Illegality of Contracts
by Hein Kötz
1. In general
Under a generally accepted principle a contract is invalid to the extent to which it is in conflict with good morals (boni mores), public policy (ordre public, ordine pubblico, öffentliche Ordnung) or mandatory rules of law. In France and Italy the question is dealt with in terms of the doctrine of cause or causa. Thus a contract has no effect in law if it is based on a cause illicite, a cause being illicite when it is prohibée par la loi or contraire au bonnes mœurs ou à l’ordre public (see Arts 1131, 1133 Code civil, Arts 1343, 1418 Codice civile). In common law jurisdictions an illegal or immoral contract is often said to be unenforceable.
In determining what is contrary to good morals or public policy different legal systems may reach different results, and in one legal system the results may even change over time and in accordance with the prevailing norms of society as they develop. What in one legal system is prohibited by a mandatory rule of statutory law may well in another system be incompatible with a fundamental principle of public policy. If the legislature deals with the problem, it can do no more than lay down rather broad and indefinite statutory provisions. For this reason, the rules determining whether specific contracts are void on these grounds can only be identified and analysed by reference to court decisions and typical classes of case. This applies also to the problem of whether and to what extent any benefits conferred in pursuance of the void contract may be reclaimed from the other party.
2. Contracts infringing good morals or public policy
In one group of cases, contracts may be void as a result of being incompatible with generally accepted principles of family life and sexual morality. In another group, contracts may be illegal because they involve the deception of public authorities, interfere with the proper cause of justice, aim at the commission of an unlawful act, or oust the jurisdiction of the courts. In some legal systems a contract is illegal under which an attorney and his client agree on a contingent fee in the form of a percentage of any damages awarded to the client.
Contracts will also be invalid if they unduly restrict another’s personal or economic freedom. Such agreements often figure in contracts of employment since employers are afraid that employees may leave and join the staff of a competitor or set up a business of their own and then exploit the special skills or information they gained in their former employment. Similar arrangements are often made in partnership agreements or where a business is sold and the seller promises not to enter into competition with the buyer. Such covenants not to compete are invalid to the extent to which they go further, as to their scope, duration, geographical area and type of activity, than is reasonably necessary for the protection of the employer’s or buyer’s interest. Such limitations are sometimes laid down by statute, eg with respect to employment contracts or contracts with commercial agents, and will in other cases be determined by the courts. A restraint on competition which is too wide in scope, duration or area will as a rule not be held invalid in toto but be reduced by the court to an acceptable level. This applies in particular to exclusive supply agreements under which a publican or the operator of a filling station must buy all beer or petrol from a brewery or oil company for a period of time which, while manifestly excessive, may be cut down to size by the court. In cases of this type the clause may also be incompatible with national or European competition law.
Some legal systems allow a party to withdraw from a contract if what he is to receive from the other party is worth less than one half or seven-twelfths of the value of his own performance (laesio enormis). However, the principle is that a party may not escape an unfavourable deal merely on the ground that he agreed to a disproportionately low or high price or rate of interest. Even so, many legal systems treat a contract as invalid if, in addition to a manifest disparity between performance and counter-performance, the disadvantaged party was ‘dependent on or had a relationship of trust with the other party, was in economic distress or had urgent needs, was improvident, ignorant, inexperienced or lacking in bargaining skill’ (Art 4:109 PECL). In this case the disadvantaged party may treat the contract as invalid if the other party was or should have been aware of his predicament, inexperience or lack of judgment and exploited it to his advantage. Some legal systems dispense with the requirement of disparity. Under Art 3:44(4) Dutch Civil Code, for example, if an inexperienced widow is persuaded by a ruthless businessman to sell her property she may invalidate the agreement even though the price he promised was fair. Other legal systems reach similar results through other routes, eg by allowing the disadvantaged party to withdraw from the contract on the ground of erreur (mistake), dol or violence (in France) or economic duress or undue influence (in Britain; duress, fraud). Special rules apply when the disadvantaged party is a consumer who agreed to pay a disproportionately high rate of interest (consumers and consumer protection law, consumer credit (regulatory principles)), or when the disadvantageous clause is a standard contract term and may therefore be invalidated by the court (standard contract terms).
3. Breach of a statute
Where a mandatory statute prohibits or regulates the performance of a contract, breach of the statute makes the contract void or unenforceable. This is clear in cases in which the statute expressly prescribes the invalidity of the offending contract or term. The difficult cases are those in which the statute provides for a sanction, such as the withdrawal of a licence or the imposition of a penalty, but gives no clear lead as to whether or not the contract infringing the statute should be held void. Here the judge must construe the statute in order to discover whether its purpose and policy require that contracts formed in breach of it should be void. If the statutory prohibition is directed at both parties, one must generally conclude that the contract is invalid. But what about statutes merely prohibiting one party from entering into a contract, eg court officials from making deals on their own account, unlicensed accountants from providing services to their clients, attorneys from acting as brokers for profit, or retailers from selling their wares on legal holidays? What effect the statute has in these cases will depend on various considerations. Can the aim and purpose of the statute be achieved by simply applying the sanctions expressly laid down in it or should the contract be invalidated? What mischief is the statute designed to prevent? Does the party relying on the validity of the contract belong to a class of persons the statute seeks to protect? Was the breach of the statute intentional? Was the other party aware of the breach? Would that party be unduly benefited if he were allowed to keep what he received under the contract? (See for a list of factors to be taken into account Art 15:102 PECL.)
