final_mb0051_1

Legal Aspects of Business Unit 1

Sikkim Manipal University Page No. 1

Unit 1 Introduction to Business Law

Structure: 1.1 Introduction Objectives 1.2 Meaning and Nature of Law Characteristics of law Law and morality Ignorance of law is no excuse 1.3 Sources of Indian Law Primary sources of Indian law Secondary sources of Indian law 1.4 Legal Environment of Business 1.5 Mercantile Law Meaning and nature Objectives Sources of Indian business law 1.6 Some Basic Legal Concepts Concept of legal entity Concept of legal rights Concept of property Intellectual Property Rights Concept of ownership Concept of possession 1.7 Essentials of Law 1.8 Summary 1.9 Glossary 1.10 Terminal Questions 1.11 Answers 1.12 Case Study 1.1 Introduction

In this unit, we will try to resolve the question, What is law? For this, we need to understand the meaning and nature of law. The various classifications of law, such as civil and criminal law, as well as substantive and procedure law, are illustrated. Lastly, we will study the different sources



of Indian law such as customs, precedents and legislations. This introductory unit will cover the concept of business law and other basic legal concepts.

Objectives: After studying this unit, you should be able to: explain the nature of law analyse the essentials of law describe sources of Indian law define the legal environment of business and mercantile laws in India 1.2 Meaning and Nature of Law

The term law has many meanings in common usage: you may refer to laws of physics, mathematics or science or to the laws of football or health. Basically, law means any rule of conduct, standard or pattern to which actions are required to conform. If these standards are not conformed to, sanctions are imposed for violation of rules. When we speak of the laws of a state, we use the term law in a special and strict sense because it has its source in the states sovereign authority.

1.2.1 Characteristics of law Body of rules The law is a body of rules that prescribes the conduct,

standard or pattern, according to which people residing in that state are required to conform. However, all rules of conduct do not become laws. We resort to various kinds of rules to guide our lives. For example, our conduct may be guided by rules such as do not be arrogant or do not be disrespectful to elders or women. These are ethical or moral rules by which we guide our daily lives. If we do not follow them, we may lose our friends and their respect, but no legal action can be taken against us.

Guidance for conduct of people The rules embodied in any law are made to ensure that actions of people in the society, both human and artificial, should conform to some predetermined standard or pattern. This is necessary to ensure continuance of social order; if citizens are enlightened or self-controlled, disputes may be minimised, but will not be eliminated. Therefore, rules are made to ensure that members of the society may live and work together in an orderly manner. If rules embodied in the law are violated, obedience needs to be enforced.



Imposed on members Laws are imposed on members to bring about an order in the community or society, enabling it to continue and prosper. Obedience of laws is not dependent on the will of individual members. Rather, it is a mandatory rule imposed on members.

Enforced by executives Unless a law is enforced, it ceases to be a law as it is not recognised by those persons subject to it. If an executive passes laws without any attempts to enforce them, it may lead to chaos in the society. The force used to secure obedience of citizens for law is termed as sanctions.

For example, if A steals Bs bicycle, A may be prosecuted by a court and may be punished. Moreover, the court may order the restitution of the bicycle to its rightful owner, B.

Presupposition of state A state is a territorial division and the people in the state are subject to a uniform system of law administered by some authority of the state. Thus, law presupposes a state.

Content The law is a living thing and responds to public opinion and changes throughout the course of history. Laws can never be static. Therefore, amendments are made in different laws from time to time. For example, the Monopolistic and Restrictive Trade Practices Act, 1969, has been subjected to many amendments since its inception in 1969.

Basic ideas The two basic ideas involved in any law are to:

o Maintain some form of social order in a group

o Compel members of the group to be within that order

o These basic ideas underlie formulation of rules for members of a group. A group is created because of the social instinct of people to live together and this helps them in self-preservation. Rules are made by the members of a group so that the group does not wither away.

Purpose of law Laws are created for a purpose - social, economic or political. Laws may include:

o Moral rules or etiquette, the non-observance of which may lead to public ridicule



o Law of the land, the non-observance of which may lead to arrest, imprisonment, fines, etc.

o Rules of international law, the non-observance of which may lead to social boycott, trade-sanctions, cold war, hot war, proxy war, etc.

1.2.2 Law and morality One of the characteristics of law is that it is made for the guidance or conduct of persons. This applies to morality as well since there is a close relationship between the two. Law not only has its origin in morality, but is also easier to enforce when people yield to the government for moral reasons. However, a person may be morally bound but not legally. Thus, if a young person does not show respect for an elderly person on the street, the law will take no action although he stands condemned by the moral judgment of people on the street. On the other hand, the law occasionally has to sanction action on a person who is not at fault morally. For example, X appoints Y as his/her agent. Y enters into a contract with Z on behalf of X. Y commits fraud in the transaction and thereby injures Z. X is bound to compensate Z. Further, there are some actions in which both morality and legality are involved.

1.2.3 Ignorance of law is no excuse This is the literal translation of the maxim Ignorantia juris non excusat. Every member of the society is expected to conform to a set pattern of legal rules. For this purpose, he/she is presumed to know legal rules. A person cannot take the plea that he/she did not know the rules. While it may not be feasible to learn and know all the laws of the land, a person can obtain expert guidance from those who possess legal knowledge and can have access to books on law and to legal experts. Therefore, the maxim Ignorantia juris non excusat places a burden of gaining knowledge on law on every member of the society. In other words ignorance of law is not a good excuse.

We will discuss the sources of Indian law in the next section.



Self Assessment Questions

1. Which one of the following entities possesses the power of supreme legislation in India? (a) The President (b) Lok Sabha (c) Rajya Sabha (d) The Parliament (e) The Supreme Court

2. A _______ is a territorial division, with people therein subject to a uniform system of law administered by some authority.

1.3 Sources of Indian Law

The main sources of modern Indian law may be divided into two broad categories: Primary sources Secondary sources

1.3.1 Primary sources of Indian Law The primary sources of Indian Law are: Custom Judicial precedent (stare decisis) Statute Personal law

Custom Customs have played an important role in making law and therefore are also known as customary laws. In the words of Keeton, customary law may be defined as those rules of human action, established by usage and regarded as legally binding by those to whom the rules are applicable, which are adopted by the courts and applied as sources of law because they are generally followed by the political society as a whole or by some part of it. In simple words, it is a generally observed course of conduct by people on a particular matter. When a particular course of conduct is followed again and again, it becomes a custom.



Judicial precedent Judicial precedent is another important source of laws. It is based on the principle that a rule of law that has been settled by a series of decisions generally should be binding in court and followed in similar cases. Only those rules that lay down some new rules or principles are treated as judicial precedents. Thus, where there is a settled rule of law, it is the duty of the judges to follow the same; they cannot substitute their opinion for the established rule of law. This is known as the doctrine of stare decisis. The literal meaning of this phrase is standing by the decision.

Statute Statutory law or legislation is the main source of law. This law is created by legislation of bodies such as the Parliament. It is called statute law because it is the writ of the state and is in written form (jus scriptum). In India, the Constitution empowers the Parliament and state legislatures to promulgate law for the guidance or conduct of people to whom the statute is made applicable, either expressly or by implication. It is sometimes called enacted law because it is brought into existence by passing acts in the legislative body.

Personal Law Many times, a point of issue between the parties to a dispute is not covered by any statute or custom. In such cases, courts are required to apply the personal law of the parties. Thus, in certain matters, we follow the personal laws of Hindus, Mohammedans and Christians.

1.3.2 Secondary sources of Indian law The secondary sources of Indian Law are English Law and principles of Justice, Equity and Good Conscience.

English Law The chief sources of English law are: Common law Equity Law merchant Statute law

English law, in its application in India, has to conform to the circumstances and conditions prevailing in our country. Even though the bulk of our laws



are based on English law, our courts have to be selective in their application. It is only when the courts do not find a provision on a particular problem in the primary sources of Indian law that they may look at subsidiary sources such as the English law. For example, the greater part of the law merchant has been codified in India. The Indian Contract Act, 1872, the Indian Partnership Act, 1932, the Sale of Goods Act, 1930, and the Negotiable Instruments Act, 1882, are some of the important acts related to business transactions. When there are doubts about the interpretation of any provisions of these acts or when the branches of the law merchant have not been codified, Indian courts take the guidance of English decisions.

