Illegal Contract Terms: Business and Employment law Illegality (void and unenforceable agreements)

An illegal contract can affect any type of agreement or transaction.

Not all illegality associated with contracts is equal.

Serious illegality typically renders a contract void or unenforceable. Legal remedies may well be out of reach of one or more the contracting parties.

But then just because there is illegality involved with contract does not necessarily mean that a court will deprive a party or all parties of any legal remedy.

 

Types of Illegality in Contract Law

Broadly speaking, courts will not enforce a contract which is:

• expressly or impliedly forbidden by statute 
• entered into with the intention of committing an illegal act
• entered with no unlawful intention, but then is performed with an unlawful purpose or object.

 

What is an Illegal Contract?

An illegal contract prevents claims based on a contract when a party seeks to enforce an agreement which the law prohibits. The illegality operates primarily as a defence to legal claims.

Courts will not assist a claimant to recover a benefit from their own wrongdoing.

Whether illegally taints a contract case is decided by applying series of factors against the turn of events which gave rise to the dispute, and apply to assess the seriousness illegality.

 

Is a Breach of Contract Illegal?

Although a breach of contract could be said to be illegal, it’s not illegal in the relevant legal sense.

Unlawful or Illegal?

Breach of contract gives rise to a civil claim: a right to damages and a series of other remedies in appropriate cases. The unlawful conduct – unlawful because it is contrary to the terms of the contract - gives rise to the breach of contract. That breach in turn gives rise to the right of the innocent party to be compensated with damages for the breach (and other remedies, depending on the nature and seriousness of the breach).

When illegality exists, the situation is different.

One or more of the parties to the contract is deprived of legal remedies if it would mean that they would benefit or profit from the illegality.

The part of the contract – one or more clauses, or the entire contract - may be found to be void or unenforceable altogether.

A breach of contract does not deprive a party to a remedy for the breach.

Serious illegality by the party claiming breach will.

 

How Illegality Arises

Illegality in contracts arises in a number of ways.

Illegal Contracting

The types of illegality can overlap with one another.

What renders a contract illegal includes:

• illegality at formation:
  An intention to make a contract with:

• • knowledge of its illegality at the time it was made.
  • an intention to perform in an illegal way from the outset.

Even when a contract is capable of lawful performance, if the agreed purpose is to do something unlawful, ignorance of the illegality does not excuse it from the illegality.

• Illegal purpose or object

The purpose or object of the contract is to achieve some unlawful end.
The illegal purpose may be known to one or both of the parties. 

The illegality does not need to appear in the wording of the contract.

• illegality during performance
  A perfectly valid contract which doesn’t require an illegal act and wasn’t made for an unlawful purpose becomes illegal when it is performed in an illegal way.
  The illegality can arise by the conduct of one or both of the parties, and whether they knew about the illegality or not.
  So there’s no reason why a perfectly valid contract can’t become illegal due to an illegal purpose developing between the parties mid-stream, after the contract was made.
  Even then, when there is some illegality involved doesn’t always mean all parties are deprived of all remedies.

It depends on a range of factors, such as the seriousness of the illegality and how the illegality relates to the main purpose of the contract.

 

Illegality Defences

Whether a defence of illegality is available depends on a whole series of factors.

One factor - amongst many - is whether the illegality can be removed from the contract altogether.

Illegality in one clause in a contract may be enough to taint an entire contract, if it cannot be severed from the contract to remove the illegality. The process of evaluating whether part of a contract can be removed to save the contract from illegality is known as severance. 

It depends in large part on:

• the type of illegality claimed which is being defended
• whether the illegality is ex turpi causa
• whether the defendant knew and/or participated in the illegality

The main factor is whether public policy supports making the defence available.

 

 

Illegal Contracts Act

While some countries may have an Illegal Contracts Act, that's not the case in the UK.

The law of illegality in respect of business contracts are governed by the common law. The common law takes account all statutes when assessing illegality.

