Business law deals with legal rules and principles of primary interest to the business community. Because of the complexity of modern business, the laws affecting businesses necessarily reach into diverse areas. Many of the laws are difficult and technical. Nevertheless, the person going into business or already in business should gain at least some familiarity with basic regulations and principles.
Although not a substitute for legal advice, such basic knowledge of the law allows the business person to make intelligent decisions and to foresee problems that may actually require legal advice or assistance. The following material provides an introduction to key concepts of business law.
Establishing a Business: Formats
Typically, the person going into business wants to be the sole owner of a particular enterprise. The simplicity of sole ownership, or sole proprietorship, is attractive. Whether the owner plans to add partners or employees later, it is usually possible simply to “set up shop.”
The two main alternatives to sole proprietorship are the partnership and the corporation. In the former, two or more persons work together in a business enterprise, often on the basis of a partnership agreement. With a corporation (a separate legal entity) one or more persons can conduct business operations without taking responsibility for the debts of the business. Both the partnership and the corporation can take variant forms while maintaining a basic organizational pattern.
The Sole Proprietorship
The person operating a sole proprietorship owns the business in his or her own name. But the business can operate under the owner's name or a trade or business name: for example, “Mary Jones DBA (“doing business as”) Jones Dress Shoppe.”
Many states require that the person going into business as a sole proprietor register an assumed or fictitious business name under state and county laws. Typically, such a law is called an Assumed Names Act. Specific information is usually required, including the business name and the names and addresses of all persons who have an interest in the business.
There are many advantages to creating a sole proprietorship. The owner can keep track of the business' progress from month to month or year to year. He or she can control operating costs and can often avoid much of the paperwork required by other business arrangements. The sole proprietor remains the boss. If the business stays small, fulltime employees may not be needed.
A partnership is somewhat more complicated than the sole proprietorship but is less complex than the corporation. Formed, by two or more persons, the partnership is considered a business entity but not a tax entity. In other words, each partner must pay taxes on all partnership income.
Some other factors identify the partnership. Each partner, for example, is responsible for the debts and credit arrangements contracted by any other partner. Thus, any member of the partnership can bind the business and all its partners to business contracts and transactions. Professional partnerships were once common, but today, because most state laws allow doctors, lawyers, accountants, and other professional people to incorporate, the professional corporation has become a more standard form of business association. All members of such corporations share in the tax benefits.
The partnership agreement is sometimes informal—even oral. But ideally, partners should decide the terms of their agreement with the aid of a lawyer (see below).
A partnership has many of the advantages of a sole proprietorship but may also face similar strictures or regulations. An assumed or fictitious name must be registered. Generally, the various states levy no taxes on the right to function as a partnership or franchise. In addition, the partnership does not have to keep the general records required of a corporation. Unlike a corporation, which can stay in business indefinitely, a partnership usually dissolves on the death, retirement, or withdrawal of a partner.
The four main types of partnerships, each of which is used in specific circumstances, are the limited partnership, the joint venture, syndication, and the joint stock company.
In a limited partnership some or most of the partners can avoid the unlimited liability that characterizes the general partnership. Usually, the limited partnership has one general partner and a number of limited partners. The general partner is liable for the debts of the partnership and often for supervising all operations; the limited partners are liable only to the extent that they have invested in the partnership.
In those states that have Uniform Limited Partnership acts, the persons establishing a limited partnership must file a certificate of registration, usually with the secretary of state. The certificate gives the name of the business, its location, the names of the limited partners, and the partners' liabilities, powers, privileges, and duties.
A typical limited partnership may buy, manage, and sell apartment houses, hotels, and other kinds of real estate. The partners invest capital in the business and receive shares of the profits according to the amounts invested. A hybrid between the general partnership and the corporation, the limited partnership does not have to file articles of incorporation. Nor is it required to keep minutes or other records of operations. The limited partnership must, however, file partnership tax returns.
The Joint Venture
When two or more persons agree to join in a single transaction or project their partnership is called a joint venture. The partners in a joint venture agree to control and manage the business together. They must also agree to share profits and losses, usually on the basis of each partner's ownership interest in the property or project.
Thus, for example, should two or more persons jointly buy and own property but for some reason do not share its profits or losses, this would not be considered a joint venture. A joint venture occurs only when the parties intend to do business as a partnership.
A joint venture that involves a large number of individuals is usually known as a syndicate. As with all true joint ventures, syndication requires tax filing as a partnership.
A public offering to sell a syndicate share or interest in a property or business requires special legal handling. The Securities and Exchange Commission (SEC) has ruled that such sales to the public fall under securities laws.
