When is a Contract legally binding?

The following is an updated version of the article "Contract Foundations: everything you need to know about contract formation" that was originally published in the June 2020 edition of The Legalese.


In its most basic definition contracts are promises that can be legally enforced. To be deemed legally binding, a contract needs to satisfy four legal elements: offer, acceptance, consideration (usually money), and an intention to create legal relations.


Let's take a look at these elements a little closer.

Offer


Contracts are in essence based on an exchange; party A makes a promise to Party B in return for an act or promise by Party B. As held in Australian Wollen Mills Pty Ltd v The Commonwealth (1954) 92 CLR 424 as long as the promise is given in exchange for something, a contract will exist (i.e. there must be quid pro quo). As such, an offer is a promise to perform something in exchange for something else. There is no particular form of what would actually be considered an offer but it generally must be a promise to do something in exchange for something in return.


As held in Toyota Motor Corp Australia Ltd v Ken Morgan Motors Pty Ltd [1994] 2 VR 106 an offer must be capable of being accepted on its terms. This means that the terms of the offer must be clear so that the person accepting it is prepared to be bound by them. The moment the offer is accepted that's when the contract becomes binding provided that the other elements are also satisfied.


But what happens if a party to whom an offer was made rejects that offer, or makes a counter-offer? Simple - there is no contract. Any offer that is countered or rejected, effectively terminates the offer. Even if the party to whom the offer was made gives a response that can be perceived as acceptance but that at the same time alters or adds to the terms of the offer, it will most likely be considered as a counter-offer rather than a proper acceptance. Offers can also be terminated if the party that makes the offer revokes that offer, or it simply lapses i.e. it was not accepted within a stipulated time frame.


Acceptance


The acceptance occurs the moment a party accepts the terms of the offer. The offer can only be accepted by the party or parties to whom the offer was made. Although the party that makes the offer can stipulate the manner in which the other can accept it, there is no particular form of what would actually be required to acknowledge acceptance.


As held in Empirnall Holdings Pty Ltd v Machon Paull Partners Pty Ltd (1988) 14 NSWLR 523 acceptance can be expressed explicitly but it can also be inferred through the conduct of the party that is deemed to have accepted the offer. However as noted further in Empirnall, mere silence cannot be taken as acceptance. For example consider the difference between these two scenarios. You offer $50 to your cousin to bake you a cake for tomorrow at 9am. Your cousin hasn’t actually said “yes” and you didn’t specify whether she has to respond or not. That evening your cousin simply asks if you have any food allergies? You respond “no” and you leave it at that. The next morning your cousin comes over and brings you the cake. In this case there was no explicit agreement but it was evident that your cousin intended to bake the cake when an enquiry was made whether you have any food allergies.

Consideration


Consideration is a little bit more straight forward since it involves some benefit that you’d obtain from the contract. Consider the following scenario. Your friend is about to upgrade to a new car so you ask to buy her old car. She agrees. Is there a contract? Not really since there is no mention of consideration i.e. how much should you pay your friend for the old car.


Remember what was said at the beginning of this article. For a contract to be enforceable there must be some kind of exchange on a quid pro quo basis. This means that all parties to the contract must obtain some type of benefit in their favour from that exchange, that is the parties have to receive something from one another. The benefit does not necessarily have to be monetary, it can also be an act or a promise to do something. In other words the consideration is the promise to do something. So let’s go back to the above example. Your friend now agrees to sell you her old car for $5000 and you agree. Since there is an exchange (you get the car while your friend gets $5000) this is the consideration that is required (of course provided the other elements are satisfied).

As held in AWM v Cth (1954) 92 CLR 424 consideration must be given in exchange for the offer promised. Keep in mind that consideration is always tied to a benefit that you will receive from the contract. It does not necessarily have to be a benefit that you will receive instantaneously; the contract will be binding so long as you receive something from the contract. For example the contract in the above scenario may be that you will pay your friend next month. The promise that you will pay next month is what constitutes the consideration.

Similarly, the consideration does not always have to be tied to the person that is making the promise. For example you can have your parents pay for your car. You obtain the benefit of a having a car, while your friend obtains the benefit of having $5000 paid for that car. The contract is complete once the consideration is fulfilled. If it’s money – then the contract is complete when the money are paid; if it’s a promise to do an act or fulfill a condition - then the contract is complete when that act is done or condition is fulfilled.

Intention to create legal relations

Consider these two scenarios. Your wedding day is coming up and you go to a fashion designer to have a wedding dress designed. You sit down with the designer, you go through the specifics of the wedding dress and agree on the style and the price. Later that day you and your friend go out for cocktails and you agree to pay her $1m if she finds you the most beautiful shoes in the world. While from the first scenario it can be easily assumed that you intended to enter into a legal relationship with your designer for the purpose of obtaining a wedding dress, the second scenario suggests that you did not intend to give your friend $1m in exchange for finding you a pair of shoes.


While on first glance both scenarios appear to contain all elements of a contract, if there is a dispute then the contract must be explored from the context in which it arose to determine whether the parties intended to be bound by it. For example, unlike the first scenario where the meeting was very formal and all details were perused and agreed upon, the second scenario was in a social setting with a consideration that was clearly a hyperbole. Accordingly, circumstances leading up to the supposed contract will also have to be looked at carefully and they would generally be the starting point to determine intention. However if there is no starting point the courts have held that presumptions can be applied in some scenarios. For example in Cohen v Cohen (1929) 42 CLR 91 it was held that a promise made in social or familial context are presumed to be made without the intention to create legal relations, while promises in a commercial setting are presumed to have the intention of creating a legal relationship.


The main importance is to conduct an objective assessment of the relationship between the parties, the circumstances and context and whether to an objective observer it would appear that a party has intended to create a legal relationship (see Taylor v Johnson (1983) 151 CLR 422). Of course exceptions exist to the above presumption. For example in Todd v Nicol [1957] SASR 72 it was held that a contract existed for the occupation of a premise even though the parties were relatives. Likewise, in Shortall v White [2007] NSWCA 372 it was found that a contract exists between separating couples. Similarly in a commercial context, a promise made “subject to contract” is held to not create a contractual relationship (Masters v Cameron (1954) 91 CLR 353).


While this article explored the basics of contracts, contracts are oftentimes complex. A contract may be illegal, a party may engage in deceptive or misleading conduct, a party may be under duress or lacking the capacity to enter into a contract. This is why you should always contact a lawyer the moment you contemplate of entering into a contract to make sure that your interests are protected.


If you need legal advice on a contract matter give us a call on (02) 8005 8025. Our lawyers have years of experience drafting, defending and enforcing various contracts and can provide you with comprehensive legal advice that is tailored to your circumstances.

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