10 Legality of Object and Form
Learning objectives
By the end of this Chapter, you should be able to:
- Explain why some contracts are void or made illegal by statute and its effect on the contract.
- Explain the types of contracts that are illegal and types of contracts that are void.
- Describe a restraint of trade and explain situations where such restraints are reasonable and legally enforceable.
- Explain what ‘form’ is and its effect on a contract.
Key Terms
An understanding of the following terms will help you understand the material in this chapter on legality and form:
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- Form: in the sense it is used in contract law, those statutory procedural requirements that need to be satisfied for some contracts to be enforceable
- Restraint of trade: an agreement in which a party agrees to restrict or restrain their activities in the future to carry on their trade, profession or business with other persons who are not a party to the contract
- Void: of no legal effect
- Voidable: an agreement that may be affirmed or rejected at the option of one of the parties
Introduction
- In the last two chapters we looked at the questions of capacity to contract (Chapter 8) and genuine consent (Chapter 9). In this chapter we will look at the questions of legality and form and once we have answered these questions, we will know whether the contract we created in Chapters 5 to 7 is valid. If it isn’t, then what is it? Is it voidable, void or unenforceable contract?
- In this chapter we are concerned with two questions:
- Was the purpose of the contract legal (the question of legality)? If it is not, we have a problem.
- Are there any statutory requirements that need to be met (form)?
In this chapter consider the legal position of the parties where the contract we created is illegal or void by statute or common law. Because of the importance of restraint of trade to business, it is very useful for you to have a knowledge of it in business. Of particular importance are the restraint of trade clauses in contracts of employment and the restraints imposed on the seller (vendor) of a business.
This chapter then completes the question about the validity of the contract that you created. However, this is not the end of the story. You still need to know what has been agreed to, that is, what are the terms of the contract (Chapter 11) and what happens if you, or the party you contracted with, don’t carry out what has been agreed to in the contract, as in, has there been a breach (Chapter 12).
Step 6: Is the purpose of the contract legal?
If you are satisfied that there is no issue with the questions of either capacity or consent, then the last of the factors you must consider is illegality and form. Are the objects, or purpose, of the contract that we created legal, and are there any statutory requirements that we need to satisfy?
Because some contracts, and certain clauses in some contracts, may be void or illegal at statute or common law, it is important to understand the distinction between void and illegal contracts. Without that understanding, it is not possible to see the different consequences that can flow from each at statute or common law.
What type of contracts are illegal by statute?
What is the extent of invalidity?
The extent to which Parliament may wish to ensure that neither party has any rights or remedies at all under the transaction, or to go further and impose penalties for such an agreement, will depend on the construction of the statute’s terms in each case. This requires the court to consider two questions:
- Did the statute mean to prohibit such contracts at all?
If the answer is ‘yes’, then:
- Does the contract in issue belong to the class that the statute intends to prohibit?
Ultimately, the answer to the second question hinges as much on public policy as anything else, with the court considering what mischief the statute is intended to prevent, as well as the language used and the consequences for the innocent party.
What is the legal position of the parties where the contract is illegal by statute?
There are a number of ways in which a contract may be affected by a statutory provision:
- The contract may be to do something that a statute expressly prohibits such as a type of contract or term such as prohibiting unlicensed dealing in goods
- The contract may be one where the statute expressly or impliedly prohibits the making of the agreement itself and the contract is illegal as formed
- A statute may require that the contract must be performed in a certain way – for example, when providing a purchaser with an invoice, stating the percentages of certain chemicals contained in fertiliser. While the contract might be lawful in its formation, failure to perform the contract in the prescribed manner could result in the contract being illegal and unenforceable as performed, and therefore unenforceable.
The courts are reluctant to find that a contract is illegal by statute unless a ‘clear implication’ to that effect can be drawn from an examination of the statute. In trying to decide this, the courts consider whether the statute means to prohibit the contract or regulate the way the contract can be performed. What is the sole object of the statute? If the illegal behaviour is only incidental to the way the contract was completed, the court will not be prepared to find that the contract was unenforceable.
To some extent, the approach of the courts in considering whether a contract will be void or unenforceable based on illegality where a statute is involved is one of statutory interpretation. What was the intention of Parliament? Did it intend a fine to be sufficient punishment or did it intend the contract to be void or unenforceable as well?
What is the legal position of the parties where the contract is void by statute?
While some contracts are illegal as formed or performed, whether they are unenforceable depends on the intention of the statute. Other contracts may be made void by statute.
