How contract law works

A contract is formed when an offer by one party is accepted by the other party.

An enforceable offer must be distinguished from mere willingness by one person to negotiate further details with the other party. For example, A offers to make and sell calendars featuring Australian paintings to B. Before any agreement is reached on size, quality, style or price, B decides to not proceed further with A’s proposal. At this stage, there is no legally binding contract between A and B because there is no definite offer for B to accept until the essential terms of the bargain have been decided.

An offer does not need to be made to a specific person. It can be made to a class of people, or to the whole world.

An offer is a definite promise to be bound, provided the terms of the offer are accepted. This means that there must be acceptance of precisely what has been offered. For example, a used car dealer, A, offers to sell B a Holden panel van for $1000, without a roadworthy certificate. If B decides to buy the Holden panel van, but insists on a roadworthy certificate being provided, then B is not accepting A’s offer. Rather, B is making a counter offer. It is then up to A to accept or reject the counter offer.

A person can withdraw the offer that has been proposed before that offer is accepted. For withdrawal to be effective, the person who has proposed the offer must communicate to the other party that the offer has been withdrawn. To continue the example above, A may say to B that he will check with his supervisor and maybe a roadworthy certificate can be provided. If, while waiting for a reply, B decides he no longer wants to buy the Holden panel van and tells A of his change of mind, then there is no binding contract. It is always advisable to have the details of such conversations in writing, so follow-up any conversations about contracts with an email or letter confirming the details of the conversation.

Acceptance of an offer occurs when the party responding to the offer (called the offeree) agrees to the offer by way of a clear statement to indicate their acceptance or by some conduct or act on their part. Acceptance must be unequivocal and effectively communicated to the offeror: the law does not deem or presume a person has accepted an offer merely because they have not expressly rejected it. If, for example, A gives B a quote to provide cleaning services and, after receiving this quote, B tells A to do the work, this constitutes acceptance of the offer and is a binding contract such that B is bound to pay A the quoted amount.

A contract does not exist just because there is an agreement between two or more people. The parties to the agreement must intend to enter into a legally binding agreement. The law is not so concerned with what the parties subjectively intended, but what a reasonable person would consider the parties intended in the circumstances in which the agreement was reached. Such an intention will rarely be stated explicitly in a written document, but will be inferred from matters such as the nature of the relationship between the parties and the nature of the agreement.

Where the parties are entering into an arms-length commercial arrangement, it will generally be presumed that the parties objectively intended to create legal relations and make a binding contract.

Where an agreement is made between family members or friends and is more of a domestic or social arrangement, then it is more likely that an intention to create legal relations will not be found. In these situations, it is important to make it clear, either expressly or otherwise, that the parties intend to enter into a legally binding arrangement.

For example, offering a friend a ride in your car is not usually intended to create legally binding relations, even if that friend offers to give you money for petrol. However, if you wanted to create a legally binding arrangement that you will drive your friend to work everyday for six months in exchange for your friend paying you $20 to go towards paying the running costs of your car, you should put the agreement in writing and expressly state that you both agree to create a legally binding arrangement. Further circumstances from which an objective intention to create legal relations could be inferred would be if an invoice or written receipt was provided upon service or payment.

‘Consideration’ is the price paid for a promise made by one party to the other party. The price must be something of value, although it need not be money. Consideration may be a right, interest or benefit going to one party, or some forbearance, detriment or loss given, undertaken, tolerated or suffered by the other party.

So long as consideration exists and is of real value, a court will not question its adequacy. For example, the promise to pay a nominal amount of money as rent in return for the lease of a house could be good consideration. However, providing love and affection or a voluntary gift is not deemed to be valid consideration. Also, the consideration must not be illegal or impossible to perform.

There is an exception to this rule: documents under seal (i.e. deeds) do not require consideration for there to be a binding contract.

Deeds are often used in circumstances where the parties intend for there to be a legally binding agreement, even though there is no consideration or there is uncertainty about whether there is valid consideration (e.g. where a parent wishes to gift a car to their child or when parties want to settle their disputes and agree to release each other from any claim). 

