legal aspects of business

Legal Aspects of Business

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Unit 1Structure: 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 (IPR) Concept of ownership Concept of possession 1.7 Essentials of Law 1.8 Summary 1.9 Terminal Questions 1.10 Answers

Law

1.1 IntroductionThis unit, you begin by answering the question, What is law? This the meaning and nature of law. The classification of law, such as and criminal law; substantive and procedure law is illustrated. In you also study the different sources of Indian law such as precedents and the legislation. involves civil law this unit custom,

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Objectives This introductory unit on law will help you get familiar with the concept of business law and other basic legal concepts related to law. After studying this unit, you should be able to:

Explain the nature of law Describe sources of Indian law Define business legal environment and mercantile law Analyze the essentials of law

1.2 Meaning and Nature of LawThe term law is used in many senses: you may speak of the law of physics, mathematics, science, or the laws of the football or health. In its widest sense, law means any rule of conduct, standard or pattern, to which actions are required to conform; if not conformed, sanctions are imposed. When we speak of the law of a State, we use the term law in a special and strict sense. 1.2.1 Characteristics of law 1. Law is a body of rules. These rules prescribe the conduct, standard or pattern to which actions of the persons in the state are required to conform. However, all rules of conduct do not become law in the strict sense. We resort to various kinds of rules to guide our lives. For example, our conduct may be guided by a rule such as do not be arrogant or do not be disrespectful to elders or women. These are ethical or moral rules by which our daily lives are guided. If we do not follow them, we may lose our friends and their respect, but no legal action can be taken against us. 2. Law is for the guidance or conduct of persons both human and artificial. The law is not made just for the sake of making it. The rules embodied in the law are made, so as to ensure that actions of the persons in the society conform to some predetermined standard or pattern. This is necessary so as to ensure continuance of the society. No doubt, if citizens are self-enlightened or self-controlled, disputes may be minimized, but will not be eliminated. Rules are, therefore, drawn up to ensure that members of the society may live and work together in an orderly manner. Therefore, if the rules embodied in the law are broken,Sikkim Manipal University Page No. 2


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compulsion is used to enforce obedience, and certain consequences ensue. Law is imposed. Law is imposed on the members to bring about an order in the group, enabling it to continue and prosper. It is not something which may or may not be obeyed at the sweet will of the members of society. If you cannot impose a rule it is better not to have it. Thus, law is made obligatory on the members of the society. Law is enforced by the executive. Obviously, unless a law is enforced it ceases to be a law and those persons subject to it will regard it as dead. For example, if A steals Bs bicycle, he may be prosecuted by a court and may be punished. Also, the court may order the restitution of the bicycle to its rightful owner i.e., B. If the government passes many laws but does not attempt to enforce them, the citizens lose their respect for government and law, and society is greatly weakened. The force used is known as sanction which the state administers to secure obedience to its laws. The state. A state is a territorial division, with people therein subject to a uniform system of law administered by some authority of the state. Thus, law presupposes a state. Content of law. The law is a living thing and changes throughout the course of history. Law responds to public opinion and changes accordingly. Law 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. Two basic ideas involved in law. The two basic ideas involved in any law are: (i) to maintain some form of social order in a group and (ii) to compel members of the group to be within that order. These basic ideas underlie formulation of any rules for the members of a group. A group is created because first, there is a social instinct in the people to live together and secondly, it helps them in self-preservation. Rules are made by the members of the group, so that the group doesnt whither away. Law is made to serve some purpose which may be social, economic or political. Some examples of law in the widest sense of the term. Law in its widest sense may include: (i) Moral rules orPage No. 3



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etiquettes, the non-observance of which may lead to public ridicule, (ii) Law of the Land the non-observance of which may lead to arrest, imprisonment, fines, etc., (iii) 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 It was stated earlier that one of the characteristics of law is that it is for the guidance or conduct of persons. This is so in the case of morality also as there is a close relationship between the two. In fact law not only has its origin in morality, but also is easier to enforce when people yield to 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 decide on a person who is not morally at fault. For example, X appoints Y as his agent. Y enters into contact 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.

Figure 1.1

1.2.3 Ignorance of law is no excuse This is the literal translation of maxim ignorantia juris non excusat. Every member of the society is expected that his actions conform to a set patternSikkim Manipal University Page No. 4


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or standard as reflected in legal rules. For this purpose, he is presumed to know the legal rules. He cannot take the plea that he did not know them. No doubt, in practice, he cannot learn and know all the laws of the land, but he can obtain expert guidance from those who possess legal knowledge. Thus, he has access to books on law and to those persons who are experts in legal matters. Therefore, the maxim ignorantia juris non excusat places a burden on every member of the society with the knowledge of law. In other words, Ignorance of law is not a good excuse. Self Assessment Questions 1. Which one of the following possess the power of supreme legislation in India: (a) The President; (b) The Lok Sabha; (c) The 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 of the state.

1.3 Sources of Indian LawThe main sources of modern Indian Law, as administered by Indian courts, may be divided into two broad categories: (i) Primary sources and, (ii) Secondary sources. 1.3.1 Primary sources of Indian law The primary sources of Indian law are: (a) customs, (b) judicial precedents (stare decisis), (c) statutes and (d) personal law. Customary law Customs have played an important role in making the law and therefore is also known as customary law. Customary Law, in the words of Keeton, 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 the uniformity of conduct of all persons under likeSikkim Manipal University Page No. 5


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circumstances. 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 precedents are an important source of law Judicial precedents are another important source of law. It is based on the principle that a rule of law which has been settled by a series of decisions generally should be binding on the court and should be followed in similar cases. These rules of law are known as judicial precedents. However, only such decisions which lay down some new rules or principles are treated as judicial precedents. Thus, were there is a settled rule of law, it is the duty of the judges to follow the same; they cannot substitute their opinions for the established rule of law. This is known as the doctrine of stare decisis. The literal meaning of this phrase is stand by the decision. Statute an important source of law The statutes or the statutory law or the legislation is the main source of law. This law is created by legislation such as Parliament. In India, the Constitution empowers the Parliament and state legislatures to promulgate law for the guidance or conduct of persons to whom the statute is, expressly or by implication, made applicable. It is sometimes called enacted law as it is brought into existence by getting Acts passed by the legislative body. It is called Statute Law because it is the writ of the state and is in written form (jus scriptum). 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, the courts are required to apply the personal law of the parties. Thus in certain matters, we follow the personal laws of Hindus, Mohammedan and Christians. 1.3.2 Secondary sources of Indian law The secondary sources of Indian Law are English Law and Justice, Equity and Good Conscience. English law The chief sources of English Law are: (i) the Common Law (ii) Equity, (iii) The law Merchant and (iv) The Statute Law.