Joint Stock Company or Association
Some partnerships operate under articles of association that provide for the issuance of a share of stock or certificate to each partner. The certificates represent each partner's interest. In such a joint stock company or association, the articles of association also provide that a group of partners, called the board of directors, will control the business. Individual partners cannot bind the other partners by entering into separate transactions in the name of the company or association. But participants in the association are responsible for all the legal debts and obligations incurred by the association as a whole.
Federal and state securities laws apply to sales of joint stock company shares or certificates. But, under the typical articles of association, individual partners can transfer their certificates without the consent of other participants. The articles normally specify how long the association will exist and provide that the death or withdrawal of any member will not affect the association.
Many consider the corporation the ideal way to organize a business. By law, the person or persons who own and operate the corporation are separate from it.
The corporation may be small or large. A small corporation is usually referred to as a close, or closely held, corporation. An individual may own all the stock in such a corporation and manage it alone or jointly with a few others.
But many corporations have hundreds or thousands of shareholders or stockholders. In either case the corporation files its own tax returns and pays its own taxes. Corporate meetings must be held and minutes kept for each meeting. To do business under an assumed name, the corporation—like the sole proprietorship or the partnership—must register according to state law.
The corporation, as a flexible form of business organization, generally has the following advantages:
- The persons who invest in the corporation have no liability for corporate debts or obligations beyond the amounts each has invested.
- By selling stock and securities the corporation can raise substantial sums to finance business programs and projects.
- By corporate charter, the corporation can exist “in perpetuity”—in effect, forever.
- Because the typical corporation of any size has a manager or board of directors who run day-to-day operations, the individual shareholders need not bother with the details of such operations.
The corporate format does have some disadvantages. For example, the corporation must pay taxes on its earnings. Later, when these earnings are distributed to shareholders as dividends, the shareholders must claim them in their own tax returns and pay additional taxes on them. Careful planning, however, can reduce or eliminate the hazards of such “double taxation.” And many corporations find ways to enjoy other major tax advantages.
Another disadvantage of the corporation is that, as a separate legal entity, it must operate in accordance with specific laws and keep certain records. Some expense is involved in incorporating, and an application for a corporate charter must be accompanied by initial tax statements and other documentation in addition to the necessary filing fees.
Two other kinds of corporations or corporation-like business structures should be noted: the Subchapter S corporation and the business trust.
Subchapter S Corporations
The unique advantage of the Subchapter S structure is that such a business may operate as a corporation while following partnership tax regulations. This type of business organization, permitted under federal and most state laws, thus avoids corporate taxes while operating in corporate form.
All the income or losses of a Subchapter S corporation are taxed individually according to the amount invested by each shareholder. The shareholders have immunity from personal liability for the debts and obligations of the firm. At the same time they avoid double taxation. But a “Sub-S” corporation can have no more than 35 shareholders.
The Business Trust
The business trust is taxed as a corporation and enjoys many of the advantages of a corporation. It can be formed and operated under federal and most state tax laws. The death or withdrawal of a shareholder does not terminate the trust, nor do the shareholders have personal liability for the trust's debts and obligations.
Also known as a Massachusetts business trust or a common trust, the business trust has been defined as an unincorporated business organization. The trust document specifies that property is to be held and managed by the trustee for the benefit of beneficiaries who hold transferable certificates. The beneficiaries receive the profits from management of the property. The states that provide for the legal creation of business trusts generally require that a declaration of trust be filed before beneficiaries' shares can be sold or distributed. Transfers or sales of trust shares must take place in accordance with the securities laws of the various states.
Launching a Business: Documents and Procedures
“I'm forming a partnership with a close friend. Do I need an agreement in writing?”
This is a question that lawyers hear frequently. In nearly all cases the answer is Yes, definitely. Prospective partners may be members of the same family, old friends, or business associates, but the written agreement is nonetheless appropriate.
The reasons for drawing up such a partnership agreement are much the same as for preparation of a prein-corporation agreement. Both help to build a foundation for the enterprise and to reduce the possibility of later misunderstandings and disagreements.
The Partnership Agreement
Most states have adopted what is called the Uniform Partnership Act to guide partners as they set up and conduct their businesses. Such an act has some common-sense provisions. For example, it may provide that if no partnership agreement exists, the partners will share equally in the business' rofits. The law may also specify that each partner will, in the absence of an agreement, have an equal voice in the operation of the business.
An agreement in writing takes precedence over such legal provisions. The partners may specify in the agreement the percentage of profits each will receive or who will supervise which aspects of the business. For instance, Partner A may receive 60% of the profits and Partner B may supervise the business' ales force. Someone who brings special knowledge or expertise to the business, or who will have to work unusually long hours, may receive advance recognition. The agreement might also specify special compensation arrangements.
Other Terms of the Agreement
In general, the terms of a partnership should deal with basics as well as with the finer points of the business relationship. The basics include the name chosen for the business, the rights and duties of each partner, and the objectives of the business. The agreement can also make note of the investments or other assets contributed by each partner, such as real estate, vehicles, or office equipment.
