the house at Palakkad, while A, when he offers; he has his mind to sell the house at Calicut. So there is no consensus ad idem.
Lawful object: The object of an agreement must be lawful. It must not be illegal or immoral or opposed to public policy. If it is unlawful, the agreement becomes void.
Not declared to be void: There are certain agreements which have been expressly declared void by the law. It includes
Wagering agreement
Agreement in restraint to marriage
Agreement in restraint of trade etc.

Thus an agreement made by parties should not fall in the above category.

Certainty and possibility of performance: – The terms of the contract must be precise and certain. They should not be vague. The terms of agreement must be capable of performance. For example A agrees to sell one of his houses. A has four houses. Here the terms of agreement are uncertain and the agreement is void.
An intention to create legal relationship:- There should be an intention between the parties to create a legal relationship. Mere informal promise is not to be enforced. Social agreements are not to be enforced as they do not create any legal obligations. An oral contract is a valid contract except in those cases where writing, registration etc. is required by some statute.
Parties – The names and addresses of all the contracting parties should be clearly stated.
Term of contract – The length of the contract should be stated and it should also be noted whether there are any options to continue the contract. For example, ‘This agreement will continue for another year unless otherwise notified to [other party] by 31 January each year’.
Limitation of liability – This section caps the liability of either party to the contract. For example, ‘Neither party shall have any liability to the other party for a claim of loss of profits…’. In an ideal world both parties would be seeking to have no liability to the other side. However, in a commercial context this is unlikely to be agreed and so both parties should try and limit their liability during the negotiation stage to appropriate levels. It is worth noting that there are statutes in force (discussed below) that forbid exclusion of liability in certain circumstances.
Termination provisions – The circumstances under which the parties can terminate the contract should be stated clearly. The procedure for giving notice to the other party should be in the contract. For example, ‘This agreement can be terminated by either party giving to the other not less than three months written notice…’.
Change of Control – During the course of a contract one party may change the structure of their company. In these circumstances the other party may wish to terminate the contract, for example if the first party transfers a controlling interest to a competitor of the other party. The procedure for this situation should be in the contract.
Dispute Resolution – The procedure to be followed if the parties have a dispute should be included. For example, if there is an option for arbitration or mediation where the issue cannot be resolved through internal escalation.
Confidentiality – Some contracts deal with commercially sensitive information and the parties are likely to want to keep this information confidential. There should be confidentiality clauses drafted in the contract which identify the information being protected and the circumstances in which it can be used or disclosed.
Intellectual Property Rights – Many commercial contracts include a clause stating who will own the intellectual property rights to any products provided under the contracts. This clause should specifically state who owns such rights. Particular attention should be given to the ownership of intellectual property rights in relation to products created specifically for or in connection with the contract.
Warranties – It is common for the party providing goods or services under a contract to provide certain warranties in relation to the delivery of the goods or services. For example, if the contract is for provision of a licence the provider should warrant that it has the necessary rights to grant the licence. Warranties give the other party a contractual right to sue for damages if there is a breach of the warranty.
Indemnity – Indemnity clauses are an express obligation to compensate the indemnified party by making a money payment for some defined loss or damage. They provide for an immediate right to compensation, without the need for a lengthy dispute as to the circumstances giving rise to the specified loss or damage. For this reason careful attention should be given to the agreement of any indemnities. An example of a typical indemnity is in a software contract under which the supplier indemnifies the customer against any claims made by a third party that the normal use of the software is infringing the rights of the third party.
Force Majeure – This clause should cover situations where performance of the contract is impossible through no fault of either party. For example, if there is a natural disaster or civil unrest.
Assignation / Assignment – If there is an option for one party to transfer their contractual rights and responsibilities to another party this should be set out in the contract along with the procedure to be followed. If there is no right to assign the contract this should also be noted.

Valid contract

A valid contract is a contract that the law will enforce and creates legal rights and obligations. A contract valid ab initio (from the beginning) contains all the three essential elements of formation:

agreement (offer and acceptance);
intention (to be bound by the agreement);
consideration (for example, the promise to pay for goods or services received).

In addition, a valid contract may have to be in writing to be legally valid (although most contracts may be oral, or a combination of oral and written words).

Void contract

A void contract lacks legal validity and does not create legal rights or obligations. A contract that lacks one or more of the essential formation elements is void ab initio (from the beginning). In other words, the law says that it is not, or never was, a valid contract.

