Contract Capacity, Defined
Capacity stands at the crux of a legally binding contract. Without this critical concept, your agreement could be rendered legally void. Yet, what exactly does capacity mean in contract law? And how does this principle affect the contractual creation process? Broadly speaking, capacity refers to the minimum level of competency necessary for the signing parties to formulate a legally binding contract. Practically speaking, this encompasses their general awareness and mental health, as well as their relative ages and status as minors. Suppose you and two friends decide to enter into a contract on behalf of your new startup. You intend to secure funding for your venture from various angel investors. Both of you have reached your mid-20s and hold college degrees, but your third friend has only just finished high school. He can read and write easily enough, but has trouble with math and isn’t quite certain how to best approach a simple loan document. Without your advice, your friend might be fooled into signing the first contract he sees, even though it offers higher fees and longer repayment terms to Scrooge McFinancier .
In your eagerness to find an arrangement that works for all parties involved, you make a careless mistake: you fail to explain to your friend what he’s signing. This means your friend has not provided informed consent, which forms the basis of his capacity under contract law. Assuming your friend signs on the dotted line and only discovers the fine print later, is the contract still legally binding?
More often than not, the answer to this question is no. Under contract law, a person must possess the legal capacity to enter into a binding contract. Because your friend is still a minor, he lacks the capacity to form or consent to a contract. As such, he is not bound to the terms you and your other friend established in good faith. Because people and governments alike view minors as incapable of entering into legally binding contracts, the law voids any agreement a minor might enter into without a parent or legal guardian present. This can lead to some complications when a minor seeks to void a contract, as some contracts are more easily canceled than others. However, the general premise still holds up: if you’re underage, you’re not bound to any contract you may have signed.
Legal Capacity Requirements
An individual must be of a statutory age to be bound by a contract. Contracting with a minor voids the contract as to the minor, but not the adult. A minor can disaffirm a contract up until a "reasonable" age for the particular contract. Generally, a minor’s majority is 18 years, but could be different depending upon the transaction. If a minor enters into a contract and later disaffirms it, consideration received by the minor will be returned to the adult to the extent the minor still possesses its value. However, where goods delivered to a minor are used up, destroyed or consumed by the minor, the minor does not need to return them. On the other hand, if an adult wants the contract to stand, the minor will need to restore the consideration to the general extent possible in order to avoid liability for breach. It is not possible to contract with a minor under a parent’s signature or through a guardian. Parents are only liable for their minor children’s debts to the extent of necessaries supplied on credit to the minor, i.e., food, housing, medical care, etc.
The law requires that a person be mentally competent, generally of sound mind, in order for them to have the capacity to contract. For instance, those with severe mental illness may lack capacity; likewise, intoxicated persons may be deemed lacking capacity. However, the law presumes a person has capacity, so that a person challenging another’s capacity has the burden to prove otherwise. Relying on another’s incapacity during negotiations must be objectively reasonable to be a valid defense to contract formation, and it must be measured at the time of execution of the contract. Inadmissibility of evidence of intoxication may apply to civil, as well as criminal, cases.
Effects of Incapacity
When one party to a contract is not legally capable, the contract can become voidable or, in some cases, void. Two principle doctrines, insanity and infancy, address issues of mental health and age that can lead to contracts being declared void or voidable.
In general, contracts signed by individuals who were mentally incompetent at the time of contracting are void. An exception to this includes those that were insane at the time of contracting but later regain capacity. Contracts signed during this time are considered voidable.
An individual who has been declared insane may appoint a guardian over the property, estate and affairs. If it can be shown that the person who entered into a contract was insane at the time of the contract, the contract can be voided.
Infancy, the state of being a minor or having not reached the age of majority, is another grounds for declaring a contract void or voidable. Minors are free to enter contracts. However, contracts made by minors are voidable. This means that while the minor may void the contract, the other party may not.
The right of a minor to void a contract also applies to contracts of employment and marriage. Contracts made by minors are voidable during minority or for a reasonable period after attaining majority, but not for all time. Thus a minor is bound to his contracts after reaching the age of majority, when he is legally competent to validate them.
While contracts with minors are voidable, the minority of one of the parties does not affect the validity of the contract as to the other.
When one party to a contract is not legally capable, the contractual obligations may be terminated. However, varying state laws can protect a minor from liability if the other party suffers because of the defects of the contract.
Exceptions and Special Situations
There are few exceptions to the general principle that those who act without capacity will be held to their contractual obligations. The one that is most frequently encountered in practice is that contracts for necessities (sometimes called "necessaries") made by a minor are enforceable against the minor, despite his or her lack of capacity. The reasoning behind this exception is that ministers, parents or guardians would otherwise be held personally responsible for the minor’s welfare if he or she were left without food, clothing or shelter.
In some provinces, the parental duty to provide necessities is codified. That statutory duty extends to the purchase of food, clothing and shelter for the minor. Contracts for necessities made to enable minors to attend school and receive educational services may also be enforceable. Whether goods or services will be considered to be necessaries in any particular case is largely a question of fact, and whether the goods or services are appropriate relative to the minor’s age and understanding.
