Business Law
Chapter 6:
Capacity and Legality
Introduction
• Contracts must have a legal subject in
order to be enforceable.
Why is capacity important?
• If a plaintiff seeks to enforce a contract,
he must prove that the defendant had
legal capacity to enter into a contract.
Defining Capacity
• Capacity: Ability to do something, such
as the mental ability to make a rational
decision.
• Capacity is an essential element of a
contract because it shows that a party
understood the contractual obligation.
• Capacity refers to a party’s ability to
understand what is happening, the
effect of what agreeing to a contract
means and the ability to exercise free
will in making this choice.
• Capacity is not the same thing as wise
choice.
• A person can exercise poor judgment,
enter into a contract that is
disadvantageous, or even make a bad
bargain, and still have full, legal
capacity to contract.
A Short History of Capacity
• Prior to a more enlightened approach to
law in general and contractual
obligations in particular, certain classes
of people were absolutely barred from
entering into contracts.
Who May Contract?
• Contracts need at least two parties,
both of whom have legal capacity.
Natural Persons
• Any person who is not disqualified for
some reason can enter into a contract,
provided that he or she has legal
capacity.
Artificial Persons
• Corporations, and some other forms of
business entities, are considered to be
artificial persons.
• They can bargain, negotiate and enter
into contracts.
• Artificial persons have capacity.
Legal Competency
• To say that a person is legally
competent is to say that he has the
ability to know, understand and
voluntarily engage in actions that can
affect his interests.
Age or Infirmity
• The rules of capacity center on a
person’s age, physical or mental
infirmity.
Infancy
• When a person falls below a certain age
level, the law presumes that he or she
lacks capacity to contract.
Advanced Age
• No state, for instance, has a rule stating
that a person above a specific age is
presumed to be legally incompetent to
enter into a contract.
• A person’s age is one of the factors that
a court may take into account when it
assesses a person’s capacity.
Physical Infirmity
• A disabled person who has the mental
capacity to contract may do so,
regardless of the disability.
• A person may be in such severe pain, or
under the influence of drugs, that his
capacity will be affected.
Guardianship
• When a person has been declared
mentally incompetent, it is common for
a court to appoint a guardian to
represent that person.
Partial versus Total Incapacity
• When a person suffers from partial
incapacity, he or she may still undertake
a contractual obligation
Mental Incompetence or
Mental Illness
• When a person is of lower than average
intelligence, or suffers from some form
of mental illness less than legal insanity,
this person is still entitled to enter into a
contract.
The Other Party’s Good Faith
• A party’s good faith does not circumvent
the rules surrounding capacity.
Intoxication
• Intoxication resembles a form of
insanity.
Authority
• When we say the person has authority
to enter into a contract it simply means
that he or she has legal capacity and
has no legal impediment to becoming a
party to a contract.
Apparent authority
• If it appears that a person has the
authority to make certain commitments
in a contract, or to act for another, and
the principal does not negate this
perception, then the person has
authority, even though it was never
officially conferred upon him.
Actual authority
• When a person has actual authority it is
usually vested in him through some
overt action by another.
Third party contracts
• Third party contracts stem not from their
involvement in the contract but from the
fact that they derive some benefit from
the contract between the other parties.
Creditor
• Creditor beneficiaries are created
when a contract’s provisions include a
promise to satisfy an outstanding debt.
Beneficiary
• Anyone who benefits from something or
who is treated as the real owner of
something for tax or other purposes.
Donee
• In most jurisdictions, a doneebeneficiary is created by contract
provisions that show a clear intention by
the parties to make a gift to a third party.
Assignee
• An assignee-beneficiary is a person or
entity who will eventually be granted a
specific right under the contract, such
as a person who will eventually become
a party to the contract.
Legal subject of contract
• A contract is void when the subject of
the contract is illegal, such as a contract
to engage in illegal activity or for an
illegal purpose.
Contracts that are illegal
because of subject
• Contracts that involve illegal actions are
void for a very simple reason.
• If this were not so, then a party seeking
to enforce the contract could bring an
action through the court system and
request that a judge rule on the
contract.
Contracts that are
unenforceable because of
public policy
• The general rule followed in all
jurisdictions is that any contract that
violates public policy is void and
unenforceable.