The business name deserves some thought. Do not choose a name that could be confused with another company name already in use. It is important to select a name that will characterize the business, give it stature, or make it sound attractive or impressive. Some partnerships have names formed from partners' initials or names.
The agreement should typically indicate how long the partnership will last. If all partners feel it is appropriate, the partnership may be of indefinite duration. In such a case, the partnership will continue until it is dissolved by one or more of the partners or until one of them dies or withdraws.
Many partnership agreements state that the partnership will continue for five or ten years. At the end of the specified period the agreement can be renewed if desired.
Other clauses typically appear in partnership agreements. For example, the agreement gives the starting and ending dates of the partnership's fiscal year. Specific provisions may indicate how any partner can exercise the right to examine the partnership's books, make specific banking arrangements, and lay out procedures for hiring employees, with special attention in many cases to employment contracts.
Contribution of Capital
It is important that the partnership agreement indicate how much capital or other assets each partner has contributed. Insofar as possible, all such assets should be listed. They can include not only those items mentioned but leases, patent rights, and special equipment of one kind or another. All such items rank as capital.
In any partnership one partner may contribute one kind of capital whereas another may contribute another kind. The agreement should specify clearly what is being contributed and what its value is. Some evaluations may have to be made by rough estimate; in other cases an appraiser should be hired to place a value on a partner's noncash contribution.
The terms of the agreement should spell out, with dates or target times if possible, when partners' contributions are due. One partner may invest cash at the time the partnership comes into being; another may contribute funds a year later; a third may make working premises available from the time the partnership goes into business. A partner may agree to invest in the business the first $10,000 of his share of the partnership's profits. Another may loan money to the partnership under specified conditions of repayment. The conditions should include the interest rate to be charged.
Partners' Responsibilities and Powers
In most partnerships, the various partners perform different but complementary jobs. The roles to be played by the partners should be described in the agreement as clearly as possible.
Making such terms clear beyond the possibility of misunderstanding may be impossible. But the effort should be made. The management responsibilities and the amount of time to be devoted to each can obviously vary widely. Insofar as a determination of such details can be made, it should be.
Court cases involving partners frequently hinge on the question of whether one partner is devoting enough time and effort to the business. That fact alone suggests the importance of the advance thinking put into this part of the agreement. A number of related questions should receive attention. Is each partner to be allowed to engage in other business activities while also working for the partnership? To what extent? What other business activities? Will the partners be allowed to take part only in other activities that are completely different from the partnership business?
The answers to such questions may call for thought—in particular where the question of partners' participation in other businesses is concerned. Will a partner investing in and operating a business identical to that of the partnership be in competition with his or her partners? Such questions lie at the heart of many court decisions.
Profits and Losses
The most basic method of providing for equitable distribution of profits and losses is simple. The partners simply agree to distribute profits according to the investment of each partner in the business. A partner who contributes 25% of the funding for the partnership, receives 25% of the profits. He or she also bears 25% of the losses, if any.
That formula need not control in any given case. For any group of partners, another approach may be more appropriate. The important thing is that the partners work the formula out in advance and include it in the agreement. A special formula may work best. In one case three partners establishing a real estate management business agreed that in the first year Partner A would receive half of the first $50,000 in profits while partners B and C would receive $12,500 each. From that point on the partners would divide the profits equally.
Among other important financial questions, salaries and expense accounts rank high. Unless the agreement contains provisions on salaries, for example, no partner would be entitled to anything more than a share of the profits. Yet a salary might be appropriate if one partner is to spend more time on partnership business than the others. As for expense accounts, is any partner to have unlimited privileges? Will any partner receive advances from company funds to cover business travel and entertainment?
Dissolution of the Partnership
The terms of the partnership agreement should specify under what conditions dissolution may take place. Some examples suggest possibilities. In one case a partnership agreement provided that the business would continue if any of the four partners died or had to withdraw for health or other reasons. Thus, the agreement, in effect, ensured that a new partnership would take the place of the original one. The agreement also specified how the partner leaving the business, or that partner's family, would be compensated in case of death or withdrawal. The partnership share could, of course, have substantial value.
In another case a partnership agreement contained a buy–sell clause. That provision, common to most partnership agreements, specified the conditions under which the remaining partners could buy the share of a partner who was withdrawing for any reason. A method of establishing the value of a partnership share was also specified; an arbitrator familiar with business appraisals would be named to conduct an evaluation.
Such terms, in a sense, help to resolve legal problems in advance. They can, however, be even more specific. Some buy–sell provisions provide for a departing partner's right to select an arbitrator. The remaining partner or partners have the same right. After the two arbitrators have selected a third person to assist in the arbitration, the three jointly decide on the value of a partnership share. The decision is then final and binding.
