By Law Teacher
5.4.1 Illegality Lecture – Introduction
Welcome to the fifth lesson of this module guide – illegality! This is the last of the core vitiating factors key to contract law. There are two types to be aware of; statutory illegality and common law illegality. The consequence of either of these types of illegality can be varied, therefore the consequences for a contract that is found to be illegal must be understood.
The chapter begins with a discussion of the statutory prohibition of contracts, including express and implied prohibitions. The relevant case law is examined as well as the effect of statutory penalties. The chapter then moves on to consider the different types of common law prohibitions; public policy and restraint of trade. Finally, the effects and recovery are discussed.
Below are some goals and objectives for you to refer to after learning this section.
Goals for this section
- To understand the difference between statutory and common law prohibitions
- To understand the consequences of either of these types of illegality
- To understand what illegality is in terms of contract
Objectives for this section
- To be able to differentiate between statutory and common law illegality
- To be able to define the concept of illegality
- To understand and be able to apply the case law in this area
- To understand the effects of illegality
- To understand how recovery under illegal contracts works
- To understand the ‘blue pencil’ test and how to apply it
- To be able to determine whether a contract is reasonable
5.4.2 Illegality Lecture
Statutory prohibition of contracts
A contract may be prohibited by a statute either expressly or impliedly. This is an important distinction to make as whether or not a party may enforce the contract is dependent on this.
Express Prohibitions
If a statutory prohibition expressly prohibits a type of contract or term, there is no question as to the illegality of the contract. Neither party will be able to enforce the contract, irrespective of the innocence of either or both parties – Re MahMoud and Ispahani [1921] 2 KB 716.
Implied prohibitions
Implied prohibitions are much more difficult to identify, and there are two tests the courts may apply to determine whether the contract made is impliedly prohibited. The tests applied and the decisions made are very fact dependent.
In order to determine whether an implied prohibition is operable, the court must ascertain whether the objective of the legislation is to forbid the contract. Here is the first rule:
- If the sole object of the statute is to increase national revenue, the contract itself is not illegal
This rule covers examples such as statutes which requires individuals to have a licence to trade in a particular area or with particular goods.
It should be noted that the above must relate to the sole object of the statute. If there are other objectives, such as public policy, this rule will not operate.
- Does the statute contemplate that the prohibited act will be done in the performance of a contract?
This is a confused concept best examined with an example. Take a fictitious act which has these provisions:
Section 1 – It is a criminal offence to…
- Sell chickens
- Keep chickens as pets
Option (a) will always involve a contract, therefore it is clear that the statute would contemplate this prohibited act would take place in the performance of a contract, and would therefore be an implied illegal contract.
Option (b) may involve a contract, but more often than not, will not. You may purchase a chicken for the purpose of keeping it as a pet, but you would not contract with somebody to keep a chicken as a pet. Therefore, the statute does not contemplate this prohibited act to take place in the performance of a contract, and would not be an implied illegal contract.
Contracts which are not illegal, but have been performed in an illegal manner
A contract may well be legal, but the way in which one party has undertaken their obligations amounts to illegality.
Whether the contract is legal or not is dependent on whether the ‘innocent’ party is aware of the illegal performance of the contract or is involved in it – Ashmore, Benson, Pease & Co Ltd v A V Dawson Ltd [1973] 1 WLR 828
The general rule above may be restricted where the purpose of the legislation is not undermined by the illegal performance – Anderson Ltd v Daniel [1924] 1 KB 138
Recent case law has added more complexity to this area of law – ParkingEye Ltd v Somerfield Stores Ltd [2012] EWCA Civ 1338.
The court held that when deciding whether the illegal performance would render the contract unenforceable they would consider these things:
- The object and intent of the party attempting to enforce the contract;
- The gravity of the illegality in the context of the claim; and
- The nature of the illegality.
Each situation will be fact-dependant. Just remember to apply these factors and come to a well-reasoned conclusion.
