PastPaperHero | Existence and formation of a contract

Learning Outcomes

This article outlines the rules determining whether a party has the legal capacity to enter into a binding contract. It covers the specific rules relating to minors, individuals assessed as lacking mental capacity, and companies. For the SQE1 assessment, you will need to understand how capacity affects contract formation and enforceability. Your understanding will allow you to identify and apply the relevant legal principles to SQE1-style single best answer questions concerning the validity of contracts based on the capacity of the parties involved.

Developing fluency with capacity means knowing the default presumptions and their exceptions, distinguishing void and voidable outcomes and their remedies, and appreciating how knowledge (or constructive knowledge) of incapacity affects enforceability. In the minors’ context, you should be able to identify necessaries and beneficial contracts of service, apply the “reasonable price” rule, and understand repudiation and ratification. Under the Mental Capacity Act 2005, you should be able to apply the statutory decision-making test, the two-stage rule for voidability, and the special rule for necessaries. For companies, you should be able to apply the Companies Act 2006 framework, particularly the protection for third parties dealing in good faith and the irrelevance of internal objects restrictions to contractual validity.

SQE1 Syllabus

For SQE1, you are required to understand the concept of contractual capacity and its practical implications for contract formation, including identifying situations where capacity might be limited or absent and determining the consequences for the contract's enforceability, with a focus on the following syllabus points:

the general principles of contractual capacity
the specific rules governing the capacity of minors to contract, including contracts for necessaries and beneficial contracts of service
the assessment of mental capacity under the Mental Capacity Act 2005 and its effect on contract validity
the contractual capacity of companies under the Companies Act 2006, particularly the irrelevance of objects clauses for third parties
the distinction between void and voidable contracts and the practical remedies (rescission, ratification, restitution)
intoxication as a form of incapacity, and its alignment with mental incapacity principles
the Minors’ Contracts Act 1987 and the court’s “just and equitable” power to order the return of property
good faith protection for third parties under s.40 CA 2006, and the continuing importance of statutory limits on capacity for statutory corporations and public bodies.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

Which of the following contracts entered into by a 16-year-old is MOST likely to be binding on them?
1. A contract to purchase a luxury sports car.
2. A loan agreement with a high interest rate.
3. A reasonable contract for the supply of essential textbooks for their college course.
4. A contract to buy shares in a public company.
Under the Mental Capacity Act 2005, a contract entered into by a person (P) who lacks capacity is voidable by P if the other party:
1. Was unaware of P's lack of capacity.
2. Should reasonably have known P lacked capacity.
3. Knew or ought to have known P lacked capacity.
4. Had no reason to suspect P lacked capacity.
A company registered under the Companies Act 2006 has an objects clause in its articles restricting it to software development. The directors sign a contract to purchase commercial property. Is the contract valid in favour of the seller acting in good faith?
1. No, the contract is ultra vires and void.
2. Yes, under s.39 CA 2006, the validity cannot be questioned on grounds of lack of capacity.
3. No, because the directors acted outside their authority.
4. Yes, but only if the shareholders ratify the contract afterwards.

Introduction

For a contract to be legally binding, the parties entering into it must possess the necessary legal capacity. Capacity refers to the legal ability of a person or entity to make a binding agreement. English law presumes that adults have full contractual capacity. However, certain categories of persons have limited capacity, primarily to protect them. For SQE1, you need to understand the rules relating to minors, persons lacking mental capacity, and companies.

Key Term: Capacity
The legal competence of a person or entity to enter into enforceable contracts.

The consequence of a lack of capacity varies depending on the category of person involved, but often renders the contract voidable (valid until set aside by the party lacking capacity) rather than void (invalid from the outset). In practice, the difference matters: a voidable contract binds both parties unless and until the protected party rescinds; a void contract imposes no obligations at all and cannot be enforced.

Key Term: Void
A contract with no legal effect from the outset; neither party is bound.

Key Term: Voidable
A contract that is valid unless and until set aside by the party entitled to rescind (for example, a minor or a person lacking capacity).

Key Term: Ratification
Confirmation of a contract that was previously voidable, making it fully binding. Ratification may be express or implied (for example, by continued performance after capacity is acquired).