A recommended way to make sure that surviving partners will be able to buy the share of a deceased or ailing partner is to buy life insurance on the lives of all the partners. The insurance provides the cash needed for the surviving partners to buy the deceased's share.
Three friends have decided to go into business and incorporate. What now?
First, remember that state law controls the establishment of corporations. But different laws refer to the basic documents of incorporation in different ways. The articles of incorporation may, for example, be called the articles of agreement or charter, or the certificate of incorporation.
Second, in forming their corporation they will be making decisions regarding the ownership of the business, issuance of stock shares, contributions of the various owners, and other matters. As in the case of partnership agreements, the more thorough the answers to such questions are, the better the chance that the business will succeed.
There will be four directors. Because the state in which this corporation is formed requires a minimum of three directors, they have fulfilled a basic requirement. Many other states, as noted, would allow an individual to incorporate alone. But either way, as a group or singly, the procedures are essentially the same from state to state, with one exception. An individual incorporating as a one-person firm would not prepare a preincorporation agreement, but for four persons incorporating together, such an agreement is a good idea even though it is not required by law.
The Preincorporation Agreement
The agreement serves as an opportunity for each of the associates to make all the key decisions in advance. They can focus on areas of agreement and areas of potential disagreement and can make sure they are thinking alike. In this way they build for future business success.
The preincorporation agreement contains much that can be found in the typical partnership agreement: the corporate name, the purposes of the business, and so on. But the preincorporation agreement should address other questions as well, such as the stock to be issued, the number of shares to be authorized, the price per share, and the number of shares each associate will buy. The agreement should also specify any restrictions on transfers of shares and the procedures under which the corporation would buy the shares of an associate who dies or decides to sell out.
If such procedures are listed, the method of funding the purchases of associates' shares should be noted. Life insurance offers one effective method of funding in case of death.
Information as to how the corporation will be managed and controlled should appear in the agreement. It is important to specify the number of directors, to agree on what work each associate will perform in the corporation, and to establish salary schedules.
The name of the corporation has legal status. Most states require that the name be different enough from others already in use to avoid confusion. Because a name that is identical or very similar to any existing one may be rejected by state authorities, it is advisable to check with the governmental agency responsible for the registry of names to make sure the desired choice is available. If the name is already being used, it may nevertheless be possible to use it or a variation of it anyway, by obtaining permission from the owner of the name. Such permission should be in writing.
Most states require that the business name include a word or abbreviation indicating that the business is incorporated. The words that appear most often are Incorporated, Corporation, Company, Limited, or their abbreviated forms: Inc., Corp., Co., and Ltd.
The Articles of Incorporation
With the preincorporation agreement on paper, the articles of incorporation can follow. This is the document that actually establishes the corporation: the corporate charter, filed with a state agency and usually in a standard form according to instructions issued by the agency itself. The agency may be the office of the secretary of state. In some states the articles of incorporation have to be filed with the local county clerk as well.
Other information in the articles of incorporation parallels that of the preincorporation agreement to some extent. The corporate name appears, followed by a statement of corporate purposes. Whereas some states require only a statement that the new firm will engage exclusively in lawful activities, others need specific information. The statement should be worded broadly so that the corporation has reasonable latitude in its later selection of business activities.
The business purposes of many young corporations change with time. In such cases the corporations simply file an amendment to the articles of incorporation to broaden the range of corporate purposes.
The articles of incorporation state how many shares of stock will be issued, where the firm's main office will be, and who in the corporation can be served with lawsuit papers. Most states do not require that all the shares of stock be issued at once. For that reason many corporations issue only enough shares to cover immediate and foreseeable needs. In some states lawsuit papers have to be filed with the secretary of state, who then serves the corporate officer designated in the articles of incorporation.
Finally, the articles of incorporation should note the names and addresses of the incorporators. The period for which the corporation is formed should be given if it is not perpetual. The state collects a filing fee when the incorporators register the articles.
Normally, the beginning corporation faces five other basic challenges.
1. To draw up bylaws. Much more complete than the articles of incorporation, the bylaws detail the rights and powers of the corporate officers, shareholders, and directors. The bylaws also give a time and place for the annual meetings, specify how notices of meetings will be sent out, indicate what constitutes a quorum, make provision for special meetings, and state how shareholders can act without formal meetings.
The bylaws touch on other subjects as well. They note how many directors the corporation has—usually a president, secretary, and treasurer; who the directors are and how they are elected; and what their powers and responsibilities are. In other provisions the bylaws describe the stock certificates, name the person or persons authorized to sign contracts and insert the corporate books and records, and specify how the bylaws can be amended.