Let us briefly describe the main sources of English law:

Common law This source consists of all those unwritten legal doctrines embodying customs and traditions developed over centuries by the English courts.

Equity The literal meaning of the term equity is natural justice. In its technical and narrower sense, equity means a body of legal doctrines and rules emanating from the administrations of justice, developed to enlarge, supplement or override a narrow rigid system of existing common laws. However, like the common law, equity is also unwritten.

Statute Statutes consist of laws passed by the legislature and is the written law. The authority of the Parliament is supreme but is subject to limitations laid down by the Constitution. The Parliament can pass laws as it pleases and can override its own previous acts and decisions of courts. A statute, therefore, is superior to and can override rules of common law or equity.

Law merchant or Lex Mercatoria It is a source of law based on customs and usage prevalent among merchants and traders of the Middle Ages. Its evolution, like that of equity, can be traced to the unsuitability of the common law for commercial transactions. The common law was found to be unsatisfactory in dealing with disputes between merchants. The merchants, therefore, developed certain rules based on customs and usages to govern their mercantile transactions. These rules are known as Lex Mercatoria or the law merchant.



Justice, equity and good conscience Unlike in England, in India, we do not have separate courts administering equity. However, the equitable principles of law, i.e., justice, equity and good conscience are the guiding forces behind most of the statutes and courts decisions in our country. In instances where the law is silent on any point or there is some lacuna in a statute, the principles of equity are handy for judges to exercise their discretion. The frequent use of terms such as good faith, public interest and public policy in statutes and judgments is based on the principles of equity.

We will discuss the legal environment of business in the next section.

Activity 1: Identify a recent change in the law that will have a significant impact on business organisations in general. The change in the law may be in the form of an Act passed in the Parliament, delegated legislation or judicial decision. Hint: Refer leading newspapers and magazines in the last 3 months to identify such legislation


3. The doctrine of judicial precedent is also known as the doctrine of: (a) Stare decisis (b) Obiter dicta 4. Choose the correct answer: The important sources of law are custom,

precedent and legislation. Their appearance in the legal history has been in the following order:

(a) Legislation, custom and precedent (b) Custom, precedent and legislation (c) Precedent, custom and legislation 5. _____________ means a body of legal doctrines and rules emanating

from the administration of justice, developed to enlarge, supplement or override the rigid system of existing laws of the land.

1.4 Legal Environment of Business

We have seen the sources of Indian law in the previous section. Let us discuss the legal environment of business. Laws are almost a universal



human need. No society can exist without legal order. We need institutions and a framework of rules and regulations to provide concreteness to our mutual relations. Without laws, there would be anarchy in society. For this reason, rules of laws are essential to the modern civilised society. It also emphasises equality before law and equal conformity to law by every person subject to it.

Law and business are complementary disciplines. Almost every aspect of business is regulated by law. Even the installation of a business unit itself may involve observance of some legal provisions. For instance, in the case of a company, the various provisions of the Companies Act, 1956, and other allied laws are to be complied with for the incorporation of a business. The contracts entered into by businesses with others may be held to be void or may be against public policy. Certain business practices may amount to monopolistic, restrictive or unfair trade practices. Products supplied may be defective or there may be deficiencies in the service provided by a business. The agreement between manufacturers and their dealers may defeat the provisions of some law or the other.

Sometimes, the law may require businesses to provide certain facilities to its employees, even when the contract does not provide for the same. For instance, the provisions of labour welfare laws impose a legal obligation on employers to provide certain benefits to their workers.

Thus, the legal environment of a business is a major factor regulating the conduct of business. Some laws facilitate conducting business while other laws may be regulatory in nature. All aspects of businesses are controlled by legal rules and regulations. The various facets of any business need to be carried out according to the legal framework. If a business indulges in illegal conduct, it has to be awarded punishment in accordance with the laws of the land. In this manner, laws become the foundation for regulation and conduct of business.

We will study mercantile law in the next section.


6. Law and business are ______________ other. 7. Every aspect of business is controlled by _________________.



1.5 Mercantile Law

Now that we are familiar with the legal environment of business, let us learn about merchant law.

1.5.1 Meaning and nature Business law may be defined as a branch of law that prescribes a set of rules for the governance of certain transactions and relations between: Business persons Business persons and their customers, dealers, suppliers, etc. Business persons and the state

In the context of Indian business, some of these transactions and relations concern the following: Regulation of restrictive and unfair business practices Foreign exchange management and regulation Insolvency of business persons Promotion of conciliation and arbitration for settlement of business

disputes Regulation of companies incorporated under the Companies Act, 1956 Negotiable instruments Patents, trademarks and copyrights Actionable claims, factoring and forfeiting Import and export regulation Contracts, sale of goods, guarantee, indemnity, bailment, pledge,

charge, mortgage, partnerships, insurance, carriage of goods Prevention of food adulteration, regulation of essential commodities Regulation of stock exchange and financial securities Regulation and development of industries Economic offences Conservation of foreign exchange and prevention of smuggling activities Regulation of foreign contributions, foreign capital Excise, import and export duties, tax on income, wealth, etc.

1.5.2 Objectives From the description of the nature and meaning of business law, we can infer that the subject has many objectives to achieve. Firstly, laws lay down the framework within which business activities should be carried out. For



example, X Company issues an advertisement disparaging the products of its rival Y Company. Further, X Company prohibits its dealers to deal with the products of Y Company. The acts of X Company are not in conformity with some legal rules prescribed by some statute or the other. Thus, Y can enforce its rights, which have been infringed by X.

Secondly, a business person can resort to various judicial and quasi-judicial authorities against the government in case his/her legal rights have been violated.

Thirdly, some laws are made to facilitate the business persons to achieve their goals smoothly. For example, there are laws for getting a company incorporated, deriving all the advantages of incorporation, such as separate legal entity, limited liability, etc.

Fourthly, business laws have social objectives. Examples include anti-competition laws, pollution control laws, etc. Further, laws concerning regulation of essential commodities and prevention of food adulteration in the interest of the consumers go a long way in serving social objectives.

Lastly, business laws prevent concentration of economic power and help in the adjustment of claims of individuals against each other.

1.5.3 Sources of Indian Business Law The sources of Indian business law are: Statutes such as the Indian Contract Act, 1872, the Sale of Goods Act,

1930, the Partnership Act, 1932, the Negotiable Instruments Act, 1881, and the Insurance Act, 1938.

Common law In the absence of a legal provision on a subject, the Indian courts apply the English common law. Even in interpreting Indian laws, the Indian courts refer to English decisions.

Custom and usages Indian business customs and trade usages, unless excluded by a statute, are allowed to govern business transactions. The Negotiable Instruments Act, 1881, has not excluded the trade usage of hundis as negotiable instruments.

Precedents The main contribution of courts towards law-making is in the form of decisions in law suits. The cases decided by the Supreme Court and other courts have served as precedents to be followed by lower courts.



Justice, equity and good conscience The equitable principles of law developed by the English equity courts are the guiding force behind most Indian statutes on business laws. Moreover, Indian courts make use of these principles of equity in interpreting the Indian law as and when necessary.

Activity 2: The concept of ownership does not permit any vacuum. Explain this maxim in terms of the above discussions. Hint: Refer Sec.1.5


8. Statutes, common law, precedents, etc. are ______________ of Indian business law.

9. Business law prescribes a set of rules for the governance of transactions and relations between ____________________.

1.6 Basic Legal Concepts

We have studied about mercantile law in the previous section. Let us discuss the basic legal concepts in this section.

