Capacity in Contract Law: The Fundamentals

What is Capacity to Contract?

Capacity refers to an individual or company’s power or ability to enter into a binding contract. It essentially means someone must have the mental and physical ability to make a choice, that they fully understand the nature of the contract they are creating and that they have the capacity to carry it out. Unless capacity is established, or proven, any contract created may be void, voidable or avoided, meaning the terms of the contract become unenforceable or are negated.
Lack of capacity could occur for a number of reasons such as an individual is underage, drunk or incapacitated. In addition, a contract that is entered into under duress or undue influence may be voidable or void.
A minor, for example, does not have the legal capacity to enter into a contract so its terms and obligations will be void, with some exceptions, such as agreements for necessities which includes food, housing , education and employment. A minor can enter into a contract but has the right to return the goods or services for a full refund. However, the individual must disaffirm the contract, generally by demonstrating to the other party their intention to disaffirm.
Moreover, certain individuals such as the mentally impaired, intoxicated, underage or incompetent individuals do not provide mutual assent as required by contract law. Parties must have the legal ability to enter into a contract in order to create mutual assent and a meeting of the minds. The meaning of this term has evolved over time, what has traditionally been accepted has included the offer and acceptance but courts are now looking beyond an offer and acceptance to whether the parties acceptance or assent resulted in the creation of a contract. Capacity is a major factor in this assessment. Without the ability or capacity to establish mutual assent there can be no contract.

Legal Capacity Requirements

In order for a contract to be valid, both parties need to have the legal capacity to enter into or enforce a contract. Certain groups of people are not considered to be legally capable of carrying out a contract, including minors and those who are intoxicated or mentally incompetent. Under U.S. common law, a minor is defined as someone who has not reached the age of 18. When a minor enters into a contract with another party, the minor has the right to cancel the contract at any time. Young people may still be held to their agreements in some cases, such as when they receive a benefit in exchange for providing parental consent to marry. However, even then the minor may cancel the contract when he or she turns 18.
When a minor enters into a written agreement before turning 18, the minor is still entitled to cancel the contract. In certain states that require a minimum age of 18 to enter into certain contracts, however, people younger than 18 years old can face criminal penalties for entering into an agreement that violates the restrictions on their age.
It is possible that a guardian can legally sign a contract on behalf of a child; however, that still does not make the contract valid. In this case, the tortuous situation of the agreement being legally unenforceable generally falls back on the guardian.
How does insanity factor into capacity? Anyone who is judged to be insane, meaning that he or she can’t distinguish between right and wrong, lacks the capacity to enter into a contract. If contract party is deemed insane and has no awareness of what he or she is doing, the contract may be invalidated. As with minors, a person who isn’t legally capable of entering a contract has the power to disaffirm the contract, even if they were not insane when it was made.

Minors and Legal Capacity

In contract law minors lack capacity, meaning they cannot enter into an enforceable contract to which they are bound. However, even though courts view the underlying contract as voidable in the event of an objective showing of minority, many times contracts with minors will be considered valid subject to interesting statutory exceptions. Two notable examples include the ease with which courts will consider a minor entering the military as a valid, binding contract and the financial significance of certain contracts under state equitable doctrines such as the doctrine of necessaries. Further, some states allow for contracts with minors to be ratified upon the majority of the minor. For example, the ratification of the minor’s business agreement would lift the voidability defense leaving the minor bound to the contract. The minority status also requires extreme caution on the part of the carrier as many policies require an adult to sign the policy or policy endorsement.