So in illegality cases:

• there may be a term of the contract, an act or series of acts which are illegal
• under a statute and/or under the common law
• even if a statutory authority such as the Competition and Markets Authority or Competition Appeals Tribunal is empowered to decide a case and impose a fine, it takes a court to finally and conclusively decide whether a contract is illegal

 

Types of Illegality in Contracts

The sort of illegality (see above) which makes a contract illegal can arise through:

• statutory illegality: Contracts illegal by statute include primary legislation and those that offend delegated legislation, by doing something outlawed by the statute
• common law / public policy: It’s in the interests of society as a whole that certain types of contracts aren’t enforced. They include for example, contracts which involve:
  • criminal conduct: such as to conceal a crime, criminal conspiracies, misbehaviour in public office and receiving compensation for a crime over and above the loss or injury suffered as a result of it
  • moral turpitude: That’s serious immorality.
    For example, contracts to commit a fraud are illegal, such as:
    • fraud over shareholders of a company or a business
    • bribery in all of its forms
    • intention to commit a tort
    • use of land or other property for an unlawful purpose
  • restraints of trade, which are restrictive covenants which go too far.
    For example attempts to:

• • • restrict on free movement of employees, workforces and sellers of businesses
    • prevent or obstruct competition in industries, including offences which attract a fine or penalty

• • penalty clauses, which seek to impose an obligation to pay a level of damages in excess any commercial justification
  • interference with the administration of justice: including restraints and interference with evidence witnesses may give to a court

Contracts that contravene:

1. a statute is illegal for a simple reason: the legislature said that the type of contract is not permitted
2. public policy are illegal because the public interest overrides private contractual rights.

That is described in 3 main cases.

 

Illegal Contract Cases

The law relating to illegality follows from pre-eminent decision of Lord Mansfield  in Holman v Johnson (1775) which encapsulates the maxim (in italics):

The principle of public policy is this; ex dolo malo non oritur actio. No court will lend its aid to a man who founds his cause of action upon an immoral or an illegal act.
If, from the plaintiff's own standing or otherwise, the cause of action appears to arise ex turpi causa, or the transgression of a positive law of this country, there the court says he has no right to be assisted.
It is upon that ground the court goes; not for the sake of the defendant, but because they will not lend their aid to such a [claimant]. So if the [claimant] and defendant were to change sides, and the defendant was to bring his action against the [claimant], the latter would then have the advantage of it; for where both were equally in fault, potior est conditio defendentis [where both parties are in the wrong and the claimant can only succeed upon reliance of an illegal act, the position of the defendant is better]

The reference to ex turpi causa  by Lord Mansfield describes the standard of illegality which must be met for a claim for public policy illegality to be sustained.

Another frequently cited case is Weld-Blundell v Stephens (1920) where Lord Wrenbury said:

It has, I think, long been settled law that if an act is manifestly unlawful, or the doer of it knows it to be unlawful, as constituting either a civil wrong or a criminal offence, he cannot maintain an action for contribution or for an indemnity against the liability which results to him therefrom.

And not any old illegal activity will do to render an agreement illegal.

In Saunders v Edwards (1987) Lord Justice Bingham said:

[…] it is unacceptable that the Court should, on the first indication of unlawfulness affecting any aspect of a transaction, draw up its skirts and refuse all assistance to the plaintiff, no matter how serious his loss or how disproportionate his loss to the unlawfulness of his conduct.

 

Consequences of Illegal Contracts

Whether the illegality is sufficient to trigger legal consequences of illegality depends on the facts of the case: ie what happened and the law that made the contract illegal.

The seriousness of the illegality plays a part, along with the knowledge of the parties when the contract was made.

There are at least 3 possible outcomes from illegal agreements.

The overall effect of illegality is that courts will not lend assistance to a party to litigation by granting a remedy to a party to allow a benefit from illegal conduct. The outcome is usually that the contract is illegal and:

• void: At law, the contract never existed.
• unenforceable: The court will not – depending on how the illegality arose - assist one or more of the parties obtain legal relief under the contract; or
• a form of restitution is ordered: In many cases, transactions can be unravelled where property is transferred back to its original owner, before the contract was made.
  It’s not necessarily (depending on the facts of the case) the same as a contract being void ab initio at law.
  

 

Void Agreements

When a contract is void, it is deemed to have never existed, just like in cases where rescission is ordered.

