There are various issues to consider when entering into a commercial contract. Not only is the content of the contract important but the ability of the parties to sign the contract is also relevant; in some instances, if a party does not have capacity, the contract could be voidable or even void. That means you’ll have wasted your time and money as well as potentially having missed out on other deals.
Here we consider when a person will be considered not to have capacity and the contracting parties’ position in this situation.
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- What is capacity to contract?
- Contracts – the basics
- Contract capacity and corporations
- Contract capacity and contracting with trustees
- The capacity of an individual to contract
- Contracting with an under 18
- Contracting and mental capacity
- Contracting capacity and intoxication
- Practical tips on contracts and capacity
What is capacity to contract?
To form a contract, a party must have the legal capacity to contract. This is a basic of contract law. Without capacity the contract may not be valid and, if so, won't be enforceable.
Not checking capacity to contract is the sort of mistake that an entrepreneur or salesperson is likely to only make once, but it can be a very expensive error to make.
Capacity to contract means the person or business you are contracting with has the legal ability to enter into a contractual relationship with you. Capacity depends on whether you are contracting with:
- A corporation
- An individual acting in a particular role, such as a trustee
- An individual
Once the status of the person you are contracting with is established, then their capacity to contract is assessed using a combination of statute and common law, assisted by case law.
Contracts – the basics
It isn’t just a person’s capacity to contract that’s important when you are entering into a contract. If a person is acting on behalf of another, such as their employer, an association, a partnership or company, they need contractual authority. For detailed information on contractual authority take a look at our article: Authority in contract law | Contract formation authority.
You also need to make sure that there is:
- An offer
- An acceptance
- An intention to create legal relations
Without the basics covered you may not have a contract. That could be disastrous for you or for your fledgling business if you have entered into a contract to sell goods to A on the assumption that you have already entered into a valid contract to buy the goods from B, with a decent profit margin on sale, only to find that you have no valid contract with B to buy but you are bound by a contract to sell to A what you don’t have and can't buy on the same terms as you thought you had validly contracted with B for.
Contract capacity and corporations
The capacity of corporations to enter into contracts depends on the type of corporation. The topic is closely allied to the issues surrounding authority to contract. In summary, the position is:
- Registered companies - a registered company has a legal personality and has capacity to contract. Any person authorised by the company can enter into a contract on behalf of the company. Every director and the company secretary are authorised signatories to a contract. Provided that the other party to the contract is acting in good faith, they are not required to check whether the powers of the directors are limited in any way.
- Limited liability partnerships (LLPs) - an LLP, like a company, is a body corporate with its own legal personality. It can therefore legally contract in its own right. Each member can bind the LLP although the LLP agreement between the members may include restrictions on the powers of individual members. In usual business dealings, a third party may assume that any member of the LLP is authorised to act on behalf of, and bind, the LLP, unless they know to the contrary.
- General partnerships - a general partnership does not have a legal personality and therefore liability rests with each of the partners. The agreement which governs the relationship between the partners and any limitations on the authority of those partners, is private. Every partner acts as an agent of the partnership and of the other partners.
- Limited partnerships - a limited partnership does not have its own legal personality. Therefore, liability rests with the general partner. The general partner runs the day-to-day business of a limited partnership and acts as its agent. The limited partners have no active role and lose their limited liability status if they breach this. The general partner has a wide scope to bind the partnership and the other partners, but the private partnership agreement may set out restrictions on authority. It is important to consider the legal capacity of the general partner, for example, whether they are an individual, body corporate etc.
- Overseas companies - the position of an overseas company is governed by local law and the company constitution. It is therefore important when entering into a contract with an overseas company to obtain a legal opinion from local counsel that the company can enter into the contract and has done so correctly. This does not guarantee the enforceability of the contract but provides a little more protection than taking the word of the overseas company.
If a corporation acts outside of its powers, the actions are deemed ultra vires. An ultra vires contract will be void. It is possible for a company to ratify an ultra vires act by a special resolution, but this will not affect the liability of the directors or anyone else which has arisen as a result of the ultra vires act.
Contract capacity and contracting with trustees
The ability of a trustee to enter into a contract comes from statute and the trust instrument. Although individual trustees can enter into contracts it is crucial to review the provisions of the trust instrument as it may affect the powers of the trustees. Whilst the trustees may be personally liable by entering the contract this won't assist your business if the trustees don’t have the personal assets to compensate for loss because they lacked capacity to bind the trust.
The capacity of an individual to contract
Individuals are presumed to have capacity to enter a contract . If an individual later says they didn’t have capacity it is up to them to prove it. If they can show they lacked capacity the contract is voidable at the option of the person who lacked capacity.
An individual’s capacity can be questioned where the party claiming incapacity is:
- A minor under the age of 18
- Mentally incapacitated
- Was intoxicated at the time of the contract
Whether a minor or a mentally incapacitated or intoxicated person has the capacity to contract isn’t a simple yes or no answer as the law on whether they have the capacity to contract depends on the nature of the contract.