Voidable contract

A voidable contract is a valid contract that contains some defect in substance or in its manner of formation that allows one party (or sometimes both parties) to rescind it. A voidable contract remains valid and can create legal rights and obligations until it is rescinded. The party with the right to rescind may lose that right by affirmative conduct, or undue delay, or where the rights of an innocent third party may be harmed.

Unenforceable contract

An unenforceable contract is an otherwise valid contract that contains some substantive, technical or procedural defect. Most commonly, such a contract is illegal, either in its formation or its performance, as it offends either public policy (the common law) or some statute. As a general rule, the law will not allow the enforcement of such a contract Alternatively, the law may determine that such is a contract is void (rather than unenforceable) with the consequential loss of contractual rights.

Formal contract

A formal contract is wholly in writing, usually in the form of a deed, and does not require consideration. A promise (or term) of a contract made by deed is called a covenant. A deed can be unilateral (that is, made by only one party) and this is often called a deed poll. A deed made by two or more parties is called an indenture. Some types of contracts must be in writing and must be made by deed to be effective (for example, a conveyance of non-Torrens title land).

Simple contract

A simple contract may be oral or in writing (or a combination of both). Simple contracts are made between two or more parties and require consideration.

Contract Formation

A promise becomes an enforceable contract when there is an offer by one party (the offeror) that is accepted by the other party (the offeree) with legally-sufficient consideration changing hands. With certain exceptions, contracts may be binding whether they are in writing (express contracts) or made orally (oral contracts). At common law, a counter-offer (a new offer from the offeree which differs from the original offer) used to be deemed (=considered) to be a rejection of the original offer and did not serve to form a contract unless the counter-offer was accepted by the original offeror.

Agreement

Agreement is the first essential element of contract formation. A binding agreement involves a meeting of the minds (consensus ad idem) and a contract may be achieved by the acceptance of an offer.

Types of agreements – Void agreements: “An agreement not enforceable by law is said to be void”. A void agreement has no legal significance from the beginning. No contract comes out from a void agreement ie it is void ab initio. The following agreements are examples of void agreements

Agreement without consideration
Agreement with persons like minors
Agreement made without consideration
Uncertain agreement
Impossible agreements

Illegal Agreements

An agreement which is either prohibited by law or otherwise against the policy of law is an Illegal agreement. All illegal agreements are null and void but void agreements are not illegal. All collateral transaction to an illegal agreement is also illegal.

Offer and Acceptance

Offer and acceptance are the two basic elements which comprise an agreement. One person makes an offer to another person, when the other person accepts that offer, it becomes an agreement.

An offer may be described as a final statement or proposal by one person (offeror) to another person (offeree). The statement or proposal is usually made on certain terms and often follows a process of negotiation. In other words, an offer only exists when there is nothing further to negotiate – either the offer is accepted or it is rejected.

Whether a statement amounts to an offer depends upon whether the offeree would reasonably interpret it as an offer. This is an objective test and not a subjective test of what the actual offeree thought. There are a number of rules that have been developed to assist in determining whether an offer has been made. A valid offer:

must be communicated by the offeror to the offeree – An offer is ineffective until it is communicated by the offeror to the offeree. If the offeree is unaware of an offer, then it would be impossible to accept it.
may be made to a particular person, a group of persons, or to the entire world;
must be clear and unequivocal;
must be distinguished from ‘mere puffs’, a request for further information, or an ‘invitation to treat’.

Mere puffs – Offers must be distinguished from non-promissory statements made during the course of negotiations. Objectively, these statements are exaggerated and a reasonable person would not expect them to be true. For example, no reasonable person would believe that a toothpaste can really make teeth ‘whiter than white’.

Invitation to treat – An ‘invitation to treat’ is simply an invitation by one party to commence negotiations which may or may not lead to an offer. While an invitation to treat is not an offer, it can determine the form that a subsequent offer is to take (for example, sale by auction or tender). In other words, a person who responds to an invitation to treat is in fact making an offer, which may be accepted or rejected. The distinction between an offer and an invitation to treat depends, of course, upon the objective intention of the parties.

Other important points to note

A request for further information is not an offer.
Goods displayed in shops for sale are invitations to treat, notwithstanding that a price tag is attached.
Advertising goods in a brochure, catalogue or newspaper is generally only an invitation to treat.
An auctioneer who puts a property up for sale is not making an offer to sell but is issuing a request for bids. The various bids form a series of offers that the auctioneer can accept or reject on behalf of the seller.
A tender is an invitation for interested persons to send in offers. The recipient of the offers (or bids) can then enter into a contract by communicating acceptance with the chosen tenderer. However, if the request is made to specific persons and it is stated that the contract will be awarded to the highest or the lowest bidder (as the case may be), then this statement will be binding as a unilateral offer.