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Nowadays, English law is not very important source of Indian law. The English law, in its application to India, has to conform to the peculiar circumstances and conditions prevailing in this country. Even though the bulk of our law is based on and follows the English law, yet in its application our courts have to be selective. It is only when the courts do not find a provision on a particular problem in the primary sources of Indian Law that it my look to 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 Scale of Goods Act 1930 and the Negotiable Instruments Act, 1882, are some of the very important Acts relating to business transactions. Where, however, there is some doubt as to the interpretation of any provisions of these Acts or where certain branches of the Law Merchant have not been codified, the courts in India look to English decisions on the point, for guidance. Justice, equity and good conscience In India we do not have, no did we ever had separate courts (as in England) administering equity. But the equitable principles of law, i.e., justice, equity and good conscience, are the guiding force behind most of the statutes in our country and the decisions of the courts. Especially, where law is silent on any point or there is some lacuna in a statute, the principles of equity come handy to the judges who exercise their discretion often on equitable considerations. The frequent use of terms such as good faith, public interest, public policy, in statutes and by the judges in their judgements is based on principles of equity. Now we shall briefly describe the main sources of English law: 1. Common law. This source consists of all those unwritten legal doctrines embodying customs and traditions developed over centuries by the English courts. Thus, the common law is found in the collected cases of the various courts of law and is sometimes known as case law. 2. Equity. The literal meaning of the term equity is natural justice. The development of equity as a source of law occurred due to rigours and hardships of the Common Law. Therefore, 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 law of the land. However, likeSikkim Manipal University Page No. 7


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the common law, the equity is unwritten and is a supplement to common law as a source of law. 3. Statute law. The Statute law consists of the law passed by the Parliament and therefore, is written law. The authority of parliament is supreme but is subject to natural limitations and those laid down by the Constitution. It can pass any law it pleases and can override its own previous Acts and the decisions of the courts. Statute law, therefore, is superior to and can override any rule of Common Law or equity. 4. The law merchant or lex mercatoria. It is another important source of law and is based to a great extent on customs and usages prevalent among merchants and traders of the middle ages. Its evolution like that of equity can be traced to unsuitability of Common Law so far as the commercial transactions were concerned. The Common Law was found to be unsatisfactory in dealing with disputes between merchants. The merchants, therefore, developed certain rules based upon customs and usages to govern their mercantile transactions. These rules were known as Lex Mercatoria or the Law Merchant. Activity 1: Identify a recent change in the law which will have a significant impact on business organizations in general. The change in the law may be in the form of an Act of Parliament, delegated legislation or judicial decision. Self Assessment Questions 3. The doctrine of judicial precedent is also known as the doctrine of: (a) Stare decisis; (b) Obiter dicta. 4. 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 administrations of justice, developed to enlarge, supplement or override a narrow rigid system of existing law of the land.Sikkim Manipal University Page No. 8


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1.4 Legal Environment of BusinessThe law is almost a universal human need. No society can exist without a legal order. We need institutions and a framework of rules and regulations to provide firmness to our mutual relations. Without law, there would be complete anarchy in society. That is why we regard rule of law as the essence of civilised society. It provides certainty to our relationships. It emphasizes that laws ought to be general in character so that there is no arbitrariness in their exercise. It also emphasizes complete equality before law and equal conformity to law by officials and individuals. Law and business are closely related disciplines. They complement each other. Law is a major factor in business decision making. Almost every aspect of business is regulated by law. Even the installation of a business unit itself may involve observance of some legal provision or the other. 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 incorporation and commencement of business. The contracts entered into by business 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. There may be deficiency in the service provided by business. The agreement between a manufacturer and his dealers may defeat the provisions of some law or the other. Sometimes the law may require business to provide certain facilities to its employees, even when the contract does not provide therefore. For instance, the provisions of labour welfare laws impose a legal obligation on employers to provide certain benefits to their workers. Sometime ago, the Central Government gave complete freedom to Banks to fix interest rates, which was obviously aimed at triggering off competition in the Indian economy. But all nationalized banks in India tried to keep the prime lending rate artificially high by resorting to cartelisation which is violative of the MRTP Act, 1969. The banks arrived at the particular interest rate at the behest of the Indian Banks Association (IBA) and not by taking into consideration the cost of raising funds. Thus, the legal environment of business is one of the major factors in regulating its conduct though some of the laws may act as facilitators forSikkim Manipal University Page No. 9


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some segment of the business at some time or the other. Almost every aspect of business is controlled by law. Sometimes even the nature of the business organization itself imposes legal fetters right from the time of its formation. The buying and selling, production, marketing and other functions of the business enterprise are to be conducted within a certain framework of legal environment. The decision making process of business, right from its very inception, will be guided by law. Certain conduct is illegal, and business which commits acts or omissions declared to be illegal is subject to sanctions. There may be fines or imprisonment if the conduct is declared a crime. The sanctions may include liability for damage if the conduct amounts to a breach of contract. In addition, the law and legal sanctions may be used to prevent certain conduct or to require that certain acts be done or to make business to comply to some requirement. Thus, business people must take decisions within the framework of law otherwise sanctions will be imposed. In this way, law is the foundation for the regulation of all business conduct and decisions. Self Assessment Questions 6. Law and business are ______________ other. 7. Every aspect of business is controlled by _________________.

1.5 Mercantile Law1.5.1 Meaning and nature Business Law may be defined as that branch of law which prescribes a set of rules for the governance of certain transactions and relations between: (i) business persons themselves, (ii) business persons and their customers, dealers, suppliers, etc., and (iii) 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,Page No. 10



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Negotiable instruments, Patents, trade marks and copyrights, Actionable claims, factoring and forfaiting, 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, it can be inferred that the subject has many objectives to achieve. Firstly, law lays down the framework within which business activities shall 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 in the products of Y company. These acts of X company are not in conformity with some legal rules prescribed by some statute or the other. Thus Y company can enforce its right which have been infringed by the X company. Secondly, a businessperson can resort to various judicial and quasi-judicial authorities against the government in case his legal rights have been violated. Thirdly, some laws are made to facilitate the business persons to achieve their goals smoothly. For example, business has been extended the facility of doing business by getting a company incorporated, deriving all the advantages of incorporation, such as separate legal entity, limited liability, etc.


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Fourthly, business law has social objectives too. The anti-competition laws, the pollution control laws, etc., are some of the examples. 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 aim to 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: 1. Statutes such as the Indian Contract Act, 1872, the Sale of Goods Act, 1930, the Partnership Act, 1932, the Negotiable Instruments Act, 1881, the Insurance Act, 1938. 2. Common law: In the absence of a legal provision on a subject, the Indian courts apply English Common Law. Even in interpreting Indian law, the Indian courts refer to English decisions. 3. Custom and usages: The 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. 4. Precedents: Courts make law too. Their main contribution comes in the form of decisions in law suits. The cases decided by the Supreme Court and other courts have served as precedents to follow by the lower courts. 5. Justice, equity and good conscience: The equitable principles of law developed by the English equity courts are the guiding force behind most of the Indian statutes on business laws. Also as and when necessary, the Indian courts make use of these principles of equity in interpreting the Indian law. Activity 2: The concept of ownership does not permit any vacuum. Whats your opinion on this? Self Assessment Questions 8. Statutes, common law, precedents, etc. are ______________ of Indian business law.Sikkim Manipal University Page No. 12


