MODULE 4-A: REVIEW OF THE LAW OF CONTRACTS

MODULE 4-A: REVIEW OF THE LAW OF CONTRACTS LEARNING OBJECTIVES The study of real estate entails many subjects. Contracts form the basis for all agreements used in real estate. The law of contracts is complex. While you will not become an expert on contracts in this short course, you will become familiar with the elements of a valid contract as it pertains to real estate transactions. KEY TERMS Assignment The transfer of the rights and/or duties under a contract. Breach of contract Violation of any terms or conditions in a contract without legal excuse; for example, failure to make a payment when it is due. Consideration Something of legal value bargained for and given in exchange for a promise or an act that induces a person to enter into a contract. Contingency A necessary happening, stipulated in a contract, without which the parties will not be bound to perform the terms of the contract. Contract A legally enforceable promise or set of promises that must be performed and for which, if a breach of promise occurs, the law provides a remedy. Counteroffer A new offer made as a reply to an offer received. It has the effect of rejecting the original offer, which cannot be accepted thereafter unless revived by the offeror. Earnest money An amount of money (or other consideration), deposited by a buyer under the terms of a contract, to be forfeited if the buyer defaults but applied to the purchase price if the sale is closed. Equitable title The interest held by a buyer (vendee) under a purchase contract, installment contract or contract for deed; the equitable right to obtain absolute ownership. Executed contract A contract in which all parties have fulfilled their obligations and thus performed the contract. Land contract Another term for installment contract. Lease A written or oral contract between a landlord (the lessor) and a tenant (the lessee) that transfers the right to exclusive possession and use of the landlord s real property to the lessee for a specified period of time and for a stated consideration (rent). By state law, leases RECP Broker Transition Course Manual Student Module 4-A, Page 71

for longer than a certain period of time (generally one year) must be in writing to be enforceable. Liquidated damages A specified amount of money, which one party agrees to accept as full compensation if the other party defaults. Offer and acceptance Two essential elements of a valid contract; a meeting of the minds, also called mutual assent. Offeror The party who makes an offer. Offeree The party to whom the offer is made. Option An agreement to keep open, for a set period of time, an offer to sell or purchase property. It must be supported by consideration. Valid contract A contract that, by complying with certain essentials, is binding and enforceable on all parties to the agreement. Void contract A contract that has no legal force or effect because it does not meet the essential elements of a valid contract. Voidable contract A contract that is valid on the surface but that may be rejected or disaffirmed by the party who might be injured if the contract were to be enforced. ADDITIONAL TERMS Parol evidence rule A rule of evidence that dictates that if the terms of a contract are written, no oral testimony is to be allowed regarding matters prior to or contemporaneous with the written agreement if the purpose of such testimony is to contradict the terms of the agreement. LECTURE OUTLINE I. Introduction to Contracts The basis for all relationships in the brokerage business is found in the law and the requirements it establishes for guidelines. Since almost all real estate dealings originate with an agreement known as a contract, it is essential for real estate brokers to understand the basic elements of contracts. Furthermore, contracts establish the legal relationship between the parties involved, so students must understand all the basic elements of a contract. RECP Broker Transition Course Manual Student Module 4-A, Page 72

A. Definition A contract is an enforceable promise. One that can be sued upon for nonperformance by one of the parties. B. Steps in the Contracting Process: 1. Negotiation There must be the intent to create a legal obligation. The terms of the negotiation should be definite, certain, and complete concerning such items as: price, property description, delivery, and the parties to the contract. 2. Agreement and Consideration The parties mutually agree upon the terms of the contract and exchange consideration. 3. Signing of the Contract (execution) 4. Performance or Discharge 5. If non-performance takes place, then: a. Legal excuses for the nonperformance are given. b. A breach is declared and action taken to get the proper remedies for the injured party. C. English Common Law and the Statute of Frauds Common Law was established prior to the Revolutionary War, and has been altered by individual states from time to time, but the same basic principles hold true throughout most of the United States. A portion of the Common Law especially important to the real estate business is the Statute of Frauds. Its purpose is to prevent various types of contracts from being entered into fraudulently. Under Common Law, a writing was never necessary to the formation of a contract; and today, in the absence of statutory requirement, an oral contract is as enforceable as a contract in writing. 1. All contracts for the sale or purchase of real estate must be in writing and signed by the parties involved to be enforceable. 2. Any contract for the lease of real estate for a period of more than one year must be in writing and signed by the parties involved to be enforceable. Certain states go beyond requirements of the Statute of Frauds placing additional requirements on the writing of contracts. (Indiana s requirement, for example, is three years.) 3. Parol evidence rule applies to the cases listed above. Parol evidence is verbal evidence. An oral promise that is made in addition to a written agreement will be unenforceable by the parties in real estate situations. Such oral agreements are not admissible in a court of law for contracts covered by the Statute of Frauds. The parties to the contract may adjust the written contract by such an agreement and abide by it, but the contract would be unenforceable in court. Example: A seller may agree orally to repair a water leak before the property closes, but the oral agreement would not make the contract unenforceable if the seller didn t perform. 4. Other contracts that are usually required to be in writing to be enforceable are: RECP Broker Transition Course Manual Student Module 4-A, Page 73