1.6.1 Concept of legal entity Persons are the subjects of law. A person is an entity who has rights and duties. There are two kinds of persons, natural and artificial. All human beings are natural persons. They are tangible and visible. On the other hand, an artificial person is a metaphysical body, intangible and invisible. An artificial person is brought into existence by following a procedure given in some laws. For example, a public company is an artificial person and is brought into existence by following the procedure given in the Companies Act, 1956. There must be at least seven persons for bringing a public company into existence. This way, an artificial person comes into existence when the law confers such a status up on a group of persons or any object or institution. An artificial person is also known as a legal entity when it comes into existence. It has one corpus or body in law, distinct from the members who constitute it. In addition to the Companies Act, 1956, there are some other laws under which artificial persons can be brought into existence. Some such laws are the Societies Registration Act, 1860, and the Co-operative Societies Act, 1912.



1.6.2 Concept of legal rights We have earlier mentioned that a person is an entity possessing certain rights and duties. The sources of different rights may be customary, statutory, contractual or personal laws. Some rights that a person has are interest in life, liberty or property, domestic relations and contractual relations. Of these, the rights recognised or protected by law are enforceable. These rights have their origin in a source of law, such as customs, statutes, personal laws and law of torts.

1.6.3 Concept of property The idea of business law originates from the idea of property. Thus, the concept of property is very important for business law. In laymans terms, property means movable assets (personal property such as furniture) or immovable assets (real property such as land and buildings.), which are referred to as tangible property. Legally, however, the term property refers neither to objects nor to land alone. In its legal sense, property refers to legally protected rights to use, possess, enjoy and dispose off a thing. Land and other physical objects can exist where there is no law, for example, rocks on the moon. However, property rights can exist only where there is some law to define and enforce them. Laws protect people in the exercise of property rights. The law contributes to enhancing the value of things in this way.

1.6.4 Intellectual Property Rights A trademark, a copyright, or a patent right are incorporeal assets. These are known as Intellectual Property Rights (IPR). For instance, a musical copyright with respect to songs, tunes, literary and artistic copyright belongs to its creator as it is his/her property. Thus, in the case of IPR, the subject matter of proprietary interest is not the product (such as a book, a cassette), but the exclusive right of the author, singer or inventor to publish a book, record music, manufacture a product or allow others to do so only at his/her order.

1.6.5 Concept of ownership The term ownership may be described as a bundle of rights in rem (against the whole world). It has certain characteristics, namely, the right of unspecified duration and use, and generally being inheritable and transferable.



1.6.6 Concept of possession It is said that law attaches great importance to mere possession even without ownership. Even a wrongful possession is protected. For example, an owner of a property (say X) dispossesses an occupant (say Y) without Ys consent. X is liable to restore possession to Y even though Y is unable to show any proof of possession. Thus, even a trespasser who occupies a place out of negligence by the owner cannot be thrown out even by the true owner because the trespasser is treated as a person having settled position. A wrong possession of property for a period of 12 years is known as adverse possession. It destroys the right of the owner in relation to the occupant. A person acquires title to anything that is previously unowned. It is known as res-nullius.


10. Custom is: (a) Neither written nor unwritten law (b) Both written and unwritten law (c) Unwritten law (d) Written law

11. The rights that pertain to the realm of status that indicates the proposition of a person in the eye of law in the society is known as: (a) Property rights (b) Information rights (c) Personal rights (d) None of the above

12. Of the following, which one is not the source of English law? (a) Common law (b) Business law (c) Equity (d) Statute law

1.7 Essentials of Law

Now that we have discussed the basic legal concepts, let us read about the essentials of law. There are certain essentials that must be present in law to make it effective. These are: Predictability



Flexibility Reasonable application and coverage

The law must be such that it one is enabled to predict with some accuracy the legal consequences of an action. For example, business people enter into contracts on the premise that if the other party fails to keep their promise, they would have certain remedies under the law.

Laws must be flexible, in the sense that it must not be rigid and unchanging and be impossible to mould to the present world. Laws must be flexible enough to meet changing conditions. If it is found, at a later stage, that the existing laws are incapable of tackling certain changes, then the laws must be amended to accommodate the changes.

Laws must be reasonable, both in its application and coverage. Wide publicity should be given to a law that is enacted. This is to give an opportunity to those affected by the law to know the requirements of the law and the consequences for non-compliance of those requirements. However, the old doctrine of ignorance of law is no excuse stands on its own feet. Regarding reasonableness of the laws coverage, people must consider the law reasonable. Therefore, a law that a large number of people consider unreasonable will soon become ineffective.

Activity 3: Suggest your overview on The right has a source in a contract in a customs or in natural law. Hint: Refer Sec. 1.6


13. The Indian legal system handles cases in two separate ways - _______________ and criminal. (a) Business law (b) Personal law (c) Substantive law (d) Civil law

14. Private laws include (a) Family laws (b) Laws of property



(c) Laws of contract (d) All of the above

15. All the following laws are included in public law except a) Criminal law b) Constitutional law c) Law of tort d) Municipal law

16. IPR stands for (a) Intellectual Promising Rights (b) Intellectual Property Rights (c) Indian Property Rights (d) International Property Rights

1.8 Summary

Let us recapitulate the important concepts discussed in this unit:

This subject introduces some common forms of business organisations, including some forms unique to India like the Joint Hindu Undivided Family firm.

Different types of organisations like Sole Ownership, Partnership, Private Limited Company, Public Limited Company, Joint Stock Company along with the rationale for adopting these forms are explored.

Business laws are essential for management students as it helps them understand legal rules and aspects of business.

Business management is incomplete without the proper study of its laws.

Any form of business needs legal sanction.

It is imperative that a manager understands the various ways in which businesses can be organised.

1.9 Glossary

English Common Law A system of law based on English customs, usages and traditions that were developed over centuries by English courts.

Equity The branch of the English law that developed separately from the common law.



Law A body of principles recognised and applied by the state in the administration of justice.

Statute Law The law laid down in the acts of the Parliament.

State A territorial division with people therein subject to a uniform system of law administered by some authority of the state. 1.10 Terminal Questions

1. Legal constraints tend to control or limit the discretion of businesses on the grounds that absolute rights cannot be conferred in the modern society. Comment.

2. You must have come across some law or the other that has either been amended or enacted recently. Describe its objectives, legal provisions and impact on business and society.

3. What are the sources of Indian law? Discuss any one important source of law and justify why it is important.

4. What are the nature and significance of business law? 5. Possession, right or wrong, is protected by law. Explain. 6. The study of law is not limited to learning legal rules; knowledge of the

legal environment of business is very necessary. Comment. 1.11 Answers Self Assessment Questions

1. (d) 2. State 3. (a) 4. (b) 5. Equity 6. Complement 7. Law 8. Sources 9. Business entities

10. (c) 11. (c) 12. (b)



13. (d) 14. (d) 15. (c) 16. (b)

Terminal Questions

1. Law and business are complementary disciplines. Certain business practices may amount to monopolistic, restrictive or unfair trade practices. Products supplied may be defective or there may be deficiencies in the service provided by a business. For more details, refer to section 1.4.

2. The rules embodied in any law are made to ensure that actions of people in the society, both human and artificial, should conform to some predetermined standard or pattern. This is necessary to ensure continuance of social order; if citizens are enlightened or self-controlled, disputes may be minimised, but will not be eliminated. For more details, refer to section 1.2.

3. The main sources of modern Indian law, as administered by Indian courts, may be divided into two broad categories primary sources and secondary sources. For more details, refer to section 1.3.

4. Business law may be defined as that branch of law that prescribes a set of rules for the governance of certain transactions and relations between business persons themselves, business persons and their customers, dealers, suppliers, etc. and business persons and the state. For more details, refer to section 1.2.

5. It is said that law attaches great importance to mere possession even without ownership. Even a wrongful possession is protected. For more details, refer to section 1.6.

6. The legal environment of business is one of the major factors in regulating its conduct, though some laws may act as facilitators for some segment of the business at one time or the other. For more details, refer to section 1.4.



References:

Aggarwal, Rohini (2003). Students Guide to Mercantile and Commercial Laws, Taxmanns, New Delhi

Kapoor, N.D. (2003). Elements of Mercantile Law, Sultan Chand and Sons, New Delhi.

Kucchal M.C. (2002). Business Law, Vikas Publishing House Pvt. Ltd., New Delhi.

Tulsian P.C. (2002). Business Law, Tata McGraw-Hill Pvt. Ltd., New Delhi.

