If you are starting or buying a small business, you need to know about contracts. A contract is a legally binding promise. It is formed when one party offers to do something, the second party accepts the offer, and each party promises to provide something of value to the other, such as cash, services, or goods. For example, if your company offers to buy equipment from a seller for $10,000, and the seller accepts your offer, there is a contract for the sale of equipment.
Chances are you will enter into many different kinds of contracts while you are in business. These may include:
- an agreement to purchase an existing business
- leases for real and personal property
- agreements to purchase equipment, goods, or real property
- agreements to sell goods to customers (also called bills of sale)
- agreements to perform services for clients or customers
- employment agreements with employees you hire
- independent contractor agreements with nonemployees you hire
- loan agreements and promissory notes, and
- an agreement to sell your business.
Each party to a contract is responsible for fulfilling its terms. The failure to perform the obligations of a contract is called a breach of contract. If a breach is serious enough—what lawyers call a “material breach”—there can be serious legal consequences.
When you enter into a contract you are legally obligated to perform your contractual duties—that is, do what you promised to do in the contract. Nonperformance is the failure to fulfill your obligations under a contract. However, you do not have to perform your promises under a contract until performance is due. For example, if you agree to pay the seller of equipment on delivery of the equipment, you do not have to pay the seller until the equipment is delivered. You will not be in breach of the agreement until the equipment is delivered and you then fail to pay the seller.
But there can be cases where a contract is breached before the time for performance comes. This occurs when one party decides before performance is due that he or she will not perform as promised and communicates the decision to the other party. The second party can sue the first party for breach of contract even though the time for performance has not arrived. This is called anticipatory breach of contract
When Is a Contract Breached?
A contract is breached (broken) when either one or both parties fails to perform as promised in the contract. A breach may occur when a party:
- refuses to perform its promises under the contract
- does something that the contract prohibits, or
- prevents the other party from performing its obligations under the contract.
Some contract breaches are more serious than others. The law distinguishes between material (or total) breaches and immaterial (trivial) breaches of contract.
Material Breach of Contract
A material breach of contract (sometimes referred to as a "total" breach), is serious and gives rise to a cause of action in court. A material breach goes to the very heart of the contract. It renders the contract "irreparably broken" and defeats the purpose for making it in the first place. For example, suppose your company agrees to pay a violinist $500 to play at a company-hosted event, but the violinist shows up at the party without his violin. The violinist has materially breached the contract to perform if he cannot play.
When there is a material breach of contract, the injured party can go to court and seek damages–a money payment adequate to cover economic losses resulting from the breach. A total breach of contact will also usually terminate the nonbreaching party’s duty to perform any of the promises he or she made in the contract. For example, your company would have no legal duty to pay the violinist who couldn’t play as promised.
Immaterial Breach of Contract
An immaterial breach of contract is a trivial breach that does not render the contract irreparably broken or defeat its purpose. An immaterial breach does not terminate the contract. Example: A building owner enters into a service contract for a heating system that provides that the system will be inspected each month on Thursday. Contrary to the contract, the service person makes inspections on Mondays. This act is a technical breach of the contract, but it is immaterial, unless for some significant reason the inspections needed to be done on Thursday as opposed to any other day. Since this breach is immaterial, the contract can’t be terminated by the building owner. The two sides should work out an accommodation—the service person can agree to show up on Mondays, or the building owner accepts that the inspections will be done on Thursdays, perhaps in return for paying slightly less.
Excuses for Not Keeping Your Contractual Promises
Sometimes the law excuses a material breach of contract. This may occur, for example, where the contract is impossible to perform due to unexpected circumstances--for example, you contract with a freelance web designer to create a website but the designer dies.
In other instances a contract may be legally unenforceable—for example, because:
- there was a mutual mistake as to an essential fact in the contract--for example, both parties were mistaken as to the authenticity of a painting
- a party lacked capacity to contract—for example, one party was a minor or mentally incapacitated
- a party was fraudulently induced to enter into a contract—for example, one party lied to or threatened the other to get him or her to make the promises in the contract
- the contract is unconscionable—for example, it is grossly unfair, or
- the contract is illegal--for example, it enables prostitution, violates tax laws, or requires the destruction of records.
See “Getting Out of a Contract” for detailed guidance on when nonperformance contractual obligations may be excused.