a. Contracts that cannot be fully performed within one year of entering into the agreement. b. Promises to pay the debts of another. c. Promises made in contemplation of marriage. d. Personal property contracts for more than $500. Special note: Executory verbal contracts are unenforceable, but fully executed agreements are valid transfers. For example, a verbal contract to sell a house for $75,000 cannot be enforced, but once the consideration has been paid and the title transferred, the transaction is complete and cannot be set aside because it was a verbal agreement. 5. Other items necessary for compliance with the Statute of Frauds: a. Names of the parties to the contract. b. A statement of the subject matter to which the contract relates. c. All material terms and condition. d. The signature of the party to be charged with the contract or the authorized agent. II. Essential Elements of a Valid Contract A. Offer An offer must be made to begin the formation of a contract. B. Acceptance There must be acceptance of the terms of the offer by the other party. C. Consideration Something of value must be given or given up to make the contract binding upon the parties and able to be sued upon. D. Legal capacity The parties must be legally competent to enter into contracts. E. Realty of Consent (Validity) Must be free of duress, fraud, undue influence, misrepresentation and mistakes. F. Illegality and Impossibility Purpose of the contract must be legal and it must be possible to perform (referred to as legal objectivity.) III. Review of the Essential Elements of a Valid Contract A. The Offer 1. The offer is the initial step in the formation of a contract and is, of course, an essential element. In the absence of an offer, no contract can result because the party who is alleged to be the offeror has not defined what responsibility he/she is willing to assume nor what he/she will accept in return for his/her offer. 2. The offer must be free and voluntary. RECP Broker Transition Course Manual Student Module 4-A, Page 74

3. The offer, to be effective, must be reasonably certain. While the offeror may clearly understand what is meant of his/her offer, this is not the legal standard by which the offer is measured. The law provides an arbitrary standard by which the clarity and certainty of the offeror s terms are to be measured the standard of the so-called. 4. The offeror is in complete command of the terms of the offer. 5. Revocation of the offer The offer may be withdrawn by the offeror at any time before it is acted upon. This may be done by the offeror even though the offer stated it would remain open for a specified period of time. The act of placing an acceptance in the mail constitutes an acceptance, but mailed revocation is not effective until received. It is recommended that the revocation be in writing. 6. The offer must be communicated to the offeree. 7. Under the Statute of Frauds, which applies to contracts for the sale of real estate, all contracts must be in writing to be enforceable. As an element of a valid contract, the offer must be in writing. 8. Time limitations may be placed on the offer. The offer may be terminated by the passing of time and no action by the offeree. Example: the offer to purchase will expire on midnight of the 5 th day of September. 9. Death of the offeror or offeree prior to acceptance immediately terminates the offer. Death of the corporate officer of a corporate offeror or offeree does not terminate the offer since the corporation is considered to be a person not the officer. B. Requirements for the Acceptance 1. The offer by itself is meaningless unless and until those to whom the offer is made indicate that is satisfactory to them and that they are willing to enter into an agreement under which they will receive the fruits of the offer and will be willing to do what the offeror demands in return. 2. To be effective legally, the acceptance of the offer must be unequivocal. That is, it must be absolute, without any exceptions or any additional terms. 3. The acceptance of the offer must be communicated to the offeror by a recognized method or method specified in the offer. 4. The acceptance of the offer must be in writing. The Statute of Frauds demands a written agreement to be enforceable in court. 5. The acceptance must be delivered. Delivery to the agent (broker) is legally the same as delivery to the principal (seller) and does not mean that the broker becomes the agent for the purchaser. The offer must be delivered by either the offeree (seller) or the agent (broker) to the offeror to be a legally effective acceptance. 6. The acceptance must be done in a timely fashion as required by the offer or within a reasonable time after the offer is made to be effective. If no time limit is expressed in the offer a reasonable time for an offer for a residential property to remain open is 30 days. RECP Broker Transition Course Manual Student Module 4-A, Page 75