The parties are put in the position they would have been if they had never entered into the illegal agreement. From a legal perspective that’s the position which they should always have been in due to the illegality.

Illegal contracts are declared void to restore the position the parties to the position they should have been in the first place: they never should have entered into the contract in the first place. To do otherwise undermines the Rule of Law and the civil justice system.

 

Unenforceable Contracts

Unenforceable contracts on the other hand are agreements where the contract is seen (at law) to have existed, but no remedy will be granted. The contract  remains in force.

It's just that courts will not make any order to enforce what would otherwise be enforceable legal rights.

 

Difference between Void and Unenforceable Contracts

The difference between a void agreement and an unenforceable contract can be significant.

For example, ownership of property might have passed under the contract.

With a void agreement, the transfer of ownership of property is reversed (such as with rescission).

If a court finds that an agreement is unenforceable and no remedy is to be granted, then the property transferred under the agreement lies where it falls. There is no reversal of ownership rights.

Transfers of property are not reversed. It remains owned by the party that that received it under the contract because the party cannot obtain a remedy.  That could be money, land, moveable property (aka chattels) and/or incorporeal rights, such as intellectual property rights.

 

Types of Illegality

Back to the types of illegality:

• common law illegality at common law, because the contract offends public policy recognised by courts; and
• statutory illegality, because the type of contract or clause(s) within the contract have been outlawed by either legislation or delegated legislation.

 

Public Policy Illegality

Contracts which are illegal for public policy reasons – aka common law illegality - can become tainted by illegality in an infinite number of ways.

It’s the harm that would be done to the public interest which is assessed by reference to the facts of the particular case.

It used to be that court used a rule-based approach to assess illegality arising from public policy, and the consequences which should follow from it.

Now, it’s a factors-based approach.

The series of factors are taken into account to assess:

• the seriousness of the illegality, and
• the consequences of the illegality: the orders that a court is likely to make to address the illegality.

 

Illegal Contracts: Public Interest

In Patel v Mirza (2016) the Supreme Court said that the factors to assess illegality and the consequences of it are:

1. the purpose of the law offended:
   For the illegality to arise in the first place, some law must have been broken.

The underlying purpose of that law - the prohibited conduct – is assessed to identify precisely what it was that was illegal.

The prohibition implemented by statute (say the Competition Act) or recognised at common law (say the common law of bribery) may have come about to:

• • deter fraudulent conduct, and prevent insulation of a fraudster from their own reprehensible conduct
  • protect society as a whole against conduct which would serve to degrade the betters interests of the public, such as:
    • excessive restrictive covenants
    • penalty clauses and
    • rules against forfeiture of property (which are a form of penalty clause).

2. public policy considerations:
   Competing objectives of public policy are balanced against one another.
   “Public policy” not a single policy.
   It is comprised by a number of different interests of the public, such as:

• • enforcing legally binding contracts
  • disallowing profit from unlawful conduct
  • deterring unlawful behaviour
  • maintaining consistency with the criminal law: if the criminal law imposes a penalty, the civil law should not provide the means to evade or reduce criminal consequences
  • maintaining the integrity of the legal system, such as:
    • prevention of fraudulent legal claims or those based on forged or manufactured documents
    • outlawing contracts to withhold evidence from a court
    • prohibiting contract which would lead to perjury

The assessment of competing public policies is required because an overly simplistic or narrow-minded approach may render important public policy objectives ineffective or less effective by denial of the claim or success of the claim.

3. proportionality:
   The response to illegal conduct from civil courts should be proportionate to the illegality.

The more serious or deliberate the illegality, the more hardened the approach a court is likely to be to deny remedies.
The criminal courts are there to punish criminal conduct on behalf of society: fine and penalties are imposed on behalf of society.

On the other hand, civil courts enforce private rights.
Civil court cases result in financial compensation and other remedies to recognise those rights: the private interests of members of the society are recognised. It’s required for society to function.
All illegal conduct is serious. Some crimes are more serious than others. Those involving fraud - wilful deception - are at the top of the list.
If a legal claim or defence is to be denied, it should be a proportionate response to the unlawful activity, taking account of factors such as:

• • the seriousness of the conduct of those participating in the lawless conduct
  • the main purpose of the contract in question
  • whether the unlawful conduct was intentional
  • whether there is a significant difference between the parties’ blameworthiness for the illegality
  • whether granting a remedy (or not) would undermine the legal system

The overarching objective of the assessment is to prevent people acting unlawfully from profiting from their own wrongdoing, and for the civil law to remain consistent with the criminal law.