Mental Incapacity and Capacity

The determination of mental competence is essential to establishing contractual capacity. Generally, there is a rebuttable presumption that an individual has the mental capacity to enter into a contract. For example, in Centimark Corp. v. Martin Family Trust, No. 3:02-CV-2284-BD, 2003 U.S. Dist. LEXIS 28538 (N.D. Tex. Feb. 11, 2003), the court considered whether an adjudication of incompetence was a prerequisite to establishing mental incapacity for the purposes of avoiding liability on a guaranty agreement. The court held that, under Texas law, "an adjudication of incompetence pursuant to the provisions of Texas Probate Code Sections 5B and 5C is sufficient, but not necessary, to establish a party’s mental incapacity to enter into a contract." Id. at *14 (citing Wilkins v. Powell, 893 S.W.2d 537 (Tex. App.C-Austin 1994, writ denied)). As a result, the defendants were able to avoid liability under the guaranty agreement based on circumstantial evidence showing that a litigant was incompetent and therefore did not have contractual capacity.
Texas law also provides an exception to the general rule that an adjudication of incompetency is not required to establish mental incapacity. See Dye v. Sierra Pac. Mortg. Co., No. 01-02-01051-CV, 2004 Tex. App. LEXIS 15, at *4-5 (Tex. App.C-Houston [1st Dist.] Jan. 8, 2004, no pet.) (holding that "an adjudication of incompetency is not a prerequisite to a finding of mental incapacity if the adjudication was entered in favor of someone other than the adverse litigator"). The Supreme Court of Texas has stated that a finding of mental incapacity should be based on objective evidence of dementia or another mental illness that renders one incapable of executing a valid contract. See Wilmeth v. Cailloux, 941 S.W.2d 468, 466 (Tex. App.C-Austin 1997, writ denied). A court may consider objective evidence such as evidence showing that the litigant lacked the ability to concentrate and to understand the subject of the contract, or that the litigant failed to appreciate the consequences of his action in entering into the contract at issue. Id.
The burden of proof regarding a litigant’s mental capacity is upon the party seeking to avoid liability. See Dye, 2004 Tex. App. LEXIS 15, at *4-5 (citing Kutz v. Stuckey, 761 S.W.2d 285, 287 (Tex. App.C-Dallas 1988, writ denied)). The plaintiff must prove by a preponderance of the evidence that the defendant was incompetent at the time the contract was entered into. See Wilmeth, 941 S.W.2d at 467. While there is no requirement that medical testimony be presented to establish mental competence, such testimony "is often the best and perhaps the only means of proving insanity". See Dye, 2004 Tex. App. LEXIS 15, at *5 (citing Kutz, 761 S.W.2d at 287). The preponderance of evidence test applies to all defenses to a breach of contract action and those defenses that presume a direct injury to the party. See Cotton v. Hatch, 33 S.W.3d 452, 462 (Tex. App.C-Houston [14th Dist.] 2000, pet. denied).

Intoxicated Persons and Lack of Capacity

A person who is voluntarily intoxicated may have their capacity to enter into a contract called into question. Such questions often arise in relation to contracts of sale, contracts of guarantee and contracts of partnership. The circumstances which may give rise to a challenge of a contract on the basis that one party lacked capacity are many and varied and the law has developed in an ad hoc fashion.
Later cases where incapacity due to intoxication was called into question include those where intoxication was caused by the use of narcotic drugs and those which involve contracts to dispose of land. In these circumstances a variety of legal tests and rules have been formulated by the courts to assist in determining whether a person has contractual capacity.
One judicial rule which has been developed in this context is that a person who is voluntarily intoxicated and who conforms to the ordinary standard of capacity before he became drunk cannot be held to his normal state of capacity merely by the accident of intoxication . In such a case it is the more important to assess whether or not the intoxicated person was in fact capable of fully understanding the nature of the contract. A contract which is entered into by a person in a state of inebriation may be set aside.
However, there must be objective evidence that while under the influence of alcohol the person agreed to the contract in question. The burden of proof on the intoxicated party to show he lacked capacity is heavy.
In Harris v Sherwood Ltd, the court held that a contract would be set aside where a plaintiff could establish on the balance of probabilities that by reason of his intoxication he did not know what he was doing and so lacked the requisite knowledge and prudence to enable him to be held to the transaction.

Vitiating Effect of Lack of Capacity

The consequences of a lack of capacity when it comes to a contract are complex. When an individual enters into a contract, the time at which he or she does so is important; if the person is a major or generally of sound mind at the time of signing the contract as opposed to during contract performance or after contract breach. If a person fails to satisfy the contractual obligations, several legal conditions could come into play.
When the issue of capacity arises: When a party enters into a contract with a lack of mental capacity, the flawed contract is deemed voidable. This means that the party will be able to resile from the contract. Certain contracts such as wills, marriage and donations inter vivos, that are made by parties lacking legal capacity are void ab initio if they are made at a time when the parties are incapable of contracting and there was no ratification. When a party enters into a contract with a lack of capacity the contract is voidable, which means that the party who lacked capacity and was taken advantage of may proceed to set the contract aside. If a contract is void, the contract is regarded as never having been entered into. The party who lacked capacity will not be allowed to enforce the contract. There can never be a ratification of a void contract. The party who lacked capacity may also sue for damages against the person who took unfair advantage of the party because he or she lacked the necessary capacity.