A contract void by statute will not be enforced by the courts and there are no rights that can be enforced by either party – for example, gaming or wagering contracts, certain money lending practices under the consumer credit legislation and some contracts with minors/infants (see chapter 8). Sometimes, instead of striking down the whole contract, a statute may declare that only part of the agreement is void, and the remainder valid.
Subsequent transactions directly related to the contract rendered void by statute, but not illegal, may themselves be rendered void if that is the intention of the statute. If the subsequent transaction is to get its validity from the earlier contract, which is now rendered void by statute, then that transaction will fail because the consideration for the later contract is the validity of the earlier one. As this no longer exists, there is a total failure of consideration.
If the contract is rendered void, but not illegal, any money paid under the contract is irrecoverable, irrespective of whether or not the party who has paid it can prove a total failure of consideration. However, any amounts paid under a void contract may be recoverable in restitution.
Reflection questions
First break. Reflect on what you have just read and think about the following question.
- Brass hired a roulette table, with all the ancillary equipment needed to play roulette, from ACME Hire. When they entered into the contract, neither party was aware of the provisions of their state’s gaming and betting legislation that made the game unlawful but did not prohibit it. When Brass discovered the Act, he refused to pay the hire price. Can ACME Hire recover the hire charges?
What is the common law position of contracts that are illegal and contracts that are void?
In brief
Contracts illegal at common law
The main classes of contract illegal at common law are:
- contracts to commit a crime, tort or fraud against a third party
- contracts that promote sexual immorality or prejudice the status of marriage
- contracts that are to the prejudice of public safety or good relations with foreign countries
- contracts that are prejudicial to, or delay, the administration of justice
- contracts that promote public corruption
- contracts that defraud the state of revenue; and
- contracts that involve a breach of duty.
What type of contracts are illegal at common law?
Are contracts to commit a crime, a tort or a fraud against a third-party void?
The courts will not enforce a contract that has as its object the breaking of the law. For example, a contract between robbers to divide the proceeds of a robbery or commit tax fraud would be void because the purpose of the contract is illegal.
Are contracts that are sexually immoral unenforceable?
Contracts violating the social or moral attitudes of the community are prohibited as being contrary to ‘public policy’. Of course, an interesting question here is what exactly does ‘sexually immoral’ mean?
Are contracts that are to the prejudice of public safety or of good relations with friendly countries valid?
There are two types of agreement here:
- an agreement with an enemy alien
- an agreement that could endanger friendly relations existing between two countries.
In both cases, an agreement would be regarded as illegal and unenforceable.
Are contracts prejudicial to the administration of justice unenforceable?
Any attempt to affect the administration of justice is illegal and void.
Are contracts that tend to promote corruption in public life invalid?
Contracts which involve the corruption or bribery of a public official are illegal. A contract that interferes with the impartial judgment of public officials, including Members of Parliament are invalid because they involve corruption.
Are contracts to defraud public authorities of revenue invalid?
A clear infringement of public policy can be found in agreements that intend to defraud the revenue of a country, whether at the national, state or local level are invalid because they involve corruption.
Are contracts that involve a breach of duty by an employee invalid?
Contracts involving a breach of duty by an employee or agent are generally illegal. If the breach of duty by the employee endangers others, then the contract is void. But what if the contract, while it involves a breach of the employee’s duty, has as its purpose to improve the safety and protection of other employees?
What type of contracts are void at common law but not illegal?
In brief
Contracts void at common law
These three types of contracts (or clauses in contracts) are void, but not illegal, at common law:
- contracts prejudicial to the status of marriage, but see the Marriage Act 1963
- clauses in contracts that attempt to oust the jurisdiction of the courts; and
- clauses in contracts in restraint of trade.
Can you oust the jurisdiction of the courts?
If the parties try to create a legally binding contract but include a clause attempting to oust the jurisdiction of the courts, in the event of a dispute the clause will be void and, if possible, severed. If the clause cannot be severed, the contract will be void.
A contract with a clause providing for arbitration in the event of a dispute between the parties will be valid only if it is to operate as a condition precedent to any recourse to the courts. It cannot attempt to exclude review of the arbitrator’s decision by a court if there is, for example, a denial of natural justice or the application of the wrong law. Note that an arbitration clause is common in commercial transactions because it provides the parties with a quicker, cheaper and simpler resolution of a dispute than they will get through the courts.
Problems can arise where courts are asked to distinguish between contracts that attempt to oust the jurisdiction of the courts and contracts that are binding in honour only. In the latter, the parties expressly declare that they do not intend to create legal relations.
Are contracts in restraint of trade void?
