If you're starting or buying a small business, you need to know about contracts. Start by familiarizing yourself with the definition of a contract and how a contract can be breached. We'll go over when a contract can be breached, what types of breaches there are, and the kinds of damages you can recover from a breach.
What Is a Contract?
A "contract" is a legally binding exchange of promises. It's formed when one party offers to do something, the second party accepts the offer, and each party promises to provide something of value to the other, such as cash, services, or goods. For example, if a seller offers to sell equipment to your company for $10,000 and you accept the offer, there's a contract for the purchase and sale of equipment. The seller is obligated to provide the equipment and you're obligated to pay for it.
Chances are you'll enter into many different kinds of contracts while you're in business, which might include:
- an agreement to purchase an existing business
- leases for real and personal property
- agreements to purchase equipment, goods, or real property
- agreements to sell goods to customers
- agreements to perform services for clients or customers
- employment agreements with employees you hire
- independent contractor agreements with nonemployees you hire
- loan agreements and promissory notes, and
- an agreement to sell your business.
For more information on the basic requirements of a contract and the elements of a written contract, see our section, Contracts 101.
What Is a Breach of Contract?
When you enter into a contract (either verbally or in writing), you're legally obligated to perform your contractual duties—that is, do what you promised to do in the contract. "Nonperformance" is the failure to fulfill your obligations under a contract. When you don't perform your contractual obligations, it's called a "breach of contract."
In our equipment contract example, if the seller fails to deliver the equipment as specified in the contract, that failure to perform is a breach of the contract. If the seller does deliver the equipment but you fail to pay for it, you have breached the contract.
There are different types of breaches and ways to deal with a breach. If a breach is serious enough—a “material breach”—the injured party might be able to sue for damages under breach of contract. We'll discuss the different types of breaches and the contract damages available below.
Types of Breaches of Contract: Material vs. Immaterial Breaches
Some contract breaches are more serious than others. The law distinguishes between material (or total) breaches and immaterial (trivial or minor) breaches of contract. Typically, the type of breach determines whether you need to still perform your side of the contract if the other party breaches. You can sue under either type of breach (as we'll discuss later).
Material Breach of Contract
A "material breach" occurs when one person doesn't perform a significant or essential obligation under the contract, such that the value of the contract to the nonbreaching party is seriously impaired.
If the seller in our example fails to deliver the equipment or delivers defective equipment, they'll have materially breached the contract. Delivery of working equipment goes to the heart of the contract. Similarly, if you fail to pay for the equipment, you'll have materially breached the contract. Payment is your primary obligation and the seller’s primary expectation under the contract.
In general, if one side has materially breached the contract, then the other side no longer has an obligation to perform their duties under the contract.
Immaterial Breach of Contract
A minor, immaterial breach doesn't significantly impair the value of the contract to the nonbreaching party. While one side has technically not performed exactly as the contract specified, in general, the nonbreaching party is only slightly inconvenienced.
Suppose that the contract calls for payment to be made by wire transfer within 10 business days of delivery. Due to a mix-up in your accounting department, you instead send a check via overnight mail the day after delivery, well in time for the check to be deposited and cleared before the 10-day due date. While this is technically a breach, the seller isn't disadvantaged in any significant way and the breach is immaterial.
Typically, if one side immaterially breaches the contract, then both sides must still perform their duties under the contract. But the nonbreaching party can still sue the breaching party over their broken promise.
When Is a Contract Breached?
A contract can be breached either at the time performance is due or beforehand. The law distinguishes between breaches that occur when performance is due (actual breaches) and breaches that occur before performance is due (anticipatory breaches).
Actual Breach of Contract
A contract is breached (broken) when either one or both parties fail to perform as promised by the contract's deadline.
For example, say in our equipment contract scenario, the seller is supposed to deliver 10 dollies by January 31. The contract also calls for you to pay the full amount owed upon delivery of the dollies. If the seller doesn't deliver all 10 dollies by January 31, the seller is in actual breach of the contract. On the other hand, if all 10 dollies are delivered by January 31 and you fail to pay for the equipment when the dollies are delivered, then you'd be in actual breach.
Anticipatory Breach of Contract
A contract can be breached before performance is due. An “anticipatory breach of contract”—also known as “repudiation”—occurs when one party decides that they'll not perform as promised and communicates their decision to the other party. The second party can sue the first party for breach of contract even though the time for performance hasn't yet arrived.
For example, suppose the seller of the equipment in our example indicates that they've discontinued the model of equipment that you contracted for. The seller sends you an email telling you that they won't fulfill your order. At that point, you could sue for breach of contract (assuming that the contract doesn't explicitly allow them to do this).
Suing for Damages After a Breach of Contract
When there's a breach of contract, the side that's injured by the breach can go to court and seek damages—a money payment adequate to cover economic losses resulting from the breach. As mentioned earlier, a material breach of contract will also usually terminate the nonbreaching party’s duty to perform any of the promises they made in the contract. For example, your company would obviously have no legal duty to pay for equipment that isn't delivered.