Gulshan S.S. (2006). Business Law, Excel Books, New Delhi.

E-reference:

http://www.indialawinfo.com/bareacts/soga.html



Unit 2 Law of Contracts

Structure: 2.1 Introduction Objectives 2.2 Definition of a Valid Contract Contract Agreement Essentials of a contract Classification of contracts 2.3 Offer and Acceptance Modes of making an offer Acceptance of an offer Communication of offer and acceptance 2.4 Capacity to Contract Competency to contract Minors contracts Soundness of mind 2.5 Consent Definition Free consent 2.6 Consideration Definition No consideration, no contract 2.7 Performance of Contracts Definition Offer of performance Onus of performance 2.8 Discharge of Contracts Performance or tender Mutual consent Impossibility of performance Operation of law 2.9 Breach of Contract and Void Agreements Discharge of contract by breach Remedies for breach of contract



2.10 Quasi Contracts Definitions Types 2.11 Freedom to Contract Myth or illusion Standard form contract 2.12 Summary 2.13 Glossary 2.14 Terminal Questions 2.15 Answers 2.16 Case Study 2.1 Introduction

In the previous unit, we have understood the definition and basic concepts of law. This unit discusses the law of contracts in detail and the salient features of a contract as provided under the Indian Contracts Act, 1872.

We will first study how contracts are created as it is important to understand that we enter into contracts voluntarily, for example, purchase or sale of shares of a company or a plot of land. There are other types of contracts entered into without our volition, for example, hiring a taxi, buying a book, etc. Contracts, irrespective of the method of formation, confer legal rights on one party and subject the other party to some form of legal obligation. Contracts are the life blood of a business as every business transaction is built on the usage of contracts. Thus, business executives, corporate counsels, entrepreneurs and professionals in different fields frequently deal with contracts.

Objectives: After studying this unit, you should be able to: describe the essentials of a valid contract define terms related to contracts recognise the various types of contracts identify the standard form of a contract



2.2 Definition of a Valid Contract

Let us look at the definition of a valid contract in this section.

2.2.1 Contract According to Section 2 (h) of the Indian Contracts Act, 1872, a contract is an agreement enforceable by law made between at least two parties as per which rights and obligations are mutually created for both parties. If the party who had agreed to do something fails to do that, then the other party has a remedy in law.

Example: D Airlines sells a ticket on 1 January to X for the journey from Mumbai to Bangalore on 10 January. The airline is under an obligation or duty to take X from Mumbai to Bangalore on 10 January. In case the airline fails to fulfill its promise, X has the right to sue the airlines for breach of contract.

2.2.2 Agreement Section 2 (e) of the Contracts Act defines an agreement as every promise and every set of promises forming a consideration for each other. For an agreement, a promise becomes essential. The word promise is defined by Section 2 (b) of the Contracts Act. In a contract, there are at least two parties. One of them makes a proposal (or offer) to the other to do something with a view of getting approval of the other to such an act. When the person to whom the proposal is made provides his/her assent, the proposal is said to be accepted. A proposal, when accepted, becomes a promise according to Section 2 (b).

Enforceability by law: The agreement must be enforceable by law to become a contract. Thus, there are certain agreements that do not become contracts as the element of enforceability by law is absent.

2.2.3 Essentials of a contract Section 10 of the Contracts Act provides that all agreements are contracts if they are made by free consent of parties competent to contract for a lawful consideration with a lawful object and are not expressly declared by law to be void. To constitute a contract, there must be an agreement between two or more parties. One cannot enter into a contract with oneself. An agreement is composed of two elements offer or proposal by one party and acceptance thereof by the other party.



Effect of absence of one or more essential elements of a valid contract: If one or more essentials of a valid contract are missing, then the contract may be voidable, void, illegal or non-enforceable.

2.2.4 Classification of contracts Contracts may be classified as follows:

Classification according to formation: A contract may be made: In writing (express) By spoken words (implied) Inferred from the conduct of parties or circumstances of the case.

Contracts are also classified as formal or informal on the basis of their formation. A formal contract is one in which the law gives special effect because of formalities or special language used in creating it. The best example of formal contracts is negotiable instruments such as cheques. Informal contracts are those in which the law does not require formalities or special language.

Classification according to validity: Contracts may be classified according to their validity as follows: Valid Voidable Void Non-enforceable

Valid means that the contract possesses all the elements of a contract as mentioned in Section 10 of the Contracts Act. If one or more of the essential elements are missing, the contract is voidable, void, illegal or non-enforceable. As per Section 2 (i), a voidable contract is one which may be repudiated (i.e., avoided) at the will of one or more parties, but not by others.

In the next section, we will discuss offer and acceptance.


1. A promise for a promise is a good consideration. (True/False) 2. A stranger to consideration cannot maintain a suit. (True/False) 3. An agreement, the meaning of which is not certain or capable of being

made certain, is valid. (True/False)



2.3 Offer and Acceptance

So far, we have seen the definition of a contract. Now, we will discuss offer and acceptance. Offer is the basic building block on which a contract rests. An offer is synonymous with a proposal. As per Section 2 (a) of the Contract Act, the offeror or proposer expresses his/her willingness to do or not to do something (i.e., act or abstain from doing something) with a view to obtain consent of the other party to such act or abstinence. The person making the offer is called the Offeror / Promisor / Proposer and the person to whom the offer is made is called the Offeree / Proposee. When the Offeree accepts the offer, he/she is called the Acceptor or Promisee as per Section 2 (c).

2.3.1 Modes of making an offer An offer can be made if a person commits an act or omission by which the person intends to communicate a proposal or which has the effect of communicating it to the other party according to Section 3 of the Contract Act. An offer can be either express or implied or specific or general.

Express offer It is an offer made by words (whether written or oral). The written offer can be made by letters, telegrams, telex messages, advertisements, etc. The oral offer can be made either in person or over the telephone.

Implied offer It is an offer made by conduct such as positive acts or signs, so that the person acting or making signs conveys something. However, silence of a party can, in no case, amount to an offer by conduct.

Offer by abstinence An offer can also be made by a party by omission to do something. This includes such conduct by a party that the other person takes it as his/her willingness or assent.

Case study: Harvey vs. Facey Harvey and Facey exchanged three telegrams as follows:

(i) Will you sell us your Bumper Hall Pen? Telegraph lowest cash price answer paid (Harvey to Facey)

(ii) Lowest price for Bumper Hall Pen 900 (Facey to Harvey) (iii) We agree to buy Bumper Hall Pen for 900 asked by you (Harvey to

Facey)

Here, there was no concluded contract between Harvey and Facey. The first telegram asked about the willingness to sell as well as the lowest price.



While Facey replied only to the second question, he did not make any offer to sell. If Facey had replied in the affirmative to the last telegram, a contract could have been created between the two parties. As he did not make an offer to sell, there was no contract.

2.3.2 Acceptance of an offer According to Section 2 (b), when the person to whom the offer is made agrees and conveys his/her assent thereto, the offer is said to be accepted. Thus, acceptance is the act of giving consent to the proposal. The offeree is deemed to have accepted when he/she gives assent to the proposal. The acceptance of an offer may be express or implied. It is expressed when the acceptance has been signified in writing, by words of mouth or by the offeree performing some act. Acceptance is implied when it can be gathered from the surrounding circumstances or the conduct of the parties.

2.3.3 Communication of offer and acceptance It is necessary for the offeror to communicate an offer to the offeree. It is also necessary for the offeree to communicate his/her acceptance to the offeror. Section 4 of the Indian Contract Act states that the communication of an offer is complete when it comes to the knowledge of the person to whom it is made. For example, when A proposes by a letter to sell his/her car to B at a certain price, the communication of the offer is complete when B receives the letter. The completion of communication of acceptance has two aspects namely: As against the offeror, when it is put into a course of transmission to

him/her As against the acceptor, when it comes to the knowledge of the

proposer

Section 4 of the Act states that revocation or recall of an offer or acceptance is permitted. Both offer and acceptance may be revoked at any time before communication of the same is complete as against the other person, but not afterwards. Section 5 states that if communicated by post, the acceptance is complete as against the offeror as soon as the letter is correctly addressed, sufficiently stamped and posted. The contract is complete even if the letter of acceptance is lost in postal transit or through some accident. Contracts over telephone / telex have the same effect of face-to-face oral agreements.