The effect of statutory penalties
In some cases, the performance of an illegal contract will be subject to a statutory penalty. The courts have held that where the penalty is proportionate and sufficient to the breach, the contract is enforceable by either party – St Johns Shipping Corporation v Joseph Rank [1957] 1 QB 267.
Common law prohibition of contracts – Public Policy
Contracts may be prohibited via the common law, on grounds of public policy or morality. There is a lot of uncertainty in this area, and the when the court can prevent a contract from operating is often unclear. The courts approach this area of law with a consideration of the common values of society – if the contract breaches common values of society it will be void for common law illegality.
Contracts to commit crimes
The case of Bigos v Boustead [1951] 1 All ER 92 confirms a contract which includes an obligation to commit a crime will be illegal. Furthermore, a criminal or criminal’s estate may not benefit from the crime (Beresford v Royal Insurance Co Ltd [1938] 586).
Contracts which prevent the administration of justice
Despite the law of contract mostly being self-regulatory, in the event of a dispute, the courts will intervene. Contracts which preclude parties to the contract accessing justice, or prevent the courts interfering with a contract, may be illegal on the ground that they prevent the administration of justice. See Hyman v Hyman [1929] AC 601 and Scott v Avery (1855) 5 HL Cas 811.
Contracts which are sexually immoral
Sexually immoral contracts refer to those relating to contracts for sexual acts or services – Pearce v Brooks(1865) LR 1 Ex 213.
However, this approach has evolved along with societies views – Sutton v Mishon de Reya [2003] EWHC 3166 (Ch).
Contracts which involve public corruption
Some contracts are invalid because they involve corruption – Parkinson v College of Ambulance Ltd [1925] 2 KB 1.
Common law prohibition of contracts – restraint of trade
To ensure there is a continuing freedom of contract, contracts that restrain trade can be void for illegality – Nordenfelt v Maxim Nordenfelt Guns and Ammunition Co Ltd [1894] AC 535.
In assessing whether the restraint on trade is enforceable, the courts will focus on whether the contract between the two parties is reasonable, and if the limitation would not be in the public’s interest.
Is the contract reasonable?
In Herbert Morris Ltd v Saxelby [1916] AC 688, the courts identified general presumptions for deciding whether or not a contract may be illegal due to a disproportionate restraint on trade.
- Employment contracts that restrict former employees from being employed by competitors would not normally be valid
- Employment contracts that prevent the loss of trade secrets or stealing of custom would normally be valid
- Terms in a contract for the sale of a business preventing the seller setting up another business in competition with the purchaser’s business are normally valid
Once one of these presumptions has been identified, the duration and the geographical extent of the limitations made by the contract will be considered. These limitations should not be disproportionate. Some further case examples can be found below:
Mason v Provident Clothing & Supply Co Ltd [1913] AC 724
Home Counties Dairies Ltd v Skilton [1970] 1 WLR 526
Reasonableness as to the public interest is a further important consideration for the courts. The public interest consideration will be invoked where a contract will have an effect on the competitive structure of a certain market – Herbert Morris Ltd v Saxelby [1916] AC 688.
Exclusivity dealing contracts
Exclusivity dealing contracts, also known as ‘tie agreements’, are those between parties at different stages in a commercial chain which force a closer ties between the parties than a mere contract – Esso Petroleum Co Ltd v Harper’s Garage (Stourport) Ltd [1968] AC 269.
Exclusive service agreements
An exclusive service agreement is similar to an exclusive dealing contract, but instead it relates to where a person provides services for only one recipient.
These contracts do not usually involve a contract of employment, only a contract of restriction. Generally, these courts will apply the same rules as those for contracts of employment – that generally these agreements are not valid, dependent on the geographical restraint and duration of the term.
See Creig v Insole [1978] 1WLR 302 and Eastham v Newcastle United Football Club Ltd [1964] Ch 413.
The court will also take into consideration whether the individual subject to the contract has been treated fairly, has undertaken independent legal advice, and whether they have been taken advantage of. Their age, the fairness of the contract, and the duration of the contract will be helpful in assessing this – Proactive Sports Management Ltd v Rooney [2011] EWCA Civ 1444.