For a deed to be valid in Victoria, it must be in writing and:

• in the case of individuals, be signed and expressed to be sealed and delivered (see ss 73, 73A Property Law Act 1958 (Vic) (‘Property Act’); or
• in the case of companies, be expressed to be executed as a deed and either signed or sealed and witnessed by two directors, or by a director and a secretary, or for a proprietary company that has a sole director who is also the sole secretary, by just the director (see s 74 Property Act; s 127 Corporations Act 2001 (Cth)).

Not all people are free to enter into a valid contract. Contracts involving:

• people who have a mental impairment;
• young people (minors);
• bankrupts;
• corporations (people acting on behalf of a company); and
• prisoners,

may have issues related to consent and legal capacity.

People who have a mental impairment

People with a mental impairment – or people who are temporarily impaired by drugs and/or alcohol – are protected by the rule that a contract is not valid and enforceable unless the person had the capacity to genuinely consent to its making.

Capacity to give consent involves a general understanding of the nature of the contract but not necessarily its fine details. For example, a person with a mental impairment may have the capacity to understand some contracts (e.g. buying a loaf of bread) but not to understand other, more complicated contracts (e.g. buying a car on credit).

Where a person did not understand, due to a mental impairment, the general nature of a contract they signed, a court can intervene to set aside the contract only if:

• the other party knew (or ought to have known) of the person’s mental impairment or lack of capacity and it would be unfair for them to take advantage of that; and
• the benefit received by the other person has not been sold to a third party who did not know the previous transaction might not be valid. To escape the consequences of a contract, the other party should be notified of the intention not to be bound by the contract within a reasonable time.

Some people with a mental impairment (temporary or long-term) are assisted by an administrator appointed by the Guardianship List of the Victorian Civil and Administrative Tribunal (VCAT). For more infor­mation about an administrator’s role, see Chapter 8.6: Guardianship and medical treatment. People with disabilities who have an administrator appointed to act on their behalf are generally not free to enter into contracts, unless this is approved in writing by their administrator or by a VCAT order.

A person with an intellectual or psychiatric disability is only liable to pay a reasonable price for necessaries sold and delivered (s 7 Goods Act 1958 (Vic)). ‘Necessaries’, and the rules applicable here, are dealt with in ‘Young people’, below, because the definition is the same for both groups.

Young people

The term ‘young person’refers to anyone under the age of 18 years (s 3 Age of Majority Act 1977 (Vic)). Young people are sometimes called minors or infants.

The exact capacity of young people to bind themselves to, and be bound by, a contract is limited and unclear, because no Act of parliament completely covers this area of law. The Supreme Court Act 1986 (Vic) (ss 49–51) is a useful reference.

Binding contracts and young people

Contracts for the supply of goods that are ‘necessaries’ are generally binding. There are no hard and fast rules to identify what is ‘a necessary’, but necessaries include basics such as food, clothing, a place to live, medicine, and other things that a young person needs to live a reasonable lifestyle.

Binding contracts for necessaries also include contracts relating to a young person’s education, apprenticeship or something very similar, if it can be shown to benefit the young person. While a court has not yet considered the issue specifically, mobile phones are probably necessaries if a young person requires one for educational or work purposes.

A young person who is contracting for the supply of necessaries must pay a reasonable price (although that may not be the contract price) for any necessaries actually sold and delivered. (‘Delivery’ is a technical term. Generally, delivery takes place when the seller has given the buyer the power to take the goods away.) Where necessaries have been sold but there has been no delivery, the young person does not have to take delivery or pay for the goods.

Non-binding contracts and young people

Two classes of contract are deemed to be void and are therefore not binding on a young person:

1. contracts for goods that are not ‘necessaries’; and
2. contracts for the repayment of money lent or to be lent (that is, any form of credit contract).

Where a young person has already paid money under a non-binding contract, that money is not recoverable unless no benefit has been received by the young person. However, the young person can refuse to make any further payments under the contract. It is not certain who then owns the goods that are not necessaries. It appears that they become the property of the young person unless the young person has fraudulently misrepresented their age.

Even after turning 18, a person cannot confirm a prior contract and then become bound by it. Any money paid by a young person under such circumstances may be recovered.

Bankrupts

Bankrupt people are not deprived of their general capacity to enter contracts. However, there are provisions of the Bankruptcy Act 1966 (Cth) (‘Bankruptcy Act’) that relate to dealings and contracts by bankrupts. For example, applying for or buying goods and services on credit for an amount of $3000 or more without disclosing your bankruptcy is an offence and you would be liable for a penalty under the Bankruptcy Act (s 269). (See ‘The effect of bankruptcy on debts’.)

