Contracts Basics

I have commented to my students many times that one reason they  have trouble with Biz Orgs is that they lack a basic foundation in contract law.   Why is this, I wonder?  Students think of contracts as offer, acceptance, consideration, counter-offers, the mail box rule, the mirror-image rule and so on.  It’s really far  more simple than that.  I gave an exam in my UCC class once where a guy bought a computer at Frys.  When paying for the computer, he gave the check-out person a purchase order.  The purchase order had a bunch of terms, which, of course, were completely to the benefit of the buyer.  But the clerk took the form, took his money, and the guy walked out the door with the computer.  Most of the students struggled trying to identify the “offer,” the “acceptance,” etc.   The issue was whether the terms of the buyer’s purchase order were part of the contract.  There is clearly a contract.  There was never any conceivable issue about whether a contract existed.    

As I have said in class a million times, contracts are promises people make to each other that courts enforce.  The student should assume that a contract exists unless someone is refusing to perform saying “what contract”?  In the real world, the legal issues that arise over contracts are overwhelmingly “what were the promises that the parties made to each other.”  What is it that Fred said he would do that Bill is now seeking to enforce?

To state a cause of action for breach of contract, the plaintiff need only state that a contract exists between plaintiff and defendant, the general terms of the contract, that plaintiff did what he promised and defendant did not do what he promised, and that damages flow from the breach.  If plaintiff establishes these facts at trial, he will get a judgment against defendant for an amount usually equal to the benefit of the bargain, the amount he would have in his pocket if defendant did what he said he would do.    Sometimes plaintiff will get an order from the court requiring defendant to do – literally – what he promised to do, i.e., specific performance.

So the issues to focus on are:

  • who are the parties to the contract; who promised what to who.  In my practice – bankruptcy – people commonly have a credit card that they use for business.  Perhaps the business is owned by an LLC.  They want to say that the debt is business related therefore the LLC owes the debt, not them.  My response is  who made the promise to pay the card charges, you or the LLC?  They don’t know.  Well, look at the thing you signed when you got the credit card.  Either you promised to pay it or the LLC promised, perhaps both.  It has nothing to do with what the card was used for.   The client then asks, “does my wife have to file bankruptcy as well as me”?  My response, did she promise Visa she would pay that card?  Is she a party to the contract?  “Well, she’s my wife.”  Answer, so?  I suppose California may say she is liable to pay it or that her property can be seized for non-payment but the question still is whether or not she is a party to the contract.  It cannot be breach of contract unless the defendant is a party to the contract, i.e., made promises to the other side of the contract.
  • What are the promises that were made; what is it that the court is going to make the defendant do?  This is by far the typical issue in contract disputes.  Documents prepared to memorialize the terms of the contract are often confusing, vague, contradictory, impossible to perform.  I have written settlement agreements myself and when I look at the agreement years later, I read it wondering what I meant by saying such and such.  The written words are often supplemented by oral promises at the same time or perhaps later modifying the terms of the original agreement.  There are a bunch of rules designed to help courts figure out what the parties meant such as the parol evidence rule.  Resolution of these types of issues are obviously factually intensive.  There are often things that come up later that the parties hadn’t thought of.  How do those get resolved?  Well, I don’t know.  If the issues are not part of the promises made by the parties to each other, it is beyond the scope of the breach of contract action.
  • Conditions; is the promise someone made conditioned on something else. The argument goes, “you said you would do this and you didn’t.”  “Well I was waiting for you do what you promised first.”  If a promise is conditional, obviously the condition must be met before the promisor has a duty to perform.  For example, I will buy your house if I can get a loan.  The answer to that is obvious.
  • Damages; did the failure of the promisor to do what he said he would do cause the other guy – the plaintiff – damages?   This is really a remedies issue but it is fairly common that the attorney is telling his prospective client that there appears to be no damages and therefore it is pointless to proceed.  It is still a breach of contract but the plaintiff is really no worse off by the non-performance of the other guy.

The often tested issue in business organizations is shareholders agreements.   Shareholders will enter into an agreement – among themselves – which purports to do things that only the board of directors can do.  An example of this is who will be the officers of the corporation.  Officers are appointed by the board, not shareholders.  Therefore a contract that purports to appoint officers is unenforceable, at least as to the promise that so and so will be president.  The court will not enforce that promise because performing the promise is impossible.  If I am a shareholder and I promise the other parties to the contract that Fred will be president, how can the court make me do that?