When most people sign a contract, they expect the other side to honor its terms. Unfortunately, however, the world isn't always so dependable, and contracts are broken in a variety of ways;
- Vendors fail to deliver the goods they promised in the correct quantity.
- Independent contractors fail to perform at the time and in the manner they promised.
- Businesses might abandon a contract when they decide it's no longer lucrative.
- Buyers can refuse to pay.
Contract disputes such as these are all too common. When another party breaches an agreement, what can you do? There are several types of contract remedies available to you if the other party breaches a contract and you decide to sue.
Specific Performance of the Contractual Obligation
Perhaps the most complete remedy for a party's failure to perform a contract is for a court to force that party to perform. When a court orders the party that broke the contract to perform their obligations as agreed in the contract, this is known as "specific performance."
Specific performance is usually available when the contract involves some kind of unique goods or other unusual benefit to the other party and ordinary money damages aren't sufficient to make the aggrieved party whole. The following are some examples of when specific performance might be appropriate:
- a commissioned work of art
- a part that's custom-ordered for a project
- an antique piece of furniture
- a real estate contract; or
- an item of personal value
Courts generally will not grant specific performance on employment contracts, as courts are usually hesitant to force individuals to work for others against their will.
Compensatory Damages for Breach of Contract
Compensatory damages, perhaps the most common type of contract damages, help compensate you for the economic loss caused by a broken contract.
For example, imagine that Mr. Smith signs a contract agreeing to buy ten hours of landscaping services from Green's Landscaping for $50 an hour. If Mr. Smith breaks the contract and doesn't use any of Green's Landscaping's services, compensatory damages paid to Green's Landscaping would be $500, which is the economic loss suffered. If Green's Landscaping breaks the contract, and Mr. Smith is forced to hire another service for $60 an hour, compensatory damages paid to Mr. Smith would equal $100 ($10 an hour—the difference in price between the original contract and the new contract).
Note that compensatory damages aren't meant to be punitive. In other words, the goal isn't to punish the breaching party for "immoral" conduct, but rather to put the non-breaching party back into the position they would have been in, had the contract been performed. Absent specific language in a contract, it's far more common for courts to award simple compensatory damages than punitive damages.
Consequential Damages for Breach of Contract
"Consequential damages" are those caused indirectly by the broken contract. They are damages above and beyond standard compensatory damages.
For example, imagine that a retail store buys customized software to run its cash registers and inventory system. The software is guaranteed to work without issue for the next year. One month later, the system completely breaks down. As a result, the store must close for the day to repair the system. The store's loss of business for that day is a consequential damage of the broken contract. The software company knew the store's operations were dependent on the software working. So, the software company should be able to foresee that the store would be forced to close and lose out on business if the software was unusable.
Put differently, consequential damages aim to address the flow of problems that reasonably result from a party's breach of contract. As a plaintiff filing a court case, it's your burden to establish the precise quantity of these damages to you or your business.
Liquidated Damages Written In the Contract
"Liquidated damages" are damages specified in the contract itself as a remedy for breach. They can operate as an incentive not to break the contract, but the dollar amount doesn't have to be directly related to the actual loss caused by the breaking of the contract.
For example, suppose you want to have your kitchen remodeling job finished in time for your big birthday party. You include a provision in the contract that says the contractor must pay you $100 per day for every day after the stated completion date that the job isn't completed. If the contract requires him to finish your project by August 1, but he does not finish for another week, that would be seven days (or $700) of damages explicitly provided for in the contract.
Courts tend to be hesitant to enforce liquidated damages clauses that are excessive. To protect against a court throwing out this provision, your clause should be reasonable in the amount of damages specified so they're not viewed as heavily punitive. Also, some state laws specifically restrict the amount of liquidated damages allowed for certain types of contracts.
Punitive Damages for Breach of Contract
"Punitive damages" are damages that punish the wrongdoer in a breach of contract lawsuit. These damages aren't based on actual economic loss like compensatory damages, or even on a clause in the contract, as with liquidated damages. Rather, they're designed to make an example out of the party who broke the contract and impose punishment for the wrongful conduct.
It's rare for a court to award punitive damages in breach of contract lawsuits. For the most part, courts don't like to punish parties for breaching standard commercial contracts, absent some sort of additional malicious or harmful conduct.
Is Nonperformance or Breach of Contract Ever Excused?
Sometimes the law excuses a material breach of contract. This excuse of nonperformance can occur, for example, when the contract is impossible to perform due to unexpected circumstances. For instance, if the factory that makes the equipment you ordered is destroyed by a fire and no other factory is available, then the nonperformance and breach might be excused. Under this circumstance, the seller wouldn't be liable to you for damages.
See our article on getting out of a contract for detailed guidance on when nonperformance of contractual obligations can be excused.
For a more complete discussion of legal defenses against a breach of contract claim, check out our article on defenses to a breach of contract claim.
Talking to a Contracts Lawyer
Many times, people create, perform, and end contracts without any issues. But if an issue does arise, it might be a good idea to talk to a contracts attorney. Whether you've breached a contract or you think the other side has breached the contract, a lawyer can help you figure out your next steps. An attorney can also help you draft a contract, make amends (changes) to an existing contract, and resolve a breach of contract.