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

1.6 Some Basic Legal Concepts1.6.1 Concept of legal entity Law applies only to persons. Thus, persons are the subjects of law. A person is an entity which is clothed with rights and duties. There are two kinds of persons. A person may be a natural or an artificial person. 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 law. For example, a public company is an artificial person and is brought into existence by following the procedure given in the Companies Act, 1956. Thus there must be at least seven persons for bringing a public company into existence. In this way, an artificial person comes into existence when law confers such a status upon 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 Companies Act, 1956, there are some other laws under which artificial persons can be brought into existence. Some such laws are: Societies Registration Act, 1860; Co-operative Societies Act, 1912. 1.6.2 Concept of legal rights We have mentioned earlier that a person is an entity clothed with certain rights and duties. The sources of different rights may be customary, statutory, contractual, personal laws, etc. Some of the rights, which a person has, are interest in life, or liberty or property or extending over domestic relations and even to contractual relations. Some of these interests are not recognised or protected by law. The rights recognised or protected by law alone are enforceable. These rights have their origin in some source or the other, such as custom, statutes, personal law, law of tort. 1.6.3 Concept of property There could be no such thing as business law, or even business, if there were no such thing as property. Thus the concept of property is very important in business law. In a laymans restricted sense property meansSikkim Manipal University Page No. 13


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movable (personal property such as furniture) or immovable assets (real property such as land and buildings.) This is what is known 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 of 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. Law protects people in the exercise of property rights. In this way, the law contributes to the value of things. 1.6.4 Intellectual Property Rights (IPR) A trademark, a copyright, or a patent right are incorporeal assets. These are known as IPR. For instance, musical copyright in respect of songs, tunes and literary and artistic copyright belong to the author as his property. Thus, in this 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 or singer or inventor to publish a book, record music, or manufacture a particular thing or allow others to do so only at his behest. 1.6.5 Concept of ownership The term ownership may be described as a bundle of rights in rem (against the whole world), having 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 property (say X) dispossess an occupant (say Y) without Ys consent. X is liable to restore possession even though the occupant is unable to show any right to be in possession. Thus, even a trespasser, if allowed to be in occupation by negligence, cannot be disturbed even by the true owner. This is so as 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 vis--vis the occupant. A person acquires title to anything which is previously unowned. It is known as res-nullius.


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Self Assessment Questions 10. Custom is: (a) Neither written nor unwritten law; (b) Both written and unwritten law; (c) Unwritten law (d) Written law. 11. The rights which pertain to the realm of status which indicates the proposition of person in the eye of law in the society is known as. (a) Property rights (b) Information rights (c) Personal rights (d) None 12. Out 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 LawThere are certain essentials which must be present in law in order to make it effective. These are: (i) Predictability, (ii) Flexibility and (iii) Reasonable application and coverage. Law must be such that 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 its promise, they would have certain remedies under the law. Law must be flexible in the sense that it must not be so rigid and unchanging as to be impossible to mould to the present. The world is changing. New inventions are being made. Law must be flexible enough to meet changing conditions. And, if at a later stage, it is found that the existing law is incapable of tackling certain changes, then it must accommodate them by amendments thereto. Law must be reasonable both in its application and coverage. Wide publicity should be given to the law enacted so as to give an opportunity to those affected by it to know its requirements, and consequences for nonSikkim Manipal University Page No. 15


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compliance of those requirements. However, the old doctrine of ignorance of law is no excuse stands on its own feet. As regards reasonableness of laws coverage, the subject matter thereof must be considered reasonable by the people at large. Therefore, a law that a large number of persons consider to be unreasonable will soon become ineffective. Activity 3: Suggest your overview on The right has a source either in a contract, or in a customs, or in natural law. Self Assessment Questions 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 law include (a) Family laws (b) Law of property (c) Law of contract (d) All of the above 15. All the following laws include 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 SummaryBusiness laws are essential for the students of management to understand the legal rules and aspects of business. Just like any other study evenSikkim Manipal University Page No. 16


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business management is incomplete without a proper study of its laws. Any form of business needs legal sanction. Therefore, it is imperative that a manager understands the various ways in which businesses can be organized. This subject introduces some of the common forms of business organizations, including some forms unique to India like the Joint Hindu Undivided Family firm. Different types of organizations like Sole Ownership, Partnership, Private Limited Company, Public Limited Company, Joint Stock Company along with the rationale for adopting these forms are explored. What form of business organization is the best under a particular set of conditions? What advantage or disadvantage does it have over other forms of business? Glossary English Common Law: English common law is a system of law based upon English customs, usages and traditions which were developed over centuries by the English Courts. Equity: It refers to that branch of the English law which developed separately from the common law. Law: Law is a body of principles recognized and applied by the state in the administration of justice. Statute Law: The statute law refers to the law laid down in the Acts of Parliament. State: A state is a territorial division, with people therein subject to a uniform system of law administered by some authority of the state.

1.9 Terminal Questions1. The legal constraints tend to control or limit the discretion of the business 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 which has either been amended or enacted recently. Describe its (i) Objectives (ii) Legal provisions (iii) 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?Sikkim Manipal University Page No. 17


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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.

1.10 AnswersAnswers to Self Assessment Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. (d) State (a) (b) Equity Complement Law sources business entities (c) (c) (b) (d) (d) (c) (b)

Answers to Terminal Questions 1. Refer 1.4 Explain the various legal constraints of business in todays scenario. 2. Refer 1.2 How legal provisions affect the business what are their objectives. 3. Refer 1.3 The main sources of modern Indian Law, as administered by Indian courts, may be divided into two broad categories: (i) Primary sources and, (ii) Secondary sources. 4. Refer 1.2 Business Law may be defined as that branch of law which prescribes a set of rules for the governance of certain transactions and relations between: (i) business persons themselves, (ii) businessSikkim Manipal University Page No. 18


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persons and their customers, (iii) business persons and the state.

dealers,

suppliers,

etc.,

and

5. Refer 1.6 Effect of possession in the business. 6. Refer 1.4 The legal environment of business is one of the major factors in regulating its conduct though some of the laws may act as facilitators for some segment of the business at some time or the other. Mini-case The Enron Development Corporation of USA, which is one of the largest integrated natural gas companies in the world, started construction in Maharashtra, in April 1995, on the 695, MW gas fired plant. But the new government of Maharashtra-the Shiv Sena - BJP combine ordered a review of the project. The BJP had opposed the deal on various counts when it was being struck between Enron and then the government of Maharashtra headed by Congress party. Some of the counts on which the project was criticised were: (i) the social and environmental aspects of the project, (ii) the alleged bribes paid by Enron, (iii) the high cost of the project, (iv) the lack of transparency, and (v) the absence of competitive bidding. The Congress leaders alleged that cancelling the project was a politicallymotivated decision. Also, it is pertinent to refer to the ruling by the Bombay High Court in 1994, when it threw out a petition filed against the project by one of the leaders of BJP. In a strongly worded verdict the court had said, The proposal was deliberated at length for two and a half years, draft agreements were prepared from time to time, and it was ultimately the eighth or ninth draft which was finalised. Nothing was done secretly. There was total transparency at every stage of negotiation. There is nothing to show that anybody was being favoured for any specific reason. Also the Government of India had taken a series of decisions concerning inviting private sector participation in the power sector and announcing a list of incentives. Firstly, the first few private sector projects were to be given the status of pioneer projects what later came to be known as fast track ones, and were to be given every facility by the government. Secondly, for the first few projects, the government would not go in for public tendering. Naturally, Enron cannot be blamed for government policies.