7. Counteroffer results from any acceptance that varies from the original offer. Once an offer is rejected it is considered dead and any later acceptance constitutes a new offer. IV. Consideration Consideration is the third major element required before a binding contract can result, even though there has been a valid offer and acceptance. A. Consideration is a technical requirement of contract law that is necessary to make the agreement of the parties enforceable. B. Consideration is something of value that is committed by each party to a contract. The commitment to pay or do something of value constitutes consideration and makes the promises of the parties enforceable. A promise unsupported by consideration really is a promise to make a gift and therefore is unenforceable in most cases. If the contract is breached, the consideration shows a loss and allows a judge to award the appropriate damages. C. Consideration does not have to be fair, although grossly inadequate consideration could be evidence of fraud or undue influence. Valuable consideration is a right, interest, profit, or agreement to refrain from a lawful act, any one of which the promisor considers valuable. V. Legal Capacity by Competent Parties Each party to a contract must have the legal capacity or power to enter into and to commit him/herself to the performance of its terms. A contract with one who has no power or capacity to enter into it is not a contract at all. A. Age Legal age of 18 years for those entering into a contract. Persons under the age of 18 cannot usually buy or sell real estate. An emancipated minor such as a married minor can contract. B. Insanity The parties to the contract must be capable of understanding the agreement and the ramifications and obligations. An incompetent person is unable to do this. A distinction would be made between an adjudged incompetent and one who is not. Also diseases such as Alzheimer s and others will render a person incompetent. C. Capacity Other areas of capacity to contract relate to whether or not the individual has the authority to contract such as a corporation, partnership, or power of attorney relationship. Corporations will have documentation as to who has the authority to contract and what corporate actions such as a corporation resolution may be needed. Partnerships are governed by their structure. Any general partner may bind the partnership to contractual obligations and the other partners must honor the contract. RECP Broker Transition Course Manual Student Module 4-A, Page 76

VI. Legal Objectivity A. Illegality of Purpose A contract requiring the performance of an act by one of the parties, determined to be illegal under federal, state or local law, is usually void and cannot be enforced by either party. Examples: 1. A enters into a lease with B for the use of property for operating a gambling casino in a state where gambling is illegal. Since the purpose of the lease violates a criminal statute, it is void and cannot be enforced by either party. 2. A deeds real estate to S, his son, on the condition that S never marries. The deed is not void, but the condition violates public policy and the effect of the deed will be an absolute transfer of title and the condition will be disregarded. B. The real point to be noted in connection with illegality of purpose is that the illegal purpose need not be criminal in nature to make a contract voidable. VII. Classification of Contracts There are many ways to classify contracts. The following categories are frequently used: A. A valid contract possesses all the required elements of a contract, is for a legal purpose, legally binds all parties involved to the agreement, and is enforceable in a court of law. The requirements for a valid contract are: 1. Legally Competent parties. 2. Mutual agreement/ consent. 3. Consideration. 4. Legal purpose. 5. Offer and acceptance. B. Void Contract Any agreement that has no legal status (i.e., never formed a legal contract and was therefore never binding on the parties) is considered a void contract. If a contract fails to meet one of the basic requirements, then it is considered to be void. For example, an agreement made with a person who has been legally declared incompetent is void from the outset. It lacks an essential element of a valid contract: legal capacity. C. Voidable Contract In a voidable contract, one party or the other party may take action to have the agreement declared void. The parties capable of voiding the contract change under different circumstances. For example, a contract made with a minor is voidable at the option of the minor until the minor reaches the age of majority, and then it is binding. RECP Broker Transition Course Manual Student Module 4-A, Page 77

