Chapter 12: Capacity and Legality

Introduction to Capacity and Legality

• Law presumes that parties have the requisite contractual capacity to enter into a contract

• Persons who do not have this capacity are:

  • Minors

  • Insane persons

  • Intoxicated persons

• A contract to perform an illegal act is called an illegal contract

  • Are void contracts: they cannot be enforced by either party to the contract

  • The term illegal contract is a misnomer, however, because no contract exists if the object of the contract is illegal

Minors

• A minor is a person who has not reached the age of majority

  • Does not have the maturity, experience, or sophistication needed to enter into contracts

• Many states have enacted statutes that specify the age of majority

  • Generally 18 years of age for both males and females

• Any age below the statutory age of majority is called the period of minority

Infancy Doctrine

• The infancy doctrine is a doctrine that allows minors to disaffirm (cancel) most contracts they have entered into with adults

  • Based on public policy, which reasons that minors should be protected from the unscrupulous behavior of adults

• Under the infancy doctrine, a minor has the option of choosing whether to enforce a contract or not

  • It is a voidable contract: a contract in which one or both parties have the option to void their contractual obligations; if a contract is voided, both parties are released from their contractual obligations

• The adult party is bound to the minor’s decision

• If both parties to a contract are minors, both parties have the right to disaffirm the contract

• A minor may not affirm one part of a contract and disaffirm another part

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• Disaffirmance is the act of a minor to rescind a contract under the infancy doctrine

  • Can be done orally, in writing, or by the minor’s conduct

  • No special formalities are required

  • The contract may be disaffirmed at any time prior to the person’s reaching the age of majority plus a “reasonable time”

Duties of Restoration and Restitution

• If a minor’s contract is executory and neither party has performed, the minor can simply disaffirm the contract: There is nothing to recover because neither party has given the other party anything of value

  • If the parties have exchanged consideration and partially or fully performed the contract by the time the minor disaffirms the contract, however, the issue becomes one of what consideration or restitution must be made

Minor’s Duty of Restoration

• Duty of restoration: a minor is obligated only to return the goods or property he or she has received from the adult in the condition it is in at the time of disaffirmance

Competent Party’s Duty of Restitution

• Duty of restitution: if a minor has transferred money, property, or other valuables to the competent party before disaffirming the contract, that party must place the minor in status quo

  • That is, the minor must be restored to the same position he or she was in before the minor entered into the contract

    • This restoration is usually done by returning the consideration to the minor

      • If the consideration has been sold or has depreciated in value, the competent party must pay the minor the cash equivalent

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• Most states provide that the minor owes a duty of restitution and must put the adult in status quo on disaffirmance of the contract if the minor’s intentional, reckless, or grossly negligent conduct caused the loss of value to the adult’s property

• On occasion, minors might misrepresent their age to adults when entering into contracts

  • Most state laws provide that minors who misrepresent their age must place the adult in status quo if they disaffirm the contract

Ratification

• If a minor does not disaffirm a contract either during the period of minority or within a reasonable time after reaching the age of majority, the contract is considered ratified (accepted)

  • Hence, the minor (who is now an adult) is bound by the contract; the right to disaffirm the contract is lost

• Ratification is the act of a minor after the minor has reached the age of majority by which he or she accepts a contract entered into when he or she was a minor

  • Can be expressed by oral or written words or implied from the minor’s conduct

Parents’ Liability for Their Children’s Contracts

• Generally, parents owe a legal duty to provide food, clothing, shelter, and other necessaries of life for their minor children

• Parents are liable for their children’s contracts for necessaries of life if they have not adequately provided such items

• The parental duty of support terminates if a minor becomes emancipated

• Emancipation is the act or process of a minor voluntarily leaving home and living apart from his or her parents

  • The courts consider factors such as getting married, setting up a separate household, or joining the military in determining whether a minor is emancipated

Necessaries of Life

• Necessaries of life are food, clothing, shelter, medical care, and other items considered necessary to the maintenance of life

  • Minors must pay the reasonable value of necessaries of life for which they contract

• The seller’s recovery is based on the equitable doctrine of quasi-contract rather than on the contract itself

  • Under this theory, the minor is obligated only to pay the reasonable value of the goods or services received

Special Types of Minors’ Contracts

• Many states have enacted statutes making certain contracts enforceable against minors:

  • Medical, surgical, and pregnancy care

  • Psychological counseling

  • Health insurance

  • Life insurance

  • The performance of duties related to stock and bond transfers, bank accounts, etc.