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Question Describe various reasons behind the increment in cost of Enron plant in Maharashtra. (Hint: Due to the political reasons)


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Unit 2

Unit 2

Law of Contract

Structure: 2.1 Introduction Objectives 2.2 Meaning and Essentials of a Valid Contract Contract Agreement Essentials of a contract Classification of contracts 2.3 Proposal (or Offer) and Acceptance Modes of making an offer Acceptance of an offer Completion of communication of offer and acceptance (Sec.4) 2.4 Capacity to Contract Persons who are competent to contract Capacity of a minor to enter into a contract Mental incompetence prohibits a valid contract 2.5 Consent and Free Consent Meaning of consent Free consent 2.6 Consideration (Secs.2(d), 23-25 and 185) Meaning of consideration No consideration, no contract (Secs.10 and 25) 2.7 Agreements Declared Void (Secs.26-30) Agreements against public policy (Secs.26-28) Agreement in restraint of trade 2.8 Contingent Contract (Secs.31-36) Contingent contract defined (Sec.31) Essential characteristics of a contingent contract 2.9 Quasi Contracts Meaning of quasi contracts Cases which are treated as quasi contracts 2.10 Performance of Contracts (Secs.37-67) Meaning of performance of contract Meaning of offer to perform Who must perform the promise under a contract?Sikkim Manipal University Page No. 21


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2.11

2.12 2.13

2.14 2.15 2.16

Different Modes of Discharge of Contracts (Secs.73-75) Discharge of contracts by performance or tender Meaning of mutual consent (Sec.62) Discharge of contracts by impossibility of performance Discharge of a contract by operation of law Discharge of contracts by breach Remedies for Breach of Contract Freedom to Contract Freedom to contract is a myth or an illusion What is a standard form contract? Summary Terminal Questions Answers

2.1 IntroductionIn the previous unit, you came to know about the law and basic concepts of law. In this unit you will study about the contract of law. In this unit you will study how to enter into the contracts. Some of these are made consciously, for example, purchase or sale of a share of a company or a plot of land. Sometimes we do not even realize that we are making a contract, e.g., hiring a taxi, buying a book, etc. In any case, contracts, howsoever made, confer legal rights on one party and subjects the other party to some legal obligation. In the case of people engaged in business, they carry on business by entering into contracts. Thus, the business executives, corporate counsels, entrepreneurs, and professionals in different fields deal frequently with contracts. Objectives After studying this unit, you should be able to:

Describe the essentials of a valid contract Enumerate the capacity of contract Define acceptance Define consent


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2.2 Meaning and Essentials of a Valid Contract2.2.1 Contract A contract is an agreement, enforceable by law, made between at least two parties by which rights are acquired by one and obligations are created on the part of another. If the party, which had agreed to do something, fails to do that, then the other party has a remedy. Example: D Airlines sells a ticket on 1 January to X for the journey from Mumbai to Bangalore on 10 January. The Airlines is under an obligation to take X from Mumbai to Bangalore on 10 January. In case the Airlines fails to fulfil its promise, X has a remedy against it. Thus, X has a right against the Airlines to be taken from Mumbai to Bangalore on 10 January. A corresponding duty is imposed on the Airlines. As there is a breach of promise by the promisor (the Airlines), the other party to the contract (i.e., X) has a legal remedy. 2.2.2 Agreement Sec.2(e) defines an agreement as every promise and every set of promises forming consideration for each other. In this context, the word promise is defined by Sec.2(b). In a contract there are at least two parties. One of them makes a proposal (or an offer) to the other, to do something, with a view to obtaining the assent of that other to such act. When the person to whom the proposal is made signifies his assent thereto, the proposal is said to be accepted. A proposal, when accepted becomes a promise (Sec.2(b)). Enforceability by law: The agreement must be such which is enforceable by law so as to become a contract. Thus, there are certain agreements which do not become contracts as this element of enforceability by law is absent. 2.2.3 Essentials of a contract Sec.10 provides that all agreements are contracts, if they are made by free consent of parties, competent to contract, for a lawful consideration, and 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 than two parties. No one can enter into a contract with himself. An agreement is composed of two elements offer or proposal by one party and acceptance thereof by the other party.Sikkim Manipal University Page No. 23


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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 either voidable, void, illegal or unenforceable. 2.2.4 Classification of contracts Contracts may be classified as follows: Classification of contracts according to formation: A contract may be (a) Made in writing (b) By words spoken and (c) Inferred from the conduct of the parties or the circumstances of the case. Formal and informal contracts: This is another way of classifying contracts on the basis of their formation. A formal contract is one to which the law gives special effect because of the formalities or the special language used in creating it. The best example of formal contracts is negotiable instruments, such as cheques. Informal contracts are those for which the law does not require a particular set of formalities or special language. Classification according to validity: Contracts may be classified according to their validity as (i) Valid, (ii) Voidable, (iii) Void, (iv) Unenforceable. A contract to constitute a valid contract must have all the essential elements discussed earlier. If one or more of these elements are missing, the contract is either voidable, void, illegal or unenforceable. As per Sec.2(i) A voidable contract is one which may be repudiated (i.e., avoided) at the will of one or more of the parties, but not by others. Self Assessment Questions 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 Proposal (or Offer) and AcceptanceOffer is not only one of the essential elements of a contract but it is the basic building block also. An offer is synonymous with proposal. The offerer or proposer expresses his willingness to do or not to do (i.e., abstain from doing) something with a view to obtain acceptance of the other party to such act or abstinence (Sec.2(a)).Sikkim Manipal University Page No. 24


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2.3.1 Modes of making an offer An offer can be made by any act or omission of party proposing by which he intends to communicate such proposal or which has the effect of communicating it to the other (Sec.3). An offer can be either express or implied, and specific or general. Express offer: It means 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 telephone. Implied offer: It is an offer made by conduct. It is made by positive acts or signs so that the person acting or making signs means to say or convey something. However, silence of a party can, in no case, amounts to offer by conduct. Offer by abstinence: An offer can also be made by a party by omission to do something. This includes such conduct or forbearance on ones part that the other person takes it as his willingness or assent. 2.3.2 Acceptance of an offer When the person to whom the offer is made signifies his assent thereto, the offer is said to be accepted (Sec.2(b)). Thus, acceptance is the act of giving consent to the proposal. The offeree is deemed to have given his acceptance when he gives his assent to the proposal. The acceptance of an offer may be express or implied. It is express when the acceptance has been signified either in writing or by words of mouth or by performance of some required act of the offeree. Implied acceptance: Acceptance is implied when it is said to be gathered from the surrounding circumstances or the conduct of the parties. 2.3.3 Completion of communication of offer and acceptance (Sec.4) It is necessary to communicate offer to the offeree and the acceptance to the offeror. When is it that the communication is considered to be completed? The communication of an offer is complete when it comes to the knowledge of the person to whom it is made. Where A proposes by a letter to sell his 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, viz.; (i) As against the offer or and (ii) AsSikkim Manipal University Page No. 25


