Contract law II: terms, defects, performance and breach

Forming a contract is only the beginning. Disputes usually arise later, over what the contract means, whether one party was misled into signing it, whether an unexpected event excuses performance or whether a failure to perform justifies ending the relationship. This lesson covers the content of contracts, including express and implied terms, interpretation, exclusion clauses and good faith; the defects that can make a contract voidable or void; how contracts are discharged; and how the law classifies breach. Remedies follow in lesson 5.

Express and implied terms

Express terms are those the parties stated, orally or in writing. Implied terms are added by law or by the courts. Courts imply terms in three main ways: terms implied by statute, such as the conditions of quality and fitness in sale of goods law (lesson 5); terms implied by custom or trade usage, when a practice is so well known in an industry that the parties must have intended it; and terms implied in fact, to give business efficacy to a contract when the term is so obvious that it goes without saying. Courts will not imply a term merely because it would be reasonable, and will not imply a term that contradicts an express one.

When the meaning of a written contract is disputed, American courts start with the plain meaning of the words, read in light of the contract as a whole. Courts differ on how readily they consider outside evidence: some, such as New York's, admit extrinsic evidence only if the contract is ambiguous on its face, while others, notably California's, allow evidence to show that seemingly clear words were reasonably susceptible to another meaning. Under the parol evidence rule, a written contract that the parties intended as their final and complete agreement (an integrated contract) cannot be contradicted, or if fully integrated even supplemented, by evidence of earlier or contemporaneous agreements; contracts often contain a merger or integration clause to show this. For sales of goods, UCC section 1-303 lets courts use course of performance, course of dealing and usage of trade to explain or supplement terms. Ambiguities are construed against the drafter (contra proferentem).

Exclusion and limitation clauses

Business contracts commonly limit or exclude liability: a cap on damages equal to the fees paid, an exclusion of consequential damages such as lost profits, or a disclaimer of implied warranties. These clauses allocate risk and affect price, and courts generally enforce them between sophisticated parties. They are read narrowly, however, and they must clearly cover the loss in question. Consumer protection statutes often prohibit or limit them in consumer contracts.

Courts generally enforce limitation and exclusion clauses between businesses, subject to several limits. Under UCC section 2-316, a disclaimer of the implied warranty of merchantability must mention merchantability and, if written, be conspicuous; phrases such as "as is" also disclaim implied warranties. Under UCC section 2-719, a limited remedy, such as repair or replacement only, gives way if it fails of its essential purpose, and a limitation of consequential damages for personal injury from consumer goods is presumed unconscionable. Under general contract law, courts may refuse to enforce unconscionable terms, and most states will not enforce clauses that purport to exclude liability for intentional misconduct, fraud or gross negligence. The federal Magnuson-Moss Warranty Act limits disclaimers of implied warranties when a written warranty is given to consumers.

Good faith

Every contract in the United States carries an implied covenant of good faith and fair dealing, recognized in Restatement (Second) of Contracts section 205, and UCC section 1-304 imposes an obligation of good faith on the performance and enforcement of every contract within the UCC. The covenant prevents a party from acting to deprive the other of the benefit of the bargain, for example by using a discretionary power in bad faith, but it cannot override express terms. In most states, breach of the covenant in an ordinary commercial contract supports only contract damages; a few states allow tort damages in special relationships, notably insurance, where an insurer that unreasonably refuses to pay a claim may face bad-faith liability including punitive damages. Courts also vary in how far the covenant limits an employer's right to fire at-will employees (lesson 10).

Defects in formation

A contract that appears valid may be defective because of how it was made. A void contract never had legal effect; a voidable contract is valid until the innocent party chooses to rescind it. Rescission unwinds the contract and returns both parties to their original positions, so it is lost if that is no longer possible, if an innocent third party has acquired rights or if the innocent party affirms the contract after learning the truth.

