Key Takeaways:

  • Capacity is the legal ability to enter a binding contract.

  • Minors can enter contracts, but they are usually voidable.

  • Intoxicated individuals may lack capacity if judgment is impaired.

  • Companies need corporate capacity to enter contracts legally.

  • Jurisdictional differences can affect rules around contractual capacity.

One of the most important and foundational concepts that any business owner should know is the capacity to contract. But exactly what is contractual capacity? What are the criteria for it and who may not be eligible to have it? In this guide, we explore this concept and how it affects agreements and contracts in business.

What is Contractual Capacity?

For any contract or agreement to be legally enforced, all the parties involved must have the legally recognized ability to enter into the agreement. This is known as contractual capacity. It ensures that all the parties involved in the contract have the capacity to understand the terms and consequences of the agreement.

If any party is found not to have contractual capacity, the agreement would be considered void. For this reason, businesses and individuals should understand the criteria for contractual capacity, who may lack the capacity to contract, and how it affects the enforceability of contracts.

Key Criteria for Capacity to Contract

The legal ability of any individual to enter a contract depends on several factors. Below are the three main requirements that determine if a party has the capacity to contract.

Age of Majority

Age of majority refers to the age when an individual is considered an adult mature enough to make their own decisions, with full awareness of the consequences. In most states, the age of majority is 18. Any individual below this age is considered a minor and generally lacks the legal capacity to contract. While minors can still enter contracts, these agreements are often voidable, meaning the minor can choose to honor or cancel the contract.

Mental Competence

To have contractual capacity, individuals must be mentally capable of understanding the terms and nature of the agreement. This is a separate criterion and distinct from the age of majority criteria because there may be situations where an adult lacks the mental competence to fully understand a contract. This could be due to a cognitive impairment or mental health condition that affects their ability to comprehend the contract. In such situations, they may lack the capacity to contract. Courts may declare such contracts void if it is proven that one party could not fully understand the agreement.

Sobriety

An agreement is only legally binding if individuals or entities enter into the contract without being under the influence of any substances that could hinder their judgment–such as alcohol and drugs. In such cases, the individual could rescind the contract upon regaining sobriety, provided there is sufficient evidence that their capacity to contract was compromised.

Who Lacks the Capacity to Contract?

Typically, if an individual or an entity fails to meet the three main requirements for contractual capacity would not be able to enter a legally enforceable agreement. Here are some examples:

  1. Minors: Contracts entered into by minors are usually voidable at the minor’s discretion. Exceptions may apply, such as contracts for essential items like food, clothing, or medical care.

  2. Mental Incapacity: Individuals who cannot understand a contract due to cognitive impairments may lack the capacity to form a binding agreement. Courts often require medical evidence to assess mental competence.

  3. Intoxicated Persons: If a person is under the influence and cannot understand the contract's terms, the agreement may be voidable. The individual must demonstrate that their intoxication affected their ability to make an informed decision.

Courts may declare a contract void or voidable if one party lacked capacity when entering the agreement. The decision usually depends on the severity of the incapacity and the contract's circumstances.

How Does Capacity Affect Contracts?

Lack of capacity can have a significant impact on the enforceability of a contract. If a party to a contract is found to lack capacity, the contract may be deemed either void or voidable:

  • Void Contracts: These are agreements that are considered legally invalid from the beginning. They cannot be enforced because one or more parties did not have the capacity to enter into a binding agreement.

  • Voidable Contracts: These agreements are valid and enforceable unless one party chooses to void the contract. For example, a contract with a minor is usually considered voidable at the minor’s discretion.

When a contract is deemed voidable due to lack of capacity, courts may restore both parties to their original positions as if the contract had never existed. This is particularly common in cases involving minors or individuals with mental incapacities.

Capacity of Companies to Contract

Companies, just like individuals, must have the legal capacity to contract. This is referred to as corporate capacity, meaning the company can enter into agreements as a separate legal entity. Here are some factors that determine a company’s capacity:

  • Legal Personality: Companies have a distinct legal identity, separate from their owners or shareholders, allowing them to enter contracts. This reduces the liabilities for the owners or shareholders of the company.

  • Common Law and Civil Law Differences: In common law countries, companies may be restricted by their memorandum of association (founding document), which defines their business scope. In civil law countries, companies generally have legal capacity as long as the act falls under routine business operations.

  • Ultra Vires Doctrine: In some common law jurisdictions, contracts entered outside a company’s specified business activities may be considered ultra vires (beyond the company’s powers) and potentially unenforceable.

Examples of Capacity to Contract in Different Legal Systems

Contractual capacity can differ based on jurisdiction. Here are examples from various legal systems:

  • Civil Law Systems (e.g., France, Spain): Companies have legal capacity to enter contracts as long as the activity falls under day-to-day operations. For individuals, the rules regarding age, mental competence, and sobriety are similar to those in common law countries.

  • Common Law Systems (e.g., United States, United Kingdom): Companies are restricted by their memorandum of association, which outlines the scope of their legal activities. For individuals, the three main criteria for capacity—age of majority, mental competence, and sobriety—apply.

These differences emphasize the importance of understanding local laws when entering contracts, especially in international business contexts.

Common Mistakes and Misunderstandings About Contractual Capacity

Many people have misconceptions about who has the capacity to contract and under what circumstances. Here are some common errors:

  1. Assuming Minors Cannot Enter Contracts at All: While minors can enter contracts, these agreements are often voidable. Certain contracts, such as those for necessities, may still be legally binding. A minor’s parent or legal guardian may be required to approve the participation in the agreement in writing.

  2. Misunderstanding Mental Competence: A person may appear mentally competent but still lack capacity if they have an underlying condition affecting their ability to understand the contract.

  3. Overlooking Intoxication Rules: A common misconception is that if a person is intoxicated, it automatically nullifies a contract. However, it must be proven that the intoxication significantly impaired judgment.

  4. Failing to Consider Corporate Capacity: Business owners should ensure that their company has the legal authority to enter contracts, especially when engaging in activities outside its usual scope.

  5. Ignoring Jurisdictional Differences: Different legal systems have varying rules regarding capacity. It is important to be aware of these differences, particularly for international contracts.

Final Thoughts

Understanding contractual capacity is essential for anyone entering a legal agreement. Whether you're an individual or a business entity, ensuring that all parties have the capacity to contract can help avoid disputes and ensure that your agreements are legally sound. When in doubt, consulting legal professionals can provide clarity and help you navigate the complexities of contract law. You can use UpCounsel’s resources to consult a contract attorney in order to better understand the laws and regulations around contracts and stay legally compliant.

FAQs

What is the capacity to execute a contract?

Capacity to execute a contract refers to the legal ability of a person or entity to enter into a binding agreement.

What is the capacity clause of a contract?

The capacity clause is a statement in a contract affirming that all parties involved have the legal capacity to enter the agreement.

Why is capacity important in a contract?

Capacity ensures that all parties understand the terms of the contract, making the agreement legally binding and enforceable.

How do you prove capacity in a contract?

Proving capacity may involve demonstrating that a person is of legal age, mentally competent, and not under the influence of intoxicants at the time of signing.