While a person should be bound by their contracts, one of the fundamental rights in contract law is a person’s freedom to contract. Contracts, or clauses (called ‘covenants’) in contracts, that attempt to restrict or restrain the freedom of one party to contract are not illegal, rather, they are unenforceable at common law because they are against public policy unless it can be shown by the party relying on the clause is protecting a legitimate business interest (such as goodwill, trade secrets or confidential information) and is reasonable.
It should not be assumed that issues of restraint of trade are restricted to just the common law. Contracts (or clauses) that are in restraint of trade can also be caught by legislation such as the Independent Consumer and Competition Commission Act 2002.
What is a restraint of trade?
What is the position at common law?
The common law view of clauses in restraint of trade is that they tend to:
- injure the person involved by reducing their means of earning a livelihood (as in, by restricting their freedom to work)
- deprive the public of the services of persons in the capacities in which they may be most useful to the community as well as to themselves
- discourage industry and enterprise and reduce the products of ingenuity and skill, and
- restrict competition.
Even today, many contracts, and clauses (covenants) in contracts, attempt to restrict the freedom of one party to the contract to do something in the future. For example, in contracts of employment there is often a clause providing that, on termination of employment, if you are an employee that you will not compete against your employer for a certain period. If you are working, have you ever looked at your contract of employment to see what the terms and condition of your employment are?
In the sale of a business, to protect the purchaser’s goodwill, there will usually be a clause prohibiting the vendor (the seller) from setting up a similar business within a reasonable distance and for a reasonable time near you if you are the purchaser. In contracts between manufacturers and traders, it used to be common to find clauses restricting the trader from selling the manufacturer’s goods below a certain price or to a competitor
A contract, or clause in a contract, is a restraint of trade if it limits freedom to trade. At first sight it appears to be void because it is considered to be contrary to public policy. However, this is a presumption and if the person relying on the contract or a clause in a contract can show that the restraint is reasonable, the restraint may be enforceable.
What has to be shown for a restraint clause in a contract of employment to be valid?
Because employees often have access to confidential information, business contacts, trade secrets and the like, it is not unusual for employers to try to incorporate a restraint of trade clause or covenant into the employee’s contract of employment. The reason for such a clause is to attempt to stop employees who change employers from giving their new employer confidential information about their previous employer.
Restraint of trade clauses in contracts of employment usually take two forms:
- restraints on the use of confidential information or trade secrets learnt during employment – for example, secret formulas (such as the recipe for Coca-Cola) and processes; or
- protection of trade connections, such as customer lists, but only to the extent where the employee has come into contact with the clients or customers and has acquired influence over them – a restraint against an employee who has had no contact with the employer’s clients or customers would not succeed.
The following factors should be considered when trying to decide whether information was ‘secret’ and therefore protectable, or ‘general know-how’ and generally not protectable:
- the extent to which the information is known inside and outside the business
- the value of the information to competitors
- the effort spent in developing the information; and
- the difficulty in acquiring or duplicating such information.
In the case of trade secrets, an employer may generally validly restrain an employee from making any unauthorised use of that information both while working for them and for a reasonable time after the contract of employment has ended. An employer is entitled to protect and safeguard the confidential techniques they have developed. They could therefore legally restrain a former employee from using the information while employed by a rival firm. However, note that while an employer is entitled to protect their trade secrets, they cannot prevent an employee from using their own skills and knowledge after they have left the employment, even if those skills were learnt from the employer.
Even then, it is still very difficult to convince the courts that the restriction placed on the employee by the employer is reasonable and not in restraint of trade. The reason for the court’s attitude is that frequently there is an inequality in the bargaining power between the employer and the employee, with the employer dictating the terms on which the employee may accept the position. As a result, the courts will look at the relative bargaining power of the parties. One of the factors which would support the reasonableness of a restraint is if both sides took legal advice so there was no inequality in bargaining power between the parties.
As a general rule, if there is an inequality of bargaining power between the parties, the courts will interpret these clauses contra proferentem – that is, strictly against the party relying on them (in this case, the employer). As a result, if the clause is merely an attempt to limit competition, the courts will usually find little difficulty in striking down the clause.
In brief
A person calling something ‘confidential’ does not automatically make it confidential within the scope of what equity will protect. It must be something that is not public knowledge or public property. The matter of confidentiality is viewed at two points in time:
- For the purposes of determining whether the information is confidential and should be protected, look to the facts at the time the parties made their contract
- Whether an injunction should be granted is determined by looking at the facts at the time of the hearing.
When is a restraint clause valid in a contract of employment?
A restraint clause in a contract of employment that will be held to be valid in most instances is one that goes to the employee’s present employment and provides that the employee must not compete directly or indirectly (either with a rival firm or even operating as a sole trader) while still working for their current employer.