2. To adopt the bylaws and elect the first board of directors. This task falls to the shareholders of the new corporation, the persons holding ultimate power. In a meeting held after the state has approved the articles of incorporation, the shareholders adopt the bylaws and elect the corporation's first board of directors.
In a small corporation, the same people may be officers, directors, and shareholders. When they set the ground-rules under which the business will operate, they are in effect making rules for themselves. In a larger corporation, the shareholders set policy but do not take part in day-to-day operations. They meet at least annually—and more frequently if the need arises. The annual meetings provide opportunities to review the corporation's annual report, elect new directors or reelect incumbents, and vote on policy changes.
3. To hold the first directors' meeting. The directors of the new corporation usually meet for the first time after the incorporators' meeting. Among other items of business, the directors elect the corporate officers, consider and ratify contracts, and approve all management plans. The board of directors may also confirm corporate banking arrangements and authorize the issuance of stock.
4. To issue corporate stock. Once the stock has been paid for, the corporation issues certificates that show the name of the corporation, the number of shares that each certificate represents, the type of share, and the name of the individual shareholder. Usually, the corporate president and secretary sign the certificates. If the stock sale is restricted, this information generally appears on the back of each certificate.
5. To make a Subchapter S election. In this step the business founders decide whether they want to be treated, for federal tax purposes, as a Subchapter S corporation. To be eligible to make such an election, the firm cannot have more than 35 shareholders. It must also have only one class of stock. The election must be made during the first 75 days of the tax year. All the shareholders must agree that the election of Subchapter S status should be made.
The Factor of Control
Whether a new business starts as a partnership or corporation, the founders should carefully consider the question of control: of ways and means of maintaining the authority of the founders and protecting their interests in the business.
A number of considerations are involved, such as those framed in the following questions: Who will be allowed to buy, inherit, or otherwise gain ownership of partners' or other shares? How do the controlling parties ensure that they retain management and supervisory responsibility? Who might be admitted to the inner circle in the future?
Retention of control involves complex legal questions. These reinforce the contention that a lawyer should help prepare all the basic business documents. The type of business, the methods by which interests may be transferred to others, possible restrictions on such transfers, employment contracts—all are important. Particular questions may hinge on interpretations of state laws dealing with restrictions on transfers of shares, on transfers of business control, and on other questions.
Some widely used methods of retaining control include the following:
1. Restrictions on transfers of interest. In general, the law frowns on restraints on sales or on assignments of business or property rights. But shareholders in a corporation can, for example, agree on a stock transfer restriction. Under such an agreement, the other partners or shareholders have the right of first refusal before a business share or stock can be sold to a third party outside the business. Where multiple shares are for sale, the other shareholders can usually buy in proportion to the total number of shares each owns.
Stock transfer restrictions generally appear in corporate bylaws. They are also printed on share certificates. The printed restriction puts a prospective purchaser on legal notice that resale restrictions exist.
2. Employment Contracts. An employment contract, or a series of them, between a partnership and its partners or between a corporation and its officers ranks as another way to retain control of a business. The contract spells out the rights, duties, and obligations of both parties—company and individual. The contract may restrict the individuals' ownership rights.
An employment contract may have other purposes. It may, for example, help the owner of a business protect patents or inventions with which the employee becomes acquainted. The contract may also provide details on a complicated compensation plan, or protect against competition from the employee should he or she leave the firm's employment.
3. Voting Rights. As businesses grow and add employees, shareholders, and others, voting rights become extremely important. A majority of shareholders might, in a given case, try to assume control by changing the business' purpose, design, or basic direction. Various kinds of voting restrictions can be used to protect the business operation, among them these:
- A corporation may provide for voting and non-voting stock, for voting rules that ensure that the minority group is represented on the board of directors, and for elections of different directors in specified years.
- Shareholder agreements may require that shareholders vote their stock in a certain way. Shareholders might, for example, be able to vote only for other shareholders for the board of directors. “Outsiders” would be excluded. It should be noted, however, that such restrictions on voting or transfers of shares could inhibit many investors from buying the company's stock.
- Using a voting trust agreement, a number of shareholders may join together to give a lesser number, called the trustees, the right to vote on all the shares. The trustees themselves can agree on how the votes will be cast.
- Where state laws permit, the charter and bylaws of a corporation may provide for special requirements on quorums and shareholder votes. For example, a two-thirds majority might be needed to change the business' bylaws.
- A corporation's bylaws, a partnership agreement, or a shareholder agreement might make arbitration an alternative where disagreements arise. The arbitration option would be invoked in case of a voting deadlock.
4. Buy–Sell Agreements. A buy–sell agreement among the shareholders of a corporation ensures that the corporation can buy the stock of a deceased stockholder. The estate of the deceased has to sell the stock; the corporation has an obligation to buy. To ensure the corporation's ability to repurchase such shares, the firm must have a stock retirement program. Under an alternative program, called a cross-purchase plan, other stockholders can buy the shares of the deceased.
