Illegality Lecture

The last of the vitiating factors of contracts we will cover is illegality. This chapter will first explore the two different types of illegality; statutory illegality and common law illegality. The consequence of either of these types of illegality can be varied, therefore the final section will examine the consequences for a contract that is found to be illegal.

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.

The case of Re MahMoud and Ispahani [1921] 2 KB 716 involved the example of a statute prohibited unlicenced dealing in linseed oil. The purchaser of the oil claimed he had a licence to purchase the oil, but in fact did not. When the sellers delivered the oil, the purchaser refused delivery, explaining he did not actually have a licence. Despite the fact the seller of the oil was completely innocent, the contract could not be enforced due to the statutory provision.

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, so try and be aware of the tests and make a sensible decision as to which one you apply if faced with a problem-scenario.

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:

1. 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. Take for example a fishing licence. There is no other reason for a licence to be imposed other than to increase national revenue.

Case in focus: Smith v Mawhood (1845) 14 M & W 452

In this case, Smith, a tobacconist, sold an amount of tobacco to Mawhood. It was subsequently found that Smith did not have the required licence to sell the tobacco, and therefore statute required he paid a penalty for £200. Smith then attempted to recover the price of the tobacco he had delivered to Mawhood.

It was held that the contract was not illegal, and he could claim the price of the tobacco back. This was because the statute’s primary purpose was revenue. Parke B stated ‘Looking at the act of Parliament, I think its object was not to vitiate the contract itself, but only to impose a penalty upon the party offending, for the purpose of revenue’.

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. An example of this would be individuals requiring a licence to trade with certain dangerous types of animal. The requirement of the licence may be to raise revenue, but it is also for the public benefit as the licence can ensure dangerous animals are not introduced into the country in the incorrect way.

2. 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…

1. Sell chickens
2. 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.

Case in Focus: Archbolds (Freightage) Ltd v Spanglett Ltd [1961] 1 QB 374

In this case, a contract was formed for the shipping of a consignment of whisky to London. Unknown to the claimants, the shippers did not have the required licence to use the transportation vehicle. The consignment of whiskey was then stolen. In order to avoid liability, the shippers attempted to argue that the contract was illegal in the first place, and therefore damages could not be claimed.

The courts held that the contract itself was not illegal (to ship a consignment of whiskey), the method used was illegal (using that particular vehicle). Therefore, because the claimants were not aware of the illegal method of transport being used, they were able to enforce the contract.

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. In Ashmore, Benson, Pease & Co Ltd v A V Dawson Ltd [1973] 1 WLR 828 one party carried goods which exceeded the statutory maximum weight for lorry transportation. The fact the other party were present at the loading and did not object to the illegality meant they could not claim damages under the contract when some of the goods were damage. Therefore, the general rule is: The party or parties who are aware of the illegal performance of the contract cannot enforce any terms of the contract.

The general rule above may be restricted where the purpose of the legislation is not undermined by the illegal performance. The case of Anderson Ltd v Daniel [1924] 1 KB 138 provides a clear example of this. In this case, a landlord failed to provide a tenant with a rent book, which was a statutory requirement. If the general rule was applied, the landlord would not be able to claim any rent under the contract. The statutory purpose of the provision was not to allow the tenant to avoid paying rent, it was to ensure he had a rent book; therefore the landlord was able to claim rent.

Recent case law has added more complexity to this area of law. In ParkingEye Ltd v Somerfield Stores Ltd [2012] EWCA Civ 1338. This case concerned the installation of a monitoring system of a car park that would charge customers for overstaying. The defendants ended the 15-month contract early and the claimants who were making revenue from the charges claimed damages from the defendants for loss of revenue. The defendants claimed the contract was illegal due to the illegality of the letters the claimants sent to customers to induce them to pay.

The court held that when deciding whether the illegal performance would render the contract unenforceable they would consider these things:

1. The object and intent of the party attempting to enforce the contract;
2. The gravity of the illegality in the context of the claim; and
3. The nature of the illegality.

