CONTRACTS LAW

What Is a Contract?

A contract is a legally enforceable agreement between two or more parties. The core of most contracts is a set of mutual promises called "consideration." The promises made by the parties define the rights and obligations of the parties.

Contracts are enforceable in the courts. If one party meets its contractual obligations and the other party doesn't ("breaches the contract"), the nonbreaching party is entitled to receive relief through the courts.

EXAMPLE / Web Developer promised to pay Graphic Designer $5,000 for creating certain graphics for Developer's Web site design project. Graphic Designer created the materials and delivered them to Developer, as required in the contract. Developer admits that the materials meet the contract specifications. If Developer does not pay Graphic Designer, Graphic Designer can go to court and get a judgment against Developer for breach of contract.

Generally, the nonbreaching party's remedy for breach of contract is money damages that will put the nonbreaching party in the position it would have enjoyed if the contract had been performed. Under special circumstances, a court will order the breaching party to perform its contractual obligations.

Because contracts are enforceable, parties who enter into contracts can rely on contracts in structuring their business relationships.

EXAMPLE / Web Marketer entered into a contract with Composer, promising to pay Composer $4,000 for composing a short jingle for use on Marketer's Web site. Shortly after Composer started work on the piece for Marketer—before Marketer paid Composer any money—Composer got an offer from a movie studio to compose all the music for a movie. Composer accepted the movie studio's offer and abandoned Marketer's project. Marketer had to pay another composer $6,000 to do the work that Composer had contracted to do. Marketer can sue Composer and obtain a judgment against Composer for $2,000 (the amount that will result in Marketer's obtaining the music for a net cost of $4,000, the contract price).

In this country and most others, businesses have significant flexibility in setting the terms of their contracts. Contracts are, in a sense, private law created by the agreement of the parties. The rights and obligations of the parties are determined by the contract's terms, subject to limits imposed by relevant statutes.

EXAMPLE / Web Marketer promised to pay Composer $5,000 to create music for Marketer's Web site. Composer created the music and delivered it to Marketer, as required in the contract. Marketer did not pay Composer, so Composer sued Marketer for breach of contract. Marketer's defense was "Composer did what she promised to do, but I never should have agreed to pay her $5,000 for that work. Two thousand dollars is a fair price." The court will enforce Marketer's promise to pay Composer $5,000.

Written Contracts

A deal done on a handshake—"You do X for me, and I'll pay you Y"—is a contract, because it is a legally enforceable agreement involving an exchange of promises. Most contracts are enforceable whether they are oral or written. Nonetheless, you should always have written contracts for all your business relationships.

There are several reasons why written contracts are better than oral contracts:

• The process of writing down the contract's terms and signing the contract forces both parties to think about—and be precise about—the obligations they are undertaking. With an oral contract, it is too easy for both parties to say "yes" and then have second thoughts.
• When the terms of a contract are written down, the parties are likely to create a more complete and thorough agreement than they would by oral agreement. A hastily made oral agreement is likely to have gaps that will have to be resolved later—when the relationship may have deteriorated.
• With an oral contact, the parties may have different recollections of what they agreed on (just as two witnesses to a car accident will disagree over what happened). A written agreement eliminates disputes over who promised what.
• Some types of contracts must be in writing to be enforced. The Copyright Act requires a copyright assignment or exclusive license to be in writing. (See "Assignments" and "Licenses," chapter 3.) State law requirements vary from state to state, but in most states, a contract for the sale of goods for $500 or more must be in writing. (See "Important Provisions of Article Two," chapter 18.)
• If you have to go to court to enforce a contract or get damages, a written contract will mean less dispute about the contract's terms.

Who Can Enter Into a Contract?

Minors and the mentally incompetent lack the legal capacity to enter into contracts. All others are generally assumed to have full power to bind themselves by entering into contracts. In most states, the legal age for entering into contracts is eighteen. The test for mental capacity is whether the party understood the nature and consequences of the transaction in question.

Corporations have the power to enter into contracts. They make contracts through the acts of their agents, officers, and employees. Whether a particular employee has the power to bind the corporation to a contract is determined by an area of law called agency law or corporate law. If you doubt whether an individual with whom you are dealing has authority to enter into a contract with you, insist that the contract be reviewed and signed by the corporation's president.

A corporation has a separate legal existence from its founders, officers, and employees. Generally, the individuals associated with a corporation are not themselves responsible for the corporation's debts or liabilities, including liability for breach of contract.

EXAMPLE / Lisa, a Web developer, entered into a Web development agreement with Start-Up Company. Lisa fulfilled her duties under the agreement, but Start-Up doesn't have the money to pay her. Start-Up's president has plenty of money, and Lisa would like to collect the money from him. She can't, unless the president personally guaranteed Start-Up's obligations.

