ICAI Notes 1.1 - Nature of contract - CA Foundation PDF Download

Learning Objectives

• Understand meaning of the terms ‘agreement’ and ‘contract’ and note the distinction between the two.
• Note the essential elements of contract.
• Be clear about various types of contract.
• Understand the concept of offer and acceptance and rules of communication and revocation thereof.

THE LAW OF CONTRACT : GENERAL PRINCIPLES 

As a result of increasing complexities of business environment, innumerable contracts are entered into by the parties in the usual course of carrying on their business. ‘Contract’ is the most usual method of defining the ‘give and take’ rights and duties in a business transaction. This branch of Private law is different from other branches of law in a very important respect. It does not prescribe so many rights and duties, which the law will protect or enforce; it contains a number of limiting principles subject to which the parties may create rights and duties for themselves. In a sense, parties to a contract are the makers of law for themselves. They can frame any rules they desire to the subject matter of their agreements, and law takes cognizance of their decision unless they are not legally prohibited. All agreements are not studied under the Indian Contract Act, 1872, as some of those are not contracts. Only those agreements, which are enforceable at law, are contracts. This unit refers to the essentials of a legally enforceable agreement or contract. It sets out rules for the offer and acceptance and revocation thereof. It states the circumstances when an agreement is voidable or enforceable by one party only, and when the agreements are void, i.e. not enforceable at all.

1.1 WHAT IS CONTRACT?

Section 2(h) of the Act defines the term contract “as an agreement enforceable by law”.
Section 2(e) defines agreement as “every promise and every set of promises, forming the consideration for each other”. Again Section 2(b) defines promise in these words: “When the person to whom the proposal is made signifies his assent thereto, the proposal is said to be accepted. Proposal when accepted, becomes a promise”.

From the above, it is obvious that an agreement is a promise or a set of reciprocal promises, that a promise is the acceptance of a proposal. There must be an offer or a proposal which the other person accepts and when he accepts he knows that the acceptance will give rise to a binding contract. But as Section 2(h) requires an agreement to be worthy of being enforceable by law before it is called ‘contract’, there arises an important question : On what conditions does the Indian Contract Act recognise the “agreement” of the parties (which contains a promise) as a “contract”? The answer to this question will form the subject of our discussion in this Unit.

1.2 ESSENTIAL ELEMENTS OF A VALID CONTRACT

According to Section 10, “All agreements are contracts if they are made by the free consent of parties competent to contract, for a lawful consideration and with a lawful object, and are not hereby expressly declared to be void.” The following essential elements must co-exist in order to make a valid contract:
1. Proper offer and proper acceptance with intention to create legal relationship.
2. Lawful consideration.
3. Capacity.
4. Free consent.
5. Lawful agreement.

1. In the first instance, the parties ought to have the intention to create a legal obligation between them through the form of offer an acceptance. They should have intention to impose duty on the promisor to fulfil the promise and bestow a right on the promisee to claim its fulfilment. It must not be merely a moral one but it must be legal.
2. The second aspect to look for is the presence of “lawful consideration” which is an essential element of a valid contract. Consideration is a technical word meaning thereby quid pro quo i.e. something in return. It must result in benefit to one party and detriment to the other party or a detriment to both.

Example : A agrees to sell his books to B for Rs. 100, B’s promise to pay Rs. 100 is the consideration for A’s promise to sell his books and A’s promise to sell the books is the consideration for B’s promise to pay Rs. 100.

If the two essential elements are there we can say that there is a contract which prima-facie will hold good; or at least we can say that there is an existence of contract, although some more necessary elements of validity may be wanting.

3. Thirdly, the parties to a contract must have capacity (legal ability) to make valid contract. In every case there must be assent of the parties. The assent presupposes a free, fair, and serious exercise of the reasoning faculty. If, therefore, either of the parties to an agreement is deprived of the use of his understanding or if he be deemed by law not to have attained it, there can be no such agreement which shall bind him. Section 11 of the Indian Contract Act specifies that every person is competent to contract provided,
(a) he is of the age of majority according to the law to which he is subject and
(b) he is of sound mind and
(c) he is not disqualified from contracting by any law to which he is subject. In other words (a) a minor, (b) a person of unsound mind (a person of unsound mind can enter into a contract during his lucid intervals) and (c) a person disqualified from contracting by any law to which he is subject, e.g. an alien enemy, foreign sovereigns and accredited representatives of a foreign state, insolvents and convicts are not competent to contract 

4. The consent of the parties must be genuine. The term ‘consent’ means parties to a contract must agree upon the same thing in the same sense, i.e. there should be consensus-adidem. Consent is said to be not free when it is vitiated by coercion, undue influence, fraud, misrepresentation or mistake. In such cases, the contract becomes voidable at the option of the party whose consent is not free.