Establishing a price for stock to be purchased from the estate of a deceased shareholder may or may not be a problem. If the shares are traded on a regional or national stock exchange, the price quotation for a given day determines the price. In a close corporation, however, the problem of evaluation becomes critical. A mandatory buy–sell agreement always outlines an effective method of determining the price of a share of stock. The methods include the appraisal, the book value, and various other methods.
5. Partnership Buy–Sell Agreement. Under a partnership buy–sell agreement, the estate of a deceased partner has an obligation to offer the decedent's partnership interest for sale to the surviving partner or partners. The agreement should specify the terms of the sale. Both the partners and their spouses should sign the agreement. In many cases, life insurance offers the best method of purchasing the partnership interest of a deceased partner.
You decide to have your office painted. You sit down with Tom Johnson, a painter, to discuss cost. Tom says he can do the job for $550. He would have the work completed in exactly two weeks. You say, “It's a deal.” With those words you have a legally binding contract. All the necessary elements are present:
- Parties competent to contract.
- An offer (Tom's indication that he can do the work at a certain price by a certain date).
- Acceptance (your agreement to pay the $550).
- Consideration. The two of you are exchanging things of value. You have promised to pay $550 and Tom has promised to paint your office.
The Four Elements
Obviously, business contracts are rarely as simple and straightforward as the above example. But all contracts have to share the basic elements or they will not be regarded as contracts under the law.
The requirement that the parties to the contract be competent has special meaning. The contracting parties cannot be minors, for example, under the laws of the state in which the contract is made. Also, the parties must be sane. They must be capable of handling their own affairs.
At the offer stage of contract formulation, the law presumes that one party to the arrangement can provide something of value. In the example, Tom the painter offered to paint your office. He told you what the work would cost. He did not say he could probably do the work for $550, or that he would need half of that sum down, with the rest to follow on completion of the job; he stated his price.
Your acceptance followed when you said, “It's a deal.” Where the second element involves mutuality of obligation, the acceptance phase involves legal consideration: in this case, what you agree to pay. The legal consideration can be many things besides money or property. An exchange can involve services.
Another type of consideration is known as detrimental reliance. You would have created the possibility of such a consideration if you had said to five painters, “I will pay $500 if one of you will paint my office.” A painter relies on your promise, paints your office, and can sue you for breach of contract if you do not pay the $500.
Legality of purpose has equally broad legal meanings. No contract is enforceable if its purpose is illegal. But what does illegal mean? If the contract calls for the performance of an immoral or statutorily illegal act, it is unenforceable. The same applies if it goes contrary to a state's public policy. Examples of the latter include contracts to restrain trade, to evade or oppose revenue laws, and to corrupt legislative or judicial bodies.
Breach of Contract
Whether written or oral, a contract that has the four basic elements is enforceable at law. Enforcement becomes an alternative in the case of a breach of contract by one party or the other. A lawsuit in such a case seeks to recover whatever damages are suffered because of the breach.
The Uniform Commercial Code (UCC), valid in all states except Louisiana, sets the standards of some key aspects of contract law. The UCC, for example, provides that a written agreement be produced in a breach-of-contract case involving the sale of goods for $500 or more. The agreement need not be extremely detailed. It has only to indicate that the parties agreed on the sale and that such-and-such a quantity was involved. The UCC requires inclusion of such other factors as price, time and place of delivery, and quality of the goods.
Article Two of the UCC deals with the sale or transfer of goods or personal property. It specifies that a “merchant” (a person with special knowledge, skills, and familiarity with a business) has special rights and obligations. He or she has a kind of professional status. Three principal rules apply:
- Between merchants, the law usually requires a written contract where goods valued at more than $500 are sold.
- A merchant's offer to buy or sell goods, made in writing and signed by the merchant, must be held open for a “reasonable” or specified length of time—and is not revocable during that time.
- A definite, written, and timely expression of acceptance creates a contract between merchants.
Violation of any of the stated UCC rules creates a cause of action—a reason to sue. A successful plaintiff generally receives compensatory damages. Insofar as possible, these compensate the plaintiff for damages ensuing from the broken contract. But there are other kinds of damages:
- Consequential damages, awarded where a plaintiff proves that a breach of contract had secondary negative effects.
- Liquidated damages, awarded when, for example, delay in the delivery of services or goods resulted in day-by-day losses for a plaintiff.
- Equitable relief may be invoked by a court to compel a delinquent defendant to deliver on a promise in a contract. A defendant may be required to deliver, for example, a work of art or an item of jewelry as promised in a legal contract.
