CHAPTER

McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved

Capacity and Illegality

SEVEN

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Objectives

Chapter Objectives:

• Use vocabulary regarding the capacity and illegality properly

• Discuss the three categories of incapacity

• Evaluate the ramifications of each kind of incapacity on the enforceability of a contract

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ObjectivesChapter Objectives:

• Determine if ratification or disavowal of the contract has occurred given a certain set of facts

• Determine whether the subject matter of the contract is illegal and if so whether it is malum in se or malum prohibitum

• Evaluate whether a court would sever an illegal clause from a contract or hold the entire contract void

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This chapter will explore:

• WHO may create a binding legal contract and WHO may not

• WHAT the agreement may pertain to and WHAT it may not

Objectives

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• Defects in the formation of a contract are affirmative defenses to enforcement. The contract was never formed and therefore cannot be properly or legally performed upon

Affirmative Defenses

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• A party may avoid enforcement of an agreement if unable to understand the transaction due to:– diminished capacity, either lack of

majority or mental infirmity, or– if the subject matter of the contract is

improper, either requiring a criminal or statutorily prohibited act

Affirmative Defenses

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• There are certain circumstances under which a person cannot enter into a contract as it is deemed legally impossible

Affirmative Defenses

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• The law of contracts protects persons who are:– under 18 (minors) – once a person has reached 18, they

have reached the age of majority

Affirmative Defenses

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• The law of contracts protects persons who are:– mentally infirm– persons not having the capacity to

understand a transaction due to a defect in their ability to reason therefore, do not have the requisite mental intent to enter into a contract

Affirmative Defenses

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• The law of contracts protects persons who are:– under the influence of drugs or alcohol– persons who do not have the capacity to

understand a transaction due to overconsumption of alcohol or drugs do not have the requisite mental intent to enter into a contract

Affirmative Defenses

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• A person must have the present intent to contract. The people in these three categories are unable to make an informed decision regarding their potential contractual obligations

• The law protects those least able to protect themselves

Affirmative Defenses

7-12Diminished Capacity: Minority

• Contracts entered into by minors are voidable, not per se void– A contract that is void is invalid and

never enforceable

7-13Diminished Capacity: Minority

• A minor has the option upon attaining the age of 18 to ratify the contract. By ratifying the contract, the minor validates it– Ratification: The minor, upon reaching

majority, can simply continue to abide by the contract. This continued performance indicates that the former minor intends to honor the contract

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• The first exception to rule of avoidability is a contract for necessities– Necessities: Goods and services that are

required; basic elements of living and employment

Exception to Rule of Avoidability

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• Public policy prefers that all citizens obtain the necessities of living; the law protects the suppliers of these necessities by disallowing avoidance – The supplier (the adult in the contract) is

protected without fear that the minor will be able to escape his/her obligations

– It must be noted that the item contracted for be truly necessary to the minor

Exception to Rule of Avoidability

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• The second exception to rule of avoidability is legislation– Legislation: Regulations codified into

laws by Congress

• Contracts include educational loan documents, military enlistments, marriage or child-support agreements, banking, and insurance contracts are disallowed avoidance to facilitate legally enforceable contracts between a minor and the other parties

Exception to Rule of Avoidability

7-17Diminished Capacity:Mentally Infirm

• Mental Disability: – It is not enough to show that the

contracting party was under a mental disability, but also that the mental disability rendered the party incapable of understanding the transaction

– The mental disability must relate to the capacity to contract

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• The standard for mental infirmity is hard to meet• The party wishing to avoid the contract, or his/her representative, must show that the condition rendered that person

incapable of understanding the transaction at issue• This means that a person may be mentally incapable of performing certain acts but still retain the capacity to

contract

Diminished Capacity:Mentally Infirm

7-19Diminished Capacity:Under the Influence

• Intoxication– Under the influence of alcohol or drugs

which may, depending on the degree of inebriation, render a party incapable of entering into a contractual relationship

• Medicinal side effects– Under the influence of over-the-counter

or prescription drugs having an impact on mental capacity which may render a party incapable of entering into a contractual relationship

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• The most elusive of the capacity standards

– Courts have little sympathy for self-induced reduction of capacity and overindulgent persons and will hold them to their contractual undertakings

– The court also will look to the other party in the transaction

– It is a matter of reasonableness

Diminished Capacity:Under the Influence

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• There must be a present intent to contract

• There is no present intent because the very nature of the transaction cannot be understood by the impaired party

Diminished Capacity:Under the Influence

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Illegality

• Malum in se– An act that is prohibited because it is

“evil in itself ”– It is an act that is universally

recognized as immoral and repugnant, such as murder, arson, or rape

• These “contracts” are absolutely unenforceable as their purpose is inherently bad and the courts will never find any justification in them. There can never be any “innocent” party to award damages in equity

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• Malum prohibitum is “prohibited evil,” – Malum prohibitum is not morally

reprehensible; it is a violation of the law

– Certain acts are not allowed in order to maintain a harmonious and fair society

• Sometimes, the court deems them void and unenforceable; other times, the court will try to protect an “innocent” party to the transaction or one who has relied on the contract to his/her detriment

Illegality

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• Illegal scheme– A plan that uses legal steps to

achieve an illegal result

• On more unclear ground are the contracts that appear to have a legal purpose but for which the performance is part of an illegal scheme

Illegality

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• Covenant not to compete

– Generally speaking, public policy and fairness dictate that agreements that restrict trade, market competition, and a person’s livelihood are invalid. A covenant not to compete is usually found in the employment contract. A company will attempt to control what an employee does after he/she leaves that particular company—to limit the scope of his/her subsequent employment

• It prohibits the former employee from working for a competitor for a certain period of time in a certain geographical area

Illegality

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• Severability of contract– The ability of a court to choose to

separate and discard those clauses in a contract that are unenforceable and retain those that are enforceable

Illegality

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Summary

• Contract law gives an affirmative defense to those parties who find themselves in a contract that they were not capable of making in the first place or for which the subject matter is illegal

• In the most general sense, freedom of contract allows anyone to contract for anything; however, there are some reasonable restrictions on this laissez-faire attitude

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Summary

• Courts also restrict the subject matter of the contract, what the parties can bargain for. The transaction must not involve illegal activities or illegal purposes

• These prohibited activities and purposes can either be characterized as malum in se, an act that is morally reprehensible, or malum prohibitum, an act prohibited by law for the well-being of society