What is a Legally Binding Contract?

A contract is an agreement that imposes obligations on both parties. But when does a back-and-forth negotiation turn into a contract that holds up in court? Legislation and past cases have developed many essential rules that every business owner should know.

Elements of Contracts

There are six fundamental elements of a contract you must meet for the contract to be valid. These are:

  • An offer
  • Acceptance
  • Consideration
  • Legal nature
  • Contractual capacity
  • Contractual intent

An offer is the first step towards building a contract. It is the initial ‘pitch’ thrown that illustrates the desire and intention of composing a valid contract. Acceptance occurs if the offer is well-received by the other party. If both parties do not agree, however, then no contract exists. The service, object, or other such payment is the contract’s consideration. For one or both parties to accept the contract, both parties must be receiving equal consideration – or at least consideration that both parties consider equal. For instance, if you offer your colleague use of your boat for $500/week while they’re on vacation, your colleague might weigh the value of using your boat as opposed to renting one from a charter company.

For a contract to be legal and binding, the subject matter of the contract must be legal and must also follow any potential regulations that might apply. You can create a contract with your colleague to rent your boat, but not to use your boat in the commission of a crime.

Contract law also states that anyone entering into a contract must have contractual capacity, i.e., have reached the legal age to be able to do so, and must be of sound mind at the time of contract signing.

Contractual intent must exist. In other words, the above contract to rent your boat is legal – but say your colleague is your boss. Imagine there’s no money exchanged as the contract states, but instead your boss has threatened your position: loan him the boat or you don’t have a job. The pressure this might induce means you’d not be subjectively entering into this contract if you were to go ahead and lend the boat.

Regardless of the type of business you own, any and all contracts you enter into must have these elements to be legally binding. Understanding some basic information regarding what a contract can and cannot stipulate of you or your business is vital.

Contract Formalization

In the process of creating a contract, emphasis should be on the formalization of said contract. In other words, if certain steps or rules are not adhered to, you may have a contract that is not legally binding.

If a contract is handwritten, the parties to the contract must sign the document by their own hand – except in the event a law or regulation states it’s only necessary to obtain the signature of the obligated party. Other laws might allow for a written copy – in this case, the names of the parties must be on the document, but it doesn’t necessarily need a signature. Sometimes, something that bears the symbol of a contracting party is also permissible, such as a seal. With electronic contracts and signatures, you must be able to match the electronic signature or seal with the contract’s content, parties, and time of entrance.

How to formalize a contract

You must include this data for a contract to be legally binding:

  • When and where the parties entered into the contract
  • Who the contracting parties are
  • The contract’s object
  • The monetary value of the contract and a means of settling the amount, such as routing and account numbers
  • The obligations of both parties
  • Term of the contract (how long do the parties have to both fulfil their positions?)
  • What sanctions you'll impose in the event the other party breaches
  • Any other provisions or conditions, such as supporting documents
  • Signatures

An oral contract, or verbal agreement, is when two or more parties exchange declarations of intent with such significance that they agree to be legally bound by their word. While admissible in court, oral contracts must also meet certain criteria to be legally binding. Of course, not every agreement reached during the course of chatting socially is binding. The difference between an agreement and a contract is the contract has a legal guarantee. Oral contracts are not mandatory for one reason – without an audio recording, a verbal agreement is not easy to prove. Contracts should, as much as possible, be in writing.

When Legislation Comes into Play

Sometimes, Congress enacts laws that unwittingly interfere with contracts written and entered into prior to enactment. This can cause disappointment among contracted parties, especially if the legislation is not in their favor. Some parties have actually sued the United States – and won. Parties to these types of cases have settled for billions of dollars. While rare, this litigation does happen – but it could be entirely avoided with a footnote in the legislation noting that it only applies to contracts written after the date of enactment.

Contracting parties expect to be able to settle their contracts, and this is a necessary protection in an ordered society. At the same time, new issues arise from time to time that the government must address.

Executing a Contract

It is imperative that a contract is properly executed, otherwise it may result in:

  • An inability to enforce the contract
  • Confusion about whether there is an actual agreement
  • Shorter period of enforcement

To ensure your contract is executable, make sure every essential element of a contract is present. At any point in the creation of the contract, if you do not have any necessary element, you might have to amend the document and re-execute it, or start from scratch and prepare a new contract.

Once you’ve prepared the contract and all parties are in agreement, decide the parties that must sign the contract. For simple contracts between two or more individuals, the concerned individuals must sign. For contracts between individuals and corporations or between companies, you must identify a person with authority to sign on behalf of the corporation or entity. An individual signing the contract without the proper authority to do so won’t result in an unenforceable contract in all cases, but it’s still a good idea to visit the company’s articles of incorporation to find the proper individual. 

Finally, decide how you'll sign the contract. The most usual method of signing a contract traditionally is wet-ink, or ball-point pen, on a hard copy document. The document circulates to all parties and each party signs in front of someone with the authority to witness the signing. Wet ink signatures are the preferable method for signing a contract for several reasons, namely forgery. While electronic signatures are gaining traction, it’s difficult to prove the actual signor unless you employ another method of verification.

Breach of Contract

A breach of contract happens when one of the parties does not uphold their obligation according to the terms of the contract. There are several ways in which a party can fail to perform, such as:

  • Not performing within the timeframe set forth in the contract
  • Not performing according to the terms of the contract
  • Total failure to perform

When a party fails to fulfill their portion of a contract and the other party has performed all duties, the party who has performed can seek legal remedies for the breach. Usually, the remedy is for the other party to perform their duty as originally set forth within the contract. If that is not possible, the non-performing party must set the performing party equal to the instance had there not been a contract to begin with. In other words, if the performing party spent any money in the performance of duties associated with the contract, the judge will normally find that the non-performing party owes this amount, known as damages (plus any other fees and costs as deemed by the court), to the performing party.

Types of contractual breaches

There are four main types of contractual breaches:

  • Minor
  • Material
  • Fundamental
  • Anticipatory

A minor breach happens if a party performs a substantial amount of the contract but fails to meet a minor condition that doesn’t affect the terms of the contract.

A material breach substantially breaks the terms of the contract. In normal contractual circumstances, this excuses the party who did not breach the contract from performing any further duties associated with the contract’s terms and allows them to seek damages.

Fundamental breaches occur when a party violates a contract’s terms so substantially it allows the other party to terminate and seek damages if they desire.

A contract usually has specific fulfillment dates. Should a party fail to perform prior to these dates, it results in an anticipatory breach. The performing party can immediately consider taking legal action against the non-performing, breaching party.

Importance of Contract Management 

When gauging the importance of contract management within your company, consider that contracts are literally the economic backbone of the business. Nearly every transaction conducted between any two businesses is consummated by the execution of a contract. Your entire contractual situation (risk, value, compliance, etc.) can be summed up by the language contained within these documents and the data that surrounds them.

Your effectiveness as a business can also be dependent upon how quickly and accurately you are able to draft, negotiate, and execute a contract. For many companies, closing contracts faster enables them to bring on more customers in the quarter, recognize revenue faster, purchase raw materials faster and at a better price, hire skilled in-demand personnel, and the list goes on. Better contract execution affords you the luxury of being more competitive in your respective market by being more agile while still controlling risk.

A dedicated contract management software, like Contracts 365 helps contract professionals promote operational efficiency, capitalize on opportunities, maximize growth, and mitigate contractual risks. Adopting contract management software is the fastest way to achieve excellence and improvements in these respective areas. If you’d like to learn more about our Contracts Management Software for businesses that run Microsoft 365, please don’t hesitate to reach out to us or, even better, request a demo and we can show you how it works in real-time.