Typically, the courts will examine whether a minor has been given sufficient parental control and guidance to be able to enter into contracts. Thus, in cases where the minor is living away from his or her parents with independent income at his or her disposal, contracts made with the intention of obtaining credit, rather than for necessities, may not be enforced against the minor.
In the case of a contract made by a minor, the court may allow the minor to rescind (or "repudiate") the contract or it may allow the other party to enforce the contract. The general rule is that the court has discretion to enforce the contract in favor of the other party , unless the minor was misled with respect to the nature, purpose and legal effect of the transaction. The court’s discretion to order the performance of a contract of the minor will depend on the value of the goods and services provided to the minor and whether the minor has a full understanding of the nature and effect of the transaction. Where the minor lacks the ability to understand the nature, purpose and legal effect of the contract and no reasonable steps can be taken to ensure that the minor understands these matters, the right to rescind the contract may not be exercised by the minor’s representative.
The contract to lend money to the minor may be enforceable despite the minor’s lack of capacity to enter into agreements. There is a statutory framework for those contracts including those made by minors for loans over $500 made through a provincial scheme. In such cases, the minor’s personal liability may be limited to the value of any received.
Contracts in restraint of trade with an unemancipated minor are voidable on the minor’s behalf at any time before the minor reaches the age of majority. However, a work contract with a minor is enforceable if it appears to be to the minor’s benefit and not unfairly oppressive to him or her.
Where a minor signs a written guarantee, co-signs a promissory note, or becomes a borrower under a loan agreement or security agreement, the law allows the lending institution to sue the minor if the minor defaults on the obligations in the agreement. However, some banks impose a minimum age requirement for obtaining credit cards.
Capacity Problems in Contracts: Real-World Examples
The concept of capacity has been addressed in the context of many different types of agreements, from employment contracts to construction contracts to credit agreements. Some of the real-world examples below have zooned in on specific aspects of contractual capacity, such as mental illness (as discussed in our first example) or a parent’s ability to provide consent for their child to enter into a contract with significant financial consequences.
- Statutory Disabilities in Credit Agreements: In Federation of Law Societies of Canada & Legal Services Board v. B.C., 2007 BCSC 170, a company, in reliance on a legal professional privilege opinion, agreed to commence a test case in respect of the enforceability of an agreement made with a legally incompetent party. In that case, one party to a commercial lease had become unsound of mind and unable to make legal decisions after the signing of the lease. The tenant claimed the landlord was aware of his state and was aware of his cognition of the obligations at the time of signing. Despite this knowledge, the landlord did not disclose its knowledge of the tenant’s incapacity to the other tenants who were unaware of the tenant’s incapacity to enter into the agreement. The opinion stated that the prevailing legal uncertainty surrounding the enforceability of a contract with an insane or non compos mentis person would not be overcome by a trial judge, notwithstanding the possibility of a successful appeal. The law remains unsettled and uncertain in this area.
- Disorderly Marriages: Rule 6.16 of the Unjust Enrichment rules of the Civil Code of Québec recognizes the right of a husband or wife who lacks the capacity to enter into an agreement to set aside his or her spouse’s contracts that unreasonably strain the family patrimony, but only where the transactions are "illegal, immoral or disorders the family marriage." In one case, a husband chose to take out a $4.5 million mortgage on his house to enter into a complicated series of stock market transactions that resulted in the loss of the entire family patrimony. In ruling in the wife’s favour, the court made an extensive and particularized analysis deciding that the wife lonely benefited because the transaction ultimately left her and her children with no money in the event of her husband’s death or incapacity. This case serves to illustrate Section 6.16 of the Civil Code of Québec, as the obligations under the credit agreement in question were illegal, immoral and disorderly in that the man had no right under the laws of Quebec to endanger the family patrimony to the detriment of his wife and children.
- Capacity of the Financing Parent: Credit Bureau of Canada v. Hi Option International, 2010 ONCA 120, is a case dealing with the defendant parents’ capacity to borrow funds to purchase a construction trailer for business purposes. A bailiff’s sale occurred in 2007 for default upon the part of Hi Option. The defendants bought the trailer in 2005 with their daughter-in-law’s funds. She eventually sued both parents. The trial judge applied the doctrine of stupefaction and dismissed the claim against the father by finding that he was incapable of understanding the nature of the transaction and, therefore, he lacked the requisite capacity. The trial judge also applied the doctrine of stupefaction to the purchase transaction. In dismissing the appeal with respect to the mother, the Court of Appeal found that the trial judge’s analysis was flawed because he failed to make a finding as to her knowledge of her husband’s lack of capacity. The trial judge treated the mother and father as one unit whose individual capacities were the same.
Validity of Capacity in Contracts
To ensure that the parties to a contract are properly represented, practical steps need to be taken such as ensuring that companies and statutory boards enter into an agreement under their registered name or business name, that the agreement is executed in accordance with the requirements of their constitutions and by-laws, that directors or members of the governing body have authority to do so, and that if the party is an individual that they are 18 years or older . As a further precaution, it is also a good idea for the other contracting party to request proof of authority for signing the document such as in the case of a company, a resolution of its board of directors. If the person or entity which signed the agreement does not have authority to do so, then (unless ratified by a party having authority to do so), an agreement may be unenforceable in certain circumstances.