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Formation of contracts

This guide was last updated in February 2008. It is based on the laws in the UK (and it explains differences between the position in England and Wales and the position in Scotland). See also: Onlin...

This guide was last updated in February 2008. It is based on the laws in the UK (and it explains differences between the position in England and Wales and the position in Scotland).

See also: Online contract formation

Contract basics

A contract is an agreement reached between two or more parties which is legally enforceable when executed in accordance with specific requirements. Contracts should be project specific and reflect the agreement between the parties. Contracts are obviously a key part of every business and it is therefore fundamental that all parties to a contract understand the terms included in a contract and the rights and responsibilities of the parties under that contract.

Every contract should have:

  • Offer;
  • Acceptance;
  • Consideration (although note the position in relation to Scotland below); and
  • Intention to create legal relations.

'Acceptance' of an offer occurs when there is an unqualified acceptance of all the offered terms. However, this is unusual and there will normally be a period of negotiation. New terms and conditions introduced through negotiation in effect amount to a series of counter offers to the original offer, cancelling the terms of the original offer.

Communication of acceptance

A contract offer has only been accepted when the acceptance is brought to the attention of the offeror. This applies in the case of instantaneous communication, such as by telephone, where the party giving acceptance will often know at once if a communication is unsuccessful so will have the opportunity of making a proper communication. The exception to this rule is when the acceptance is posted. The offer is deemed to be accepted when the offeree posts their acceptance.

The now commonplace use of email raises the question of whether the "postal acceptance rule" applies to emailed acceptances. Currently there is no statutory law on this point. The contract could be formed when the email acceptance is read or when the email acceptance is sent.  If the parties to a contract wish to send notices by email then specific provisions should be included which set out when a notice sent by email is deemed to be received.

As a general rule, silence does not constitute acceptance.

Consideration

Consideration is the requirement of reciprocal obligations on the parties to a contract. Both parties must receive valuable consideration for performance of their side of the contract. Consideration is not required in Scotland where donation is accepted in the law of contract. However, it is extremely unlikely that a commercial organisation would provide goods or services for free.

Terms of contract

Contracts can be in writing, made orally, or created through the actings of the parties. For clarity, most commercial contracts are in writing to maintain a proper record of the agreement. Oral contracts create a greater potential for disputes on the terms with the parties having problems evidencing their position.

Contracts can be formed through a course of dealing between the parties. Again, the terms and conditions may not be clear. Common terms are likely to be incorporated in these contracts but if they are not written down there are still evidential problems.

It is common for contracts to be on a company's standard terms and conditions. Problems can arise when both parties purport to contract on their own standard terms and conditions. Qualified acceptance of an offer while imposing your own standard terms and conditions is seen as a counter offer. Obviously being unaware of which terms and conditions the parties are contracting does not provide the desired clarity or certainty of the contract.

There are different tactics for those parties who wish to contract on their own terms and conditions including incorporating the terms into as many pre-contractual documents as possible and ensuring that the terms appear on the last document between the parties before the delivery of goods.

Essential Terms

In general the following terms should be included in any contract:

  1. Parties – The names and addresses of all the contracting parties should be clearly stated.
  2. Definitions and Interpretations – If there are any defined terms in the contract this section should provide specific and clear definitions. For example, a "Business Day" means any day which is not a Saturday or Sunday or public holiday in England or "Associate" has the meaning given to it in section 435 of the Insolvency Act 1986.  Provisions dealing with general matters of interpretation should also be included where applicable, e.g. "unless the context otherwise requires the singular shall include the plural and vice versa and the words 'day', 'month' and 'year' shall mean calendar day, calendar month and calendar year."
  3. Payment Provisions – The exact price to be paid for the goods or services provided and the date or dates for payment to be made should be clearly set out. It may be relevant to provide for adjustments to the price to be made upon the occurrence of certain events or at certain intervals (e.g. where there is a change in any relevant exchange rate or to take into account inflation). This section should also note any agreed rate of interest payable on overdue amounts and the consequences for failure to pay.
  4. A specific description of the goods or services that will be provided under the contract including the level of service if the contract is for services. This section should also include who is responsible for supporting and maintaining any products throughout the term of the contract.
  5. 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'.
  6. Timescale – The specific timescale for the project should be noted including any deadlines that have to be met. This section should include any pre-agreed payments (or liquidated damages) payable by the supplier if the deadlines are not met.
  7. 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.
  8. 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...'.
  9. 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.
  10. 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.
  11. 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.
  12. 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.
  13. 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.
  14. 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.
  15. 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.
  16. Assignation (Scotland) / Assignment (England/Wales) – 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.
  17. Applicable law – There should be a clause indicating which law governs the contract. For example, 'This Agreement shall be governed by and construed in accordance with the laws of England'.

Specific types of contracts will require specific terms, which are particular to the relevant type of contract.  Examples of specific types of contracts where specific terms are required include software licence/development contracts, facilities management contracts (See: Facilities management contracts: 10 tips) and outsourcing contracts (See: Outsourcing).

Implied Terms

Certain terms may be implied into contracts by law, or by usage or custom. The Sale of Goods Act and the Sale of Goods and Services Act contain terms which are implied into all contracts for the sale of goods and services, primarily for the purpose of consumer protection. The supplier of goods or services must provide goods of a satisfactory quality which are fit for the consumer's purpose or perform the services with reasonable skill and care.

A more general statute to protect buyers is the Unfair Contract Terms Act. This Act seeks to prevent parties limiting or excluding their liability in contracts. Generally, any exclusion of liability must be reasonable.

Execution

Written contracts must be executed in accordance with specific requirements otherwise they will not be legally enforceable.

Scotland

Following a change in the law in 1995 in order to execute a deed only a signature is required. However to be formally valid a document should be subscribed by the granter and witnessed by one other aged person at least 16. It is worth noting that when carrying out any due diligence on contracts executed pre-1995 those contracts should have two witnesses before they are legally enforceable.

England and Wales

If a document containing contractual terms has been signed, in the absence of fraud or misrepresentation, the signatory is bound by the terms even if he has not read them.

If a document is unsigned a party is not bound unless he is aware that the document contained contract terms or the other party had taken reasonable steps to bring the terms to his notice. Stringent tests are applied to electronic contracts.

Directors who sign on behalf of a company do so in their capacity as the company's agent. Contracts signed in this way are treated as if they had been made by the company itself and it will be bound.

Contract management

Once the contract has been concluded it is important to monitor its performance. Often there are governance mechanisms set out in the contract which govern the relationship between the parties, and provide forums to monitor performance and deal with change. Internally, each party should check that the other is fulfilling its obligations and that any timescales and payment plans in the contract are being adhered to. It is useful to have regular project meetings to ensure that everything is going according to plan and to solve any problems as they arise.

Contacts

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