The primary duty of an employee is to the employer. This situation must be distinguished from situations that relate to the position of employees after leaving their present employment. The question that then should be considered is whether a former employee should continue to owe a contractual duty to their former employer.
The case where the employee is going to be held to their contract is one which is reasonable or fair, considering the interests of both parties. In A Schroeder Music Publishing Co Ltd v Macaulay [1974] 1 WLR 1308 (an English case), the publishing company had used its superior bargaining power over Macaulay (a young, unknown song-writer) and a ‘take it or leave it’ contract to exploit Macaulay’s earning power for the next 10 years. As a result, the bargain between the parties was unconscionable, or not fair, since the terms combined required a total commitment by Macaulay with a total lack of obligation by the publishers.
Business tip
Making an employer–employee restraint valid
Because the parties in an employer–employee relationship are (usually) in an unequal bargaining position, restraint clauses in employee contracts will be struck down by the courts unless they:
- only protect intellectual property rights (such as trade secrets) or customer connections, or prevent an employee from working for a competitor during their current employment
- are of reasonable length in time (this is a question of fact in each case and will be determined by what is being protected); and
- are of reasonable geographical width (again, this is a question of fact in each case and will be determined by what is being protected).
Care must be used, or the provisions of the Employment Act 1978 may be triggered.
Reflection questions
Time for a break. But first, reflect on what you have just read regarding restraint clauses in contracts of employment, and apply that to these questions.
- Explain why a restraint clause in a contract of employment is most likely to be struck down by the courts. In what circumstances will a restraint clause be likely to be considered valid in a contract of employment?
- Samson was employed as a computer salesman. Part of Samson’s contract of employment contained the following clause:
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The employee expressly agrees not at any time during one year after the termination of his employment . . . either on his own account or as a representative or agent of any person or company, to act as a computer salesman. . . for any person or company who at any time during the last two years of his employment shall have been a customer of the employer in the course of his employment.
- Is the restraint between Samson and his employer valid?
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Roberta was employed as a works manager with Littlewoods Recycling Works in Port Morseby. Her contract of employment contained a restraint of trade clause whereby she agreed that in the event of leaving Littlewoods she would not work in the recycling industry in PNG for five years from the time of leaving the company’s employ. Roberta has been approached by a rival firm in Lae who has offered to double her existing salary if she will go and work for them. Roberta wishes to know whether the restraint clause in her contract of employment is valid. What advice would you give her?
Can you impose a restraint on the vendor of a business?
In the sale of a business, where there is an element of goodwill, it is reasonable to expect that if you were the purchaser you would want to stop the seller from opening a similar business to the one, they just sold to you within a certain area and time period. Here it is assumed that the parties are dealing on a ‘more’ equal basis, and there is a legitimate commercial interest that requires protection (as in, goodwill), and as a result the courts are generally prepared to uphold the validity of such clauses.
Each case should be treated on its own merits and it will be a question of fact as to whether the restraint is reasonable in its protection of your interest as the purchaser but not unreasonable in preventing the vendor from carrying on normal business activities. Look closely at whether the length of time and the geographic extent of the exclusivity clause and think about whether they were reasonable.
In brief
Factors that determine whether a restraint on a business is reasonable
Whether or not a restraint is reasonable in the interests of the parties and the public is determined at the date of the agreement after consideration of the following factors:
- the geographical extent of the restraint
- the time period involved
- the bargaining strengths and positions of the parties during the negotiations; and
- the type of business and the activity being restrained.
Where the sale of a business is concerned, note carefully the type of business, as the size of the area and the length of time will vary with the type of business. For example, if you buy a Toyota dealership you would expect that you would not want the seller setting up in competition just down the road. Also, look carefully at the wording of the restraint of trade clause in a contract. Ensure that it is clear and not vague. The question in each case is what is reasonable to protect the parties. Not only must the restraint be reasonable in area and time, but the size of the area and the length of time can vary with the type of business.
Keep in mind that the size of the area and the length of time will vary with the type of business. Thus, a restraint imposed on the vendor of a café will not be the same as the restraint imposed on the vendor of a car dealership, although in both cases it will still be valid if it is reasonable.
A restriction should not demand too much. Where a restrictive clause is held to be too wide, the likely outcome is that the clause will be void. The courts are very reluctant to narrow it to a reasonable scope.
While the courts will neither redraft nor narrow the operation of a restriction that is unreasonable, they will sever an unreasonable restriction from one that is reasonable if there are two restrictions. However, they must be two separate restrictions and the severed restriction must not affect the meaning of the reasonable restriction.
What happens in trading agreements?