 

Ex Turpi Causa

A particular standard needs to be met for a contract to be tainted by common law illegality.

Ex turpi causa is an abbreviation for the full form of the legal maxim, ex turpi causa non oritur action. It means “no disgraceful action may ground an action”. 

The legal policy implemented ex turpi causa is encapsulated in Holman v Johnson (1775) (see above).

In brief, ex turpi causa:

• describes a particular type of conduct
• indicates the measure of badness required to amount to a "disgraceful action": moral turpitude.

While different people may have different views on what is bad or unacceptable behaviour, it typically involves an element of deception: fraud in all of its forms, no matter how it might be dressed up.

It’s that quality that drags what you and I may think of bad behaviour down to the standard of serious immorality and subsequent illegality for the purpose of contract law.

It’s that sort of immorality that the interests of society – public policy - overrides the private party contractual interests in disputes.

 

Civil Case Example

In the Supreme Court decision, Patel v Mirza (2016):

An investor had paid £620,000 to a stockbroker.

The stockbroker was to use the money to bet on the movement of shares in Royal Bank of Scotland on the stock market, using inside information that was to be obtained: insider trading. It’s a type of contract illegal by statute.

Insider trading is a criminal offence.

The inside information never materialised, and the money was never used to buy stocks and shares. The planned insider trading never took place.

The illegal scheme was ultimately not carried out.

The investor sued the stockbroker for return of the money. When the stockbroker refused to return the money, the investor sued for its return. 

The Supreme Court ended up ordering the stockbroker to return the money to the investor.

The investor did not carry through with the plan. For that reason, it was not against the public interest to allow the investor to recover money paid over, although the money was paid for an illegal purpose.  

The illegal purpose of the contract was had not been performed. 

There are several morals to the story:

• Public policy does not prevent a party who had withdrawn from an illegal purpose from recovering the money paid in pursuance of that purpose
• By commencing the legal case, the investor was not seeking to profit from the arrangement. The investor was trying to unravel it
• If the money was not returned to the investor by the stockbroker, the stockbroker would have been unjustly enriched – made a profit by its own intended illegal purpose.

Restoring the parties to the position which they were in before the unlawful agreement fulfilled the legal policy considerations lying behind the doctrine of illegality in that case.

 

Crime Case Example

A claimant agreed to set fire to motor cars for the defendant for the purpose of making insurance claims for the vehicles for payment.

The claimant was arrested and detained. Bail conditions were set in place.

The claimant sued the other contracting party for payment of the amount agreed.

The agreement was illegal, and the arrest and jail time resulted from the main purpose of the agreement. It involved serious illegality: it was a conspiracy to defraud an insurance company. The claimant was not entitled to recover the amount agreed to be paid.

 

Illegality by Statute

Statutory illegality arises in two different ways:

• express: the statute states expressly that the contract of the type agreed or provisions in it are unenforceable, or
• implied: the illegality is implied from the statute.

Types of Statutory Illegality 

Statutory illegality can arise in at least 3 ways. For example a statute could:

• outlaw parties entering into a type of agreement
• render carrying on a particular activity or business illegal, without regulatory approval
• ban particular types of clauses designed to achieve a particular end or objective

When parties nevertheless do so, the contract is usually void for illegality. The rationale is that Parliament intended to outlaw the type of agreement, and legal effect is given to that intention by courts.

The legislative provision may also provide that the entire type of contract or some particular term, is unenforceable by one or other party, rather than outlaw it altogether.

Also, a statute can:

• ban one or more parties forming or performing a contract when they have no authority to do so, or
• impose a penalty if they do so.

When that happens, the contract is prohibited.

It does not necessarily follow that the contract is void or unenforceable by both parties.

It might only be enforceable by one of the parties. For one party it is enforceable, and for the other party it might be unenforceable.