Cases Addressing Capacity in Contract Law

To further illustrate how contractual capacity is applied in the real world, the following cases consider whether various parties to an agreement had the capacity necessary to bind themselves under the terms of the contract:
Davis Securities, Inc. v. Hade
In Davis Securities, Inc. v. Hade, 659 So.2d 1174 (Ala.Civ.App.1995), a minor, Gregory Hade, entered into an agreement with a securities broker to invest a sum of money he had received as a gift from his grandparents. At the time the agreement was executed, Hade was approximately 17 years old. The broker agreed to invest Hade’s funds for a period of 22 months, issuing a 13% return on the original investment each month. Hade made several compliance payments during the course of the agreement, including a single payment of $3,400.00 when he turned 18, but refused to make any further payments under the agreement on the grounds that he was not required to perform as the contract was voidable due to Hade’s status as a minor and the absence of a guardian to represent him.
The Alabama Court considered this specific issue and held that:
[A]s a general proposition, the constitutionally based right to enter a binding contract cannot be exercised until one party has reached the age of majority, i.e., 19 years of age; in other words, in the absence of a guardian, a contract can be voidable at the option of a minor, thereby freeing the minor from performance.
While it is possible for a minor to be sued in tort on the basis of negligent or intentional conduct, a voidable contract does not create any such exception. Rather the right to recover damages for breach of contract lies solely with the party who is already obligated to perform under the contract.
On the basis of this holding, the Alabama Court of Appeal affirmed a prior decision in favor of the minor. While acting as a minor is not an absolute defense to breach of contract allegations, it must be adhered to when the contract attempts to bind the minor to perform an act criminal in nature or one that would be objectively bearer than the minor’s current circumstances.
Chadwick v. Franklin:
The Washington Court of Appeals, Division II had a chance to rule on an issue of contractual capacity in Chadwick v. Franklin, 39 Wn. App. 416, 693 P.2d 1355 (Wash. Ct. App. 1984). In this decision, a woman (Mrs. Franklin) signed two warranty deeds, effectively transferring her interest in two parcels of real property to her friend (Mrs. Chadwick). This deed also contained a provision by which Mrs. Franklin agreed to purchase the property back from Mrs. Chadwick for $4,500 after a specified period of time. Thereafter, Mrs. Franklin sought to have the deed set aside on the basis that she was not mentally capable of entering into a contract since she was suffering from Alzheimer’s disease at the time the deed was executed. In considering Mrs. Franklin’s mental capacity, the court relied heavily on Mrs. Franklin’s actions after executing the deed. Specifically, it considered the fact that Mrs. Franklin had not obtained any type of medical treatment for her illness until well after the deed was executed and that substantial evidence existed to suggest that she did, in fact, understand the elements of the contract at the time she agreed to it. Given these factors, the court overturned the trial court’s decision to invalidate the deed and found that scope of Mrs. Franklin’s dementia was insufficient to vitiate the contract.
These cases are representative of the manner in which courts consider an individual’s contractual capacity in order to determine whether or not certain terms of the agreement may be enforced. By doing so, courts seek to ensure that a basic level of intellect is present when an individual enters into a contract, thereby giving the individual the ability to fulfill his or her duties under the agreement.

Confirming Capacity: Best Practices for Contracting

It’s not always obvious as to who lacks the capacity to contract. The contract and the surrounding circumstances may not contain any "red flags" that a contracting party is incapable of contracting. However, those involved in the contract might be equipped to identify a contracting party with a lack of capacity. In contract negotiations, think critically on whether all parties have the requisite capacity to enter into a contract to avoid future remedies against you.
For example, when inquiring into whether minors, mental incompetents, intoxicated individuals, or entities have the requisite capacity, do the following: If you are in doubt as to whether a party has the capacity to enter into a contract, ask questions of the individual or entity and look for potential "red flags" that a party may lack capacity in a contract negotiation phase or legal due diligence period. If a party still poses a risk, consider obtaining written assurance that the party has the requisite capacity (i.e., a statement from the individual or entity that they’ve considered the matter and are able to contract . ) Include a representations and warranties clause in the contract stating that the parties have the capacity to contract. This will allow the other party to bring a breach of contract claim against the party without capacity. Additionally, have your attorney prepare a certificate which includes a "cogency" statement. "Cogency" is a legal term that refers to the soundness of a claim in written form. A cogency statement is made under oath by someone who is knowledgeable about the subject matter and certifies that they’ve taken specific actions to obtain cogent evidence. For example, "I have taken steps to verify that Company ABC was duly formed, is in good standing, and has the full capacity to contract . . ." This document demonstrates the party’s capacity to contract and strengthens the bargaining position should there be a fight someday. If you suspect something is amiss from an individual or entity, don’t proceed with the contract. It’s not worth the risk to your company if you can.