Corporations

A corporation is an artificial body created by law. A corporation has a legal existence, or ‘personality’, that is separate from the individual people who constitute it.

However, a company has the legal capacity of a natural person and therefore has the capacity to enter into contractual relations (see s 124 Corporations Act 2001 (Cth)). This is so even if there is an express prohibition contained in the company’s constitution that governs its operations. Such transactions are not deemed void simply because the exercise of such powers is in breach of the restrictions placed in the company’s constitution (s 125(1)).

A company has the capacity to enter into contractual relations, but such relations are only binding on the company if those acting on behalf of the company do so with the company’s express or implied authority (s 126(1)). The courts have been quite liberal in their interpretation of implied authority. It has been found that in cases where directors with express authority have acquiesced and allowed a director with no authority to frequently enter contractual relations on behalf of the company, that such directors have implied authority and therefore can contractually bind the company.

Prisoners

During their imprisonment, prisoners may enter contracts, including contracts to buy and sell property. The usual restrictions about supervision and censorship of anything coming into prisons applies, so the permission of Corrections Victoria is required before a prisoner may sign for, deliver or receive any document. (For more information, see Chapter 3.8: Imprisonment, supervision and prisoner rights.)

Entering into a contract must involve the elements of free will and proper understanding of what each of the parties is doing. In other words, the consent of each of the parties to a contract must be genuine. Only where the essential element of proper consent has been given is there a contract that is binding upon the parties.

Proper consent may be affected by any of the following matters:

• mistake;
• misrepresentation or misleading conduct;
• duress;
• undue influence or unconscionability; and
• unfair contract terms in standard form contracts.

Mistake

Only limited types of mistakes will cause a contract to be non-binding on the parties: they must be mistakes that go to the very basis of the agreement.

For example, a contract of sale for a car that both parties assume exists, but has actually been destroyed by fire, is non-binding on the parties.

By contrast, where the parties are only mistaken about the model of the car, the mistake does not go to the heart of the bargain and so such a contract would be binding.

Another example is when a person signs a written document mistakenly believing that it relates to something different from what it actually relates to. In this case, the person may not be bound by it. This means that if A signs a document that A reasonably believes to be a character reference to assist B obtain a loan from a finance company, and the document is actually a guarantee of the loan contract, then the guarantee would not be binding on A.

A third example is when C cannot read, due to blindness, illiteracy or other disability. Someone else tells C what is in the document and C signs it. The document C signed is not what C was told it was. The document C signed would not be binding on C.

By contrast, if a person who signs a document – believing it to be a contract – does not read the terms and conditions, that person is bound by the contract and is not entitled to plead mistake.

Other factors may also be relevant to a successful plea of mistake. For instance, whether or not the defence of mistake will be allowed often depends on whether an innocent third party will be adversely affected by a decision that the contract is non-binding. Again, if the signer failed to take reasonable precautions, the defence will not succeed.

Misrepresentation or misleading conduct

Misrepresentation or misleading conduct in a contract scenario can be dealt with under the common law and equitable principles. However, misrepresentation or misleading conduct is now often dealt with under the Australian Consumer Law (ACL). Whether a party relies on the common law and equitable principles and/or the ACL depends on the nature of the transaction (e.g. whether the transaction was made in trade or commerce), the type of misrepresentation, and the remedy a party is seeking.

This section focuses on the common law and equitable principles. For information about statutory protections against misleading or deceptive conduct, and the making of false representations in relation to the sale of goods and services, see Chapter 7.2: Consumer protection laws.

If you think that misrepresentation or misleading conduct has occurred in the context of a contract, consider the statutory protections under the ACL. It can be easier to prove misleading or deceptive conduct and false representation under the ACL, and the ACL provides more flexible remedies compared to the common law and equitable principles.

What types of remedies are available for misrepresentation?

The remedies that are available for misrepresentation are rescission and/or damages and/or termination.

Rescission

Under the common law and equity rules, if a person is induced to enter into a contract as a result of another party’s misrepresentation or misleading conduct, then the misled party may choose to ‘rescind’ the contract. This means that the contract is void from the beginning and is unenforceable. Rescission of a contract also means that both parties are restored to the positions they were in before they entered into the contract (this may require the court to order some monetary adjustments).