The effect of illegality
The case of Holman v Johnson(1775) 1 Cowp 341 is authority for the general principle of illegality – that the illegal contract will be unenforceable. Dependent on the circumstances, one or none of the parties may enforce the contract, and on occasion only part of the contract will be unenforceable.
Severable illegal contracts
The courts have the power to enforce a contract, but only when the illegal parts of the contract have been removed. There is a three-part test to apply when attempted to sever parts of the contract – Sadler v Imperial Life Assurance Co of Canada Ltd(1988) IRLR 388:
- The ‘blue pencil’ test – can the illegal provision be removed without modifying the words of the remaining terms. If it still makes sense, the illegal provision can be removed.
- The remaining terms following the ‘blue pencil’ rule must be supported by consideration
- Following the blue pencil rule, the contract must continue to be the same sort of contract that the parties entered into in the first place. It cannot be changed to the extent that it changes the character of the contract.
The final requirement is a question of fact, and can be difficult to assess – Attwood v Lamont [1920] 3 KB 571.
Collateral contracts
Where there is one illegal contract, but there is a collateral contract that allows a recovery of all or part of the contract, this may be enforceable, but only if providing for a remedy under the collateral contract is not equal to enforcing the illegal contract – Fisher v Bridges(1854) 3 El & Bl 642.
A collateral contract must have the effect of protecting an innocent party to whom a promise or misrepresentation has been made.
Claims based on an illegal contract
The general rule is any claim based upon an illegal contract is invalid, unless the claim is related to an unrelated part or transaction of the contract which the illegality does not affect – Euro-Diam Ltd v Bathurst [1990] 1 QB 1.
Recovery under illegal contracts
The final assessment to make when considering an illegal contract is whether or not any money or property may be recovered subject to the contract.
Both parties are guilty
When both parties are guilty in relation to the illegal contract, the general rule from Holman v Johnson (1775) 1 Cowp 341 is that there can be no recovery of any kind of money or property.
This rule has been challenged as being contrary to Article one of the Human Rights Act – ‘no one shall be deprived of his possessions except in the public interest’ – dismissed in Shanshal v Al-Kishtaini [2001] EWCA Civ 264.
One party unfairly induced into the illegal contract
If both parties are guilty of entering an illegal contract, but one party has been forced into the contract as a result of duress or undue influence, the contract will not be enforced, but the victim may successfully recover money or property they have passed subject to the contract – Hughes v Liverpool Victoria Legal Friendly Society [1916] 2 KB 482.
One party withdraws from the contract
If one party withdraws prior to the illegal part of the contract coming into effect, the doctrine of locus poenitentiae comes into effect. The result of this is that the party who withdrew may recover any money or property subject to the contract. The fact one party has withdrew will suffice – Tribe v Tribe [1996] Ch 107.
There has been some debate as to when the withdrawal from the contract must occur – Kearley v Thomson(1890) 24 QBD 742 is the correct approach.
The withdrawal from the contract needs to be voluntary – Bigos v Boustead [1951] 1 All ER 92.
5.4.3 Illegality Lecture – Hands on Example
The following section will test your knowledge of illegality in the context of contract law – in what ways a contract can be illegal, how this is assessed and the exceptions, and the effect of illegality. After studying the detailed version of illegality you should be able to identify the issues in these questions and apply the law correctly. The answers for the questions can be found at the very bottom of this page.
A question involving illegality can usually be identified by there being a mention of a statutory prohibition on a type of contract, a contract which places restraints on someone’s freedom to trade, or one of the discussed contracts contrary to public policy arising. The below example should allow you to get a general idea of how questions involving illegality of a contract may appear.
When addressing an issue involving the illegality of a contract, this would be the appropriate method:
- Is the contract expressly illegal through a statutory provision?
- Is the contract impliedly illegal through a statutory provision?
- Has the contract been performed in an illegal manner?
- Is the contract subject to illegality due to any public policy reasons, such as preventing the administration of justice?