Offer and Acceptance

A contract is formed when one party (the "offeror") makes an offer that is accepted by the other party (the "offeree"). An offer—a proposal to form a contract—can be as simple as the words, "I'll wash your car for you for $5." An acceptance—the offeree's assent to the terms of the offer—can be as simple as, "You've got a deal." Sometimes acceptance can be shown by conduct rather than by words.

When an offer has been made, no contract is formed until the offeree accepts the offer. When you make an offer, never assume that the offeree will accept the offer. Contractual liability is based on consent.

EXAMPLE / John offered to pay Photographer $500 to use Photographer's photo in John's e-commerce Web site. Photographer said, "Let me think about it." John, assuming that Photographer would accept the offer, used the photo. Photographer then rejected John's offer. Unless fair use applies, John has infringed Photographer's reproduction and public display rights by using the photograph. John should not have assumed that he would be granted a license (a form of contract) by Photographer.

When Is an Acceptance Effective?

According to the "Mailbox Rule," an acceptance that is mailed is effective when it is deposited in the mail. When is an emailed acceptance effective—when the sender pushes the "send" button, when the email message is available for the recipient to open, or when the recipient opens it? Good question, there is no answer yet.

When you are an offeree, do not assume that an offer will remain open indefinitely. In general, an offeror is free to revoke the offer at any time before acceptance by the offeree. Once the offeror terminates the offer, the offeree no longer has the legal power to accept the offer and form a contract.

EXAMPLE / Animator offered his services to Developer, who said, "I'll get back to you." Developer then contracted with Client to quickly produce a Web-based product involving animation (making the assumption that Animator was still available to do the animation work). Before Developer could tell Animator that he accepted Animator's offer, Animator sent Developer an email that said, "Leaving for Mexico. I'll call when I get back." Developer and Animator did not have a contract. Developer should not have assumed, in entering into the contract with Client, that Animator was still available.

When you are the offeree, do not start contract performance before notifying the offeror of your acceptance. Prior to your acceptance, there is no contract. An offer can be accepted by starting performance if the offer itself invites such acceptance, but this type of offer is rare.

EXAMPLE / Big Company offered to pay Web Developer $20,000 to create an e-commerce Web site for Big Company. Before Developer's president notified Big that Developer accepted the offer, Big sent Developer an email that said, "We've changed our minds. Due to budget cuts at Big Company, we're canceling the project." In the meantime, Developer's staff had begun preliminary work on the project. Developer and Big did not have a contract, so Developer has no legal recourse against Big for loss of the deal or for the costs of the preliminary work.

Until an offer is accepted, the offeror is free—unless it has promised to hold the offer open—to revoke the offer.

EXAMPLE / On June 1, Big Company offered to hire Developer to create an interactive training work for Big. On June 4 (before acceptance by Developer), Big notified Developer that it was giving the contract to Developer's competitor. Big terminated the offer to Developer. Developer has no legal recourse against Big Company.

If you need time to make up your mind before accepting an offer, get the offeror to give you a written promise to hold the offer open for a few days. That will give you time to decide whether to accept.

Don't reject an offer and then try to accept it. Once an offeree rejects an offer, the offer dies and the offeree's legal power to accept the offer and form a contract terminates.

EXAMPLE / Publisher offered to buy the e-book rights to Author's book for $10,000. Author, hoping for a better offer, said no. Then Author realized that Publisher's offer was the best Author could do. Author called Publisher and said, "I accept your offer." Because the offer was no longer open, Author cannot form a contract by trying to accept the offer.

Except for the simplest deals, it generally takes more than one round of negotiations to form a contract. Often, the offeree responds to the initial offer with a counteroffer. A counteroffer is an offer made by an offeree on the same subject matter as the original offer, but proposing a different bargain than the original offer. A counteroffer, like an outright rejection, terminates the offeree's legal power of acceptance.

EXAMPLE / Publisher offered to buy all electronic rights in Author's book for $10,000. Author responded by saying, "I'll give you an exclusive right to distribute the book online for the next three years for that price." Author's response to the offer was a counteroffer. Author no longer has the legal power to form a contract based on Publisher's offer to purchase the electronic rights in the work.

Forming Contracts Online

There are a number of ways in which contracts are formed online:

• By exchange of emails.
• By merchant acceptance of orders entered on e-commerce Web sites.
• Through online conduct, such as clicking on an "I accept the terms" button.
• Through Electronic Data Interchange (EDI), electronic exchange of purchase orders, and other standardized business documents between computers in a computer-processable format.