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against the acceptor. The communication of acceptance is complete (i) As against the offer or when it is put into a course of transmission to him so as to be out of the power of the acceptor; (ii) As against the acceptor, when it comes to the knowledge of the offer or. Self Assessment Questions 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 its made, when it comes to his knowledge. (True/False)

2.4 Capacity to Contract2.4.1 Persons who are competent to contract Any one cannot enter into a contract; he must be competent to contract according to the law. Every person is competent to contract if he (i) is of the age of majority, (ii) is of sound mind, and (iii) is not disqualified from contracting by any law to which he is subject (Sec.11). 2.4.2 Capacity of a minor to enter into a contract Age of a person determines enough maturity to make a contract. The contract law defines maturity as the age of majority. That usually is 18 years. Does this mean that a minor is not competent to contract? No, a minor may make a contract, but he is not bound by the contract; however the minor can make the other party bound by the contract. 2.4.3 Mental incompetence prohibits a valid contract A person who is not of sound mind may not enter into a contract; he must be of sound mind so as to be competent to contract. A test of soundness of mind has been laid down by law. A person is said to be of unsound mind for the purpose of making a contract if at the time he makes it he is incapable of understanding it and of forming a rational judgement as to its effect upon his interests. The liability for necessaries of life supplied to persons of unsound mind is the same as for minors.Sikkim Manipal University Page No. 26


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A lunatic is a person who is mentally deranged due to some mental strain or other personal experience. An idiot is a person who is of permanently unsound mind. He does not have lucid intervals. He is incapable of entering into a contract and therefore a contract with an idiot is void. A person who is drunk, intoxicated or delirious from fever so as to be incapable of understanding the nature and effect of an agreement or form a rational judgement as to its effect on his interests cannot enter into valid contracts whilst such drunkenness or delirium lasts. Activity 1: A company issues a prospectus giving false information about the unbounded wealth of Nevada. A shareholder buys shares on the faith of such information. He wants to avoid the contract. Can he do so? Self Assessment Questions 7. A married woman cannot enter into a contract. (True/False) 8. When the promisee does not accept the offer of performance, the promisor is not responsible for non-performance. (True/False)

2.5 Consent and Free Consent2.5.1 Meaning of consent Offer by one party is accepted by the other party. The consent of the offeree to the offer by the offer or is necessary. It is essential to the creation of a contract that both parties agree to the same thing in the same sense. When two or more persons agree upon the same thing in the same sense they are said to consent. 2.5.2 Free consent For a contract to be valid it is not only necessary that the parties consent but also that they consent freely. Where there is a consent but no free consent the contract is voidable at the option of the party whose consent was not free. Thus, free consent is one of the essentials of a valid contract. A consent is said to be free when it is not caused by: (i) coercion, (ii) undue influence, (iii) fraud, (iv) misrepresentation or (v) mistake.Sikkim Manipal University Page No. 27


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Meaning of coercion (Secs.15 and 72) Coercion is (i) the committing or threatening to commit any act forbidden by the Indian Penal Code or (ii) the unlawful detaining or threatening to detain any property to the prejudice of any person whatever with the intention of causing any person to enter into an agreement. (Sec.15). Meaning of fraud (Secs.17 and 19) Fraud means and includes any of the following acts committed by a party to a contract with an intent to deceive the other party thereto or to induce him to enter into a contract: (i) the suggestion as a fact of that which is not true by one who does not believe it to be true; (ii) active concealment of a fact by one having knowledge or belief of the fact; (iii) promise made without any intention of performing it; (iv) any other act fitted to deceive; (v) any such act or omission as the law specifically declares to be fraudulent. Meaning of misrepresentation (Secs.18-19) Misrepresentation is also known as simple misrepresentation whereas fraud is known as fraudulent misrepresentation. Like fraud, misrepresentation is an incorrect or false statement but 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 it believes it to be true. In this way, fraud is different from misrepresentation. Meaning of mistake (Secs.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. Self Assessment Questions 9. Consent obtained by fraud makes the agreement void. (True/False) 10. An attempt to deceive which does not deceive is not fraud. (True/False) 11. Cancellation of a contract by mutual consent of the parties is called waiver. (True/False)

2.6 Consideration (Secs.2(d), 23-25 and 185)2.6.1 Meaning of consideration One of the essential elements of a valid contract is that it must be supported by consideration.Sikkim Manipal University Page No. 28


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In simple terms consideration is what a promisor demands as the price for his promise. The term consideration is used in the sense of quid pro que, i.e., something in return. This something or consideration need not be in terms of money. This something 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. Also a promise by one party may be consideration for the promise of other party. 2.6.2 No consideration, no contract (Secs.10 and 25) 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 equivalent of some loss, damage, or inconvenience that may have or may have been occasioned to the other party in respect of the promise. Self Assessment Questions 12. Past consideration is no consideration. (True/False) 13. If the offeree does not accept the offer according to the mode prescribed by the offeror, the offer does not lapse automatically. (True/False)

2.7 Agreements Declared Void (Secs.26-30)The Act declares certain agreements to be void. Some of them (such as the following) have already been explained: (i) agreements entered into through a mutual mistake of fact between the parties (Sec.20); (ii) agreements, the object or consideration of which is unlawful (Sec.23); (iii) agreements, part of consideration of which is unlawful (Sec.24); (iv) agreements made without consideration (Sec.25). Some other agreements which are declared to be void are explained below. 2.7.1 Agreements against public policy (Secs.26-28) An agreement which conflicts with morals of the time and contravenes any established interest of society is void as being against public policy. Some of the agreements which are against public policy and have been declared to be void by law. These are as follows: (i) Trading with enemy: (ii) Agreements for stifling prosecution. (iii) Contracts in the nature of champerty and maintenance. (iv) Agreement for the sale of public offices and titles are void. (v) Agreements in restraint of parental rights are void. (vi) Agreements in restraint of marriage of any person other than a minor is void.Sikkim Manipal University Page No. 29


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2.7.2 Agreement in restraint of trade Sec.27 provides that every agreement by which any one is restrained from exercising a lawful profession, trade or business of any kind is, to that extent, void. All agreements in restraint of trade, whether general or partial, qualified or unqualified, are void. It is, therefore, not open to the courts to enter into any question of reasonableness or otherwise of the restraint [Khemchand v. Dayaldas, (1942) Sind, 114]. Self Assessment Questions 14. An agreement to agree is a valid contract. (True/False) 15. Social agreements are enforceable in courts. (True/False)

2.8 Contingent Contract (Secs.31-36)2.8.1 Contingent contract defined (Sec.31) A contingent contract is a contract to do or not to do something, if some event, collateral to such contract does or does not happen. Example: A contracts to pay B Rs 10,000 if Bs house is burnt. This is a contingent contract. 2.8.2 Essential characteristics of a contingent contract There are three essential characteristics of a contingent contract: (i) The performance of a contingent contract depends upon happening or nonhappening of some future event. (ii) The event must be uncertain. If the event is bound to happen and the contract has got to be performed in any case, it is not a contingent contract. (iii) The event must be collateral, i.e., incidental to the contract. Activity 2: X an old lady, by a deed of gift, made over certain property to her daughter D, with the specific directions that she should pay P, who is the sister of the old lady, a sum of Rs 100 per month. The same day D entered into an agreement with P to pay her the agreed amount. D, now refuses to pay her aunt P, the above amount on the plea that no consideration had move from P to D, P, therefore, sues D. is the suit maintainable and can D be held liable to pay the amount?