In this case, the court decided a repudiation of the contract would be disproportionate. Instead the defendant should have informed the claimants that their letter was illegal so they could have made the necessary amendments. Therefore, 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.

In St Johns Shipping Corporation v Joseph Rank [1957] 1 QB 267 the statutory breach in question was the overloading of a ship. There was a fine imposed for this breach, but the defendants attempted to withhold the goods as it was an illegal contract. It was held the fine was sufficient punishment, and the contract would be enforceable.

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 obligations 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).

Other examples of contracts which would fall under this area are:

• Tax fraud contracts (Alexander v Rayson [1936] 1 KB 169)
• A third party claiming damages from the guilty party after a criminal offence (Gray v Thames Trains Ltd [2009] UKHL 33)

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. Here are some of the main examples:

• Agreements between husband and wife where one agrees not to apply to the court for maintenance (Hyman v Hyman [1929] AC 601). Note that this does not invalidate the whole agreement, only the term that prevents the court application (Section 34 of the Matrimonial Causes Act 1973)
• Contracts that preclude the jurisdiction of the courts, unless the administration of justice is replaced with arbitration (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. An example of this can be found in Pearce v Brooks (1865) LR 1 Ex 213, where a contract for the hire of a carriage used for prostitution was held to be illegal due to public policy.

However, this approach has evolved along with societies views. As mentioned before, the public policy laws will consider the values of society at that point in time. More recently, there have been a number of cases which have taken the opposite view and allowed contracts for sexual acts and services to be enforced.

In Sutton v Mishon de Reya [2003] EWHC 3166 (Ch) a contract outlining an agreement between two people in a master/slave sexual relationship was held to be valid and not contrary to public policy. This is an excellent example of how the courts are less likely to rule that a contract is illegal under grounds of public policy.

Contracts which involve public corruption

Some contracts are invalid because they involve corruption. The most common examples of contracts which are corrupt are contracts for public office or honours.

In Parkinson v College of Ambulance Ltd [1925] 2 KB 1, one party to a contract paid £3,000 to a charity because some of the charity officials had persuaded him they may be able to get him a knighthood if he donated. This was not in fact true, and was therefore invalid due to corruption (the promise to get him a false knighthood). It should be noted that the contract was also invalid due to statutory illegality.

The most common examples of contracts which are corrupt are contracts for public office or honours.

Common law prohibition of contracts - restraint of trade

As we know, contract law is governed by the principle of contractual freedom, that parties can agree to any contracts and terms they wish. In some circumstances this freedom may be abused. An example of such abuse is where a term in a contract prevents somebody from working for somebody else, or trading with somebody else.  To ensure there is a continuing freedom of contract, contracts that restrain trade can be void for illegality.

Lord Macnaghten famously summed up this principle by stating the public has ‘an interest in every person’s carrying on his trade freely’. This statement was made in Nordenfelt v Maxim Nordenfelt Guns and Ammunition Co Ltd [1894] AC 535. In this case, a contract prevented a seller from engaging in the business of ammunition and arms for a period of twenty-five years.

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?

The case of Herbert Morris Ltd v Saxelby [1916] AC 688 is the leading authority for the assessment of reasonableness in this area of law. This case involved an employment contract that included a term that restricted the defendant from carrying on any related trade for seven years in the event he left the plaintiff’s employment. The defendant left the job and the plaintiff attempted to enforce this term. The courts held that this term was not enforceable. In this House of Lord judgment, the courts identified general presumptions for deciding whether or not a contract may be illegal due to a disproportionate restraint on trade.

1. Employment contracts that restrict former employees from being employed by competitors would not normally be valid
2. Employment contracts that prevent the loss of trade secrets or stealing of custom would normally be valid
3. 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. For example, a contract which prevents the seller of a business setting up a competing business in the same area would likely be valid, but not one preventing the seller setting up a similar business anywhere in the world. Some further case examples can be found below.

In Mason v Provident Clothing & Supply Co Ltd [1913] AC 724 one term in the defendant’s contract of employment stipulated that he must not enter into a similar business within 25 miles of London. The employment was in Islington, and therefore the restraint was too wide to be proportionate and reasonable.