  • Student loans

Mentally Incompetent Persons

• Mental incompetence may arise because of mental illness, dementia, schizophrenia, mania, brain damage, and the like

• The law protects people suffering from substantial mental incapacity from enforcement of contracts

• To be relieved of duties under a contract, law requires a person to have been legally insane (incompetent) at the time of entering the contract

  • Legal insanity: state of contractual incapacity, as determined by law

  • Most states use the objective cognitive “understanding” test

  • Mere weakness of intellect, or slight psychological or emotional problems, do not constitute mental incompetence

• The law has developed two standards concerning contracts of mentally incompetent persons: (1) adjudicated mentally incompetent and (2) mentally incompetent but not adjudicated mentally incompetent

Standard 1: Adjudicated Mentally Incompetent

• An adjudicated mentally incompetent is a declared legally insane individual by a proper court or administrative agency; a guardian will be appointed on the person’s behalf

• Any contract entered into by a person who has been adjudged mentally incompetent is void (no contract exists and has no legal effect)

• The court-appointed guardian is the only one who has the legal authority to enter into contracts on behalf of the person

Standard 2: Mentally Incompetent but Not Adjudicated Mentally Incompetent

• A mentally incompetent but not adjudicated mentally incompetent is mentally incompetent but a court or administrative agency has not declared that person to be mentally competent

• A contract entered into by such person is generally voidable

  • Insane persons are liable in quasi contract to pay the reasonable value for the necessaries of life they receive

• Any contracts made by such persons during a lucid interval are enforceable

• Contracts made while the person was not legally competent can be disaffirmed

Case 12.1 Mental Capacity

• Case

  • Ivie v. Smith

  • Supreme Ct. of Missouri, 439 S.W.3d 189 (2014)

• Facts

  • A woman with Alzheimer’s made her husband the beneficiary to various accounts right before her death

  • When she died, the husband was sued by her family members arguing that he wasn’t entitled to the funds

• Issue

  • Did Watson lack contractual capacity at the time she changed beneficiary designations?

• Decision

  • The Supreme Court of Missouri affirmed the circuit court’s decision

Intoxicated Person

• An intoxicated person is a person who is under contractual incapacity because of ingestion of alcohol or drugs to the point of incompetence

  • Voidable by the intoxicated person

  • Not voidable by the other party if that party had contractual capacity

• Under the majority rule:

  • Contract is voidable only if the person was so intoxicated when the contract was entered into that he or she was incapable of understanding or comprehending the nature of the transaction

    • In most states, this rule holds even if the intoxication was self-induced

    • Some states allow the person to disaffirm the contract only if the person was forced to become intoxicated or did so unknowingly

• A person who disaffirms a contract based on intoxication generally must be returned to the status quo

  • In turn, the intoxicated person generally must return the consideration received under the contract to the other party and make restitution that returns the other party to status quo

  • After becoming sober, an intoxicated person can ratify the contracts entered into while intoxicated

• Intoxicated persons are liable in quasi-contract to pay the reasonable value for necessaries they receive

Lawful and Illegal Contracts

• A lawful contract is a contract that has a lawful object

• An illegal contract is a contract that has an illegal object

  • Such contracts are void

• A contract contrary to law is a contract to perform activities that are prohibited by law

Case 12.2 Illegal Contract

• Case

  • Ford Motor Company v. Ghreiwati Auto

  • U.S. District Ct for the Eastern District of Michigan, 2013 U.S. Dist. Lexis 159470 (2013)

• Facts

  • Ford and Ghreiwati Auto had a contract for the sale and service of Ford vehicles in Syria, then the U.S. issued an executive order prohibiting American companies from selling products and services in Syria

  • Ford then terminated its dealership agreement with Auto

• Issue

  • Did the presidential executive order make the dealership contract illegal for Ford to perform?

• Decision

  • The U.S. district court held that the executive order rendered the Ford–Auto dealership agreement illegal and that Ford had therefore terminated the agreement properly

Usury Laws [Prohibited Contract]

• Usury laws set an upper limit on the interest rate that can be charged on certain types of loans

  • Lenders who charge a higher rate than the state limit are guilty of usury

  • Intended to protect unsophisticated borrowers from loan sharks and others who charge excessively high rates of interest

• Certain states provide that a usurious loan is a void contract, permitting the borrower not to have to pay the interest or the principal of the loan to the lender

• Most usury laws exempt certain types of lenders and loan transactions involving legitimate business transactions from the reach of the law

  • These exemptions usually include loans made by banks and other financial institutions, loans above a certain dollar amount, and loans made to corporations and other businesses

Contracts to Commit Crimes [Prohibited Contract]

• Contracts to commit criminal acts are void

• If the object of a contract becomes illegal after the contract is entered into because the government has enacted a statute that makes it unlawful, the parties are discharged from the contract

  • The contract is not an illegal contract unless the parties agree to go forward and complete it

Contracts in Restraint of Trade [Prohibited Contract]

• A contract in restraint of trade is a contract that unreasonably restrains trade

  • Are void

• Contracts like agreements to collude and reduce competition in markets

Contracts Contrary to Public Policy [Prohibited Contract]

• A contract contrary to public policy is a contract to perform activities that have a negative impact on society or interfere with the public’ safety and welfare

  • Are void

• An immoral contract is a contract whose objective is the commission of an act that society considers immoral

  • May be found to be against public policy

  • Judges are not free to define morality based on their individual views

    • Instead, they must look to the practices and beliefs of society when defining immoral conduct

  • Example A contract that is based on sexual favors is an immoral contract and void as against public policy.