For example, A induces B to enter into a contract of sale to purchase a business by presenting overinflated profit and loss statements that show the business to be much more profitable than it actually is. B can choose to rescind the contract on the basis that A misrepresented the business’ profit and loss statements and engaged in misleading conduct. Rescission would result in B having any money that they paid for the business returned as if the contract of sale never occurred.

If it is not substantially possible to restore the parties to their original positions, then rescission may not be available.

If the misled party chooses to rescind the contract, then they cannot sue the other party for breaching the contract (because, for example, the misrepresentation constitutes a term of the contract). This is because it is not possible to both cancel a contract from the beginning and sue for breaching it.

So using the above example, if B wanted to keep the business, despite the misrepresentation (and assuming the misrepresentation constituted a term of the contract), B could choose to keep the contract and instead sue A for breach of contract and claim any damages, including loss of profit, that they would have suffered as a result of the misrepresentation.

Under the ACL, the court has the discretion to order rescission.

Rescission is a defence to any action for damages or specific performance against the misled party.

Damages

A misled party may also have a right to damages (either in addition to, or instead of, rescission):

• in the tort of deceit, where there is fraudulent misrepresentation;
• in the tort of negligence, where there is negligent misrepresentation;
• under the ACL; and 
• where the misrepresentation constitutes a term of the contract (whether as a condition, an ‘intermediate term causing a substantial loss of benefit’ or a warranty), and the other party breached that term with misrepresentation. For more information about conditions and warranties, see ‘The terms of a contract’, below.

It is important to note that in the first three scenarios above, the misled party may have the right to damages, even where the misrepresentation does not constitute a term of the contract.

Where this is the case, the amount of damages is not the amount necessary to put the misled party into the position they would have been in had the misrepresentation been true. Rather, damages is the amount necessary to put the misled party into the position they would have been in had the misrepresentation not occurred.

By contrast, where the misrepresentation consti­tutes a term of the contract, the amount of damages is based on the amount necessary to put the misled party into the position they would have been in had the contract been performed (i.e. as if the misrepresentation was true).

Termination

If the misrepresentation constitutes a condition of the contract (i.e. it is essential to the parties), or is an intermediate term of the contract (a breach of which would cause substantial loss of benefit), a misled party may choose to terminate the contract (which is different to rescinding the contract). The effect of terminating a contract is that the contract is valid up to the date of termination, but is then at an end and the parties are discharged from any remaining obligations they have under the contract. Under the ACL, the court has the discretion to order a contract be terminated.

A misled party can sue for ‘loss of bargain’ damages, which is the amount necessary to put the misled party in the position they would have been in had the contract been completed and the parties had fulfilled all their obligations.

If the misrepresentation constitutes a warranty (that is, it is a non-essential and subsidiary term of the contract), then the misled party is not entitled to terminate the contract, but they are entitled to damages for the loss suffered as a result of the breach of that warranty.

What type of misrepresentation was made?

Under the common law and equitable principles, there are three types of misrepresentation:

1. fraudulent misrepresentation;
2. negligent misrepresentation;
3. innocent misrepresentation.

Fraudulent misrepresentation

To prove fraud, it is necessary to show that the person making the statement knew it was false, had no belief in its truth, or knew it might be false and recklessly went ahead and made it anyway, not caring whether it was true or false. This is a subjective test; if the person who made the representation honestly believed that the representation was true, no matter how unreasonable, negligent or silly, then that person has not made a fraudulent misrepresentation. Accordingly, it is very difficult to prove fraud.

However, once fraud is proven, the misled party can rescind the contract if they were induced to enter into the contract due to such fraud or sue for damages for deceit. It may be possible to recover damages for the loss caused by the fraud even where the loss was unforeseeable. As set out above, the misled party may also be entitled to contractual remedies (e.g. damages/termination) if the fraudulent misrepresentation constituted a term of the contract.

Negligent misrepresentation

To prove negligent misrepresentation, it must be shown that:

• the person making the representation owed a duty of care to the other party to ensure that any information they gave was true and reliable; and
• the person breached that duty of care because the statement was misleading or false and made without due care; and
• the misled party suffered loss or damage by relying on that misrepresentation, which was reasonably foreseeable and not too remote.