Contracting with an under 18
For some businesses, whose sales are targeted at the youth market, it is crucial to understand the capacity to contract of under 18s so your business understands its risks.
With under 18s and contract capacity , it is all about the nature of the contract. That’s important to know if you are selling apps, games, tech stuff or trainers etc.
There are three relevant types of contract:
- Contract for necessaries – under 18s are bound by a contract for necessaries. The Sale of Goods Act 1979 defines them as ‘goods suitable to the condition in life of the minor and to his or her actual requirements at the time of the sale and delivery’. Necessaries includes food, clothes, accommodation and other essentials and the law says a minor who purchases such necessaries must pay a reasonable price for them.
- Contract of apprenticeship, education and service – under 18s are bound by this type of contract if the minor will benefit from it.
- Any other contract entered into by an under 18 – if the contract doesn’t fall into the above two categories it is voidable at the minor’s option. This means the contract can be avoided by the under 18 before they reach 18 years of age or within a reasonable time after. What is deemed a ‘reasonable time’ depends on the circumstances of each case. Frustratingly for businesses, there is no requirement for the under 18 to explain or justify the reason for voiding the contract . However, if the contract is voided, the under 18 should return any goods acquired under the contract. If the under 18 has paid money under a contract, they are unlikely to be reimbursed unless they can prove the contract did not benefit them. When a minor reaches 18 years of age, they can choose to ratify the contract and so make it valid and enforceable.
Contracting and mental capacity
Contracting and mental capacity is becoming a hot topic as businesses, and their employees, can't always recognise that a person has an invisible condition that may affect their capacity to contract. Trying to hold a person to a contract can result in reputational damage and adverse publicity but the reality is that it can be hard to identify if someone doesn’t have the mental capacity to contract.
The law under the common law and the Mental Capacity Act 2005 (MCA) says a person can assume the other contracting party has mental capacity and the onus is on the other party, or their advocate, to prove that they didn’t have capacity when they entered the contract.
With mental capacity and contracts, the type of contract is relevant. Under the MCA, a mentally incapacitated person must pay a reasonable price for necessary goods or services supplied or provided to them. ‘Necessary’ means suitable to the person's condition in life and to their actual requirements at the time when the goods or services were supplied.
Any other contract will be valid and binding unless the person challenging the contract on the basis of mental incapacity can prove that:
- When they entered into the contract, they did not have the mental capacity to do so and
- The other party to the contract knew, or should have known, that they didn’t have capacity
There is case law on what amounts to mental capacity and knowledge but each case turns on its facts. A person who was mentally incapacitated at the time of the contract can choose to rescind the contract. This places the parties in the position they were in prior to the contract.
Contracting capacity and intoxication
According to an 1811 case (Pitt v Smith (1811) 3 Camp 33) an intoxicated person doesn’t have capacity to enter into a contract. However, an intoxicated person will be bound by a contract for necessaries and is required to pay a reasonable price for any such necessaries purchased by virtue of the Sale of Goods Act.
The problem with contract capacity and intoxication is that there are degrees of drunkenness. To determine whether a person was so drunk as to lack contractual capacity, the courts have said the following two questions are relevant:
- When the intoxicated person entered into the contract, were they too drunk to understand and
- Did the other party have, or should have had, knowledge of the intoxication
If a person is successful in claiming that they didn’t have capacity through intoxication they can either rescind or ratify the contract. Rescinding the contract puts the parties in the position they were in prior to the contract. Ratifying the contract makes the contract binding and enforceable.
Practical tips on contracts and capacity
Reading an article on contract capacity can really bring it home to sole traders, start-ups and big businesses that you have to have your wits about you when you enter into a contract. In some ways that’s easier when you are a founder and it is just you, and maybe a trusted partner, negotiating all your contracts. That’s not possible as your business grows and you scale up so here are some practical tips:
- Carry out a risk profile for your business - are most of your sales to overseas companies or to youngsters under the age of 18? Is your product likely to attract those who may not have individual capacity? These are the types of questions you need to be asking to assess your business risk profile.
- Consider if your products are necessities - if you are in the food and hospitality industry selling burgers you will be OK but maybe not if you are high end retail or if you market top of the range technology and digital products.
- Do you carry out risk checks when contracting with individuals - for example, if you are selling phones on a contract, do you carry out an age check?
- Checklists on contracting – even if you and your team are highly experienced, a checklist can be very helpful, not least because without it you may not remember the difference in contractual capacity between a LLP and general partnership.
- Training – where you have staff negotiating contracts on your behalf it is sensible to not only have a thorough induction process but ongoing training to remind of the importance of contract basics, such as contract capacity, contract authority and whether you are contracting without realising it through exchange of email. For more information on this topic take a look at: Are emails enforceable contracts?