Gambling Statutes [Prohibited Contract]

• Gambling statutes are statutes that make certain forms of gambling illegal

• All states prohibit or regulate gambling, wagering, lotteries, and games of chance via gambling statutes

  • States provide various criminal and civil penalties for illegal gambling

• The Indiana Gaming Regulatory Act (IGRA) of 1988 established a framework for permitting and regulating Native American gambling casinos

  • There are approximately 500 establishments operated by approximately 240 of the more than 560 federally recognized tribes

  • Federal law permits these casinos only if the state permits such gambling

Effect of Illegality

• The effect of illegality is a doctrine that states that the courts will refuse to enforce or rescind an illegal contract and will leave the parties where it finds them

• Certain situations are exempt from the general rule of the effect of finding an illegal contract

  • If an exception applies, the innocent party may use the court system to sue for damages or to recover consideration paid under the illegal contract

• Allowable exceptions:

  1. Innocent persons who were justifiably ignorant of the law or fact that made the contract illegal

     • Example A person who purchases insurance from an unlicensed insurance company may recover insurance benefits from the unlicensed company.

  2. Persons who were induced to enter into an illegal contract by fraud, duress, or undue influence

     • Example A shop owner who pays $5,000 in “protection money” to a mobster so that his store will not be burned down by the mobster can recover the $5,000.

  3. Persons who entered into an illegal contract who withdraw before the illegal act is performed

     • Example If the president of New Toy Corporation pays $10,000 to an employee of Old Toy Corporation to steal a trade secret from his employer but reconsiders and tells the employee not to do it before he has done it, the New Toy Corporation may recover the $10,000.

  4. Persons who were less at fault than the other party for entering into the illegal contract

     • In pari delicto is a situation in which both parties are equally at fault in an illegal contract

Exculpatory Agreements

• An exculpatory agreement is a contractual provision (or release of liability clause) is an agreement that relieves one (or both) of the parties to a contract from tort liability for ordinary negligence

  • Cannot be used in a situation involving willful conduct, intentional torts, fraud, recklessness, or gross negligence

• Exculpatory clauses are often found in leases, sales contracts, sporting event ticket stubs, parking lot tickets, service contracts, and the like

• Such clauses do not have to be reciprocal (i.e., one party may be relieved of tort liability, whereas the other party is not)

• Exculpatory clauses that either affect the public interest or result from superior bargaining power are usually found to be void as against public policy

• Although the outcome varies with the circumstances of the case, the greater the degree to which the party serves the general public, the greater the chance that the exculpatory clause will be struck down as illegal

  • The courts will consider such factors as the type of activity involved; the relative bargaining power, knowledge, experience, and sophistication of the parties; and other relevant factors

• Example If a department store had a sign above the entrance stating, “The store is not liable for the ordinary negligence of its employees,” this would be an illegal exculpatory clause and would not be enforced.

Case 12.3 Exculpatory Agreement

• Case

  • Langlois v. NOVA River Runners, Inc.

  • Supreme Ct. of Alaska, 2018 Alas. Lexis 31 (2018)

• Facts

  • Plaintiff’s husband signed a release form before he went on the white water rafting trip operated by defendant

  • He died as a result of the trip

• Issue

  • Does the Release bar the plaintiff’s negligence claim?

• Decision

  • The Supreme Court of Alaska affirmed the trial court’s decision holding that the Release was enforceable and barred the plaintiff’s negligence claim

Restrictive Agreements in Employment and Business Contracts

• Many employment and other contracts include restrictive covenants/agreements agreements, that are designed to protect employers from employees, past employees, and others using certain secret or proprietary knowledge gained during employment or access to the company to harm the company

• The most common restrictive agreements are (1) confidentiality agreements, (2) non-solicitation agreements, and (3) noncompete agreements

(1) Confidentiality Agreements

• A confidentiality agreement (nondisclosure agreement / NDA) is an agreement whereby employees, independent consultants, and others who are privy to a company’s secret or proprietary information agree not to disclose such information to any other party