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Self Assessment Questions 16. A person who is usually of unsound mind cannot enter into a contract even when he is of sound mind. (True/False) 17. Payments made by a debtor are always appropriated in chronological order. (True/False)

2.9 Quasi Contracts2.9.1 Meaning of quasi contracts Quasi Contracts are so-called because the obligations associated with such transactions could neither be referred as tortious nor contractual, but are still recognised as enforceable like contracts, in courts. According to Dr Jenks, quasi contract is a situation in which law imposes upon one person, on grounds of natural justice, an obligation similar to that which arises from a true contract, although no contract, express or implied, has in fact been entered into by them. 2.9.2 Cases which are treated as quasi contracts Following are the cases which are to be deemed quasi contracts: 1. Claim for necessaries supplied to a person incapable of contracting or on his account. If a person, incapable of entering into a contract, or any one whom he is legally bound to support is supplied by another person with necessaries suited to his condition in life, the person who furnished such supplies is entitled to be reimbursed from the property of such incapable person (Sec.68). 2. Reimbursement to a person paying money due by another in payment of which he is interested. A person who is interested in the payment of money which another is bound by law to pay, and who, therefore, pays it, is entitled to be reimbursed by the other. (Sec.69). Self Assessment Questions 18. Commercial impossibility does not make the contract void. (True/False) 19. A threat to commit suicide does not amount to coercion. (True/False)


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2.10 Performance of Contracts (Secs.37-67)2.10.1 Meaning of performance of contract A contract creates obligations. Performance of contract means the carrying out of obligations under it. The parties to contract must either perform or offer to perform their respective promises unless such performance is dispensed with or excused under the provisions of the Indian Contract Act, or some law (Sec.37). 2.10.2 Meaning of offer to perform It may happen that the promisor offers performance of his obligation under the contract at the proper time and place but the promisee refuses to accept the performance. This is called as 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 lose his rights under the contract. 2.10.3 Who must perform the promise under a contract? The promise may be performed by promisor himself or his agent or by his legal representative. (i) In case, there was an intention of the parties that the promise must be performed by the promisor himself, such promise is to be performed by him only. Thus, where A promises to paint a picture for B, then A must perform this promise personally. (ii) If there is no such intention of the parties, then the promisor may employ a competent person to perform the promise. If A has promised to deliver some items of grocery to B, A may perform this promise either personally delivering the items to B or causing it to be delivered to B through someone. (iii) In case of death of the promisor, the legal representative must perform the promise unless a contrary intention appears from the contract. A promises to deliver goods to B on a certain day on payment of Rs 1,000. A dies before that day. As legal representatives are bound to deliver the goods to B, and B is bound to pay Rs 1,000 to As representatives. Self Assessment Questions 20. The liability of joint promisors is joint and several. (True/False) 21. If there is no such intention of the parties, then the promisor may employ a competent person to perform the promise. (True/False)


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2.11 Different Modes of Discharge of Contracts (Secs.73-75)A contract may be discharged by (i) performance, (ii) tender; (iii) mutual consent; (iv) subsequent impossibility; (v) operation of law; (vi) breach. 2.11.1 Discharge of contracts by performance or tender The obvious mode of discharge of a contract is by performances that is where the parties have done whatever was contemplated under the contract, the contract comes to an end. Thus, where A contracts to sell his 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 promise but the other party refuses to accept, the promisor stands discharged of his obligations. 2.11.2 Meaning of mutual consent (Sec.62) If the parties to a contract agree to substitute a new contract for it, or to rescind it or alter it, the original contract is discharged. A contract may terminate 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. 2.11.3 Discharge of contracts by impossibility of performance A contract may be discharged because of impossibility of performance. There are two types of impossibility: (i) Impossibility may be inherent in the transaction (i.e., the contract), (ii) Impossibility may emerge later by the change of certain circumstances material to the contract. 2.11.4 Discharge of a contract by operation of law Discharge by operation of law may take place in four ways: (i) By death. Death of the promisor results in termination of the contract in cases involving personal skill or ability. (ii) By insolvency. The insolvency law provides for discharge of contracts under certain circumstances so where an order of discharge is passed by an insolvency court the insolvent stands discharged of all debts incurred previous to his adjudication. (iii) By merger. 2.11.5 Discharge of contracts by breach A breach of contract is one partys failure, without a legal excuse, to live up to any of its promises under a contract. A contract terminates by breach of contract. If the promisor has not performed his promise in accordance withSikkim Manipal University Page No. 33


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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 of this is that the promisee becomes entitled to certain remedies. The breach of contract may arise in two ways: (i) anticipatory and (ii) actual. Anticipatory breach of contracts: The anticipatory breach of contract occurs when a party repudiates it before the time fixed for performance has arrived or when a party by his own act disables himself from performing the contract. Actual breach of contracts: The actual breach can occur by (i) failure to perform as promised, (ii) making it impossible for the other party to perform. The failure to perform means that one party must not have performed a material part of the contract by a stated deadline. The actual breach by failure to perform may take place (a) at the time when performance is due, or (b) during the performance of the contract. Thus, if a person does not perform his part of the contract at the stipulated time, he will be liable for its breach. Self Assessment Questions 22. ____________ means substitution of a new contract for the original one. 23. A contract terminates by breach of contract. (True/False)

2.12 Remedies for Breach of ContractWhen someone breaches a contract, the other party is no longer obligated to keep its end of the bargain. From there, that party may proceed in several ways: (i) the other party may urge the breaching party to reconsider the breach; (ii) if it is a contract with a merchant, the other party may get help from consumers associations; (iii) the other party may bring the breaching party to an agency for alternative dispute resolution; (iv) the other party may sue for damages; or (v) the other party may sue for 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 obligations under the contract.Sikkim Manipal University Page No. 34


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Damages (Sec.75): Another relief or remedy available to the promisee in the event of a breach of promise by the promisor is to claim damages or loss arising to him therefrom. Damages under Sec.75 are awarded according to certain rules as laid down in Secs.73-74. Sec.73 contains three important rules: (i) Compensation as general damages will be awarded only for those losses that directly and naturally result from the breach of the contract. (ii) Compensation for losses indirectly caused by breach may be paid as special damages if the party in breach had knowledge that such losses would also follow from such act of breach. (iii) The aggrieved party is required to take reasonable steps to keep his losses to the minimum. What is the most common remedy for breach of contracts: The usual remedy for breach of contracts is suit for damages. The main kind of damages awarded in a contract suit are ordinary damages. This is the amount of money it would take to put the aggrieved party in as good a position as if there had not been a breach of contract. The idea is to compensate the aggrieved party for the loss he has suffered as a result of the breach of the contract. Self Assessment Questions 24. There are three remedies under the Specific Relief Act, 1963. (True/False) 25. Damages under Sec.75 are awarded according to certain rules as laid down in Sec.73-74. (True/False)

2.13 Freedom to Contract2.13.1 Freedom to contract is a myth or an illusion The freedom of the parties is limited by two factors. There are certain laws for the protection of the employees, and an employer cannot, therefore, induce his employees to enter into any contract favourable to the employer. 2.13.2 What is a standard form contract? A standard form contract is a document which is generally printed, containing terms and conditions, with certain blanks to be filled in. It is prepared by the business people. The customer has only to sign it. Therefore, from his standpoint, the freedom to contract is restricted. Many of


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the contracts now being entered into by consumers are not the result of individual negotiations; rather they are one-sided contracts. Self Assessment Questions 26. A contract is imposed by a party having a strong bargaining power on a party having a weak bargaining power. (True/False) 27. The freedom of the parties is limited by four factors. (True/False) Activity 3: Discuss the statement 'Freedom to contract is a myth or an illusion' in the light of day-to-day transactions in the market & the essentials of the law.