Examples: Prohibited by Statute

• Short term money lenders are required to be licensed to lend money. If a lender is not licensed, the loan is probably unenforceable by the lender.
• In transport logistics, laws prevent overloading of trucks to ensure the safety of property, crews and the public.
  If a truck is accidentally overloaded, it is probably not illegal to defeat a claim for payment for the price of the freight.
  If the truck was deliberately overloaded or both parties knew of the overloading and did nothing to correct it, the contract is probably not enforceable by either party.

Thus it is possible that a type of contract may to be prohibited by statute, but the contract remains valid and enforceable.

Example: 

• Suppose a statute requires a party to have authorisation to carry out a type of services, such as for insurance
• Two parties enter into a contract for insurances services
• The would-be insurer doesn’t have authorisation to operate an insurance business

The contract of insurance or banking services entered into by the unauthorised insurance company is usually void. 

It’s void in the sense that the contract is deprived of any legal effect. That’s not to say that insured would be necessarily precluded from recovering premiums paid for insurance coverage.

 

Illegal Employment Contracts

Contracts of employment are governed by precisely the same law as business contracts.

They can be void, unenforceable and legal remedies may be available despite the illegality.

Accordingly, performing a contract of employment and committing an illegal or immoral act will not by itself destroy an employment contract unless:

• the contract itself is outlawed by statute, rendering it an illegal employment contract, or
• that was the purpose of the employment contract was illegal from the outset.

When an illegal employment contract has been made and an employee makes an unfair dismissal claim (which is a statutory right), there are two at least two competing public policy objectives. They include:

• Courts should not enforce contracts performed illegally.
  For example, employment law does not exist to protect those engaging in legal relationships to knowingly break the law by wilfully defrauding third parties and
• To uphold the statutory right not to be unfairly dismissed.

In employment contracts, knowledge of the facts and participation by the employee in the illegality are minimum requirements for the employee to be deprived of their employment rights.

Case Examples

• An employee participates in their employer’s PAYE fraud. The employee is not likely to be permitted to claim for unfair dismissal.
• An employee had been unlawfully trafficked to the UK by the employer. The employer could take advantage of the employee owing to their vulnerability, and did so before dismissing them.
  The employee sued for unlawful discrimination.
  The employer defended the claim on the basis that the employee participated in their own trafficking to the UK.
  The defence failed because the unlawful discrimination was not based on the employment contract (which was illegal). The claim was based on a statutory right which stood separately from the contract of employment
• A student worked in breach of the terms of their student immigration visa by working more than 20 hours a week during term.
  During vacations there was no limit to the number of hours that the student could work. The employee could not recover for all the hours worked over and above the allowance during term.

 

Are Zero Hours Contracts Illegal?

Contracts known as “zero hours contracts” are typically agreements where an individual or another company agrees to be paid for actual hours worked and:

• if no work has been performed, then no payment is due.
• there is no obligation to give the individual or company any work.

Zero hours contracts aren’t contracts of employment. They’re consultancy agreements. There is no employment relationship.

These types of contracts haven’t been outlawed by Parliament, and so of themselves are valid and enforceable unless there is something else that interferes with their illegality (see above).

By default they’re valid and lawful agreements due to the principals of freedom of contract.

 

Consequences of Illegal Contracts

The possibilities for the consequences of an illegal contract now rides on what is essentially a reasoned value judgment based on the particular circumstances of the illegality, the law that has been offended, the other factors to assess what the outcome should be.

The consequences of illegality include the possibilities of:

• money paid under an ineffective (eg a void) transaction may be recoverable
• reversing transfers of ownership of money and property
• not enforcing any claim by awarding compensation, injunctions or make a declaration that would result in a profit being made to a person acting illegally ... or making orders such as those to unwind transactions to avoid that consequence
• no remedy being ordered in favour of either party
• declare that loans and guarantees as void contracts
• severance of the terms of the contract, whereby the parts that remain constitutes an enforceable agreement.

 

Examples: Types of Illegality in Contracts

Illegality comes in all shapes and sizes, and any arise in any number of ways.

A provision in a contract which is illegal potentially taints the entire contract.

And the illegality does not need to appear in the contract itself.