In the next section, we will discuss capacity to contract.




4. Communication of offer is complete when the letter of offer is posted. (True/False)

5. A proposal when accepted becomes a valid contract even though acceptance is not in the prescribed mode. (True/False)

6. The communication of acceptance is complete, as against the person to whom it is made, when it comes to his/her knowledge. (True/False)

2.4 Capacity to Contract We learnt about offer and acceptance in the previous section. In this section, we will discuss the capacity to contract.

2.4.1 Competency to contract A person must be competent to enter into a contract according to the law. According to Section 11 of the Act, a person is competent to enter into a contract if: That person is a major as per age That person is of sound mind That person is not disqualified from contracting by any law to which

he/she is subject

2.4.2 Minors contracts The law protects minors against their own inexperience and the possible improper designs of those who are experienced. The Contract Act states that only a person who is a major can enter into a contract. Section 3 of the Indian Majority Act, 1875, states that a minor is a person who has not completed 18 years of age. An agreement with a minor is void and cannot be ratified by him/her until he/she attains majority. However, a minor can be a promisee or beneficiary under a contract and can enter into special types of contracts for necessaries (articles that are reasonably required for a minor to maintain his/her status and position) of life.

Case study: Mohiri Bibi vs. Dharamadas Ghose A minor mortgaged his house in favour of a money lender to secure a loan of Rs. 20,000 of which the minor was paid Rs. 8,000. Later, the minor sued the money lender for setting aside the mortgage on the pretext that he was under age. The mortgage was deemed to be void and cancelled. The



moneylenders contention that the minor should repay the amount was not accepted.

2.4.3 Soundness of mind Section 12 of the Contract Act states that a person is of sound mind to make a contract if that person is capable of understanding the terms of the contract at the time of its creation and is capable of making rational judgments in his/her interests. According to the Act, lunatics (deranged due to personal trauma), idiots (completely lost mental capacity) and drunken persons (intoxicated and under the influence of substances) do not have the mental capacity to enter into a contract. While a lunatic or drunken person may have lucid intervals, an idiot is a person who does not possess any soundness of mind and all contracts with such persons are void. Lunatics and drunks can enter into valid contracts during periods of lucidity but not otherwise.

In the next section, we will discuss about consent.

Activity 1: G, a minor, entered into a contract with R, a noted billiards player, to pay him a fee to learn the game and play matches with him around the world. R spent time and effort arranging matches. G subsequently refused to pay the fee claiming that he was not interested. Can R sue G for breach of contract? (Hint: Minor is liable to pay for necessaries supplied to him)


7. A married woman cannot enter into a contract. (True/False) 8. When a promisee does not accept the offer of performance, the

promisor is not responsible for non-performance. (True/False) 2.5 Consent

In the last section, we learned about the capacity to contract. In this section, we will look into the idea of consent.

2.5.1 Definition It is essential that both parties to a contract agree to the same thing in the same sense for the creation of the contract. This is known as Consensus ad idem. Section 13 of the Contracts Act claims that consent is the act of



assenting for the offer and is present when two or more persons agree to the same thing in the same sense.

2.5.2 Free consent For a contract to be valid, it is necessary that the parties provide free consent to its terms. If there is no free consent, the contract is voidable at the option of the party whose consent was not free. Consent is said to be free when it is not caused by: Coercion Undue influence Fraud Misrepresentation Mistake

Coercion (Sections 15 and 72) Coercion refers to any of the following: 1. committing or threatening to commit any act forbidden by the Indian

Penal Code 2. unlawful detaining or threatening to detain any property, with the

intention of forcing a person to enter into an agreement.

Case study: Ranganayakamma vs. Alwar Setty

A girl aged 13 lost her husband and was forced to adopt a boy by her husbands relatives, who prevented the corpse from being removed for cremation until she consented. The adoption was set aside by the court as the consent was obtained by coercion.

Undue influence (Section 16) When a special relationship exists between two parties in such a way that one person has the ability to influence the other by persuasion and is able to dominate his/her will so as to get undue advantage, then he/she is said to have exercised undue influence. Normally, undue influence is exercised when a person has authority over another, is in a fiduciary relationship or is a caregiver for a person who is physically or mentally disabled. Undue influence is also called moral coercion.

Fraud (Sections 17 and 19) Fraud is an intentional misrepresentation to deceive a person and make him/her enter into a contract. It could be:



A false suggestion made as a fact by one who does not believe it to be true

Concealment of a fact by one having knowledge of that fact Promise made without any intention of keeping it Any other act to deceive Any act or omission specifically declared to be fraudulent by law

As there is active concealment of facts, the contract is voidable even though the aggrieved party has the means to discover the truth with ordinary diligence.

Case study: Peek vs. Gurney The prospectus of a company did not refer to the existence of a document disclosing liabilities. This resulted in the company appearing to be doing well. If the document was disclosed, it would have changed the impression about the company. The court ruled that the non-disclosure amounted to fraud and anyone who purchased shares on the faith of this prospectus could avoid the contract.

Misrepresentation (Sections 18-19) Misrepresentation is also known as simple misrepresentation while fraud is known as fraudulent misrepresentation. Like fraud, misrepresentation is an incorrect or false statement; however, the falsity or inaccuracy is not due to any desire to deceive or defraud the other party. Such a statement is made innocently. The party making the statement believes it to be true. It can be avoided by the party subject to such misrepresentation.

Meaning of mistake (Sections 20-21) Mistake may be defined as an erroneous belief on the part of the parties to the contract concerning something pertaining to the contract. A mistake of fact is excused but a mistake of law is inexcusable.

In the next section, we will discuss consideration.


9. Consent obtained by fraud makes the agreement void. (True/False) 10. Undue influence is also called moral coercion. (True/False) 11. Coercion refers to committing or threatening to commit any act for

bidden by the Indian Penal Code. (True/False)



2.6 Consideration

In the previous section, we discussed consent. In this section, we will discuss consideration.

2.6.1 Definition Sections 2 (d), 23-25 and 185 of the Indian Contracts Act deal with consideration. One of the essential elements of a valid contract is that it must be supported by consideration. In simple terms, consideration is what a promisor demands as the price for his/her promise. The term consideration is used in the sense of quid pro quo, i.e., something in return. The consideration need not be in terms of money; it may even be some benefit, right, interest or profit accruing to one party, or some forbearance, detriment, loss or responsibility given, suffered or undertaken by the other party. Additionally, a promise by one party may be a consideration for the promise of the other party.

2.6.2 No consideration, no contract Sections 10 and 25 of the Contracts Act deal with the maxim no consideration, no contract. A promise without consideration cannot create a legal obligation. A person who makes a promise to do or abstain from doing something usually does so as a return of some loss, damage or inconvenience that may have or may have been occasioned to the other party with respect to the promise. A consideration must move at the desire of the promisor; it can be from the promisee or any other person. The consideration must be real and, need not be adequate; it can be given in the past, present or future.

In the next section, we will deal with performance of contracts.


12. Consideration can be given in the past, present or future. (True/False) 13. Consideration is based on the principle of Quid Pro Quo or something

in return. (True/False) 2.7 Performance of Contracts

In the previous section, we dealt with consideration. In this section, we will learn about the performance of contracts.



2.7.1 Definition Sections 37-67 of the Contracts Act deal with the performance of a contract. A contract creates obligations. Performance of a contract takes effect when the parties to the contract fulfill their obligations within the time and manner specified under the contract. The parties to a contract must either perform or offer to perform their respective promises unless such performance is dispensed with or excused under the provisions of law (Section 37).

2.7.2 Offer of performance It may happen that the promisor offers performance of his/her obligation under the contract at the proper time and place, but the promisee refuses to accept the performance. This is called tender or attempted performance. If a valid tender is made and is not accepted by the promisee, the promisor shall not be responsible for non-performance nor shall he/she lose his/her rights under the contract (Section 38).