- Does the contract set a restraint on trade?
- Once you have identified which type of illegality applies to the contract, how will the illegality affect the contract?
This step-by-step approach will cover all of the potential illegalities and ensure you do not miss one. You will need to have knowledge of the relevant legal principles and relevant cases once you manage to identify the type of illegality.
Scenario
Gareth owns a motorbike garage and deals in buying and selling race motorbikes. He also has a number of lucrative sponsorship contracts with famous racers. He has been accused of making a few illegal contracts and would like some advice on these.
- Gareth has two types of licence to sell motorbikes; one to sell generic bikes and the other to sell dangerous, race specification superbikes. Gareth’s licence to sell the regular motorbikes recently ran out. He had forgotten to renew it but was planning on doing so in a few weeks. He sold a motorbike to Ben, who agreed to pay six months later. Now Ben has discovered that Gareth sold the motorbike without a licence he is refusing to pay Gareth.
Is this contract illegal, and if so, what happens as a result?
- A member of the royal family approached Gareth wanting to buy a particular motorbike which Gareth was planning on selling to somebody else. The member of the royal family promised Gareth he would get him a knighthood as part of the deal.
Is this contract illegal?
- One of Gareth’s former employees, Rob, has begun working at another motorbike garage in America. In Rob’s termination of employment contract with Gareth there was a term that stated ‘After the term of employment ends, you shall not work for any competitors anywhere in the world for five years’. Rob was not paid anything on termination of his employment.
Is this contract enforceable or is it illegal?
- There is a statutory prohibition on selling ‘Tamaya’ motorbikes to people under 25. Gareth has formed a contract with John, who is 22, which includes the clause:
‘John will purchase 2 Tamaya motorbikes along with 1 Londa motorbike’
If this contract is illegal, can Gareth enforce the promise to buy the Londa motorbike?
- This contract is subject to an implied prohibition. The case to apply here is Smith v Mawhood (1845) 14 M & W 452. It is clear that a licence is required to sell generic motorbikes only as a way to increase the national revenue, and is not for any public policy reasons (whereas the license to sell dangerous superbikes might be for public policy reasons).
- This contract is illegal under public policy as it involves public corruption. The case of Parkinson v College of Ambulance Ltd [1925] 2 KB 1 can be applied due to the similar facts. Therefore this contract is illegal and invalid.
Therefore, as the sole purpose of a statute is to increase the national revenue, the contract itself is not illegal, meaning Gareth can enforce the contract and force Ben to pay him the price for the bike.
- This contract will amount to a contract which imposes a restraint on trade. Whether or not the contract is valid is dependent on the reasonableness of the terms. The leading case to apply is Herbert Morris Ltd v Saxelby [1916] AC 688, which states generally that employment contracts restricting former employees from being employed by competitors are not valid.
In order to make a complete decision, the duration and the geographical extent of the limitations must be assessed. In the case of Mason v Provident Clothing & Supply Co Ltd [1913] AC 724, a term preventing employment within 25 miles of London when the employment was in Islington was held to be disproportionate and therefore illegal. Therefore, it is clear that a clause preventing employment in the rest of the world would also be illegal. The duration of five years is also extremely excessive.
- The principle issue here is the effect of illegality, and whether the illegal part of the contract is severable from the legal part of the contract. The test from Sadler v Imperial Life Assurance Co of Canada Ltd (1988) IRLR 388 must be applied.
The first step is the ‘blue pencil’ test, where it is considered whether the illegal provision can be removed without modifying the words of the remaining terms. If the illegal provision is removed, the contract will read ‘John will purchase along with 1 Londa motorbike’. It is clear that once the illegal provision has been removed, the remainder of the clause does not make grammatical or verbal sense, and therefore the test fails at the ‘blue pencil’ stage.
If the clause had passed the blue pencil test, it would be considered whether the remaining terms were still supported by consideration, and whether the contract was still of the same character.
In conclusion, Gareth cannot enforce any part of this contract due to the failure of the ‘blue pencil’ test.