One of the fundamental skills for a business owner is the ability to deal with contracts. Every day in Ontario, thousands of contracts are entered into for thousands of different reasons…. Quite often by people who don’t really understand what they’re agreeing to, and the consequences of not living up to their end of the bargain.
A contract is a binding agreement to exchange value between two or more entities, called “parties”. A contract can be either written or oral, so long as it has all of the essential parts discussed below. Oral agreements are more likely to end up in a he-said she-said if there’s ever a dispute. Most commercial contracts will be in writing so that there is a clear record of what was agreed upon. If there’s a dispute later on, the parties can look at the contract to see exactly what was meant. Certain types of contracts, such as those for the sale of land, are required by law to be in writing.
It’s good business practice to have your key agreements – with suppliers, distributors, franchisees, employees, contractors, and creditors – in writing. It’s also smart to let your lawyer do the writing, or at least review and edit what you wrote to make sure it’s sound. The more money or business risk that’s involved if the contract is broken, the more important it is to have a legally sound agreement from the start. The legal fees up front are far cheaper than a damages award. I’ve seen companies fail because they didn’t get legal help with their major contracts, and when push came to shove, their agreements weren’t binding, and didn’t say what they thought they did.
The essential parts of a contract
- Offer and acceptance. To form a contract, one party must make an offer to enter into a legal relationship, which at least one other party must accept. Both parties must willingly enter into the contract, and have the mental capacity to enter into and understand the terms of the agreement. The subject matter of the contract must also not violate any laws… so don’t come to me if you haven’t been paid for your work as an assassin…
- Consideration. Each party to the contract must gain value from it. In business this often boils down to the exchange of money for goods or services. The need for consideration is what separates bargains from gifts, which are when one party gives value and gets nothing in return. Gifts and contracts have different legal rules around them.
- Meeting of the minds. Both parties must intend to make a contract in the first place, and have a “reasonable” common understanding of what they’re actually agreeing to. This way, misunderstandings or vagueness can be cleared up by interpreting what a reasonable person in the situation would have thought they agreed to.
What does a contract look like?
You’ll usually find the following things in most written contracts:
- Identifying the parties to the agreement. Full legal names of who is entering into the contract.
- Definitions of important or frequently used terms. This keeps everyone on the same page about what’s being talked about in the contract, makes it shorter, and easier to read.
- Intentions or reasons for entering into the agreement. Though it’s usually not a binding part of the contract, it becomes a “guiding light” for anyone reading or interpreting the contract. It shows a meeting of the minds. If there’s a dispute, a judge will resolve vague terms, or unexpected problems with the parties’ intentions in mind.
- Representations and Warranties. A representation is a statement of an existing fact that makes the other party to want to contract with you – such as, that you actually own the thing you’re selling.A warranty is a guarantee that you’ll do certain things if things don’t work out as you’ve planned – such as, if the part you sell breaks in the first year, you’ll replace it at no charge.
- Terms of the deal. The responsibilities of each party, details about the money to be paid for a good or service, quality expected, delivery schedule, etc.
- General terms. The legal framework of the contract itself – how to end it, what law governs it, dispute resolution, how to give written notice, indemnity, and so forth.
- Signatures of both of the parties. Evidence that both parties agree to what’s written in the contract.
What if the contract is broken?
A breach of a contract occurs when one of the parties fails to perform one or more of the responsibilities agreed to in the contract. In situations such as these, the other party will want to be compensated for the losses suffered. Some remedies include:
- Damages. This is the usual solution to a broken contract – called a breach of contract. If the other party breaches a contract, you’re entitled to be put in the position you would have been in had lived up to their end of the deal. This usually means an award of expectation damages – monetary payment to make up for the losses directly resulting from the breach – or sometimes an order for the other party to do what they promised to – specific performance, discussed below.Consequential damages may also be awarded where your losses are not a direct result of the breach, but could have been reasonably foreseen by the party that broke the contract – such as business profits that you didn’t make because they didn’t send you the parts as promised.Punitive damages are additional compensation to punish the breaching party for being really really naughty. They’re rare, and only awarded in cases where a party, such as an insurance company, breaches a duty of “good faith” or acts unethically towards the other party.
- Reliance interest. In cases where the expectation damages are difficult to calculate, the court may award the expenses spent in reliance on the contract going through as promised instead. You can’t have both, as then you’d have been compensated for both lost profits and expenses.
- Specific performance. A court order to do what was promised under the contract. It can occur where goods or services are unique, not readily available from other sources, or where money isn’t enough to compensate for your losses.
- Rescission. If representations (above) turn out to be false, and the whole contract can be set aside, and the parties will be returned to the position they were before they struck the deal. As in, “I never would’ve signed the contract if I’d known that…”
That’s the quick & dirty on the basics of contracts. I’m indebted to my student intern, Claudia Dzierbicki, for her work in putting together the guts of this article. I’ll get in the process of how to use a lawyer to help you draft and negotiate contracts in another article soon.