Welcome to the Fair! The dangers of oral contracts

June 9th, 2010

During the summer two parties agree to a transfer of a mobile festival concessions business for a total sales price of $150,000. The assets of the business to be transferred include a truck, a trailer, kitchen equipment, signs and lighting apparatus. The purchasers (a mother and daughter) pay $10,000 cash up front, with the balance due once the purchaser secures bank financing. The purchasers take possession of the assets and operate the business for several months, paying the sellers (a husband and his wife) a modest consulting fee to assist with the business transition. Insurance and title to the assets remains in the sellers’ name, pending payment of the $140,000 balance owed. The purchasers buy replacement equipment, pay the business’s taxes and pay the business’s employees.

By the end of the festival season, the profits do not meet the purchasers’ expectations. The purchasers’ loan has been approved, but the funds have not been transferred. The purchasers attempt to return the truck and equipment to the sellers’ storage facility and avoid the parties’ oral agreement. Who wins and why?

This law school-worthy fact pattern presented itself in a 2008 case from Illinois, Jannusch v. Naffziger, 883 N.E.2d 711 (Ill. App. 2008), and the entertaining scenario provides a well-suited platform for analyzing contract issues relevant to commercial transactions and business acquisitions of all shapes and sizes.

The purchasers argued that the parties had never entered into a valid agreement for the sale of the concessions business named “Fesitival Foods”. Specifically, the purchasers asserted that the parties’ discussions did not address numerous essential terms that were necessary for a binding agreement, including allocation of the purchase price among equipment and goodwill, whether there would be a covenant not to compete binding the sellers, how lien releases would be obtained, and what would occur if the financing never came through. The court disagreed, finding that the parties had agreed to all the necessary “essential terms” which were the purchase price and the items to be transferred. Thus, the purchasers’ argument that the parties course of conduct was merely preliminary to a potential future purchase agreement was found unpersuasive:

“The conduct in this case is clear. Parties discussing the sale of goods do not transfer those goods and allow them to be retained for a substantial period before reaching agreement. [The purchasers] replaced equipment, reported income, paid taxes, and paid [the sellers] for [their] time and expenses, all of which is inconsistent with the idea that [the purchasers were] only ‘pursuing buying the business.’ An agreement to make an agreement is not an agreement, but there was clearly more than that here.”

Contracts for the sale of goods are governed by Article 2 of the Uniform Commercial Code (“UCC”). However, whether a business acquisition constitutes a “sale of goods” is not always cut and dry. Where a transaction, such as a typical business acquisition, involves sales of both goods and services, courts apply the “predominant purpose” test to determine whether Article 2 applies. In Jannusch, the court held that the fact that, “significant tangible assets were involved” was sufficient to place the parties’ transaction within the scope of Article 2.

As noted by the purchasers, the general rule under Article 2 is that contracts for the sale of goods over $500 must be in writing to be enforceable. However, even oral contracts in excess of $500 will be enforced if one side has either acknowledged the agreement in court or partially performed its obligations under the agreement. Thus, in Jannusch, even though the parties’ contract was oral, it still was governed by Article 2 because both sides had partially performed. Specifically, the sellers had delivered the equipment, the purchasers had made the $10,000 down payment and, most importantly, the purchasers had applied for and obtained a bank loan to pay the $140,000 balance of the purchase price. In addition, one of the purchasers acknowledged in her testimony that the purchasers had agreed to pay $150,000 for the business, she just couldn’t recall exactly when.

As a result, despite the lack of formality and the limited terms upon which the parties had actually agreed, the trial court found—and the appellate court affirmed—that the parties had entered into a valid, binding and enforceable contract for the sale of the business. The defendants’ attempt to “get out of the deal” because of disappointing profits during two months of operations failed, and the defendants were liable for a $140,000 judgment.

Court decisions like Jannusch are important for businesspeople because they demonstrate that a party’s subjective understanding of a transaction—or even a communication not intended to form a transaction—can be irrelevant to the legal results that arise. While the purchasers’ claims in this case may have been an after-the-fact attempt to avoid the effects of their knowing conduct, the implications extend to cases of legitimate misunderstanding and lack of intent to form a contract. Parties considering any substantial sale or purchase need to be careful to take steps to ensure that their oral or informal (e.g., email) interactions with potential buyers or sellers are limited so that they do not reach a binding agreement without intending to. Carefully drafted documentation is the best way to avoid disputes based upon conflicting intents and understandings.

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