4. Restitution of benefits conferred
Neither party to a void contract can demand performance from the other, nor can damages be claimed for non-performance. It is another question, however, whether any benefits conferred in pursuance of the contract may be reclaimed. In Roman law the question was answered in the negative: In pari turpitudine melior est causa possidentis. This venerable principle lingers on in some civil codes (see eg § 817, 2nd sentence German Civil Code, § 1174 Austrian Civil Code, Art 66 Swiss Code of the Law of Obligations; Art 2035 Italian Civil Code); in other legal systems it has been accepted by the courts (eg France and Britain). Denial of restitution is sometimes justified as a means to protect the dignity of the court, punish the claimant or deter the public from entering into unlawful agreements. While these reasons may carry some weight where both parties have flouted basic moral precepts or conspired to do something clearly punishable by law, they are much less persuasive in cases involving merely the infringement of provisions of a rather technical or administrative nature of which one or both parties may not even have been aware at the time of the conclusion of the contract. In these cases, as in the cases mentioned earlier (see 3. above), the judge must construe the rule of law which makes the contract immoral or illegal and determine whether it is recovery or non-recovery which is more likely to promote or defeat the purpose behind the rule. This is the basic rationale of the generally accepted rule under which claims for restitution will be denied when the parties were in pari delicto, but not where the plaintiff is relatively ‘innocent’ or was unaware of the breach, or where the other party took advantage of his predicament, inexperience or fecklessness. On the other hand, restitution will be ordered where its denial would undermine the policy and purpose of the invalidating rule or uphold a situation which that rule was designed to prevent. It is generally accepted, for example, that a brothel let under an illegal or immoral contract may be reclaimed by the lessor. The reason is not, as English courts have often said, that the lessor can rely on his ownership and does not have to found his claim on the illegal contract, nor is it satisfactory to say, as some German courts have done, that a defendant may not defeat a claim for possession if made by an owner. The real reason for allowing recovery is that if the defence were upheld, the lessee could continue to do what the law seeks to avoid, ie use the premises for an illegal or immoral purpose.
5. European contract law
According to Art 15:101 PECL a contract is ‘of no effect’ to the extent to which it is contrary to ‘principles recognised as fundamental in the laws of the Member States of the European Union’ (see also Art II.-7:301 DCFR). This formula was intended to avoid the varying national concepts of nullity, invalidity or unenforceability, on the one hand, and boni mores, ordre public or ‘public policy’ on the other. Guidance as to what principles are ‘fundamental’ may be obtained from the TFEU, the European Convention on Human Rights and the fundamental rights laid down in the constitutions of the Member States. Furthermore, Art 15:102 provides that a contract may be of ‘no effect’ to the extent to which it infringes a mandatory rule applicable to the contract under the forum state’s rules of private international law. Given the extent of statutory regulation in modern states, infringements covered by Art 15:102 PECL will often be of a merely technical nature. In determining the effects of an illegality upon a contract, regard is to be had first to what the mandatory rule in question provides upon the matter. If the rule gives no clear lead, it is for the judge to decide, in the light of the factors listed in Art 15:102(3), whether the contract shall have full effect, some effect or no effect (see 3. above).
Under Art 15:101 it would seem that a contract which is contrary to European fundamental principles of law is always of no effect and that the judge is given no discretion in this respect. Even so, Art 15:101 provides that the contract is of no effect only ‘to the extent’ to which it infringes fundamental principles. If, eg, a covenant not to compete violates the fundamental right to free movement of services or persons, the court will reduce it in scope, duration or area in the light of factors similar to those listed in Art 15:102(3). At any rate, as to the restitution of benefits conferred under an immoral or illegal contract, no distinction is made between the two types of invalidity (see Art 15:104 PECL; Art II-7:303 DCFR).
Heinrich Honsell, Die Rückabwicklung sittenwidriger oder verbotener Geschäfte—Eine rechtsgeschichtliche und rechtsvergleichende Untersuchung zu § 817 BGB (1974); John P Dawson, ‘Unconscionable Contracts: The German Version’ (1976) 89 Harvard LR 1063; Arthur T von Mehren, ‘A General View of Contract’ in IECL VII/1 (1980) ch 1, paras 37 ff; Reinhard Zimmermann, The Law of Obligations (1990) 697 ff, 862 ff; Tony Weir (tr), Hein Kötz, European Contract Law, vol I (1997) 154 ff; Tony Weir (tr), Konrad Zweigert and Hein Kötz, Introduction to Comparative Law (3rd edn, 1996) 380 ff, 575 ff.