2.7.3 Onus of performance The promise may be performed by the promisor himself/herelf, his/her agent or his/her legal representative. In case there was an intention of the parties that the promise must be performed by the promisor himself/herself, such a promise is to be performed by him/her only. Thus, where A promises to paint a picture for B, then A must perform this promise personally. If there is no such intention of the parties, then the promisor may employ a competent person to perform the promise. If A had promised to deliver some items of grocery to B, A may perform this promise either personally or have it delivered to B through someone. In case of death of the promisor, the legal representative must perform the promise unless a contrary intention is mentioned in the contract.

In the next section, we will see the discharge of contracts.


14. If the promisor attempts to perform the contract, but the promisee does not accept the same, then the contract is not performed. (True/False)

15. If there is intention of personal performance of promisor, then the promisor may employ a competent person to perform the promise. (True/False)



2.8 Discharge of Contracts

In the previous section, we dealt with performance of contracts. In this section, we will learn about the discharge of contracts.

Discharge refers to the termination of contractual relationship between the parties. The contract ceases to operate, i.e., when the rights and obligations under the contract ends. According to Sections 73-75 of the Contracts Act, a contract may be discharged in several modes.

2.8.1 Performance or tender The obvious mode of discharge of a contract is by performance, where the parties have done whatever was contemplated under the contract. Thus, where A contracts to sell his/her car to B for Rs. 1,85,000, as soon as the car is delivered to B and B pays the agreed price for it, the contract comes to an end by performance. The tender or offer of performance has the same effect as performance. If a promisor tenders performance of his/her promise but the other party refuses to accept it, the promisor stands discharged of his/her obligations.

2.8.2 Mutual consent Section 62 of the Act states that if the parties to a contract agree to substitute a new contract for the old or rescind or alter the terms, the original contract is discharged. A contract may be terminated by mutual consent in any of the six ways, viz., novation, rescission, alteration and remission, waiver and merger. Novation means substitution of a new contract for the original one.

2.8.3 Impossibility of performance A contract may be discharged because of impossibility of performance. There are two types of impossibility: One that is inherent in the transaction (i.e., the contract) One that may emerge later by the change of certain circumstances

material to the contract. 2.8.4 Operation of law Discharge by operation of law may take place in three ways:

(i) By death of the promisor in cases involving personal skill or ability



(ii) By insolvency, where an order of discharge is passed by an insolvency court and the insolvent stands discharged of all debts incurred previous to his adjudication.

(iii) By merger

In the next section, we will deal with breach of contract.


16. ____________ means substitution of a new contract for the original one.

17. A contract terminates by breach of contract. (True/False) 2.9 Breach of Contract and Void agreements

In the previous section, we discussed the performance of contracts. In this section, we will read about breach of contracts.

2.9.1 Discharge of contract by breach A breach of contract is one partys failure to live up to the promises under a contract without a legal excuse. If the promisor has not performed his/her promise in accordance with the terms of the contract or where the performance is not excused by tender, mutual consent or impossibility or operation of law, then this amounts to a breach of contract on the part of the promisor. The consequence is that the promisee becomes entitled to certain remedies. The breach of contract may arise in two ways anticipatory and actual.

Anticipatory breach of contracts: This occurs when a party repudiates the contract before the time fixed for performance or when a party by their own act disables themselves from performing the contract.

Actual breach of contracts: This occurs by failure to perform as promised or by making it impossible for the other party to perform. The actual breach by failure to perform may take place at the time when performance is due or during the performance of the contract. Thus, if a person does not perform his/her part of the contract at the stipulated time, he/she will be liable for its breach. When someone breaches a contract, the other party is no longer obligated to keep his/her end of the bargain. The other party may urge the breaching party to reconsider the breach; for a business contract, the



aggrieved party may get help from consumers associations, sue for damages or consider other remedies.

Rescission of the contract: When a breach of contract is committed by one party, the other party may treat the contract as rescinded. In such a case, the aggrieved party is freed from all his/her obligations under the contract.

Damages (Section 75): Another relief or remedy available to the promisee in the event of a breach of promise by the promisor is to claim for damages or losses arising to him/her. Damages are awarded according to certain rules as laid down in Sections 73-74 as follows:

Compensation as general damages will be awarded only for those losses that directly and naturally result from the breach of contract.

Compensation for losses indirectly caused by breach may be paid as special damages if the party in breach had knowledge.

The aggrieved party is required to take reasonable steps to keep his/her losses to a minimum.

2.9.2 Remedies for breach of contract The usual remedy for breach of contracts is to sue for damages. The main type of damages awarded is ordinary damages. This is the amount of money that would take to put the aggrieved party in a position as if there had not been a breach of contract. The idea is to compensate the aggrieved party for the losses suffered as a result of the breach of contract.

Sections 26-30 of the Act declare certain agreements to be void. Some of them that have already been explained are agreements entered into through a mutual mistake of fact between the parties (Section 20); agreements, the object or consideration of which is unlawful (Section 23); agreements, part of consideration of which is unlawful (Section 24); agreements made without consideration (Section 25). Agreements, the meaning of which is uncertain or capable of being made certain, are void. Uncertainty may be regarding the existence, quantity, quality or price or title of subject matter. Self Assessment Questions

18. The two types of breach of contract are anticipatory and antagonistic breaches. (True/False)



19. Damages under Section 75 are awarded according to certain rules as laid down in Sections 73-74. (True/False)

20. An agreement to agree is a valid contract. (True/False) 21. Social agreements are enforceable in courts. (True/False) 2.10 Quasi-Contracts

In the previous section, we learned what void agreements are. In this section we will discuss quasi-contracts.

2.10.1 Definition A person may receive a benefit under certain circumstances for which the law regards another person to be better entitled, or for which the law considers that the other person should be paid even in the absence of a contract between them. Such relationships are quasi-contracts as the law considers as if a contract exists between the parties, in spite of there not being a contract between the parties. Quasi-contracts are so called because the obligations associated with such transactions could neither be referred to as tortious nor as contractual, but are still recognised as enforceable, like contracts in courts. It is based on the principle of equity that one person should not be allowed to enrich oneself unjustly at the expense of another.

2.10.2 Types The following are the cases that are to be deemed as quasi-contracts:

1. Claim for necessaries supplied to a person incapable of contracting or on his/her account. If a person incapable of entering into a contract or his/her dependent is supplied with necessaries suited to his/her condition in life, the person who has furnished such necessities can be reimbursed from the property of such an incapable person. Such necessaries must be suitable to the persons stature in life (Section 68).

2. Reimbursement to a person paying money due by another in payment of which he/she is interested. A person who is interested in the payment of money that another is bound by law to pay, and who pays it is entitled to be reimbursed by the other (Section 69).

In the next section, we will deal with freedom to contract.




22. Quasi-contracts are based on the principle of equity that one person should not be allowed to enrich himself unjustly at the expense of another. (True/False)

23. If a person pays the money that is due from another by law, he is entitled to reimbursement. (True/False)

2.11 Freedom to Contract

In the previous section, we learned what are quasi-contracts. In this section we will discuss freedom to contract.

2.11.1 Myth or illusion The freedom of parties is limited by two factors. There are certain laws for the protection of employees, and an employer cannot, therefore, induce his employees to enter into any contract favourable to the employer.

2.11.2 Standard form contract A standard form contract is a document that is generally printed, containing terms and conditions, with certain blanks to be filled in. It is prepared by business people. The customer has to only sign it. Therefore, from his standpoint, the freedom to contract is restricted. Many of the contracts now being entered into by consumers are not the result of individual negotiations; rather, they are one-sided contracts.


24. A contract is imposed by a party having strong bargaining power over a party having weak bargaining power. (True/False)

25. The freedom of the parties is limited by four factors. (True/False)

Activity 2: Discuss the statement 'Freedom to contract is a myth or an illusion' in the light of day-to-day transactions in the market and the essentials of law.

Hint: Refer Sec.2.11



2.12 Summary

Let us recapitulate the important concepts discussed in this unit:

Essential features of a contract are offer and acceptance, capacity, consideration and consent

Contracts can be normally performed or discharged. Non-performance leads to breach of contract

Quasi-contracts are types of agreements which resemble a contract

Freedom to contract is a legal myth as parties are constrained by the terms of the contract and contract law

2.13 Glossary

Agreement Every promise and set of promises forming the consideration for each other.