A duty of care will be found where the person making the representation could reasonably be expected to foresee that the statement would be relied on. This can be due to some special skill or superior knowledge that they possess, as compared to the other party, and it is reasonable in the circumstances for the other party to rely on the statement.

If the negligent misrepresentation caused the misled party to enter into the contract, then the misled party can rescind the contract or sue for damages for negligence. Unlike fraud, the misled party can only recover damages that were reasonably foreseeable. The misled party may also be entitled to contractual remedies (e.g. damages/termination) if the negligent misrepresentation constituted a term of the contract.

Innocent misrepresentation

An innocent misrepresentation is where a misrepresentation is made with no intention to deceive and without any negligence.

If the misled party is nevertheless induced to enter the contract, either because it was a reasonable consequence of the misrepresentation (even though the representor did not intend or expect this) or because of its own idiosyncrasy, the misled party may be entitled to rescind the contract. However, it is arguable that if no reasonable person would have been induced to enter the contract or rely on the misrepresentation, then the misled party would not be entitled to rescind the contract.

Where there is innocent misrepresentation, the misled party is not entitled to damages for any tort.

The misled party is only entitled to the contractual remedies of damages/termination if the representation constituted a term of the contract, and the other party breached that term by their misrepresentation.

Duress

Proper consent may be affected by duress. Under the common law, duress is where there has been actual or threatened violence either to the other contracting party directly or to their immediate family, near relatives or close associates. The duress may be made by someone acting under the instructions of the party to the contract. The effect, though, will have been that a party has been forced into the contract by being deprived of their free will to act.

Duress now extends to contracts entered into as a result of threats to a party’s economic wellbeing, that is, a threat to a person’s business or trade. This form of duress is called economic duress.

To prove duress, it must be shown that:

• a party applied unlawful or unconscionable pressure (whether physical, economic or psycho­logical pressure) to force the other party to enter into the contract; and
• such pressure meant that the other party had no reasonable alternative but to enter into the contract, and
• such pressure was a cause of the other party entering into the contract.

The consequence of establishing duress is that the contract is voidable at the election (i.e. the choice) of the wronged party. Where the wronged party elects to have the contract declared void, both parties will be restored to their original positions as if the contract had not been entered into. This may require a court to order monetary adjustments or restitution. While it is arguable that duress is a tort that gives rise to a right to damages, this is not entirely clear.

However, duress is likely to be a contravention of various provisions of the ACL where it is done ‘in trade or commerce’. This includes unconscionable conduct under sections 20, 21 and 22 of the ACL, which would give rise to a range of more flexible remedies, including rescission and damages. (See also ‘Unconscionable conduct’ in ‘Australian Consumer Law consumer protection‘).

Undue influence or unconscionability

Proper consent may be affected by undue influence. Undue influence is exercised by taking unfair and improper advantage of the weakness of another party, to the extent that it cannot be said that the other party voluntarily entered into a contract.

The main reason for the rule against the use of undue influence is to correct abuses of trust and confidence. It is applied where the parties are in a relationship where one party may be able to exercise considerable influence over the other party.

There are two categories of undue influence. The first is where no special relationship exists, but the stronger party has exerted dominance and influence over the weaker party. The weaker party has to prove that undue influence has been exerted.

The second category of undue influence is where the parties are in a special relationship of confidence; most cases of undue influence fall into this category. Such a relationship exists when one party’s position towards the other’s position involves a dependency or trust, in the form of authority or an expectation to give fair and independent advice to the weaker party.

Where a special relationship is found to exist, a presumption of undue influence will arise. It is then necessary for the stronger party to show that the contract was not the result of any undue influence. This could be shown by, for example, the weaker party obtaining independent advice before entering into the contract.

A special relationship of confidence and the presumption of undue influence can be established in two ways. First, the parties may be in a well-recognised special relationship; for example, solicitor and client, doctor and patient, parent and child, guardian and ward, and religious or spiritual adviser and devotee.

Second, the special relationship, although not falling within any well-recognised relationship, is such that the complaining party is able to show that the other party was in a position of influence.