Example: A threatened to shoot B if he (B) does not lend him Rs. 2,000 and B agreed to it. Here the agreement is entered into under coercion and hence voidable at the option of B.

5. The agreement must not be one, which the law declares to be either illegal or void. A void agreement is one, which is without any legal effects. Illegal agreement is an agreement expressly or impliedly prohibited by law.

Example: Agreements in restraint of trade, marriage, legal proceedings etc. are void agreements. Those agreements prohibited by the Indian Penal Code e.g. Threats to commit murder or publishing defamatory statements or agreements which are opposed to public policy are illegal in nature.

1.3 TYPES OF CONTRACT

1. Void Contract : It is a contract without any legal effect and cannot be enforced in a Court of Law. Section 2(j) defines a void contract as “a contract which ceases to be enforceable by law becomes void when it ceases to be enforceable”.

Examples : Where both parties to an agreement are under a mistake of fact, (Section 20), when the consideration or object of an agreement is unlawful, (Section 23), an agreement made without consideration, (Section 25), agreement in restraint of marriage (Section 26), trade (Section 27), legal proceedings (Section 28), agreement by way of wager (Section 30) are instances of void contract.

2. Voidable Contract : As per Section 2(i), “an agreement which is enforceable by law at the option of one or more the parties but not at the option of the other or others is a voidable contract.”

Examples : A contract brought about as a result of Coercion, Undue influence, Fraud or misrepresentation would be voidable at the option of the person whose consent was caused by any one of these factors.

Void and Voidable contract : Distinction 

(a) Definition : As per Section 2(j) and (i) a contract which ceases to be enforceable by law becomes void when it ceases to be enforceable and a voidable contract is an agreement which is enforceable by law at the option of one or more of the parties thereon, but not at the option of other or others.
(b) Nature : A void contract is valid when it is made but subsequently becomes unenforceable on certain grounds such as supervening impossibility, subsequent illegality, repudiation of a voidable contract, a contingent contract depending upon happening of an uncertain event, when occurrence of such event becomes impossible

A voidable contract on the other hand is voidable at the option of the aggrieved party, and remains valid until rescinded by him. Contract caused by coercion, undue influence, fraud, misrepresentation are voidable. But in case contract is caused by mistake it is void.

(c) Rights : A void contract does not provide any legal remedy for the parties to the contract. They even cannot get it performed when they so desire. The aggrieved party in a voidable contract gets a right to rescind the contract. When such party rescind it, the contract becomes void. In case aggrieved party does not rescind the contract within a reasonable time, the contract remains valid.

3. Illegal contract : It is a contract which the law forbids to be made. The court will not enforce such a contract and also connected contracts. All illegal agreements are void but all void agreements or contracts are not necessarily illegal.

Examples : Contract to commit crime. Contract that is immoral or opposed to public policy are illegal in nature.

Void and Illegal agreements : distinction. According to Section 2 (g) of the Indian Contract Act, an agreement not enforceable by law is void. The Act has specified various factors due to which an agreement may be considered as void agreement. One of these factors is unlawfulness of object or consideration of the contract i.e., illegality of the contract which makes it void. Despite the similarity between an illegal and a void agreement that in either case the agreement is void and cannot be enforced by law, the two differ from each other in the following two respects :
(a) Scope : An illegal agreement is always void while a void agreement may not be illegal being void due to some other factor e.g., an agreement the terms of which are not certain is void but not illegal.
(b) Effect on collateral transaction : If an agreement is merely void and not illegal, the collateral transactions to the agreement may be enforced for execution but collateral transaction to an illegal agreement also becomes illegal and hence cannot be enforced.
(c) Punishment : Unlike illegal agreements, there is no punishment to the parties to a void agreement.
(d) Void-ab-initio : Illegal agreements are void from the very beginning, but sometimes valid contracts may subsequently become void.