Required Written Contracts
Under the statutes of frauds enacted by all states, some contracts have to be in writing. Typically, a statute of frauds would require that contracts be written when:
- the ownership of real estate is changing hands;
- real estate is being leased for more than a year;
- someone promises to pay the debt of someone else;
- performance under the contract will take more than a year;
- someone is agreeing to pay a commission for the sale of real estate; or
- a sale of goods, or tangible personal property, is being transacted.
Ordinarily, a contract need not be a formal legal document. A memorandum may be enough. But it should give the names of the parties, information on the subject matter, and the important terms and conditions. The signatures of the contracting parties should appear on the memorandum even though both may not be required legally.
What happens when a statute of frauds states that a contract is required but the parties have proceeded under an oral agreement? A lawsuit may be possible anyway. A suit may be justified, for example, where the oral agreement has been partially performed.
Defenses in a Breach-of-Contract Suit
A defendant in a breach-of-contract suit can utilize any of a variety of defenses. He or she may, depending on the circumstances, claim any of the following:
- That no breach took place.
- That the plaintiff suffered no damages.
- That the contract is invalid because a basic element is missing.
- That the statute of frauds requires a written contract and none exists.
- That the contract is illegal or against public policy and is therefore illegal.
- That the other contracting party misrepresented the facts to induce the defendant to sign the contract.
- That the contracting parties made a mutual mistake that resulted in a misunderstanding of what was to be sold or done.
The Business and the Consumer
Currently, the consumer protection movement is gathering momentum. Based on the concept that the consumer needs the protection of the law, the movement tries to prevent companies from exerting pressure on the consumer, or from taking advantage of him or her. Because the consumer is in fact vulnerable when buying goods, borrowing funds, or investing for financial gain, a business owner should know some basics of consumer law.
Consumers have protection today in a number of areas, including the following:
- methods by which goods are presented, including during sales and in advertising;
- packaging and labeling of goods;
- methods used in selling goods;
- credit sales; and
- protection of consumer defenses.
Many more such areas could be listed. But these are among the most important. Each can be discussed separately.
Deceptive Practices in Sales
Various government agencies have passed statutes, rules, and regulations that forbid or restrict deceptive practices in the sale of consumer goods. Endorsements by persons with high public exposure, for example, may not be false or misleading. In a typical case an athlete or movie star will state publicly (perhaps on television or radio) that a specific product is safe or of outstanding quality. If the product does not meet the described standards, the endorser has taken part in deception. A lawsuit may be the consumer's best remedy.
Even if not intended to do so, a company's advertising may in effect deceive potential buyers. The deception need not involve an intentionally fraudulent act; the only test today is whether the buyer was misled.
The Federal Trade Commission (FTC) repeatedly challenges advertisers regarding misleading or deceptive advertising. The FTC also tries to protect consumers in other ways. The Public Health Cigarette Smoking Act, for example, requires that a health warning appear on each package of cigarettes sold. Radio and TV can no longer carry cigarette advertising. Other forms of cigarette advertising have to display the health warning prominently.
In advertising goods for sale at retail, store owners and others once used various forms of deception. One, called the “bait and switch,” involved ads for “specials” that were not in stock in sufficient quantity to meet anticipated demand—or that were not in stock at all. The advertiser counted on “baiting” the customer into the shop or store and then selling him or her some other item or items, usually at higher prices.
The laws of many states outlaw such practices. Such laws may also prohibit “going out of business” advertising when the business is not really being discontinued, “fire sales” when there has been no fire, or “lost our lease” sales when no lease has been lost.
Packaging and Labeling
Many federal laws have dealt in recent years with deception in labeling and packaging. Among the laws are the Fair Packaging and Labeling Act; the Fair Products Labeling Act; and the Food, Drug, and Cosmetics Act. In addition, various state and federal laws have outlawed the use of such terms as “full,” “jumbo size,” and “giant size.”
Legislation in existence also requires specifics on labels. Under the Fair Products Labeling Act, a product label must identify the type of product, the name and place of business of the manufacturer, the packer or distributor, the net quantity of all the contents, and the net quantity of one serving if the label also gives the number of servings. Both the FTC and the U.S. Department of Health and Human Services have authority to require additional information or disclosures on a label.
Other legislation establishes standards and protects consumers in various ways. Food, drugs, and cosmetics receive special attention. The federal Food and Drug Administration (FDA) regulates labeling and packaging of all such items. The FDA also has authority to prevent “quackery” in medicine and drugs and to investigate “miracle drug” claims.
Approval and Testing of Goods
Many products are sold with a guarantee, tag, or other indication that the products have been tested and approved by some agency or organization. The “seal of approval” or tag means that the product has been tested and approved for normal consumer use. The seller has violated a warranty made to the consumer and may be liable for fraud if the product has not actually been tested and approved.