The case of Home Counties Dairies Ltd v Skilton [1970] 1 WLR 526 a term in an agreement prevented a milkman from selling milk or dairy produce to any former customers he dealt with in the course of his employment. This restraint was reasonable, so long as ‘dairy produce’ was limited to the type of goods he dealt with in his employment.

Case in focus: Nordenfelt v Maxim Nordenfelt Guns and Ammunition Co Ltd [1894] AC 535

This case is the leading authority for the assessment of restrictions in the sales of businesses. In this case, Nordenfelt, an arms manufacturer, sold his business to Maxim. The contract included a term preventing Nordenfelt from selling guns or ammunition anywhere in the world for twenty-five years, and to not compete with Maxim in anyway.

The court held that this clause was partially valid. The part preventing competition ‘in any way’ was not valid due to its complete restriction on trade. However, the rest of the clause was valid due to these reasons:

• A substantial fee had been paid which reflects the fact he could not compete for 25 years
• The amount of customers willing to buy arms and ammunition was limited, therefore the restriction not to sell ammunition anywhere in the world was valid because it was no wider than necessary to protect Maxim.
• The restriction was not damaging to the public interest

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. It is admitted that these situations are rare because of the diversity and competition in business, but it is important to consider if it may occur. The case of Herbert Morris Ltd v Saxelby [1916] AC 688 is an example of this. In this case, two companies agreed not to compete with each other, which on the face of it would seem a reasonable agreement. Despite this, the public would be likely to suffer due to the inflated prices as a result of the lack of competition; therefore the contract was not valid.

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 that a mere contract. The best way to understand and identify these agreements is by reference to the leading authority in this area.

In Esso Petroleum Co Ltd v Harper’s Garage (Stourport) Ltd [1968] AC 269 the parties involved were two garages and a seller of petrol. These are clearly parties involved in different stages of the commercial chain relating to petrol. One garage agreed to only buy petrol from the seller for a term of over five years in return for a discount. The second garage agreed the same, but for a term of twenty-one years.

The courts held that only the contract providing for exclusivity for five years was valid. The courts held that for each exclusivity contract there must be an investigation as to whether there is a legitimate interest protected by the exclusivity, and whether the restraints are reasonable. The twenty-one year term was seen to be extremely disproportionate due to the sheer amount of time it tied the parties together for.

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. Here are some common examples of these:

• A singer agreeing only to appear at certain festivals
• A footballer agreeing to only appear in adverts for one company
• A celebrity agreeing to only sell their stories to one news outlet

As you can see, these mostly relate to professional entertainers and sports stars. 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.

The case of Creig v Insole [1978] 1WLR 302 involved organizers of international and county cricket attempting to exclude players who played in private games promoted by a certain company. The courts held this ban was not valid as it restricted the freedom of employment of players subject to the ban.

Another similar case is Eastham v Newcastle United Football Club Ltd [1964] Ch 413. A term in this contract prevented large clubs (Newcastle in this case), from poaching the best players from smaller clubs. It was suggested these types of contracts may be valid due to the public’s interest in watching a good level of sport at all clubs. However, the courts held the contract restricted the freedom of employment for certain members of the club, therefore making the contract invalid.

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.

In Proactive Sports Management Ltd v Rooney [2011] EWCA Civ 1444 a contract that provided for exclusivity of image rights of a sportsman was considered to be invalid. This was in light of the fact Rooney had not undertaken any legal advice, was 17 years-old at the time, the contract was for eight years, and was a flat-rate of twenty percent of all of his earnings.

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. However, as we have seen, 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. This section will consider the different effects of illegality, separating them into distinct categories that should be easy for you to remember.

Severable illegal contracts

As we touched on in Nordenfelt v Maxim, 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. The test comes from Sadler v Imperial Life Assurance Co of Canada Ltd (1988) IRLR 388:

1. The ‘blue pencil’ test - can the illegal provision be removed without modifying the words of the remaining terms. These remaining terms must be grammatically and verbally separated. It is referred to as the ‘blue pencil’ test as the best way to assess this is simply by crossing out the illegal terms. If it still makes sense, the illegal provision can be removed.