Offer or Proposal – According to sec. 2 (a) of the Contract Act, “When one person signifies to another his willingness to do or abstain from doing anything, with a view to obtaining the assent of that other to such act or abstinence, he is said to make a proposal.”

Offer is one of the essential elements of a contract. The person making the offer or proposal is called the offeror proposer or promisor and the person to whom the proposal is made is called ‘the propose’ or offeree.

Elements of an Offer

In an offer one party must express his willingness for doing or not doing a thing
It must be made to another person
Offer is made with a view to know the assent of the other person.
There must be an intention to create legal relationship.

Example: X desire to sell his Car to Y for Rs. 3,00,000 _ it does not constitute offer, because X has merely expressed his desire. On the other hand if X asks Y would you buy my Car for Rs.3,00,000, this makes an offer, and here X is the offeror.

Classification of offer

Specific offer: – When an offer is made to a specific person or class of persons, such offer is known as specific offer. The specific offer can be accepted only by that particular person or organization.
General offer: It is an offer which is made to a group of people or public at large. Such offer can be accepted by any member of that group.
Cross offer: – When two parties exchange identical offers with each other, in ignorance of each other’s offer, the offers are cross offer.
Counter offer: Incomplete and conditional acceptance of an offer is known as counter offer. In other words, when an original offer is rejected and a new offer is made, it is known as counter offer.
Standing offer (Tender):- An offer for a continuous supply of a certain article at a certain rate over a definite period is called a standing offer.

Consideration

Consideration is the third essential element of contract formation. However, consideration is only required to form a simple contract. Consideration is one of the essential elements of valid contract.

According to sec. 25 of the Indian Contract Act, an agreement made without consideration is void. Every agreement must be supported by consideration to become a contract. In true sense consideration means “something in return” to the promisor(quid proquo).

The term consideration is defined in sec.2 (d) of the Indian Contract Act as, “when at the desire of the promisor, the promisee or any other person has done or abstained from doing, or promise to do or to abstain from doing something, such act, abstinence or promise is called a consideration for the promise.”

Consideration Types

Executory – Consideration is executory when one party makes a promise in return for a counter-promise by the other party. It is a promise to do something in the future.
Executed – Consideration is executed once the promise has been performed in full.
Past consideration – Consideration can be present or future, but not past.

Contract Writing

Writing is not an essential element of simple contract formation unless it is required by statute. At common law, a contract can be wholly oral, partly oral and partly written, or wholly written. There are exceptions to this general rule and some contracts are required to be either:

made by deed (that is, a formal contract ‘under seal’);
totally in writing;
evidenced in writing.

Contract Contents

Once the existence of a contract has been confirmed, it becomes necessary to examine its contents to identify and understand the obligations and rights of each contracting party. This involves determining

what are the terms of the contract
what is the meaning of those particular terms.

Identification of terms – Pre-contractual statements can be either ‘puffs’, representations, or form contractual terms. Representations are statements of fact which induce the representee to enter into a contract, but which are not guaranteed by the maker of the statement. It is necessary to make this classification because it affects the rights of the receiving party.

Whether a statement is a representation or a contractual term depends upon the objective intention of the parties. If the content of the statement is important to the contract, then it may be more likely that the parties intended it to be a term. If a statement is not included in the parties’ written contract, then it is unlikely that it was intended to become a term of the agreement.

Identification of express terms in a contract depends upon whether the contract was oral or in writing.

Oral contracts – If a dispute arises in an entirely oral contract, then the parties will have to present oral testimony to a court as to what the contents of the contract were. The court will, thereafter, objectively assess the evidence and reach a conclusion.

Written agreements – If a contract is reduced into writing, it is presumed that the writing contains all the terms of it. The objective written evidence will override the subjective intention of a party.

Implied terms are those that are declared to be part of the contract even though the parties have not consciously included them. Terms may be implied due to the following circumstances.

Past dealings between the parties
Custom or trade usage
To give business efficacy to a contract

When a term is implied by law, rather than fact, it is usually implied because of the nature of the particular contract. In other words, because the term has traditionally been implied in similar contracts. Examples include the following contracts.