2.14 SummaryThe law of contract in India is contained in the Indian Contract Act, 1872. This Act is based mainly on English common law, which is to a large extent made up of judicial precedents. (there being a separate contract act in England). It extends to the whole of India except the state of Jammu and Kashmir and came into force on the first day of September 1872 (Sec.1 Indian Contract Act, 1872). The act is not exhaustive. Glossary Contract: An agreement enforceable by law is a contract. Agreement: Every promise and every set of promises forming the consideration for each other is an agreement. Valid Contract: Contracts which satisfy all the essential elements of a valid contract are enforceable in a court of law. Void Contract: A contract which ceases to be enforceable by law becomes void when it ceases to be enforceable.

2.15 Terminal Questions1. What do you mean by contract? What test would you apply to ascertain whether an agreement is a contract? 2. All agreement are not contracts but all contacts are agreements. Comment.Sikkim Manipal University Page No. 36


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3. Enumerate some of the contracts which 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. 6. Distinguish between a wagering agreement and a contingent contract. 7. What are the different modes of discharge of contracts? Explain the discharge of contract by performance or tender. 8. Give some example of ordinary damages. Can ordinary damages be claimed for any remote or indirect loss or damages by reason of the breach? 9. Freedom to contract is a myth or an illusion. Discuss.

2.16 AnswersAnswers to Self Assessment Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. True False False False False False False False False True False False True False False False False True False True TruePage No. 37



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22. 23. 24. 25. 26. 27.

Novation True True True True False

Answers to Terminal Questions 1. Refer 2.2 A contract is an agreement, enforceable by law, made between at least two parties. 2. Refer 2.2 The agreement must be such which is enforceable by law so as to become a contract. 3. Refer 2.2 Avoidable contract is one which may be repudiated at the will of one or more of the parties. 4. Refer 2.3 Offer is not only one of the essential elements of a contract but it is the basic building block also. 5. Refer 2.3 It is necessary to communicate offer to the offeree and the acceptance to the offeror. 6. Refer 2.8 A contingent contract is a contract to do or not to do something.. 7. Refer 2.11 A contract may be discharged by (i) performance, (ii) tender 8. Refer 2.12 Damages under Sec.75 are awarded according to certain rules as laid down in Secs.73-74. 9. Refer 2.13 The freedom of the parties is limited by two factors. Mini-case The Carbolic Smoke Ball Company 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 the vapours into the nose of the user. This would cause the nose to run, and hopefully flush out the cold. In fact the inflammation caused by the device would have probably increased susceptibility to catching influenza. The Company published advertisements in the Pall Mall Gazette and other newspapers on November 13, 1891, claiming that it would pay 100 toSikkim Manipal University Page No. 38


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anyone who got sick with influenza after using its product according to the instructions set out in the advertisement. 100 reward will be paid by the Carbolic Smoke Ball Company to any person who contracts the increasing epidemic influenza colds, or any disease caused by taking cold, after having used the ball three times daily for two weeks, according to the printed directions supplied with each ball. 1000 is deposited with the Alliance Bank, Regent Street, shewing our sincerity in the matter. During the last epidemic of influenza many thousand carbolic smoke balls were sold as preventives against this disease, and in no ascertained case was the disease contracted by those using the carbolic smoke ball. One carbolic smoke ball will last a family several months, making it the cheapest remedy in the world at the price, 10s. post free. The ball can be refilled at a cost of 5s. Address: "Carbolic Smoke Ball Company, "27, Princes Street, Hanover Square, London." 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 the Carbolic Smoke Ball Company. They 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 it is used properly the company had complete confidence in the smoke ball's efficacy, but "to protect themselves against all fraudulent claims" they would need her to come to their office to use the ball each day and checked by the secretary. Mrs. Carlill brought a 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 they ought to pay. The company argued it was not a serious contract. Question Do you agree to what the company says? Justify. (Hint: summarize this case in your word.)


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Unit 3

Contracts of Guarantee and Indemnity

Structure: 3.1 Introduction Objectives 3.2 Purpose and Meaning of the Contract of Guarantee Purpose of guarantee Definition and nature of the contract of guarantee (Sec.126) Fiduciary relationship 3.3 Kinds of Guarantee Oral or written guarantee Specific and continuing guarantee A guarantee may either be for the whole debt or a part of the debt 3.4 Rights and Obligations of the Creditor Rights of a creditor Obligations imposed on a creditor in a contract of guarantee 3.5 Rights, Liabilities and Discharge of Surety Rights against the creditor Rights against the principal debtor Rights against co-sureties Liability of surety Discharge of surety 3.6 Contract of Indemnity Meaning of indemnity Rights of the indemnified (i.e., the indemnity holder) Rights of the indemnifier Commencement of indemnifiers liability 3.7 Summary 3.8 Terminal Questions 3.9 Answers

3.1 IntroductionIn the previous units, you came to know about the law and the contract of law. In this unit you will study about the guarantee and indemnity of contracts.


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In this unit you come to know when a company needs some money for its business it approaches a bank. The bank requires that the managing director M promises to repay the loan personally should the company default. When the directors of the company including M execute the promissory note on behalf of the company, they sign as companys officials. M, the managing director signs again as an individual. The relationship between M and the bank is called a guarantee or suretyship. It is a contractual relationship resulting from the unconditional promise of M (known as the surety or guarantor) to repay the loan to the creditor (the bank) for the obligation of the principal debtor (the company) should it default. If the company fails to repay the loan, the bank can approach M for the payment. Sometimes the banks (lenders) ask for more security for the 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 the company defaults, the bank now has three options: to compel the principal debtor to pay, demand payment from the surety, or obtain a court order to either claim or sell the collateral. The bank need not look to the collateral first. But if M pays the money to the bank, then the right of the bank on the collateral gets transferred to him. The bank has yet another alternative for securing its loan to the company. It could ask that all the three directors (including M) sign the promissory note as co-sureties. If they do so and the company defaults, the bank may seek payment from any one or any two of them or all of them. The law relating to the contracts of guarantee is given in the Indian Contract Act, 1872 (Secs.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: Explain the contract of guarantee Describe the types of guarantee Explain the rights and obligations of creditor Enumerate the contract of indemnitySikkim Manipal University Page No. 41


