Capacity of Parties in Contracts

Date: Nov 03, 2014
Document Type: Article

Before ensuring the parties have fulfilled all the formal elements of a contract, a more fundamental issue to consider is whether both parties have capacity to enter into a contract. Capacity refers to a party’s legal ability to enter into a contract. It will not assist a party if they’ve simply made a mistake or misunderstood a contract. Rather, the requirement is intended to protect people from being taken advantage of who may not fully understand what they’re doing by reason of age, mental disability or intoxication. As a starting point, there is a presumption that a contracting party has full capacity. If it does become an issue after a contract has been entered into, it will be the job of the party alleging incapacity to prove capacity was absent at the time the contract was entered into. Although it is not always possible to ascertain capacity, it is an important consideration to keep in mind and may be worth double-checking before entering into a contract.

Age

In Australia, the age of majority is 18 years old. Once a person reaches this age, absent any other incapacitating factors, they are presumed to have capacity to enter into contracts.

However, a minor also has capacity to contract in many circumstances, almost all of which in NSW are governed by an extensive legislative code. In general, minors are presumed to be bound when they enter into contracts if the contract is for their benefit or if the contract was entered into pursuant to a court order granting the minor capacity.  

Mental Disability

Capacity may also come into question if a contracting party has a mental disability. A person with a mental disability will not necessarily lack capacity and is subject to the same presumption of capacity as everyone else. If their capacity is brought into question, it must be shown that they understand the broad nature and effect of the transaction when it is explained to them. They don’t necessarily have to comprehend the finer details of the arrangement, if they can understand its broad significance and importance.

This often becomes an issue when dealing with elderly people with dementia or people with intermittent mental illnesses whose conditions cause capacity to fluctuate. It is possible for such people to validly contract during a lucid interval. We would recommend in such circumstances to have lawyers or doctors present to attest to the person’s capacity at that point in time.

Intoxication or other mental impairment

A person whose mental faculties have been impaired as a result of drugs or alcohol may also suffer from a lack of capacity. A similar test to mental disability is used when deciding whether an intoxicated person has capacity to enter into a contract, requiring that they understand the general nature and significance of the contract.

Generally, where there is incapacity due to mental disability or intoxication, the court will only set aside the contract if the other contracting party knew or ought to have realised the person’s mental incapacity.

Bankrupts

When people are bankrupt they still have general capacity to enter into contracts. However they are subject to some limitations and their trustee in bankruptcy can intervene and disclaim contractual obligations for a number of reasons. Therefore, it is important to be cautious when conducting contractual dealings with a bankrupt.

Corporations

A corporation has its own legal personhood separate from the people who run and make up the company. Therefore, a corporation has capacity in itself to enter into contracts with other corporations or natural persons. A corporation can enter into contracts:

  • as itself - by execution of the contract by a certain number of company officers; or
  • through an authorised agent.

Corporations need to be especially careful in authorising agents to enter into contracts on its behalf. It is often difficult to back out of contractual arrangements if an agent oversteps the authority granted to them, if the other party believed the agent was acting with authority of the corporation.

Just because a party lacks capacity, this doesn’t necessarily mean they were taken advantage of or didn’t want the contract. In most cases, if a contracting party is found to lack capacity, the contract is not automatically void. It is only voidable, giving the incapacitated party a chance to affirm the contract if they or their authorised representatives desire.

If there is any question in your mind about a person’s capacity, it is always safer to err on the side of caution, whether this be insisting on proof of age, having a health assessment or requiring proof of authorisation. A lawyer can be extremely helpful in situations such as these, as they will often know the right questions to ask to test a person’s capacity.

Please be aware that this article was written in October 2014 and the law may have since changed. If you require any assistance in regards to contracts, please don’t hesitate to contact us.

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