MINORS

In England and Wales, a minor is an individual under the age of 18 (s 1 Family Law Reform Act 1969). The general rule is that contracts entered into by a minor are not binding on the minor, although they are binding on the other adult party. This rule is designed to protect minors from improvident agreements due to their lack of experience.

Key Term: Minor
A person under the age of 18.

While the protective presumption is robust, it is not absolute. There are two principal categories where a contract is binding on a minor, and a further category of contracts that are voidable by the minor rather than automatically unenforceable. You must also distinguish the remedies available to adults when dealing with minors, including restitutionary relief under the Minors’ Contracts Act 1987.

Contracts for Necessaries

A minor is bound by a contract to supply them with necessaries, provided the contract contains terms that are, overall, not harsh or oppressive against the minor. Necessaries are defined in s 3(3) Sale of Goods Act 1979 as “goods suitable to the condition in life of the minor… and to his actual requirements at the time of the sale and delivery”. The concept extends to services too, and the courts assess necessity with reference to the minor’s status and circumstances when the goods or services are supplied.

This involves a two-part test:

Suitability to the minor’s “condition in life” (for example, their social status, education, and lifestyle).
Actual requirements at the time of sale and delivery (for example, whether the minor already had an adequate supply of similar items or services).

Key Term: Necessaries
Goods or services appropriate to a minor’s status in life and actually needed by them when the contract is made and performed.

If goods are deemed necessaries, the minor is only bound to pay a “reasonable price” for them (s 3(2) SGA 1979), which may be lower than the contract price. This protects minors from overpaying for essential goods or services. Necessaries can include items beyond bare essentials if they fit the minor’s condition in life, but they will not include luxury items or surplus goods where the minor already has adequate provision.

To apply the test effectively:

Assess the minor’s circumstances “at the time of sale and delivery”. If another supplier has already fulfilled the need, further goods will not be necessaries even if similar items were previously necessary.
Consider whether the contract terms, viewed as a whole, are fair. If terms are oppressive (for example, excessive penalties or onerous warranties), the protection may override the necessity of the goods.

Worked Example 1.1

Aisha, a 17-year-old student from a wealthy family, orders five bespoke ball gowns costing £2,000 each. Her parents provide her with ample clothing. Is Aisha bound by the contract?

Answer:
Unlikely. While ball gowns might arguably be suitable to her “condition in life”, she is already adequately supplied with clothing, meaning they are unlikely to be “actual requirements”. They are therefore probably not necessaries, and the contract would not be binding on Aisha. Even if considered necessaries, she would only have to pay a reasonable price.

The “reasonable price” rule applies equally to services that count as necessaries (for instance, urgent medical or dental services, essential educational materials, or reasonable accommodation where it is truly needed). A minor cannot avoid paying a reasonable price for such necessaries simply by pointing to their age.

Beneficial Contracts of Service

A minor is also bound by a beneficial contract of service. This typically includes contracts of employment, apprenticeship, training, or education, provided the contract, when viewed as a whole, is substantially for the minor’s benefit. If the contract contains terms that are so disadvantageous as to outweigh the potential benefits, it will not be binding.

Key Term: Beneficial Contract of Service
A contract of employment, apprenticeship, or similar agreement that, viewed overall, is advantageous to the minor and therefore binding on them.

When evaluating whether a service contract is beneficial:

Consider training, skills, and experience gained against any restrictive or onerous terms (for example, lengthy exclusivity, unreasonable penalties, or excessive restraints of trade).
Measure the balance at the time of contracting, but continued exploitation or significant unfairness in performance may influence enforceability.
Understand that “beneficial” is not limited to pay; educational and professional development are primary indicators.

Worked Example 1.2

Ben, aged 16, enters an apprenticeship agreement with a local mechanic. The pay is low, but the training opportunities are excellent, and the working conditions are fair. Is Ben bound by this agreement?

Answer:
Yes, most likely. Although the pay is low, the agreement provides valuable training and appears fair overall. It would likely be considered a beneficial contract of service and therefore binding on Ben.

Other Contracts and Restitution

Contracts that do not fall into the categories of necessaries or beneficial service are generally voidable at the option of the minor. The minor can choose to repudiate (reject) the contract before reaching 18 or within a reasonable time thereafter. Until repudiation, certain contracts may bind both parties and produce legal consequences.

