Creating contracts - overviewContract formation

A contract is a legally binding agreement that grants rights and creates duties. It can be oral, written or partly written and partly oral or inferred entirely from the conduct of the parties.

For a contract to be effective four key elements must be present:

Offer

An offer is a pledge by a party to another promising to enter into a contract on set terms. It has to be specific, complete and capable of being accepted.

Offers can be preceded by an invitation to treat or they can stand alone. However, invitations to treat are not supported by the intention to create legal relations and do not result in a contract unless followed by an offer and the other key elements of contract formation.

An offer has to be accepted to form a contract but offers are not open for acceptance indefinitely and can be revoked in a number of ways.

Acceptance

Acceptance is the unequivocal agreement to the terms of the offer without any further negotiation. A contract is formed when acceptance is communicated to the offeror.

When acceptance does not match the original offer the offeree essentially rejects the original offer and becomes an offeror in making a counter-offer. Acceptance of a counter-offer means that the contract is formed on the terms of the counter-offer and not the original offer.

The rule that acceptance must be communicated has two exceptions:

Consideration

A contract will fail for the lack of consideration unless it is executed as a deed. The amount of consideration is not important. What is important is that the consideration has some value even if it is not adequate. Consideration can be executory (where the parties exchange promises) or executed (where one party asks for something in return for his promise). There are exceptions to this general rule. In commercial agreements courts are more likely to find consideration.

Intention to create legal relations

Unless parties intend to enter into a contract no legally binding agreement can be formed. The courts apply an objective test in determining whether such intention exists. In commercial contracts there is a rebuttable presumption that the parties intend to bind themselves.

Pre-contract negotiations

As part of the negotiations for entering into full agreements the parties may enter into the following:

Heads of terms

The purpose of a heads of terms is to summarise the principle terms of agreement between the parties and manage the process through to completion of a full agreement. The terms that relate to the full agreement will not be legally binding on the parties but terms relating to other matters such as confidentiality and exclusivity will be legally binding if stated as being as such. A heads of terms may also be known as a letter of intent or memorandum of understanding. Great care should be taken when considering entering into heads of terms, to avoid unintentionally binding the parties or creating moral obligations.

Non-disclosure or confidentiality

A non-disclosure agreement (NDA) is usually a legally binding agreement controlling and protecting the disclosure of information passing between parties who wish to protect their information whether it is confidential or not. NDA terms can stand alone or form part of the heads of terms.

Exclusivity

A party wishing to ensure that it is the only party in negotiations with another party will require an exclusivity or lock-out agreement. The aim of such an agreement is to prevent the parties from negotiating with third parties and to enable the parties concerned to get the most from the opportunity and to complete a full agreement. An exclusivity agreement is legally binding and will contain undertakings and restrictions with consequences for breach.

Capacity

Contracts entered into by parties who do not have capacity to do so will be void. Contracts usually, therefore, contain a warranty that the parties have capacity and authority to enter into the contract. A party's capacity can be determined by statute, common law or its own constitutional documents.

Privity

The legal doctrine of privity of contract states that:

The Contracts (Rights of Third Parties) Act 1999 allows third parties to rely on contracts where a benefit was conferred on it and where the contract expressly states. Where a third party gains a right to enforce a contract, the contract cannot ordinarily be varied or cancelled without the third party's consent.

Contractual terms

Contracts that do not have clear, comprehensive or unambiguous terms will fail for lack of certainty. The courts will, in some cases, infer terms but each case is judged on its own merits. Terms can be express or implied and are further classified as:

The nature of a term affects the remedies for the innocent party to a breach of the term. In addition, terms must be distinguished from representations that may have been made by one party to the other but do not form part of the contract and also give rise to remedies for breach.