The confusion comes especially when the parties to the agreement are also on the board.  Students ask me – “Is this a shareholders agreement or a board of directors agreement?”   My response is who cares?  The question is – can the promise the person made be enforced by the court?  If a board member agrees that Fred will be president for five years, can the court enforce that?  Well what is the promise the board member is making and to whom?  Is he saying he will vote for Fred at the next board meeting?  Well we know that the board member is supposed to show up to the board meeting, read the reports, listen to experts, then figure out what’s best for the corporation at that time.  The promise to vote for Fred in advance means he is promising he will ignore his fiduciary duties at the board meeting.  That is unenforceable.

But (the students ask), presidents are hired to five year contracts all the time?  Directors vote to give Pete a five year contract as president all the time.  It sounds like you are saying that is unenforceable.  But that is a contract between the corporation and Pete.  The board can change its mind and fire Pete down the road.  If it did, Pete would sue the corporation saying that IT broke its promise to him.

What about shareholders promising each other that they will vote for so and so at the shareholders meeting?  Is that enforceable?  Yes.  First, that’s what shareholders do – they vote for directors at shareholders meetings.  Second, there are no rules that circumscribe how they should do this.  Shareholders owe no fiduciary duties to anyone.   A shareholder can vote for someone for the board even if that someone hates the corporation.   What about shareholders promising other shareholders that they will not sell their stock without offering it to the other party first.  Is that enforceable?  Of course!  It’s my stock.  I can promise you that I will give you first chance to buy it before I sell it.

Another issue that comes up in Biz Orgs is the interested director transaction.   An interested director transaction is one where the director is on both sides of the transaction – a contract.  Typically it’s a transaction between the corp and the director.  I have put on a few tests that the corp decides to buy an airplane from a director.  The corp negotiates the price, the payments terms, warranties, perhaps options.  The negotiations are between the corp and the director.  Assuming it’s a consequential decision, the director must then decide whether this purchase is a good idea for the corp at the same time he is presumably trying to get the best deal for himself.   It makes sense to question the motivation of the director and to ask a court to determine whether the transaction was fair to the corp.

But suppose the corp gets a loan from the bank.  One of the directors agrees to personally guarantee the loan.  That is not an interested director transaction.   The parties to the guaranty are the bank and the director.  The loan agreement is between the bank and the corp.  The director is not on both sides of either transaction.  As to the loan he is deciding what is best for the corp.  As to the guaranty, he is negotiating for himself alone.  Now if the director asks the corp to pay him a fee in return for the guaranty, that would be an interested director transaction because the director is negotiating the fee for both the corp and for himself.  He is on both sides of that of that transaction.

Suppose the corp is considering hiring the director’s son or brother-in-law for some important position.   That is not an interested director transaction.  The contract is between the corp and the son.  The director is not on both sides of the contract.  But obviously a reasonable person would question the director’s decision when voting to approve the transaction on behalf of the corp.  The director here has a conflict and if he is accused of violating his fiduciary duty of care, the business judgment rule would not protect him.  But again here there would be an issue of damages.  If the vote of the board of directors was 10-0 to hire the son, how could the director’s decision have damaged the corp.

Yet another area of confusion for students is the sales of stock owned by a director.  Suppose director A sells some or all of his shares to B.    That is not an interested director transaction.  The sale is a contract between A and B.  The corp is not a party.  Even if B is also on the board, the corp is not a party to the transaction.   What if A offers to sell his stock to the corp?  That is obviously an interested director transaction.  The director would be trying to do what is best for him and at the same time trying to do what is best for the corp.  While we are at it:  so what if it’s an interested director transaction?  The so what is that the transaction can be avoided or unraveled if it is not fair to the corp.    If the director actually voted for the sale, the duty of care issue would come up for that director and the BJR would not protect him  because he has a conflict.

The point of the above is that much of the semester on biz orgs deals with contract issues.  The student should think for a minute about who made the promise and to whom did he make the promise.  That is the person who will be trying to enforce the promise.

The same analysis helps us understand why forming a corp protects the personal assets of the owners and operators of the corp.  The outlines call this limited liability.  But there is no rule of law that says owners and directors of a corporation have limited liability.  The owners have NO liability – at all – because they are not parties to the contracts.     The corp hires people, buys stuff, sells stuff, leases space, gets loans, runs ITS business.  The owner is not a party to the contracts the corp enters into and therefore is not liable for the breach if there is one.  And they certainly don’t have liability limited to their investment in the corp.  That really makes no sense.  They have the financial risk of loss of their investment but not limited liability.

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