D. Unenforceable A valid contract between the parties but neither party can sue the other to perform. The contract may be considered to be valid between the parties but not enforceable in a court of law. If no disagreement takes place between the parties, the contract can be fulfilled. Example: Unwritten contract for sale of real estate or unconscionable contracts If a contract is so harsh that the court considers it extremely unfair, then it would refuse to enforce it. VIII. Conditions that Affect the Validity A. Misrepresentation Misrepresentation might be best described as an innocent misstatement of fact. One of the parties has indicated something regarding the contract to be when in fact it was not. The party to whom the misrepresentation was made would have the right to treat the contract as voidable. Only material facts qualify for misrepresentation (i.e., selling a different lot than indicated during negotiations). B. Fraud Fraud occurs when one of the parties to a contract deliberately misstates a fact or makes a statement to gain an unfair or dishonest advantage over another. When fraud exists, a contract may be voided by the unknowledgeable party signing. C. Undue Influence when one party takes unfair advantage of the other parties to the contract because of a particular relationship that exists, such a contract is voidable by the party who feels unjustly treated. D. Duress When a contract is entered into by force (threat of personal injury) against the will of one of the parties involved in the contract, the forced party may void the contract at his/her election. E. Mistakes of Fact or Law 1. A mistake of fact occurs when one or both parties assume something to be a fact that is incorrect, and this error is included in their agreement. An erroneous description of real estate in a purchase agreement would be an example. 2. A mistake of law occurs when one party does not understand their legal obligations under the contract and performs erroneously. The party cannot say I did not understand the contract and consider it voidable. They are bound by their actual legal obligations. RECP Broker Transition Course Manual Student Module 4-A, Page 78

Summary of the Effects of Defects in the Formation of a Contract: DEFECT IN FORMATION EFFECT ON CONTRACT 1. Incompetence Adjudged Actual 2. Illegality of Purpose At Outset Subsequent 3. Fraud 4. Misrepresentation 5. Undue Influence 6. Mistake of Fact 7. Mistake of Law 8. Impossibility of Performance 9. Difficulty of Performance 10. Statute of Frauds Not Met IX. Types of Contracts by Structure A. By Number of Parties Involved 1. Bilateral An agreement between two parties where mutual promises are exchanged. A purchase agreement is an example. One party promises to sell a property and the other pay a specific price under specific terms. This contract is bilateral. 2. Unilateral One party gives a promise to another party in exchange for some actual performance by the second party. The promise that is made by the first party is not legally binding until there is performance by the second party. An option would be a good example. A seller signs an option agreement stating that he will sell the property for a specific price if the buyer pays the price within a stated time period. If the option is exercised, the buyer has indicated an acceptance of the contract and has performed. The seller must now perform and convey title. B. By the Writing 1. Express In an express contract, the agreement is manifested in words, either oral or written. 2. Implied In an implied contract the agreement between the parties can be inferred from their conduct alone, without spoken or written words. RECP Broker Transition Course Manual Student Module 4-A, Page 79

X. Withdrawal from the Contract Without Termination A. Assignment Transfer the rights of one of the parties under the agreement to a third party. Typically, any contract can be assigned (delegated) unless a clause exists within the agreement forbidding it. The assignee takes the place of the assignor and is primarily liable for the terms of the contract. The assignor may be secondarily responsible if the assignee fails to perform. B. Novation Occurs with the substitution of a new contract. The new contract replaces the existing agreement. The intent of the parties must be to discharge the obligations created under the old agreement or substitution of new parties to an existing obligation. An assumption of the mortgage would be an example of such a substitution. XI. Other Ways to Terminate a Contract A. Release Each party releases the other from their contractual duties. A release must have all the elements of a contract. It is in effect a contract to destroy a contract, commonly called a. B. Accord and Satisfaction A settlement or compromise of a dispute between parties to a contract with the rendering of some different form of performance by one of the parties accepted by the other party. C. Subsequent and Modifying Agreement The parties enter into a new agreement modifying the original agreement. D. Cancellation of contract If one of the parties defaults, one of the following can occur: 1. Partial Performance When only part of the contract is performed payment is made only for that work completed. (This might be called an executory contract.) 2. Substantial Performance The majority of the contract is performed and payment is due. All of the conditions of the contract may not have been met, but enough have been done to be considered as completed. 3. Impossibility of Performance An agreement that cannot be legally or physically performed. 4. Mutual Agreement To cancel the agreement between the parties. 5. Operation of Law An agreement is terminated for a legal reason, i.e., the void contract of a minor to sell real estate owned by the minor. E. Breach of Contract This happens when one of the parties to the contract violates the terms of the agreement. If so, the following may occur: 1. The Seller Defaults: a. Buyer rescinds or cancels the contract. The rescission will put both parties back to their original position. Any monies such as earnest money would be returned. RECP Broker Transition Course Manual Student Module 4-A, Page 80