It is not unusual to find a manufacturer or trader who will want to exclude competition from a market segment in which they operate in order to maximise their profits. This may take the form of, for example, exclusive selling or exclusive purchasing agreements. At common law, the validity of such agreements will depend on:
- whether the agreement is a reasonable restraint between the parties themselves; and
- whether it is in the interests of the public.
However, finding that such an agreement is reasonable at common law does not automatically mean that the agreement will have the force of law, because such agreements are also subject to statutory provisions such as the Independent Consumer and Competition Act 2002, so it might still fail on grounds of public policy.
Severance of illegal or void restraints of trade
If a clause is illegal or void by statute or common law, as may be the case with a restraint of trade clause, it doesn’t necessarily follow that the courts will strike down the whole contract. As a general rule, the courts will not sever a clause from a contract which is illegally formed. However, severance can be used in relation to restraint of trade clauses where the clauses are void but not illegal as long as the court is able to delete the unreasonable parts and enforce the reasonable parts without changing the fundamental nature, scope or effect of the contract.
A common boilerplate clause is what is called a severance clause which documents the intention of the parties that, should a contractual term such as a restraint of trade clause be found to be void or illegal, it may be severed while the remaining terms of the contract will remain valid. However, if the removal of the illegal or void clause makes the contract unworkable, then the contract will still be void.
Reflection questions
You are at the end but before you go on to the next chapter just make sure you understand what you have read about restraint of trade and make notes as you go.
- Do the courts apply the same criteria in assessing whether a restraint clause in a contract of employment is valid as they do in a contract involving the sale of a business? Explain why?
- We asked you above that if you were to buy a Toyota dealership you would expect that you would not want the seller establishing competition just down the road but, if you bought a milk bar or cafè, for example, the geographic restraint might be just a couple of kilometres if it is in town (or more in the country). What we did not ask you is whether you would you use the same restraint clause in both purchases? Explain why or why not.
Step 7: Is the purpose of the contract legal?
The last step is establishing the validity of your contract. What you are doing here is checking that there are no statutory requirements that need to be met.
Certain contracts, to be valid and enforceable, are required by statute to be wholly in writing or they are void, such as bills of exchange, cheques and promissory notes (Bills of Exchange Act 1951, ss 8(1), 79, 93(1)), while other contracts must be evidenced in writing. The absence of writing does not affect the validity of the contract, but it makes it unenforceable in a court, for example, Goods Act 1951, ss 4, 5.
The great majority of simple contracts that you will encounter in business or commerce will not be subject to any statutory requirements for them to be enforceable. You may choose to put a contract in writing if it is important for you or the other party to ensure some certainty about what it is you have agreed to do. Think about why it might be important to have a contract in writing, or at least evidenced in writing.
Key points
An understanding of the following points will help you to better revise material in this chapter.
- What is the difference between contracts that are illegal and those that are void by statute? Contracts that are illegal by statute will be either:
- illegal as formed and unenforceable because they should never have been entered into; or
- illegal as performed – the contract is legal as formed but performed in an illegal way or for an illegal purpose, and is not necessarily unenforceable if innocent conduct is incidental to performance
- Contracts that are void by statute will not be enforced by the courts and create no enforceable rights between the parties – for example, gaming and wagering contracts.
- In what ways may a contract be illegal under statute law? Contracts that are illegal by statute may be illegal as formed because they are expressly forbidden by statute (for example, many licensing statutes) or illegal as performed, as the contract is performed in an illegal way or for an illegal purpose (for example, a taxi driver carrying more than the licensed number of passengers).
- What is the difference between contracts that are illegal and those that are void at common law? Contracts that are considered to violate social or moral attitudes of the community (for example, committing a crime or tort, or promotion of corruption) are illegal and may be subject to criminal penalties. Contracts (or clauses) that are void at common law – such as those that prejudice the status of marriage, oust the jurisdiction of the courts or are in restraint of trade (unless reasonable) – are unenforceable as a matter of public policy.
- What is the effect of a clause in a contract in restraint of trade, and in what circumstances will it be legally enforceable? A clause in a contract in restraint of trade will be unenforceable if it is not reasonable. Whether or not a restraint is reasonable in the interests of the parties and the public is determined at the date of the agreement after consideration of the geographical extent of the restraint, the time period involved, and the type of business and the activity being restrained. In the case of restraint clauses in contracts of employment, the restraint must be reasonable and there must be a protectable interest, such as confidential information or trade secrets. In the case of a vendor of a business, it is assumed that the parties are in an equal bargaining position, and the question then is: What is reasonable to protect the parties?
- Why is the question of ‘Form’ important? If the contract does not any meet statutory requirements it may make the contract void or unenforceable.