As we noted earlier in this chapter, in "Written Contracts," certain contracts must be in writing to be valid. Over half the states have passed laws making electronic records the equal of "hard copy" written records (and a federal law is being considered by Congress). Unfortunately, these laws take three different approaches:

• The "automatic equivalence" approach (electronic records are the equivalent of hard copy records).
• The "by agreement" approach (electronic records are the equivalent to hard copy records if the parties to the transaction have so agreed).
• The "digital signature" approach (electronic records are the equivalent to hard copy records if they are signed with digital signatures using special encryption technology).

Consideration

Consideration, in legal terminology, is what one party to a contract will get from the other party in return for performing contract obligations.

EXAMPLE / Web Developer promised to pay Artist $500 if Artist would let Developer use one of Artist's drawings in Developer's new project. The consideration for Developer's promise to pay Artist $500 is Artist's promise to let Developer use the drawing. The consideration for Artist's promise to let Developer use the drawing is Developer's promise to pay Artist $500.

According to traditional legal doctrine, if one party makes a promise and the other party offers nothing in exchange for that promise, the promise is unenforceable. Such a promise is known as a "gratuitous promise." Gratuitous promises are said to be "unenforceable for lack of consideration."

EXAMPLE / John told Sam, "When I buy a new car, I'll give you my truck." John bought a new car but did not give Sam the truck. According to traditional legal doctrine, John's promise to give Sam the truck is an unenforceable gratuitous promise. Sam gave nothing to John in exchange for John's promise to give Sam the truck.

In some states, a gratuitous promise can be enforced if the party to whom the promise was made relied on the promise. Other states no longer require consideration for certain types of promises.

Lack of consideration is rarely a problem for promises made in the context of business relationships. In most business contracts, there is consideration for both parties ("mutual consideration," in legal terminology).

The lack of consideration problem can arise in the context of amendments to contracts, however. Also, in some states, a promise to hold an offer open (see "Offer and Acceptance," earlier in this chapter) is unenforceable unless the offeree gives the offeror consideration (pays the offeror money) to keep the offer open.

A special application of the problem of lack of consideration in contracts with employees is discussed in "Using the Employment Agreement," chapter 5.

Typical Contract Provisions

Many contracts include special types of provisions. We'll discuss these common types of provisions in the next subsections.

Duties and Obligations

The duties and obligations section of a contract is a detailed description of the duties and obligations of the parties and the deadlines for performance. If one party's obligation is to create a Web site design or online product or software or content for a Web site design or online product, detailed specifications should be stated.

Warranties and Indemnities

A warranty is a legal promise that certain facts are true. Typical warranties in contracts concern such matters as ownership of the contract's subject matter (for example, copyrights) and the right to sell or assign the subject matter. In Web development agreements and content licenses, warranties of ownership of intellectual property rights and noninfringement of third parties' intellectual property rights are common. For contracts involving the sale of goods, certain warranties are implied under state law unless specifically disclaimed by the parties (see "Important Provisions of Article Two," chapter 18). A warranty provision is usually accompanied by an indemnity in which the warranting party promises that if the warranty is breached, the warranting party will pay the other party's costs arising from the breach.

Termination Clauses

These clauses ensure that either or both parties have the right to terminate the contract under certain circumstances. Generally, termination clauses describe breach of contract events that trigger the right to terminate the contract (for example, nonpayment of royalties). Termination clauses also describe the methods of giving notice of exercise of the termination right, and whether the breaching party must be given an opportunity to cure the breach before the other party can terminate the contract.

Remedy Clauses

These clauses state what rights the nonbreaching party has if the other party breaches the contract. In contracts for the sale of goods, remedy clauses are usually designed to limit the seller's liability for damages (see "Important Provisions of Article Two," chapter 18).

Arbitration Clauses

An arbitration clause states that disputes arising under the contract must be settled through arbitration rather than through court litigation. Such clauses generally include the name of the organization that will conduct the arbitration (the American Arbitration Association, for example), the city in which the arbitration will be held, and the method for selecting arbitrators. Arbitration is discussed in "Arbitration," appendix A.

Merger Clauses

Merger clauses state that the written document contains the entire understanding of the parties. The purpose of merger clauses is to ensure that evidence outside the written document will not be admissible in court to contradict or supplement the terms of the written agreement. In complex contracts, the parties often go through several rounds of negotiations before they reach their final agreement. When a contract contains a merger clause, the final outcome of all previous discussions and drafts is considered to be "merged" into the written document.