  • Ex: trade secrets, business plans, recipes or formulas

• Confidentiality agreements in employment contracts include terms that prohibit an employee from disclosing secret and proprietary information about their employer that they are privy to during their employment

  • Such a confidentiality agreement is binding while the employee is working at the employer and also after the employee is no longer employed by the employer

(2) Non-Solicitation Agreements

• A non-solicitation agreement is an agreement in which employees agree that they will not solicit the clients or customers of the employer for their own benefit or for the benefit of a competitor of the employer after their employment ends

• Applies whether the employee voluntarily leaves the employer or is terminated by the employer

• Customer lists are important business assets that are protected by non-solicitation agreements

  • For such a list to be considered protected, the employer must have spent time, money, or energy producing it

  • If the information is generally obtainable from other sources than the employer, the customer list is not protected

• Non-solicitation agreements often prohibit employees who have left the company from soliciting other employees to leave the company

• Companies can sue prior employees who violate non-solicitation agreements, obtain cease-and-desist orders preventing past employees from further violations, and obtain injunctions to prevent competitors from using the information subject to the non-solicitation agreement

• In most states, non-solicitation agreements are enforceable

(3) Covenants Not to Compete

• A covenant not to compete (noncompete agreement) is an agreement that provides that a seller of a business or an employee will not engage in a similar business or occupation within a specified geographical area for a specified time following the sale of the business or termination of employment

• Covenants not to compete are usually considered lawful if they are reasonable in three aspects: (1) the line of business protected, (2) the geographic area protected, and (3) the duration of the restriction

Case 12.4 Covenant Not to Compete

• Case

  • Friedman v. Lasco

  • Supreme Ct. of Montana, 372 P.3d 451 (2016)

• Facts

  • Plaintiffs bought an archery business from defendant

  • The agreement contained a covenant not to compete that prohibited the defendant from competing in a 100- mile radius, defendant ignored the agreement

• Issue

  • Was the injunction lawful?

• Decision

  • The Supreme Court of Montana affirmed the district court’s decision

Licensing Statutes

• A licensing statute is a statute that requires a person or business to obtain a license from the government prior to engaging in a specified occupation

  • Ex: lawyers, doctors, real estate agents, insurance agents, certified public accountants

• Problems arise if an unlicensed person tries to collect payment for services provided to another under a contract

  • Some statutes expressly provide that unlicensed persons cannot enforce contracts to provide these services

  • If the statute is silent on the point, enforcement depends on whether it is a regulatory statute or a revenue-raising statute

Regulatory Licensing Statute

• A regulatory licensing statute is a licensing statute enacted to protect the public that require certain persons or businesses to obtain a license from the government to qualify to practice certain professions or to engage in certain types of businesses

• Generally, unlicensed persons cannot recover payment for services when they do not have the required license

  • Example If​ Marie, a​ first-year law​ student, agrees to draft a will for Randy for a​ $450 fee, but is not licensed in a state that requires those who draft wills to be a licensed​ attorney, the contract is​ unenforceable by Marie

Revenue-Raising Statute

• A revenue-raising statute is a licensing statute with the primary purpose of raising revenue for the government

• A person who provides services pursuant to a contract without the appropriate license required by such a statute can enforce the contract and recover payment for services rendered

Unconscionable Contracts

• The general rule of freedom of contract holds that if the object of a contract is lawful and the other elements for the formation of a contract are met, the courts will enforce a contract according to its terms

• Although it is generally presumed that parties are capable of protecting their own interests when contracting, it is a fact of life that dominant parties sometimes take advantage of weaker parties

• Many contracts that a consumer signs are contracts of adhesion—that is, they are preprinted forms whose terms the consumer cannot negotiate and that the consumer must sign in order to obtain a product or service

  • Examples Automobile sales contracts and leases, mortgages, and apartment leases are usually contracts of adhesion.

    • Most adhesion contracts are lawful even though there is a disparity in power of contracting

• An unconscionable contract is a contract that courts refuse to enforce in part or at all because it is so oppressive or manifestly unfair as to be unjust

  • The courts are given substantial discretion in determining whether a contract or contract clause is unconscionable

  • This doctrine may not be used merely to save a contracting party from a bad bargain

3 Elements of Unconscionability

• The following elements must be shown to prove that a contract or a clause in a contract is unconscionable:

  1. The parties possessed severely unequal bargaining power

  2. The dominant party unreasonably used its unequal bargaining power to obtain oppressive or manifestly unfair contract terms

  3. The adhering party had no reasonable alternative

• If the court finds that a contract or contract clause is unconscionable, it may:

  1. Refuse to enforce the contract

  2. Refuse to enforce the unconscionable clause but enforce the remainder of the contract

  3. Limit the applicability of any unconscionable clause so as to avoid any unconscionable result