Case in focus: Goldsoll v Goldman [1915] 1 Ch 292

This case involved a defendant who was competing with the plaintiff in the business of imitation jewellery. The defendant’s agreed to no longer compete with the plaintiff in a contract for two years in any capacity. The clause covered ‘London, England, Scotland, Ireland, Wales, or any part of the United Kingdom of Great Britain and Ireland and the Isle of Man or France, the United States of America, Russia, Spain, or within twenty-five miles of Potsdamerstrasse, Berlin, or St Stefans Kirche, Vienna’.

The courts decided that the contract was valid, except for the geographical restraints that were unreasonable. The ‘blue pencil’ rule was used to remove the words following ‘or France’, so that the limitation only applied to the United Kingdom.

2. The remaining terms following the ‘blue pencil’ rule must be supported by consideration

This part of the test is fairly straightforward. You may need a re-cap on your knowledge of consideration, but here is a simple example of this test in operation:

‘You will be paid £250 per month to not compete with the company in any capacity in the United Kingdom and the United States of America’.

If the ‘and the United States of America’ was removed as part of the blue pencil rule, the £250 part would still be included in the contract, and therefore the contract would still include some valid contract. However, if the contract was drafted in this manner:

1. You must not compete with the company in any capacity in the United Kingdom
2. You must not compete with the company in any capacity in the USA, and in consideration for not competing in the USA, you will be paid £250 per month.

Now if we attempt to use the blue pencil rule to remove the part of the clause relating to the US, it is evident that the term that includes the payment of £250 would have to be removed. This means only term ‘a’ would remain, and there is a lack of consideration in the contract.

This is an extremely simple example, and in practice the contract is likely to be much more complex. However, just remember to ensure there remains some form of consideration following the removal of any illegal terms.

3. 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. The case of Attwood v Lamont [1920] 3 KB 571 provides a good example to further your understanding.

Case in focus: Attwood v Lamont [1920] 3 KB 571

In this case, one party owned a tailoring business, whilst the other party was an employee. The contract of employment prevented the employee from working for any other tailor within ten miles of the store in the context of being a ‘tailor, dressmaker, draper, milliner, hatter, haberdasher, gentlemen’s, ladies’ or children’s outfitter’. The important fact in this case was that the employee was only a cutter in the tailoring department.

The courts held this restriction was far too wide, as the employees only skill was as a tailor. However, the clause could not be severed, as to sever it would change the scope and intention of the agreement.

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 is one such example of this. In this case, a collateral contract providing for security of an illegal contract was made. This collateral contract is ‘tainted’ by the illegality of the illegal contract, and can therefore not be enforced.

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. In Euro-Diam Ltd v Bathurst [1990] 1 QB 1, a contract for the exportation of diamonds was illegal due to the falsely invoiced tax evasion.

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’. In the case of Shanshal v Al-Kishtaini [2001] EWCA Civ 264 this argument was dismissed, as it was held to be in the public interest to prevent the recovery of property from illegal contracts.

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, as per 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. It should be noted that the withdrawal does not need to be with genuine regret or sorry, the fact one party has withdrew will suffice - Tribe v Tribe [1996] Ch 107. This has been justified as providing a strong incentive for the claimant to withdraw from an illegal contract.

There has been some debate as to when the withdrawal from the contract must occur. The two conflicting cases on this matter are Taylor v Bowers (1876) 1 QBD 291 and Kearley v Thomson (1890) 24 QBD 742. In Taylor it was suggested that withdrawal is allowed at any time before the completion of the contract, whereas in Karley it was suggested once the illegal part or purpose of the contract has started, withdrawal cannot occur. Obiter statements in Collier v Collier [2002] EWCA Civ 1095 confirm the approach in Kearley to be correct and therefore although Taylor is worth mentioning, you should apply the law in Kearley.

The withdrawal from the contract needs to be voluntary, as shown in Bigos v Boustead [1951] 1 All ER 92.

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