EXAMPLE / Sam created a Web site design for Harry pursuant to a written development agreement containing a merger clause. When Harry received the beta version of the Web site design, he was unhappy because the design did not include a feature for accepting email inquiries from site users. Nothing in the development agreement or specifications mentions this feature, but Harry claims that he and Sam discussed such a feature. Because the agreement has a merger clause, contracts law provides that the written document contains the entire understanding of the parties. Even if Sam and Harry did discuss the additional feature, evidence of that discussion would not be admissible in court. Sam does not have to add the feature.

Tips for Contracts

The contract formation process varies widely, from contracts formed quickly in face-to-face meetings to contracts formed after teams of attorneys have spent months in negotiations. Here are some general tips for all types of contracts:

• Write it down. All contracts should take the form of a written document signed by both parties. You do not have to hire an attorney to create a written contract. If you reach an agreement over the phone or in a meeting, write the agreement as soon as possible and have the other party sign the written memorandum. If you are making a written offer, you may want to make your offer in the form of a letter, with a space at the end for the offeree to indicate acceptance by signing.
• Make sure you are comfortable with your obligations. If a term—for example, a deadline—makes you uneasy, make a counteroffer that substitutes a term with which you are more comfortable. Do not assume that the other party will excuse you from strict compliance and do not rely on the other party's oral assurances that it will not insist on strict compliance.
• Remember Murphy's Law. Before you sign a contract, consider what could go wrong or what could make performance of your obligations difficult or expensive. If the actual performance is more difficult or expensive than you anticipated, that is not a valid excuse for not performing. Enter into a contract only if you believe that you can meet your obligations.
• Don't leave anything out. Accurately cover all aspects of your understanding with the other party. If the other party wrote the agreement based on an oral understanding reached earlier, make certain that the written terms match the terms of your oral agreement. Don't leave points out of the written document, even if the other party says, "We don't need to put that in writing."
• Cover all options. Cover all options, consequences, and possibilities. You should not fail to address an issue because it is sensitive. Deal with sensitive issues during negotiations. Make sure that your contract includes a merger clause (see "Typical Contracts Provisions," earlier in this chapter) to avoid disputes about whether proposals made during negotiations but not included in the final written agreement are part of your contract.
• Don't use unclear language or try to sound like a lawyer. If you don't understand exactly what the other party is expecting you to do, don't try to camouflage the lack of understanding by using vague language. Vague language leads to misunderstandings, disputes, and lawsuits. Use simple language that accurately expresses your agreement with the other party. Don't try to sound like a lawyer, and don't complicate things unnecessarily.
• Define any ambiguous terms. There's a classic contracts case in which one party contracted to sell chickens to the other party. The seller thought "chicken" meant chicken of any age, including old and tough chickens. The buyer assumed "chicken" meant tender young chickens suitable for frying. The seller shipped old chickens, and the buyer screamed "breach." To avoid such misunderstandings, define any terms that may be ambiguous.
• Be careful using "terms of art." Terms of art are words with specific meaning in the law. "Assignment," for example, has a number of meanings in the English language. In intellectual property law, assignment means a transfer of ownership of intellectual property (see "Assignments," chapter 3). Use assignment in your contracts when you mean transfer of ownership of intellectual property. Don't use the word in its other meanings or you will create confusion. A number of terms of art are defined throughout this book.
• Use terms consistently. When you write contracts, you are creating your own law. Legal writing is not creative writing. Don't use "royalty" in one paragraph, "license fee" in a second paragraph, and "use fee" in a third paragraph. Pick one term and stay with it throughout the contract.

Battle of the Forms

In the business world, contracts are often created based on an exchange of forms. The offeror sends a proposal to the offeree, and the offeree accepts by sending back a purchase order form. While the purchase order normally contains a number of terms that match the proposal's terms (price and delivery date, for example), it will generally include additional or contradictory terms as well.

The legal rules for determining what terms are included in a contract created this way are complex (attorneys call the process the "battle of the forms"). These rules are discussed in "Important Provisions of Article Two," chapter 18. To avoid the battle of the forms, don't create a contract with a client by exchanging documents containing inconsistent terms. Make every effort to get the client to sign your proposal or negotiate a separate contract. If the client must use a purchase order, read it carefully, including its fine print, as soon as you receive it. If the purchase order form contains terms that are unacceptable to you, notify the client of your objection as soon as possible

Internet Law and Business Handbook
Chapter 4

The purpose of this building block chapter is to provide an overview of the basic principles of contracts law.

In later chapters, we discuss special types of contracts: Web development agreements are discussed in chapter 8, contracts with employees in chapter 5, contracts with independent contractors in chapter 6, licenses in chapter 10 and 21, and contracts for the distribution of Web products in chapter 13. The special legal rules that apply to contracts for the sale of goods are discussed in chapter 18.