A key group of such contracts is those conferring a permanent interest in property. Agreements under which a minor acquires shares, an interest in land, or enters a partnership are generally treated as voidable rather than automatically unenforceable. The minor may repudiate either during minority or within a reasonable time after attaining majority. The effect of repudiation is to release the minor from future obligations under the contract. Any sums already paid will only be recoverable if there has been a total failure of consideration (for example, the minor received no part of what was bargained for).

If a minor repudiates a contract, the Minors’ Contracts Act 1987 (s 3) gives the court discretion to order the minor to return any property acquired under the contract (or property representing it) to the other party, if it is just and equitable to do so. This statutory power addresses unfair enrichment; it allows restoration of goods still in the minor’s possession or identifiable substitutes. The court cannot compel repayment where the property has been disposed of and nothing is left to restore, and “property” is not exhaustively defined (there is some debate about whether cash falls within “property” for these purposes).

As a practical point:

A minor who has performed their side of an improvident bargain may find it difficult to recover benefits conferred unless traditional restitution grounds (like total failure of consideration) are made out.
Adults dealing with minors should not rely on tort or restitution to enforce the substance of an unenforceable contract. Where a tort claim would undermine statutory or common law protections for minors, it will often be barred. Statutory restitution under s 3 of the 1987 Act is the principal route to recovery of property.

Two additional points often tested:

Ratification: A minor may choose to ratify certain voidable contracts upon reaching 18, either expressly or by continued performance, thereby losing the ability to repudiate later.
Guarantees: If an adult guarantor (for example, a parent) guarantees a minor’s obligations, the guarantor will be bound, even where the minor would not be.

MENTAL INCAPACITY

An adult is presumed to have full contractual capacity. However, this presumption can be rebutted if it can be shown that, at the time of contracting, the person lacked the mental capacity to understand the transaction, and the other party knew or ought to have known this.

The assessment of capacity is governed by the Mental Capacity Act 2005 (MCA 2005). The Act sets the framework for determining whether a person can make a particular decision at the relevant time and emphasises the principle of supporting decision-making.

Key Term: Mental Incapacity
Defined by the Mental Capacity Act 2005 as being unable to make a decision due to an impairment of, or disturbance in the functioning of, the mind or brain.

Under s 2(1) MCA 2005, a person lacks capacity in relation to a matter if at the material time they are unable to make a decision for themselves in relation to the matter because of an impairment of, or a disturbance in the functioning of, the mind or brain. The impairment or disturbance may be permanent or temporary (s 2(2)).

Section 3(1) states a person is unable to make a decision if they cannot: (a) understand the information relevant to the decision, (b) retain that information, (c) use or weigh that information as part of the process of making the decision, or (d) communicate their decision (by speech, sign language or other means).

The Act also sets important principles: capacity is presumed unless established otherwise (s 1(2)); all practicable steps must be taken to help a person decide before concluding they cannot (s 1(3)); and a person is not to be treated as unable to make a decision merely because they make an unwise decision (s 1(4)).

If a person lacks capacity under the MCA 2005 and enters into a contract, the contract is binding unless the other party knew or ought reasonably to have known about the lack of capacity. This reflects the common law rule derived from authority such as Imperial Loan Co v Stone (1892), now understood consistently with modern principles. Where the other party knew or ought to have known at the time of contracting, the contract is voidable at the option of the person lacking capacity. “Ought to have known” imports an objective element: facts that would have alerted a reasonable person to the incapacity may suffice even if the other party denies subjective knowledge.

Where a person lacking capacity seeks to set aside the contract, the remedy is rescission. They may also ratify the contract if capacity is later recovered.

However, under s 7 MCA 2005, if a person lacking capacity contracts for necessaries (goods or services suitable to their condition in life and actual requirements), they must pay a reasonable price for them, mirroring the position for minors. Necessaries in this context include essential care services (for example, appropriate accommodation or professional care), and the reasonable price need not equal the contract price.