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3.2

Purpose and Meaning of the Contract of Guarantee

3.2.1 Purpose of guarantee The contracts of guarantee are among the most common business contracts and are used for a number of purposes. These are: i) The guarantee is generally made use of to secure loans. Thus, a contract of guarantee is for the security of the creditor. ii) The 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 to stand behind his promise to perform the construction contract. Also 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. iii) Bail bonds, used in criminal law, are a form of contract of guarantee. A bail bond is a device which ensures, that a criminal defendant will appear for trial. In this way a prisoner is released on bail pending his trial. If the prisoner does not appear in the court as desired then the bond is forfeited. In this unit our primary concern is with the contracts of guarantee which are used for securing loan. 3.2.2 Definition and nature of the contract of guarantee (Sec.126) 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 oral or in writing. From the above discussion, it is clear that in a contract of guarantee there must, in effect, be two contracts, a principal contract between the principal debtor and creditor, and a secondary contract between the creditor and the surety. In a contract of guarantee there are three parties, viz., the creditor, the principal debtor and the surety. Therefore, there is an implied contract also between the principal debtor and the surety.Sikkim Manipal University Page No. 42


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Example: When A requests B to lend Rs10,000 to C and guarantees that C will repay the amount within the agreed time and that on C failing to do so, he will himself pay to B, there is a contract of guarantee. The contract of surety is not a contract collateral to the contract of the principal debtor, but is an independent contract. There must be a distinct promise on the party of the surety to be assumable for 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; the original contract between the debtor and creditor may be about to come into existence. Similarly, under certain circumstances, a surety may be called upon to pay though principal debtor is not liable at all. Also, where a person gives a guarantee upon 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 (Sec.144). 3.2.3 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 upon good faith on the part of the creditor. A creditor must disclose all those facts which, under the circumstances, the surety would expect not to exist. So where 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 upto a certain amount which limit 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 no part of the creditors duty to inform the surety about all his previous dealings with the debtor. Self Assessment Questions 1. As per the Indian law, a contract of guarantee must be in writing. (True/False) 2. Specific guarantee is different from continuing guarantee. (True/False) 3. For a contract of guarantee, the primary liability is of the surety. (True/False)


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3.3 Kinds of Guarantee3.3.1 Oral or written guarantee A contract of guarantee may either be oral or in writing (Sec.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. 3.3.2 Specific and continuing guarantee From the point of view of the scope of guarantee a contract of guarantee may either by specific or continuing. A guarantee is a specific guarantee, if it 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 which extends to a series of transactions is called a continuing guarantee (Sec.129) Example: A guarantees payment to B, a tea-dealer, to the amount of Rs. 10,000 for any tea he may from time to time supply to C. B supplies C with tea of the value above 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 is accordingly liable to B to the extent of Rs. 10,000. A guarantee regarding the conduct of another person is a continuing guarantee. Unlike a specific guarantee which is irrevocable, a continuing guarantee can be revoked regarding further transactions (Sec.130). However, continuing guarantee cannot be revoked regarding transactions that have ready taken place. The death of the surety operates, in the absence of any contract to the contrary, as a revocation of a continuing guarantee, so far as regards future transactions. (Sec.131). 3.3.3 A guarantee may either be for the whole debt or a part of the debt 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.Sikkim Manipal University Page No. 44


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For instance, where X owes Y Rs 50,000 and A has stood as surety for Rs. 30,000, the question may arise whether A has guaranteed Rs. 30,000 out of Rs. 50,000 or whether he has guaranteed the full amount of 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 in Xs insolvency and also enforce his 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 of the balance, i.e., Rs. 50,000 Rs. 30,000 = Rs. 20,000 which was not guaranteed. Since after paying Rs. 30,000 to Y, A can claim from Xs estate, he will get Rs. 7,500 being 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., 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. Activity 1: Provide guarantee against anything from the owner it would be sufficient to buyer? Give suggestion. Self Assessment Questions 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 which extends to a series of transactions (b) Guarantee which limited access of transactions (c) Guarantee not related to transactions (d) None of the above


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3.4 Rights and Obligations of the Creditor3.4.1 Rights of a creditor 1. The creditor is entitled to demand payment from the surety as soon as the principal debtor refuses to pay or makes default in payment. The liability of the surety cannot be postponed till all other remedies against the principal debtor have been exhausted. In other words, the creditor cannot be asked to exhaust all other remedies against principal debtor before proceeding against surety. The creditor also has a right of general lien on the securities of the surety in his possession. This right, however, arises only when the principal debtor has made default and not before that. 2. Where surety is insolvent, the creditor is entitled to proceed in the suretys insolvency and claim the pro rata dividend. 3.4.2 Obligations imposed on a creditor in a contract of guarantee 1. Not to change any terms of the original contract. The creditor should not change any terms of the original contract without seeking the consent of the surety. Sec.133 provides. any variance made, without the suretys consent, in the terms of the contract between the principal debtor and the creditor, discharges the surety as to the transactions subsequent to the variance. Example: A banker contracts to lend X Rs. 5,000 on March 4. A guarantees repayment. The banker pays X Rs. 5,000 on January 1. A in this case is discharged from his liability as the contract has been varied as much as the banker might sue X before March 4, but it cannot sue A as the guarantee is from March 4. 2. Not to release or discharge the principal debtor. The creditor is under an obligation not to release or discharge the principal debtor. Sec.134 states: The surety is discharged by a contract between the creditor and principal debtor, by which the principal debtor is released, or by any act or omission of the creditor, the legal consequence of which is the discharge of the principal debtor. Example: A gives a guarantee to banker C for repayment of the debt granted to B. B later contracts with his creditors (including C, the banker) to assign to them his property in consideration of their releasing himSikkim Manipal University Page No. 46


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from their demands. Here B is released from his debt by the contract with C and A is discharged from his suretyship. 3. Not to compound, or give time to, or agree not to sue the principal debtor. Sec.135 provides, A contract between the creditor and the principal debtor, by which the creditor makes a composition with or promises to give time to, or not to use the principal debtor, discharges the surety, unless the surety assents to such contract. If the time for repayment is extended, the debtor may die or become insane or insolvent or his financial position may become weaker in the meanwhile, with one effect that the suretys remedy to recover the money in case the principal debtor defaults, may be impaired. However, there are certain exceptions. These are: a) Sec.136 states that if the creditor makes an agreement with a third party, but not with the principal debtor, to give extension of time to the principal debtor, surety is not discharged even if his consent has not been sought. b) Mere forbearance on the part of creditor to sue the principal debtor, or to enforce any other remedy against him, does not, in the absence of a provision to the contrary, discharge the surety (Sec.137). c) If the creditor releases one of the co-sureties, the other co-surety (or co-sureties) thereby is not discharged. The co-surety released by the creditor is also not released from his liability to the other sureties (Sec.138). 4. Not to do any act inconsistent with the rights of the surety (Sec.139). Where C lends money to B on the security of a joint and several promissory note made in Cs favour by B and by A as surety for B, together with a bill of sale of Bs furniture, which gives power to C to sell the furniture and apply the proceeds in discharge of the note

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