Contract An agreement enforceable by law.

Valid Contract A contract that satisfy all the essential elements of a valid contract are enforceable in a court of law.

Void Contract A contract that ceases to be enforceable by law becomes void when it ceases to be enforceable. 2.14 Terminal Questions

1. What is a contract? What test would you apply to ascertain whether an agreement is a contract?

2. All agreements are not contracts but all contacts are agreements. Comment.

3. Enumerate contracts that are expressly declared to be void by the Indian Contract Act, 1872.

4. When is an offer to be accepted?

5. Describe the rules regarding communication of offer and acceptance.



2.15 Answers Self Assessment Questions

1. True 2. False 3. False 4. False 5. False 6. False 7. False 8. False 9. False

10. True 11. True 12. True 13. True 14. False 15. True 16. Novation 17. True 18. False 19. True 20. False 21. False 22. True 23. True 24. False 25. False

Terminal Questions 1. A contract is an agreement enforceable by law, made between at least

two parties. According to Section 2 (h) of the Indian Contracts Act, 1872, a contract is an agreement enforceable by law made between at least two parties as per which rights and obligations are mutually created for both parties. For more details, refer to section 2.2.



2. The agreement must be such that it is enforceable by law so as to become a contract. To constitute a contract, there must be an agreement between two or more parties. One cannot enter into a contract with oneself. An agreement is composed of two elements offer or proposal by one party and acceptance thereof by the other party. For more details, refer to section 2.2.

3. Voidable contract is one that may be repudiated at the will of one or both parties. Valid means that the contract possesses all the elements of a contract as mentioned in Section 10 of the Contracts Act. If one or more of the essential elements are missing, the contract is voidable, void, illegal or non-enforceable. As per Section 2 (i), a voidable contract is one which may be repudiated (i.e., avoided) at the will of one or more parties, but not by others. For more details, refer to section 2.2.

4. Offer is not only one of the essential elements of a contract, but also the basic building block. Section 4 of the Indian Contract Act states that the communication of an offer is complete when it comes to the knowledge of the person to whom it is made. For more details, refer to section 2.3.

5. It is necessary to communicate an offer to the offeree and the acceptance to the offeror. It is necessary for the offeror to communicate an offer to the offeree. It is also necessary for the offeree to communicate his/her acceptance to the offeror. For more details, refer to section 2.3.

2.16 Case Study

The Carbolic Smoke Ball Company (CSBC) made a product called the smoke ball. It claimed to be a cure for influenza and a number of other diseases. The smoke ball was a rubber ball with a tube attached. It was filled with carbolic acid (phenol). The tube was then inserted into the user's nose. It was squeezed at the bottom to release vapors into the nose of the user. This would cause the nose to run, and hopefully flush out the cold.

CSBC published advertisements in the Pall Mall Gazette and other newspapers on November 13, 1891, claiming that it would pay 100 to anyone who got sick with influenza after using its product, according to the instructions set out in the advertisement. CSBC would pay a reward to any person who contracts influenza colds, or any disease, after having used the



ball three times daily for two weeks, according to the printed directions supplied with each ball. An amount of 1,000 was deposited with Alliance Bank, Regent Street, showing the companys sincerity in the matter. Mrs. Louisa Elizabeth Carlill saw the advertisement, bought one of the balls and used three times daily for nearly two months, until she contracted the flu on January 17, 1892. She claimed 100 from CSBC. CSBC ignored two letters from her husband, who had trained as a solicitor. On a third request for her reward, they replied with an anonymous letter that if the ball is used properly, the company had complete confidence in the smoke ball's efficacy. However, to protect themselves against all fraudulent claims, they would need her to come to their office to use the ball each day and have it checked by the secretary.

Mrs. Carlill brought the claim to court. The barristers representing her argued that the advertisement and her reliance on it was a contract between her and the company, and so CSBC ought to pay. The company argued it was not a contract, as there was no offer made to Mrs. Carlill.

Discussion Question: Do you agree to what the company says? Justify. (Hint: The case refers to the concept of general offer.)

References:

Aggarwal, Rohini (2003). Students Guide to Mercantile and Commercial Laws, Taxmanns, New Delhi

Kapoor, N.D. (2003). Elements of Mercantile Law, Sultan Chand and Sons, New Delhi.

Kucchal M.C. (2002). Business Law, Vikas Publishing House Pvt. Ltd., New Delhi.

Tulsian P.C. (2002). Business Law, Tata McGraw-Hill Pvt. Ltd., New Delhi.

Gulshan S.S. (2006). Business Law, Excel Books, New Delhi.

E-reference:

http://www.indialawinfo.com/bareacts/soga.html



Unit 3 Contracts of Guarantee and Indemnity

Structure: 3.1 Introduction Objectives 3.2 Contract of Indemnity Meaning of indemnity Rights of the indemnified Rights of the indemnifier Commencement of indemnifiers liability 3.3 Contract of Guarantee Purpose Definition and nature of the contract of guarantee Fiduciary relationship 3.4 Kinds of Guarantee Oral or written guarantee Specific and continuing guarantee Bank guarantee Guarantee for limited amount 3.5 Creditor Rights of a creditor Obligations of a creditor 3.6 Surety Rights against the creditor Rights against the principal debtor Rights against co-sureties Liability of surety Discharge of surety 3.7 Summary 3.8 Glossary 3.9 Terminal Questions 3.10 Answers 3.11 Case Study



3.1 Introduction

In the previous units, we studied business laws and the law of contracts. In this unit, we will study about the contracts of guarantee and indemnity.

In a contract of indemnity, a person promises to make good or compensate the loss caused by another. The contract of guarantee is a special type of indemnity. The laws relating to contracts of guarantee are given in the Indian Contracts Act, 1872 (Sections 126-147). The sections quoted in this chapter refer to the Act unless otherwise stated.

Objectives: After studying this unit, you should be able to: describe the contract of indemnity explain the contract of guarantee and the types of guarantee analyse the rights and obligations of parties under such contracts 3.2 Contract of Indemnity

3.2.1 Meaning of indemnity Sections 124 and 125 provide for a contract of indemnity. Section 124 provides that a contract of indemnity is one in which a party promises to save the other from loss caused to him/her (the promisee) by the conduct of the promisor himself/herself or by the conduct of any other person. A contract of insurance is an example of such type of contracts. A contract of indemnity may arise either by an express promise or by an operation of law, e.g., the duty of a principal to indemnify an agent from consequences of all lawful acts done by him/her as an agent

A contract of indemnity must have all the essentials of a valid contract. There are two parties in a contract of indemnity indemnifier and indemnified. The indemnifier promises to make good the loss of the indemnified (i.e., the promisee). The indemnified or indemnity holder is the person whose loss is being made up.

Example: A contracts to indemnify B against the consequences of any proceeding, which C may take against B with respect to a sum of Rs. 20,000. This is a contract of indemnity.



3.2.2 Rights of the indemnified The indemnity holder is entitled to recover from the promisor: All damages that he/she may be compelled to pay in any suit with

respect to matters that the promise to indemnify applies All costs of suit that he/she may have to pay to the third party, provided

o The person either acted under the authority of the indemnifier or if he/she has acted in such a way as a prudent person would act in his/her own case

All sums that may have been paid under the terms of any compromise of any such suit if the compromise was not contrary to the orders of the indemnifier and was one which it would have been prudent for the promisee to make.

3.2.3 Rights of the indemnifier The Act makes no mention of the rights of the indemnifier. However, the indemnifiers rights are similar to the rights of a surety under Section 141, viz., the person is entitled to the benefits of all the securities that the creditor has against the principal debtor, whether he/she was aware of them or not.

3.2.4 Commencement of indemnifiers liability The Indian Contracts Act makes no mention of the commencement of the indemnifiers liability. Due to this reason, the English law is followed, according to which the indemnifiers liability commences only when the indemnified incurs a loss by paying the claim. In some cases, High Courts have held that the indemnifiers liability shall commence as soon as the indemnity holders liability becomes absolute.