For example, it could be that the circumstnaces of a particular relationship between a bank and its customer gives rise to the bank occupying a special position of trust in connection with the conduct of the customer’s affairs. (It has to be stressed that in ordinary circumstances no presumption of undue influence arises out of a banker–customer relationship.) See, for example, Commercial Bank of Australia Ltd v Amadio [1983] HCA 14 (for a summary of the Amadio case, see ‘Unconscionable conduct’ in ‘Australian Consumer Law consumer protection‘).

The consequence of establishing undue influence is that the contract may be held voidable at the election (i.e. the choice) of the weaker party.

For details of complaints of undue influence in relation to some types of loan contracts and related complaints of unjust contract, unconscionable dealings, harsh and oppressive contracts, etc., see ‘Unjust contracts’ in ‘Varying, re-opening and terminating credit contracts‘.

As with duress, undue influence is also likely to be a contravention of various provisions of the ACL where undue influence is exerted in ‘trade or commerce’. This includes unconscionable conduct under sections 20, 21 and 22 of the ACL, which would give rise to a broader range of remedies, including rescission and damages (see ‘Unconscionable conduct’ in ‘Australian Consumer Law consumer protection‘).

Unfair contract terms in standard form contracts

Unfair contract terms in standard form contracts are regulated by the ACL. Where a term of a standard form contract has been held to be unfair, the term is deemed to be void. However, the contract will continue to bind the parties if it can operate without the unfair term.

A term is unfair when:

• it causes a significant imbalance in the parties’ rights and obligations under the contract; and
• it is not reasonably necessary to protect the legitimate interests of the supplier; and
• it causes detriment to another party.
• In determining whether a contract term is unfair, a court must consider the transparency of the term and the operation of the contract as a whole. For example, highly advantageous terms might be balanced against other disadvantageous terms. Certain terms cannot be determined to be unfair (e.g. the price of a good, service or the main subject).
• Unfair contract terms are discussed in more depth in Chapter 7.2: Consumer protection laws.

The law will not enforce all contracts. A contract (or a term of a contract) that involves illegal conduct may be void and unenforceable. Whether contracts that are illegal by statute will be deemed void and unenforceable depends on the particular statute and the ordinary principles of statutory interpretation. Contracts absolutely prohibited by statute will be deemed to be void, whether the parties know of the illegality or not.

However, where one party performs a legal contract in an illegal manner, the other party (if they have no knowledge of the illegality) may still enforce the contract or recover damages for breaching it. They may also recover money or other property transferred under the contract. The precise extent of the enforceability of, or the recovery of any money paid under, a void contract depends on the statute.

Certain types of contracts are illegal at common law because they are contrary to public policy. These include contracts:

• to commit a crime, a tort or a fraud;
• that are sexually immoral;
• that prejudice public safety, including good relations with other states or countries;
• that prejudice the administration of justice;
• that tend to promote corruption in public life;
• to defraud the revenue;
• to oust the jurisdictions of the courts;
• that are prejudicial to the status of marriage;
• in restraint of trade (unless the restraint is reasonable both between the parties and in the public interest). In these cases, the courts will look at the relative bargaining power of the parties. Restraint imposed between equals is viewed with more favour than, for instance, a contract between an employer and employee in unequal bargaining positions.

Illegally formed contracts are generally void and unenforceable by either party at common law.

Where legally formed contracts are performed illegally (i.e. the illegal conduct was not an intended or required part of the contract, but merely incidental to the way it was performed), then the contract is not void, but:

• no remedies are available to the guilty party; and
• the innocent party retains all rights and remedies (provided they did not know the contract was to be performed illegally).

Where only a part of a contract is contrary to public policy, then the contract is not entirely void, but only so far as it is contrary to public policy. That is, the offending term(s) can be severed, provided that the rest of the contract continues to make sense.

Money paid or property transferred under a contract that is void at common law may be recoverable because the effect of the contract being void is that there is no contract, so the parties should be returned to their original positions.

Other kinds of conduct that might or might not affect the enforceability of a contract are covered by the ACL, which include prohibitions against:

• misleading or deceptive conduct;
• unconscionable conduct; and
• misrepresentation in particular matters,

all of which are discussed in ‘Australian Consumer Law consumer protection‘ (see ‘Misleading or deceptive conduct’, ‘Prohibition of misrepresentations’ and ‘Unconscionable conduct’).