b. Buyer may sue for specific performance of contract. The seller in a contract of sale could be forced by the court to complete the sale and transfer the title to the buyer. c. Buyer may sue for damages. This may be used by the buyer when they are ready, willing and able to complete the purchase but the seller does not perform. The buyer may have had expenses incurred for loan applications, appraisals, etc., or may not be able to find another property within the same price range. 2. The Buyer Defaults a. Seller rescinds the contract, i.e., places both parties in the same position they would have been in if no contract had existed. b. Seller declares the contract forfeited and keeps any monies paid such as an earnest money deposit. c. Seller sues for specific performance. d. Seller can sue for damages. This would occur if the seller is unable to sell the property at a similar price or has incurred expenses related to the sale and closing. F. Remedies for Breach of Contract 1. Compensatory Damages Money damages awarded by the court to the injured party to make up for the loss. The injured party has the duty to keep the damages as low as is reasonably possible when the contract is breached. Example: A tenant breaches a lease, the landlord has the duty to make reasonable efforts to find a new tenant. 2. Punitive Damages Damages that are awarded beyond compensatory damages to punish a party who made a willful or outrageous breach of the agreement. 3. Nominal Damages If a breach of contract does not result in actual monetary loss, the court may award some token amount. For example, the court might award damages for trespass where no actual monetary loss took place. 4. Liquidated Damages Compensation agreed to as part of the contract. Examples include: a. Construction contracts where completion dates are critical and the owner cannot occupy the property. b. Purchase agreements where they will forfeit the earnest money if they do not perform. If the damages are set too high, the court may interpret them as a penalty and not enforce them. G. Other Contract Terms 1. Executed Contract One in which all terms have been met and is complete. 2. Executory Contract One that still has performance to be completed. Such as a contract of sale where the closing has taken place but the deed has not yet been delivered. RECP Broker Transition Course Manual Student Module 4-A, Page 81

REVIEW QUESTIONS 1. B makes an offer dated January 1 to purchase real estate owned by F and allows ten days for acceptance. B: a. Can withdraw the offer any time before it is accepted. b. Cannot withdraw the offer prior to January 10 at noon. c. Cannot withdraw the offer until January 10 at midnight. d. Can withdraw the offer that F has accepted. 2. Commingling, one of the major reasons for revocation of real estate licenses, would occur when a licensee: a. Engages in blockbusting. b. Encourages panic selling. c. Puts earnest money deposits in his escrow account. d. Replenishes his general account with monies from his escrow account before closing transactions. 3. G and H entered into a contract for G to purchase a shopping center. The contract contained a provision that G would forfeit the earnest money deposit if he failed to complete the purchase. This provision or damage clause is known as: a. Compensatory. b. Liquidated. c. Punitive. d. Relief. 5. The contract remedy that would force a seller to complete a contract is: a. Liquidated damages. b. Rescission. c. Specific performance. d. Actual damages. 6. M buys a building owned by P. P has leased the building to S for five years. M must: a. Renegotiate the lease with S. b. Evict S to get possession. c. Share the space with S. d. Honor the lease agreement. 7. Which of the following would show the rejection of an offer? a. Mistake of law. b. Mistake of fact. c. Counteroffer. d. None of the above. 8. To be enforceable by the courts, a contract of sale must be: a. Accompanied by earnest money. b. Acknowledged. c. Witnessed. d. Between competent parties. 9. A contract signed voluntarily by a drunk seller is: a. Void. b. Voidable. c. Valid. d. Illegal. 4. A contract for the sale of real estate must include: a. An offer, acceptance, and consideration. b. An earnest money deposit. c. A witnessing. d. Recording. RECP Broker Transition Course Manual Student Module 4-A, Page 82