4. Unenforceable contract : Where a contract is good in substance but because of some technical defect i.e., absence in writing, barred by limitation etc. one or both the parties cannot sue upon it, it is described as an unenforceable contract. Contracts may also be classified according to formation namely, Express Contracts and Implied Contracts.

5. Express Contracts : A contract which is made by words either spoken or written is said to be an express contract. According to Section 9 insofar as the proposal or acceptance of any promise is made in words, the promise is said to be express.

6. Implied Contract : By implied contract means implied by law (i.e.) the law implies a contract though parties never intended. According to Section 9 insofar as such proposal or acceptance is made otherwise than in words, the promise is said to be implied. For example, A delivers by mistake goods at B’s warehouse instead of at C’s place. Here there is an obligation on the part of B to return the goods to A, though they never intended to enter into a contract.

7. Tacit Contract : A contract is said to be tacit when it has to be inferred from the conduct of the parties. Examples obtaining cash through automatic teller machine, sale by fall of hammer at an auction sale. Besides contracts may be classified on the basis of performance. Such contracts may be executed, executory, unilateral and bilateral.

8. Executed Contract : If the consideration for the promise in a contract (i.e., any act or forbearance) is given or executed, such type of contract is called contract with executed consideration.

9. Executory Contract : It is so called because the reciprocal promises or obligation which serves as consideration is to be performed in future.

10. Unilateral Contract : A unilateral contract is a one-sided contract in which only one party has to perform his promise or obligation to do or forbear.

11. Bilateral Contract : Where the obligation or promise in a contract is outstanding on the part of both the parties, it is known as bilateral contract.

Formal Contracts : The English Law classifies the contract into (i) formal contracts and (ii) simple contracts. 

Formal Contracts include (a) Contract of record and (b) Contract under Seal.

(a) Contract of Record : A contract of record is either a judgement of a court or a recognisance. A judgement is an obligation imposed by a Court upon one or more persons in favour of another or others. As a matter of fact it is not a contract in the real sense, since it is not based upon any agreement between the two parties. A recognisance is a written acknowledgement of a debt due to the State. It is usually met with the connection with criminal proceedings. Contracts of record derive their binding force from the authority of the Court.

(b) Contract under Seal : A contract under seal is one which derives its binding force from its form alone. It is written and is signed, sealed and delivered by the parties. It is also called a deed or a speciality contract. Now we shall discuss the term ‘offer’ and ‘acceptance’ referred to earlier, in detail.

1.4 PROPOSAL/OFFER

The words proposal and offer are used interchangeably and it is defined under Section 2(a) of the Indian Contract Act, 1872 as when one person signifies to another his willingness to do or to abstain from doing anything with a view to obtaining the assent of that other to such act or abstinence, he is said to make a proposal. Thus, for a valid offer, the party making it must express his willingness ‘to do’ or ‘not to do’ something. But mere expression of willingness does not constitute an offer. For instance, where ‘A’ tells ‘B’ that he desires to marry by the end of 2004, it does not constitute an offer of marriage by ‘A’ to ‘B’. Therefore, to constitute a valid offer expression of willingness must be made to obtain the assent (acceptance) of the other. Thus, if in the above example, ‘A’ further adds, ‘Will you marry me’, it will constitute an offer. Thus “doing” is a positive act and “not doing”, or “abstinence” is a negative act; nonetheless both these acts have the same effect in the eyes of law.

Classification of Offer :

(a) General Offer : It is an offer made to the public in general and hence anyone can accept and do the desired act. Section 8 of the Indian Contract Act points out that performance of the conditions of a proposal is an acceptance of the proposal.

(b) Special Offer : When offer is made to a definite person, it is known as specific offer and such offer can be accepted only by that specified person.

(c) Cross Offfers : When two parties exchange identical offers in ignorance at the time of each other’s offer, the offers are called Cross offers. There is not biding contract in such a case, as one’s offer cannot be construed as acceptance by the other.

(d) Counter Offer : When the offeree offers to qualified acceptance of the offer subject to modifications and variations in the terms of original offer, he is said to have made a counter offer. Counter-offer amounts to rejection of the original offer.