A misrepresentation is a false statement of fact that induces the other party to contract. Opinions, predictions and sales puffery, such as "the best pizza in town", are not statements of fact, although an opinion from someone with special expertise may imply facts. Silence is not usually misrepresentation, but a half-truth is, and so is failing to correct a statement that becomes false before the contract is signed. Some relationships, such as insurance and fiduciary relationships, require disclosure, and consumer and securities laws impose disclosure duties.

American courts generally require both procedural unconscionability, unfairness in the bargaining process such as hidden terms or lack of meaningful choice, and substantive unconscionability, terms that are unreasonably favorable to one side, though a strong showing of one may offset a weaker showing of the other. In Williams v. Walker-Thomas Furniture Co. (1965), a store's cross-collateral clause let it repossess every item a low-income customer had bought over several years if she defaulted on her latest purchase; the court held such a clause could be unenforceable as unconscionable. UCC section 2-302 lets courts refuse to enforce unconscionable contracts or clauses for goods.

Discharge: how contracts end

Most contracts are discharged by performance: each party does what it promised. Contracts can also be discharged by agreement, for example when the parties agree to end the contract (mutual release), to replace it with a new one (novation) or to accept a different performance (accord and satisfaction). A contract may also end through a condition: a condition precedent must occur before obligations arise, such as financing approval in a real estate deal, and a condition subsequent ends obligations when it occurs.

A party may be excused when performance becomes impossible, for example because the subject matter is destroyed or a necessary person dies, or commercially impracticable, when an unforeseen event makes performance vastly more difficult or expensive and the parties assumed the event would not occur. UCC section 2-615 codifies impracticability for sellers of goods. Courts apply these doctrines narrowly: a cost increase of even 50 % or 100 % is usually treated as a risk the seller assumed. Frustration of purpose excuses performance when an unforeseen event destroys the value of the performance to one party, although performance remains possible, as in the English coronation cases where rooms were rented to watch a procession that was canceled.

Because these doctrines are narrow and unpredictable, well-drafted contracts include force majeure clauses. A force majeure clause lists events beyond a party's control, such as natural disasters, war, epidemics, government orders and strikes, and states the consequence: suspension of performance, extension of time or termination after a period. Courts interpret these clauses according to their wording; a party that relies on one usually must show that the event falls within the clause, that it caused the failure to perform and that the party took reasonable steps to mitigate. The COVID-19 pandemic produced a wave of litigation over whether pandemics or government orders were covered, and many businesses rewrote their clauses afterwards.

Breach of contract

A breach occurs when a party fails to perform as promised without lawful excuse. The common law distinguishes material breaches, which defeat the essential purpose of the contract and let the innocent party suspend performance, terminate and sue for total breach, from minor breaches, which give only damages. Under the doctrine of substantial performance, a party who performs in good faith with only minor deviations can recover the contract price less damages for the defects. In Jacob & Youngs v. Kent (1921), a builder used pipe of the same quality as, but a different brand from, the one specified; the court held the owner could recover only the small difference in value, not the cost of tearing out walls to replace the pipe. For sales of goods, the UCC applies the stricter perfect tender rule (section 2-601): the buyer may reject goods that fail to conform in any respect, subject to the seller's right to cure (section 2-508) and special rules for installment contracts. Anticipatory repudiation, a clear statement that a party will not perform, lets the innocent party treat the contract as breached at once, and under UCC section 2-609 a party with reasonable grounds for insecurity may demand adequate assurance of performance.

Privity and third parties

Third parties can enforce a contract if they are intended beneficiaries: the parties meant to give them the benefit of the promise, as when a life insurance policy names a beneficiary or a contract requires a contractor to pay a subcontractor directly. Incidental beneficiaries, who merely happen to benefit, such as a neighbor whose property value rises when a building is completed, cannot sue. Rights under a contract can generally be assigned and duties delegated, unless the contract prohibits it, the performance is personal or the assignment would materially change the other party's obligations; delegation does not release the original party from liability unless the other party agrees to a novation.