In the next section, we will discuss contracts of guarantee.

Activity 1: "Indemnity is not necessarily given by repayment after payment. Indemnity requires that the party to be indemnified shall never be called upon to pay." Discuss. Hint: Refer Sec.3.2

3.3 Contracts of Guarantee

We have studied about the meaning of indemnity in the previous section. Let us discuss the contract of guarantee in this section.



Consider this example - When a company needs some money for its business, it approaches a bank. The bank requires that the Managing Director (MD) or chief executive of the company promises to repay the loan personally, should the company default. When the directors of the company execute the promissory note on behalf of the company, they sign as companys officials. The MD signs again as an individual. The relationship between the MD and the bank is called a guarantee or suretyship. If the company fails to repay the loan, the bank can approach the MD for the payment.

Sometimes, banks (lenders) ask for more security for loans in addition to the personal guarantee of an official of the borrowing company. The company may agree that a particular machinery in its factory would serve as collateral security for the loan. If a company defaults, a bank has three options: Compel the principal debtor to pay Demand payment from the surety Obtain a court order to either claim or sell the collateral

3.3.1 Purpose Contracts of guarantee are among the most common business contracts and are used for a number of purposes. These are:

The guarantee is generally made to secure loans. Thus, a contract of guarantee is made for the creditors security.

Contracts of guarantee are sometimes called performance bonds. For example, in the case of a construction project, the builder may have to find a surety for his/her promise to complete the construction contract. Moreover, employers often demand a type of performance bond known as a fidelity bond from employees who handle cash, etc., for the good conduct of the latter. If an employee misappropriates, then the surety will have to reimburse the employer.

Bail bonds, used in criminal law, are a form of contract of guarantee. A bail bond ensures that a criminal defendant will appear for trial. A prisoner is released on bail, pending his/her trial. If the prisoner does not appear in court as desired, then the bond is forfeited.

In this unit, our primary concern is with contracts of guarantee that are used for securing loans for business.



3.3.2 Definition and nature of the contract of guarantee A contract of guarantee is defined as a contract to perform the promise or discharge the liability of a third person in case of his default. The person who gives the guarantee is called surety; the person for whom the guarantee is given is called the principal debtor; and the person to whom the guarantee is given is called the creditor. A contract of guarantee may be either in oral or in writing.

From the above, it is clear that in a contract of guarantee there must be two contracts a principal contract between the principal debtor and creditor, and a secondary contract between the creditor and the surety. A contract of guarantee is a tri-partite agreement between the creditor, the principal debtor and the surety. There are three contracts as follows:

Contract between the principal debtor and the creditor, which is the foundation of the guarantee

Contract between the surety and the creditor in which surety guarantees the debt

Contract between the principal debtor and the surety by which the former indemnifies the surety by implication

Example: When A requests B to lend Rs. 10,000 to C and guarantees that C will repay the amount within the agreed time and that on Cs failing to do so, he/she will himself/herself pay the amount to B, there is a contract of guarantee.

The contract of surety is not collateral to the contract of the principal debtor, but is an independent contract. There must be a distinct promise on the part of the surety for liability towards the debt. It is not necessary that the principal contract between the debtor and the creditor must exist at the time the contract of guarantee is made. Similarly, under certain circumstances, a surety may be called upon to pay though the principal debtor is not liable at all. Moreover, where a person gives a guarantee on a contract that the creditor shall not act upon it until another person has joined in it as co-surety, the guarantee is not valid if that other person does not join (Section 144).



3.3.3 Fiduciary relationship A contract of guarantee is not a contract Uberrimae fidei (requiring utmost good faith). Nevertheless, the suretyship relation is one of trust and confidence and the validity of the contract depends on the good faith of the creditor. A creditor must disclose all facts which, under the circumstances, the surety would expect not to exist. Hence, where the guarantee is given for good conduct of an employee, the employers failure to inform the surety of any breach on the part of employee will discharge the surety. Similarly, where X guarantees the existing and future liabilities of A to B up to a certain limit that has already been exceeded, the contract of guarantee can be avoided on the ground of concealment of a materiel fact. However, it should be noted that it is not the creditors duty to inform the surety about all his/her previous dealings with the debtor.

In the next section, we will discuss the kinds of guarantee.


1. As per the Indian law, a contract of guarantee must be in writing. (True/False)

2. For a contract of guarantee, the primary liability is of the surety. (True/False)

3.4 Kinds of Guarantee

We have studied about the contract of guarantee in the previous section. Let us discuss the kinds of guarantee in this section.

3.4.1 Oral or written guarantee A contract of guarantee may either be oral or in writing (Section 126), though a creditor should always prefer to put it in writing to avoid any dispute regarding the terms, etc. In case of an oral agreement, the existence of the agreement itself is very difficult to prove.

3.4.2 Specific and continuing guarantee From the point of view of the scope, a contract of guarantee may either be specific or continuing. A specific guarantee is intended to be applicable to a particular debt and thus comes to end on its repayment. A specific guarantee once given is irrevocable.



Example: A guarantees the repayment of a loan of Rs. 10,000 to B by C (a banker). The guarantee in this case is a specific guarantee. A guarantee that extends to a series of transactions is called a continuing guarantee (Section 129).

Example: A guarantees a payment of Rs. 10,000 to B, a tea-dealer, for tea that A may supply to C. B supplies C with tea of the value over Rs. 10,000 and C pays B for it. Afterwards, B supplies C with tea to the value of Rs. 15,000. C fails to pay. The guarantee given by A was a continuing guarantee and he/she is accordingly liable to pay Rs. 10,000 to B.

A guarantee regarding the conduct of another person is a continuing guarantee. Unlike a specific guarantee that is irrevocable, a continuing guarantee can be revoked regarding further transactions (Section 130). However, continuing guarantee cannot be revoked for transactions that have already taken place.

In the absence of any contract to the contrary, the death of a surety operates as a revocation of a continuing guarantee as far as future transactions are concerned (Section 131).

3.4.3 Bank guarantee A bank guarantee is a type of guarantee in which a bank guarantees to a third person on behalf of its customer, that it will pay the latter a certain sum of money in the event of default of contractual or legal obligations by its customer. Such guarantees can be financial guarantees, performance guarantees or deferred payment guarantees. This topic has been discussed in detail in the chapter on banking.

3.4.4 Guarantee for a limited amount Difficult questions arise in case of guarantee for a limited amount because there is an important distinction between a guarantee for only a part of the whole debt and a guarantee for the whole debt subject to a limit.

For instance, if X owes Y Rs. 50,000 and A is the surety for Rs. 30,000, the question may arise whether A has guaranteed Rs.30,000 out of Rs. 50,000 or whether he/she has guaranteed the entire Rs.50,000 subject to a limit of Rs. 30,000. This matter becomes important if X is adjudged insolvent and Y wants to prove Xs insolvency as well as enforce his/her remedy against A. If A stood surety only for a part of the debt and if



Xs estate can pay only 25 paisa dividend in the rupee, then Y can get Rs. 30,000, the full amount of guarantee from A, and Rs. 5,000 from Xs estate, being quarter of the balance. Since after paying Rs. 30,000 to Y, A can claim from Xs estate, he/she will get Rs. 7,500 being quarter of Rs. 30,000 paid by A to Y. If on the other hand, A had stood surety for the whole debt of Rs. 50,000 subject to a limit of Rs. 30,000 then Y can recover from A Rs. 30,000 and from Xs estate Rs. 12,500, i.e., quarter of Rs.50,000. A will not get any dividend unless Y has been fully paid. This can happen only if Xs estate declares a higher dividend.

In the next section, we will discuss creditors.

Activity 2: What type of guarantee should be made by the owner for a prospective buyer? Give suggestions. Hint: Specific guarantee


3. Specific guarantee is different from continuing guarantee. (True/False)

4. A contract of guarantee is for the security of the _____________ (a) Buyer (b) Seller (c) Debtor (d) Creditor

5. Continuing guarantee is a: (a) Guarantee that extends to a series of transactions (b) Guarantee with limited access of transactions (c) Guarantee not related to transactions (d) None of the above

3.5 C

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