(e) Standing, Open or Continuing offer : An offer is allowed to remain open for acceptance over a period of time is known as a standing, open or continuing offer. Tender for supply of goods is a kind of standing offer.

Rules as to offer :

(a) The offer must be capable of creating legal relation : A social invitation, even if it is accepted, does not create legal relations because it is not so intended. An offer, therefore, must be such as would result in a valid contract when it is accepted.

(b) The offer must be certain, definite and not vague : If the terms of an offer are vague or indefinite, its acceptance cannot create any contractual relationship. Thus, where A offers to sell B a 100 quintals of oil, there is nothing whatever to show what kind of oil was intended. The offer is not capable of being accepted for want of certainty. But if the agreement contains reference for ascertaining a vague term, the agreement is not void on the ground of its being vague. If in the above example, A is a dealer in coconut oil only, it shall constitute a valid offer since the nature of A’s trade affords an indication as to which oil is being offered.

(c) The offer may be expressed or implied.

(d) The offer must be distinguished from an invitation to offer.

(e) An offer may be specific or general.

(f) The offer must be communicated : An offer, to be complete, must be communicated to the person to whom it is made. Unless an offer is communicated, there can be no acceptance by it. An acceptance of an offer, in ignorance of the offer, is not acceptance and does not create any right on the acceptor.

(g) The offer must be made with a view to obtaining the consent of the offeree.

(h) An offer may be conditional.

(i) The offer should not contain a term the non compliance of which would amount to acceptance. Thus a man cannot say that if acceptance is not communicated by a certain time the offer would be considered as accepted.

Offer and Invitation to Offer : An offer should be distinguished from an invitation to offer. An offer is definite and capable of converting an intention into a contract. Whereas an invitation to an offer is only a circulation of an offer, it is an attempt to induce offers and precedes a definite offer. Acceptance of an invitation to an offer does not result contract and only an offer emerges in the process of negotiation.

When a person advertises that he has a stock of books to sell or houses to let, there is no offer to be bound by any contract. Such advertisements are offers to negotiate-offers to receive offers. In order to ascertain whether a particular statement amount to an ‘offer’ or an ‘invitation to offer’, the test would be intention with which such statement is made. Does the person who make the statement intend to be bound by it as soon as it is accepted by the other or he intends to do some further act, before he becomes bound by it? In the former case, it amounts to an offer and in the latter case, it is an invitation to offer.

1.5 ACCEPTANCE 

Meaning : A proposal or offer is said to have been accepted when the person to whom the proposal is made signifies his assent to the proposal to do or not to do something [Section 2 (b)]. The rules regarding acceptance are :

1. Acceptance must be absolute and unqualified : As per Section 7 an acceptance is valid when it is absolute and unqualified and is expressed in some usual and reasonable manner, unless the proposal prescribed the manner in which it is to be accepted. Thus, if A enquiries from B, “will you purchase my dog for Rs. 100” ? and B replies, “I shall purchase your dog for Rs. 100 provided you purchase my cat for Rs. 60”. B in such a case would not be said to have accepted the proposal of A. Also an acceptance with a variation is no acceptance. It is simply a counter proposal which shall have to be accepted by the original proposer before a contract can be deemed to have come into existence. A counter proposal is the offer by the offeree and can result in a contract only if it is accepted by the other party.

2. Communicated to Offeror: It must further be remembered that an acceptance must be communicated to the person who made the offer. An offer made by the intended offeree without the knowledge that an offer has been made to him cannot be deemed as an acceptance thereto.

3. Acceptance must be in the mode prescribed: Where the mode of acceptance is prescribed in the proposal, it must be accepted in that manner. But if the proposer does not insist on the proposal being accepted in the manner prescribed after it has been accepted otherwise i.e., not in the prescribed manner, the proposer is presumed to have consented to the acceptance.

4. Time: Acceptance must be given within a reasonable time and before the offer lapses.

5. Mere silence is not acceptance 

6. Acceptance by conduct: The assent means that acceptance has been signified either in writing or by word of mouth or by performance of some act. Therefore, when, a person performs the act intended by the proposer as the consideration for the promise offered by him, the performance of the act constitutes acceptance. For example, when a tradesman receives an order from a customer and executes the order by sending the goods, the customer’s order for goods constitutes the offer, which has been accepted by the tradesman subsequently by sending the goods. It is a case of acceptance by conduct.

