THE KEY LEGAL ELEMENTS IN CONTRACT FORMATION
We now turn to the foundation of contract literacy—the key legal elements necessary to create a contract. These elements in effect represent a checklist for use in your future negotiations.
1. Agreement. the requirement that parties reach an agreement is fairly straightforward. one party makes an offer; the other party accepts the offer. In many cases, common sense should tell you whether a contract has been formed, as illustrated by facts derived from a case in China. A store sent an offer to purchase televisions to a manufacturer, with delivery to be made to the store. the manufacturer sent a reply accepting the offer, but added that the store had to pick up the televisions at the factory. in its response, the store agreed to pick them up at the factory. When the price of televisions dropped, the store claimed that there was no contract. Was the store correct?
A common sense analysis is that the store first made an offer but that the manufacturer's so-called "acceptance” was not a legal acceptance because it changed the terms of the offer by changing the place of delivery. This made the manufacturer's communication a counter offer, which was accepted by the store. So there was a contract as of the date of this final communication.
A situation entailing a much higher degree of risk can arise when parties use preliminary documents during contract negotiations. This type of document, often called a memorandum of understanding, a letter of intent or an agreement in principle, is useful in complex negotiations when the two sides have difficulty in reducing their negotiated agreement to writing.
However, these documents carry a major risk. If the parties do not document their intent not to be legally bound until a contract is signed, at some point, as the parties fill in the missing parts, the document might become detailed enough for a court to conclude that it represents a binding contract.
This risk might also affect third parties. For example, several years ago, Pennzoil negotiated a memorandum of agreement to acquire Getty oil. When texaco later entered into a separate contract to purchase Getty oil, Pennzoil claimed that its memorandum of agreement was actually a binding contract and that texaco's actions interfered with its contract rights. in a subsequent trial, the jury agreed with Pennzoil in deciding that texaco owed $10.5 billion in damages. When this judgment drove texaco into bankruptcy, the two companies reached a settlement agreement whereby texaco paid Pennzoil "only” $3 billion.
While they are useful negotiating tools, preliminary documents can result in significant risks for the parties negotiating the agreement or for third parties like texaco. to minimize these risks, you should carefully spell out in the document that it is for negotiating purposes only and is not a final contract until you so agree.
2. Consideration. Consideration is required in common law systems. While consideration has a technical legal definition, in everyday language it means that for a deal to be legally binding, both sides must give up something. For example, if a university graduate promises to donate $20 million to her university in a written signed agreement, the agreement is not binding unless the university promises to give up something in return.
In most business transactions, consideration is not a concern because both sides give up something—one side gives up a service or a product and the other side gives up payment. However, the risk of not meeting the consideration requirement increases when a contract is modified. For instance, assume that you, as a contractor, agree to remodel a building for a customer by a certain date. At your request, the customer agrees to give you a one-month extension, but you do not give the customer anything in exchange for this extension. Technically, the customer's agreement is not binding and you could be sued for breach of contract if you did not complete performance by the original date—unless you provided consideration for the one-month extension.
3. Legality. A contract that calls for the violation of a law is not enforceable. in many cases—for example, a contract to sell illegal drugs—this element is easy to understand. In other situations, where there might be a violation of public policy, the law is more complex.
For instance, your company might decide to protect confidential information by requiring employees to sign so- called non-compete agreements stating that they cannot work for a competitor within three years after leaving your company. in some countries this non-compete agreement might be illegal because it restricts the ability of your employees to obtain employment. And even where the agreement is legal, in common law countries the consideration element would require your company to give something to employees in exchange for their signing the non-compete agreement.
4. Writing. Both civil law and common law countries have rules providing that certain contracts must be in writing to be enforceable. These rules carry a huge financial risk when you make a wrong assumption about whether a writing is required, with the result that you miss a business opportunity (because you thought that your oral agreement was binding) or create an unintended liability (because you thought that your oral agreement was not binding).
As a result, you should never enter into a contract negotiation without understanding the applicable rules regarding whether a writing is required. But your understanding of the law should be supplemented by a practical strategy: during negotiations make it clear that you are not bound until a written agreement is made.