Bailment contracts – The law will imply a term that the bailee will not sell or give away the bailor’s goods, and will exercise reasonable care when handling the bailor’s goods.
Building and construction contracts – The law will imply a term that the builder will use good quality materials and exercise reasonable care when doing the building work.
Employer and employee contracts – In the absence of an express term, the law will usually imply a term that the employee must exercise proper and reasonable care in carrying out employment duties.
Professional and client contracts – The law will imply a term in a contract between a professional (for example, solicitor, engineer, etc) and a client, that all reasonable care will be taken in the performance of the contract.

If a statement does become part of a contract then it becomes necessary to determine the importance of it. This step is crucial to assess the remedies that may be available for breach of the relevant term. Contractual terms are traditionally classified into three categories: conditions, warranties and intermediate terms. In addition, terms may be classified as simply definitional or procedural.

Exclusion Clause – An exclusion clause is a condition that excludes, qualifies or limits the liability of a party for the wrongful conduct specified in that clause. They operate for the benefit of one party only which will rely on the clause (that is, as a defence) in the event of a dispute, contractual or otherwise, with the other party. There are three categories of exclusion clauses

total exclusion of liability: this is where a clause in favour of one party excludes a right that the other party would otherwise have had
limitation of liability to a specified monetary amount
placing conditions on the exercise of contractual rights: a common example is a clause requiring a claim to be made within a specified period.

In addition, a contract may contain an indemnity for loss clause that operates if third parties are involved (that is, a clause that indemnifies one party if the other party is sued by a third party). The success or failure of the exclusion clause will depend upon whether the clause actually forms part of the contract. If a court decides that the clause is relevant, then rules of construction are applied to interpret the effect of the clause.

The courts have traditionally viewed exclusion clauses with considerable disfavor, especially where the parties to a contract are not of equal bargaining power. Where the parties are of equal bargaining power, the courts are less hostile to upholding the application of an exclusion clause.

Alternative dispute resolution clauses – Many contracts now contain alternative dispute resolution (ADR) clauses. These clauses generally provide that, prior to commencing litigation, the parties agree to submit the dispute to an ADR process. Although a court may find that such a clause is certain and not incomplete, courts generally will not enforce such clauses because of a lack of an appropriate remedy.

Types of Contracts

Fixed Price (Lump Sum): If the scope is clear and well defined, we can sign a contract on a fixed total price and the risk is on the seller side as the buyer need not bother about any variations in the cost. There are 3 types of fixed price contract as shown below:
Firm Fixed Price (FFP). Seller has to fulfill the obligations with in a fixed price. The risk is on the seller side as any cost overrun will be borne by the seller.
Fixed Price Incentive Fees Contract (FPIF) (Based on the complexities or certain conditions apart from fixed price buyer will pay some incentive, if the seller is completing the project on time or meet certain performance conditions set by the buyer etc. If the cost reaches above a ceiling limit, the seller has to bear the excess cost.)
Fixed Price with Economic Price Adjustment Contracts (FP-EPA) (for a long duration project, to meet the escalation or price variations of some materials or labour charges, buyer has to pay a Fixed Price and cost of escalation within the duration of the project, it protects both the parties from price inflation.)
Cost Reimbursable Contract: In this type of contract scope is not exactly defined and not known to both the parties and the price is open based on the final incurred costs of the product. In this type of contract risk is on the buyer side as buyer has to pay for facing the uncertainties. There are 3 type of cost reimbursable contract as given below:
Cost plus Fixed Fees Contracts (CPFF). (Here the buyer has to pay the actual cost of the work plus the additional fixed fee for doing the work to the seller. Fee will not be changed based on the seller performance. Risk is moderate to the buyer as the fee is fixed and costs are variable)
Cost plus Incentive Fees Contracts (CPIF). (In this type of contract the buyer has to pay the cost of the work as it incurred and an incentive fee for exceeding the performance criteria. In the end of the project cost can be higher or lower, then both the parties share the cost based on the pre-negotiated cost sharing formula. Risk is moderate as costs are variable)
Cost plus Award Fee Contracts (CPAF) (The buyer has to reimburse all the allowable cost and award a price based on meeting the performance criteria mentioned in the contract by the seller. Risk is moderate as there is a conditional payment.
Time and Material: This is also called unit price contract and it is the mix of fixed price and cost reimbursable contract. In this cost is charged to the identified tasks of an ongoing activity, and for doing some work for which scope is not clear ex. research. Here Scope per unit is defined. For example some software companies are charging as cost per hour for their effort. In this cost can grow to a dangerous level and the risk is on the buyer. (Seller has no incentive to control costs)