Existence and formation of a contract - Capacity

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.

SQE1 Syllabus

For SQE1, you are required to understand the concept of contractual capacity and its practical implications for contract formation. You should be able to identify situations where capacity might be limited or absent and determine the consequences for the contract's enforceability.

As you work through this article, remember to pay particular attention in your revision to:

• 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.

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.

1. 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.
2. 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.
3. 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).

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.

However, there are important exceptions where contracts are binding on a minor.

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'. This involves a two-part test:

1. Are the goods or services suitable to the minor's 'condition in life' (e.g., social standing, background)?
2. Were the goods or services actually required by the minor at the time? (Were they already adequately supplied?)

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

If goods are deemed necessaries, the minor is only bound to pay a 'reasonable price' for them (s 3(2) SGA 1979), which may not be the contract price.

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.

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.

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.

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.

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).

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. 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.

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 (Imperial Loan Co v Stone [1892]). If the other party knew or ought to have known, the contract is voidable at the option of the person lacking capacity.

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.

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 was aware of their condition.

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.

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.

However, the doctrine of ultra vires has been largely abolished in relation to third parties dealing with companies by the Companies Act 2006 (CA 2006).

• Section 31 CA 2006: Unless a company's articles specifically restrict its objects, its objects are unrestricted. Most companies incorporated under CA 2006 have unrestricted objects.
• Section 39 CA 2006: The validity of an act done by a company shall not be called into question on the ground of lack of capacity by reason of anything in the company's constitution. This protects third parties.
• 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 enquire about limitations.

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.

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.

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 (e.g., employment, apprenticeship if overall advantageous).
• Minors pay a reasonable price for necessaries.
• A person lacks mental capacity if unable to make a decision due to a mental impairment (MCA 2005 test: understand, retain, use/weigh, communicate).
• Contracts are voidable by a person lacking mental capacity only if the other party knew or ought to have known of the incapacity.
• Persons lacking capacity must pay a reasonable price for necessaries (s 7 MCA 2005).
• 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.

Key Terms and Concepts

• Capacity
• Minor
• Necessaries
• Beneficial Contract of Service
• Mental Incapacity
• Ultra Vires