In other words, all of your agreements should be in writing. There are two reasons for this advice. First, by placing your agreement in writing you will not have to worry about the legal complexity of determining whether the agreement must be written. Second, and perhaps more important, you will avoid the consequences of memory failure. That is, even when the law allows oral contracts, the two sides to a contract will often have different recollections of the details of their agreement. their views might differ as to key issues—such as who the parties are, when the agreement starts, how long it continues to be in force, and when and how it can be terminated. these memory problems are avoided when the agreement is written and addresses the key issues. As noted by a Chinese proverb, even the palest ink is better than the best memory.
But another legal concern creates a separate risk once you reduce your agreement in writing. to illustrate this concern, we might assume that you have just been hired by a company in a city distant from your own. During negotiations, the company promises to pay for your moving costs but, when the agreement is put into writing, this promise is not included.
Are you legally entitled to moving costs, assuming that the company admits that it made the promise?
The answer varies depending on country law. under the law of some countries, a rule called the Parol Evidence Rule states that once you have put your agreement into writing, evidence of prior or contemporaneous agreements (such as the company's promise to pay moving costs) cannot be introduced as evidence if you decide to sue the company. This rule makes sense in that during a negotiation both sides might make many agreements that they later cast aside and don't intend to incorporate into the final agreement. If the court allowed them to bring evidence of these agreements into court instead of relying on the final, written document, courts would forever be reviewing and attempting to untangle the details of negotiations.
Even when you are negotiating a deal under the laws of a country that has not adopted the Parol evidence rule, it is likely that your contract will include a provision stating that the rule applies. These provisions appear under a variety of headings—for example, merger clause, integration clause, or entire agreement clause—and usually read as follows: "this agreement constitutes the entire agreement between the parties related to the subject matter and supersedes all prior representations, agreements, negotiations or understandings, whether oral or in writing.” For this reason, you always should read your contracts before signing them to make sure that the writing matches the agreement that you negotiated.
In following this advice, keep in mind that even in countries that have adopted the Parol Evidence Rule, it might not apply in all situations. For example, the United States has adopted the rule but has also adopted the Convention on Contracts for the International Sale of Goods (CiSG), which does not include the rule. So if you enter into a contract for the international sale of goods governed by the CiSG, evidence of prior agreements might be admissible in court unless you include a merger clause that clearly states that evidence outside the written contract is not admissible.
5. Authority. The final element necessary to create a legally binding contract is authority. in other words, does the party with whom you are negotiating have authority to make the contract? This is always the first question that you should raise when negotiating a contract because, if there is no authority, your negotiation might be a waste of time.
When you negotiate with someone who claims to represent a principal, there are three types of authority that the purported agent might possess. As illustrated by Figure 4.1, they are express authority, implied authority and apparent authority.
Express authority is created when the principal states that the agent has authority to negotiate a contract. Implied authority arises from the position held by the agent. It is implied that agents in certain positions have authority to enter into certain types of contracts. For example, it is implied that individuals
Figure 4.1 The three types of authority
hired as purchasing agents have authority to purchase goods within normal limits on behalf of the company.
Apparent authority arises when the principal leads you to believe that there is authority when there is none. For example, the principal might send you a letter of authority stating that the agent has authority to make purchases on behalf of the principal. If the principal limits the agent's authority without telling you, you could hold the principal liable because the agent would have apparent authority.
A situation based on a court case illustrates why authority is important. An employee wanted to borrow money from a bank for personal purposes, but had no collateral to secure the loan. So the bank asked for a loan guarantee from the employee's company. The company's general manager visited the bank and signed the guarantee on behalf of the company—and the guarantee stated that he had authority to do so. When the employee later defaulted on the loan, the bank sued the company on the basis of its guarantee but lost. The court concluded that the company had not given the general manager express authority to guarantee employees' personal loans. Implied authority was missing because guaranteeing employee personal loans is not something that general managers normally do. And there was no evidence of apparent authority.
In this case, the bank created unnecessary risk because it relied on the general manager's guarantee that he had authority. The important risk avoidance message is that if in doubt, and especially when dealing with guarantees or other major commitments that do not fall within the scope of your counterparty's representative's day-to-day duties, verify the authority of the person with whom you are negotiating.
The company should have asked the principal (which in this case would be the company board of directors) whether the agent had authority and should not have relied on the agent's statements about authority.