Intoxication (through drink or drugs) can also negate capacity if the person was so intoxicated they could not understand the nature of the transaction, and the other party knew or ought to have known of their incapacity. As with mental incapacity, the intoxicated person must pay a reasonable price for necessaries (see SGA 1979 s 3(2) for goods sold to persons incompetent due to drunkenness). There is no material distinction for drugs or similar substances in principle, and the same voidability rules apply.

Sometimes, unconscionable bargains may be set aside on equitable grounds even if the other party did not know of the incapacity. That is a different route, focusing on exploitation of a poor or ignorant person and harsh terms. In capacity questions, the primary analysis still follows the two-stage test of incapacity plus knowledge for voidability.

Key Term: Voidable
A contract that is valid unless and until set aside by the party entitled to rescind (for example, a person lacking capacity).

Exam Warning

Remember the two-stage requirement for a contract to be voidable due to mental incapacity: (1) the person lacked capacity at the time of contracting, AND (2) the other party knew or ought to have known this. Both elements must be present.

Practical consequences include:

If the other party lacked knowledge and could not reasonably have known, the contract stands. The incapable party may nevertheless pay a reasonable price for necessaries.
If a contract is set aside, restitution may be ordered when fair, particularly where benefits are outstanding and identifiable. Equitable limits can apply where counter-restitution is not possible.
Ratification upon recovery of capacity can validate contracts that were voidable at the time of formation.

CORPORATE CAPACITY

Registered companies, being artificial legal persons, have the capacity to enter into contracts. Historically, a company's capacity was limited by the “objects clause” in its constitution, which stated the purposes for which the company was formed. Acts beyond these objects were deemed ultra vires (beyond the powers) and void.

Key Term: Ultra Vires
Historically, an act undertaken by a company that was beyond the scope of the objects stated in its constitution. Such acts were considered void.

The Companies Act 2006 has largely abolished the doctrine of ultra vires as a defence against third parties dealing with companies.

Section 31 CA 2006: Unless a company's articles specifically restrict its objects, its objects are unrestricted. Most post-2006 companies have unrestricted objects by default, and older companies often removed restrictions.
Section 39 CA 2006: The validity of an act done by a company cannot be called into question on the ground of lack of capacity by reason of anything in the company's constitution. This protects third parties even if the act is beyond objects.
Section 40 CA 2006: In favour of a person dealing with a company in good faith, the power of the directors to bind the company is deemed free of any limitations under the company's constitution. Good faith is presumed, and the third party is not bound to inquire about limitations.

Key Term: Good Faith
In the CA 2006 s.40 context, a presumption protecting third parties who deal honestly with the company, without knowledge of internal limitations or irregularities.

Therefore, for practical purposes regarding SQE1, if a third party deals in good faith with a company, they are generally not affected by any internal restrictions on the company's capacity or the directors’ authority found in the company's constitution. The contract will be valid against the company. The internal consequences of acting beyond objects or internal authority remain: directors may be in breach of duty to the company and face internal remedies (for example, shareholder action or ratification requirements), but these do not affect the third party’s rights under s.39 and s.40.

The position is different for statutory corporations (for example, local authorities). Their powers are defined by statute, and acts beyond statutory powers may still be invalid. The CA 2006 protections do not apply to statutory corporations, and third parties must consider potential ultra vires risks when dealing with such bodies.

Limited liability partnerships (LLPs) have separate legal personality and generally enjoy capacity to contract; a person dealing with an LLP in good faith will not normally be prejudiced by internal limits on members’ authority.

Worked Example 1.3

A company's articles state its object is “to run a restaurant”. The directors enter into a contract with a supplier (acting in good faith) to purchase IT equipment for a new venture. Is the contract enforceable by the supplier against the company?

Answer:
Yes. Under s.39 CA 2006, the validity of the act (entering the contract) cannot be questioned by the company on grounds of lack of capacity. Furthermore, under s.40, the supplier dealt in good faith, so the directors’ power to bind the company is deemed free of constitutional limitations.

Directors acting outside actual internal authority can still bind the company where a third party deals in good faith. Good faith is presumed and the third party is not obliged to inquire into internal authority. The presumption can be rebutted where the third party acts dishonestly or collusively in relation to known internal limitations, but absent clear evidence, the statutory protection stands.