Tests and approvals, or tests alone, may precede the sale of some products. Products involving fire and electrical safety features may undergo tests by manufacturers' associations or testing companies for insurance purposes. Successful testing means a product meets industry safety standards. Some private and industry testing agencies, including consumer organizations that publish test results in their own magazines, simply report what their tests have revealed. No conclusions are drawn.
Some magazines also accept product advertising that includes “money back” guarantees. The guarantee requires only that the price of a product be refunded or that it be replaced if the product is defective. If a consumer is injured by the defective item, the magazine or organization giving its approval may be liable under the expanding concept of product liability.
Controls on Methods of Selling Goods
Many laws today regulate the ways in which merchants can sell their goods. The goal is always the same: to prevent violations of consumer rights. But some laws also provide for means of punishing the fraudulent or unlawful merchant. In two areas in particular, fair disclosure of contract terms and sales by mail, legislative action has created a network of protections for buyers or consumers.
Fair Disclosure of Contract Terms
The Consumer Credit Protection Act, better known as the “Truth in Lending Act,” was designed to let the consumer know exactly what the credit offered by a lender will cost. Knowing what one lender's rates are, the consumer can “comparison shop” for a better “deal.” This is true whether the individual is taking out a mortgage loan to buy a house, buying furniture or an automobile, paying for home improvements on the installment plan, or charging meals, gasoline, or repair costs.
The Truth in Lending Act does not apply if no interest or other charges are added to the basic cost of a given item. The Act does ensure the availability of information on the two key factors in the cost of credit—the finance charge, or the amount paid to obtain credit, and the annual percentage rate (APR), the percentage of interest paid over a year's time. The finance charge includes not only the interest to be paid but also any service, carrying, or other charges. The APR must be computed for the consumer on the total cost of credit.
The Truth in Lending Act deals also with advertising. Where an ad mentions one feature of credit, such as the amount of the down payment, it must also mention all the other important terms.
More and more businesses are offering goods and services through the mail. Federal laws protect the consumer from mail fraud. State statutes may also prohibit mail-order fraud or deceit. Because most mail-order sales involve small amounts, the consumer may find it difficult or impossible to recover losses.
In mail-order sales the consumer has the following rights:
- to know when shipment of the merchandise can be expected;
- to have the merchandise shipped within 30 days;
- to cancel an order when merchandise is not shipped within 30 days;
- to be notified of delays and to have a free means of replying, such as a postage-free postcard;
- to agree to a new shipping date; and
- to have any payment returned if 30 days elapse and the merchandise is not shipped.
Where a person receives free samples or items mailed by charitable organizations seeking contributions, the recipient can, as he or she wishes, regard the merchandise as a gift.
Control of Methods of Payment
Protective laws regulate the methods by which payments may be made or demanded by a creditor on a consumer sale. Some state laws provide that if a creditor accepts payment in a form other than cash or check, the creditor takes a chance. State laws may also provide that installment payments have to be applied to the oldest unpaid portions of a debt. The payment sent by a debtor who is three months delinquent on an open credit account must go toward payment of the oldest monthly charge.
Both federal and state laws regulate accelerated and “balloon” final payments. At one time unscrupulous creditors or lenders could make the last payment in a monthly series larger than the debtor could pay. The lender could then repossess the merchandise when the debtor defaulted. Most laws now specify that if the final payment is double the average of the earlier scheduled payments, the debtor has the right to refinance the final payment on terms similar to those of the original transaction.
Other Financial Areas
In many other money areas the laws protect the consumer without prejudicing the rights of the businessperson. Credit cards, for example, the symbols of the so-called “cashless society,” can no longer be issued to persons who have not applied for them. Also, in case of loss of a credit card, the owner cannot be held liable for more than $50 for purchases made illegally by the finder. But such purchases must have been made before the owner has notified the company issuing the card. If they are made after that time, the card holder cannot be held liable at all.
In contract sales, the “fine print” on the reverse sides of some agreements once provided that the buyer waived some legal protections. Under some recent consumer statutes, however, the buyer cannot inadvertently waive all such defenses. Where a household appliance is defective, for example, under the consumer protection statutes of many states the buyer has the right to withdraw from the contract.
Wages and salaries make up another sensitive area. In general, the laws provide that the right to earn a living and support one's family takes precedence over any right to garnish or attach a person's earnings.
Federal and state laws contain many other provisions designed to protect the consumer. For example, the methods by which debts may be collected are strictly controlled. Credit reporting, which affects the individual's credit rating and, often, his or her ability to get a job and to purchase needed items, falls under the provisions of the Fair Credit Reporting Act of 1970. The Act applies only to personal, household, and family credit, and not to business or commercial credit. Very importantly, the Act gives the person whose credit-worthiness is in question the right to find out the name and address of the reporting agency. The individual then has the right to have any errors in the report corrected.