1.6 COMMUNICATION OF OFFER AND ACCEPTANCE

When the contracting parties are face to face, there is no problem of communication, because there is instantaneous communication of offer and acceptance. In such a case the question of revocation does not arise since the offer and its acceptance are made instantly. The difficulty arises when the contracting parties are at a distance from one another and they utilise the services of the post office or telephone. In such cases it is very much relevant for us to know the exact time when the offer or acceptance is made or complete.

Communication of offer : The communication of an offer is complete when it comes to the knowledge of the person to whom it is made (Sect. 4). An offer may be communicated either by words spoken or written or it may be inferred from the conduct of the parties. When a proposal is made by post its communication will be complete when the letter containing the proposal reaches the persons to whom it is made. For example, A makes proposal to B to sell his house for Rs. two lakhs. The letter is posted on 10th March. This letter reaches B on 12th March. The offer is said to have been communicated on 12th, when B receives the letter.

Communication of acceptance : Communication of an acceptance is complete :
(i) as against the proposer, when it is put in course of transmission to him so as to be out of the power of the acceptor to withdraw the same;
(ii) as against the acceptor, when it comes to the knowledge of the proposer. When a proposal is accepted by a letter sent by the post the communication of acceptance will be complete as against the proposer when the letter of acceptance is posted and as against the acceptor when the letter reaches the proposer.

1.7 REVOCATION OF OFFER AND ACCEPTANCE

Under Section 4, the communication of a revocation is complete :–
(i) as against the person who makes it, when it is put into a course of transmission to the person to whom it is made so as to be out of the power of the person who makes it;
(ii) as against the person to whom it is made, when it comes to his knowledge.

Let us consider the illustration. If you (proposer) revoke your proposal by a telegram, the revocation will be complete so far as you are concerned, when you have dispatched the telegram. But in so far as I (acceptor) am concerned, it will be complete when I actually receive the telegram. As regards the revocation of acceptance, I revoke my acceptance by a telegram my revocation of acceptance is complete as against myself, as soon as I have dispatched the telegram, and as against you when it reaches you.

Under Section 5, a proposal may be revoked at any time, before the communication of its acceptance is complete as against the proposer. An acceptance may be revoked at any time before the communication of acceptance is complete as against the acceptor.

The law relating to the revocation of offer is the same in India as in England, but the law relating to the revocation of acceptance is different. In India, acceptance by a letter can be revoked by a telegram, if it reaches earlier than, or at the same time as the letter, but in England acceptance once posted cannot be revoked subsequently even by a telegram, even if it reaches earlier than the letter.

1.8 SUMMARY Contract 

Contract : A Contract is an agreement enforceable by law [Section 2(h)]. An agreement is enforceable by law, if it is made by the free consent of the parties who are competent to contract and the agreement is made with a lawful object and is for a lawful consideration, and is not hereby expressly declared to be void. [Section 10]. All contracts are agreements but all agreements are not contracts. Agreements lacking any of the above said characteristics are not contracts. A contract that ceases to be enforceable by law is called ‘void contract’, [Section 2(j)] but an agreement which is enforceable by law at the option of one party thereto, but not at the option of the other is called ‘voidable contract’ [(Section 2(i)].

Offer and Acceptance : Offeror undertakes to do or to abstain from doing a certain act if the offer is properly accepted by the offeree. Offer may be expressly made or may even be implied in conduct of the offeror, but it must be capable of creating legal relations and must intend to create legal relations. The terms of offer must be certain or at least be capable of being made certain.

Acceptance of offer must be absolute and unqualified and must be according to the prescribed or usual mode. If the offer has been made to a specific person, it must be accepted by that person only, but a general offer may be accepted by any person. Communication of offer and acceptance, and revocation thereof
(a) Communication of an offer is complete when it comes to the knowledge of the offeree.
(b) Communication of an acceptance is complete : As against the offeror when it is put in the course of transmission to him and as against the acceptor, when it comes to the knowledge of the offeror.
(c) Communication of revocation of an offer or acceptance is complete : As against the person making it, when it is put into a course of transmission so as to be out of power of the person making it and as against the person to whom it is made, when it comes to his knowledge.