Worked Example 1.4

Kamal enters a high-value gym membership contract while experiencing a severe cognitive episode that leaves him unable to understand price, duration, and cancellation terms. The gym staff notice he appears confused, needs prompts to communicate, and cannot weigh basic information. Is the contract voidable?

Answer:
Likely yes. Kamal lacked capacity at the time, meeting MCA s.2–s.3 criteria (unable to understand/use/weigh relevant information). The gym staff “ought reasonably to have known” of incapacity given obvious indicators. The contract is voidable at Kamal’s option. If gym services provided were necessaries (for example, essential rehabilitative sessions prescribed), Kamal would pay a reasonable price for those services, but not necessarily the full contract price.

Worked Example 1.5

Lena, acutely intoxicated, agrees at midnight to sell her car for half its market value. The buyer observed Lena’s condition and laughed at her slurred negotiations. The next day, Lena seeks to set the contract aside.

Answer:
The contract is voidable if Lena’s intoxication prevented her from understanding the transaction and the buyer knew or ought to have known of this. Those facts appear present. Lena must still pay a reasonable price for necessaries if any were involved; here, they were not, so rescission should be available.

Worked Example 1.6

Dylan, 17, acquires shares under a subscription agreement containing ongoing payment obligations. On turning 18, he repudiates the contract within three months, having received no dividends and minimal information. Can he avoid future obligations and recover sums already paid?

Answer:
He can repudiate the contract within a reasonable time after majority, releasing him from future obligations. Recovery of sums paid depends on whether there was a total failure of consideration: if he received no benefit at all under the contract, restitution may be available; otherwise, sums paid are not automatically recoverable. The court may, if just and equitable, order him to return any property acquired (or property representing it) under s.3 Minors’ Contracts Act 1987.

Worked Example 1.7

A local authority enters a complex interest rate swap with a bank to manage debt. The statute governing the authority’s powers does not authorise such instruments. The bank acts without probing statutory powers.

Answer:
Unlike companies governed by the CA 2006, statutory corporations are constrained by their enabling statutes. If the swap is beyond statutory powers, the contract may be invalid despite the bank’s good faith. Third parties must be alert to statutory limits when contracting with public bodies; s.39 and s.40 CA 2006 do not assist here.

Key Point Checklist

This article has covered the following key knowledge points:

Capacity is the legal ability to enter into a binding contract.
Minors (under 18) generally lack full capacity, making contracts voidable by them.
Exceptions exist where minors are bound: contracts for necessaries (goods/services suitable for their status and actual needs) and beneficial contracts of service (for example, employment, apprenticeship if overall advantageous).
Minors pay a reasonable price for necessaries.
Some contracts conferring permanent interests (for example, shares, land, partnership) are voidable by minors; minors may repudiate during minority or within a reasonable time after majority, releasing future obligations.
Ratification by a minor on reaching majority can render a previously voidable contract fully binding.
Under the Minors’ Contracts Act 1987 s 3, courts can order restitution of property (or property representing it) to avoid unjust enrichment where it is just and equitable.
Adults who guarantee minors’ obligations are bound by their guarantees.
A person lacks mental capacity if unable to make a decision due to mental impairment (MCA 2005 test: understand, retain, use/weigh, communicate), with a presumption of capacity and allowance for unwise decisions.
Contracts are voidable by a person lacking mental capacity only if the other party knew or ought to have known of the incapacity; the incapable party may ratify upon recovery.
Persons lacking capacity and persons incapacitated by intoxication must pay a reasonable price for necessaries.
Companies generally have unrestricted capacity; the doctrine of ultra vires is largely abolished concerning third parties (ss 31, 39, 40 CA 2006).
Third parties dealing in good faith with a company are protected from internal limitations on capacity or directors’ authority; good faith is presumed and third parties need not inquire.
Internal consequences (for example, director breaches) do not affect third-party contractual validity but may give rise to corporate remedies.
Statutory corporations and public bodies remain constrained by their enabling statutes; acts beyond statutory powers can be invalid despite third-party good faith.

Key Terms and Concepts

Capacity
Minor
Necessaries
Beneficial Contract of Service
Mental Incapacity
Ultra Vires
Void
Voidable
Ratification
Good Faith

Existence and formation of a contract - Capacity