It can operate outside the contract, however informally reached or how the parties to the contract actually refer to it or label it. For example, payments might be labelled an “introductory fees”, “service fees” or “maintenance fees”, but be bribes.

Contracts susceptible of being found illegal include the following.

Companies

• inducing shareholders by fraud to invest or buy shares in a company
• charging of illegal premiums for goods and services
• contracts to conceal a crime over the company
• contracts to return capital to shareholders other than the ways permitted by statute, which are:
  • a reduction of capital
  • redemption or purchase of shares in accordance with the relevant statutory provisions, and
  • a distribution in a winding up,

irrespective of how it might be dressed up

• breach of a director's fiduciary duty
• those cooperating with a director to help the director breach their duties might find themselves caught up in a conspiracy and jointly and severally liable with the director

Agents and Agency

• agents (whether independent contractors, suppliers, distributors, brokers) which:
  • breach their fiduciary duties to their principal to make an unauthorised profit from the agency relationship
  •  misuse money of the principal
  • receive a secret commission or bribe, which is properly considered (in law) as a payment to which the principal is entitled
  • pass on confidential information without authority, or use it for their own benefit or profit
  • mislead or deceive their principal

Invoicing, Payments and Referrals

• invoices produced as a result of bribery corruption or fraud, whether or not the bribe is paid
• Referrals of customers to businesses which the referring business knows that the customer will be defrauded

Inland Revenue

• agreements which avoid the proper tax due and payable to the Revenue, such as:
  • mortgage fraud
  • carousel fraud
  • PAYE fraud
  • avoidance of payment of stamp duty

Regulatory Authorities:

• misleading ratings authorities, such as the:
  • DVLA
  • Food Standards Agency
  • Valuation Office Agency, which sets business rates and council tax
• unlawfully manufacturing a state of affairs to receive social security payments
• elected members of local councils receiving financial reward for appointing contractors or having a pecuniary interest in a contract

Foreign Countries

• contravening the laws of a foreign country where performance would be illegal in that country  

Employment and Settlement Agreements

• • allocating a payment for redundancy when there is no entitlement to a redundancy payment
  • allocating a payment to redundancy when in reality it is a payment for shares

Insolvency and Liquidation

• • contracts to permit directors of a company retain assets of an insolvent company
  • agreements to facilitate fraudulent trading, that is, defraud creditors
  • contracts to transfer assets of a company at an undervalue
  • defrauding a trustee in bankruptcy
  • agreements to receive a higher sum in a composition agreement in an insolvent liquidation

Competition Law

• • price fixing, such as resale price maintenance, and suppliers attempts to set ranges of prices, discounts, or coordinate price increases
  • bid rigging which is the process of defeating competitive tendering processes, such as to predetermine the outcome of bidding
  • exchanges of sensitive information or trade secrets between competitors
  • agreements not to compete with other businesses, aka cartels

Tenancy Agreements

• • Recovering rent which was not lawfully required to be paid

 

Conclusion

Contracts are illegal or become illegal for all sorts of reasons.

Courts do not give effect to illegal transactions or rights arising from them and it defeats private rights when the claimant:

• would profit from an illegal or wrongful act
• pursues a cause of action based on an immoral or an illegal act
• would evade or reduce a penalty imposed by the criminal law.

Rights and remedies sometimes lie around the peripheries of the illegality.

Courts have power to revise transactions despite the illegality if it would mean that a profit or wrongdoing would remain in place.  The case law paves the way for recovery of benefits conferred under an illegal contract.

 

Contract Solicitors: Illegality Law

Contract illegality can arise in all sorts of ways.

Major differences can result from whether a contract is void agreement or just unenforceable. The difference adds complexity to an already difficult task of assessing your legal position, your rights and your potential liability.

Need a solicitor to advise you on a contract which you suspect - or know - is illegal?

Once we're engaged, legal professional privilege applies to our communications with you. We give confidential legal advice on illegality arising in the context of contract law, that is the civil law: we're not criminal lawyers, although we do know some good ones. 

If you're having trouble working out the consequences of illegality in a contract, or whether its available as a defence to a legal claim, we're available to advise you. 

It may be that something might be recovered despite the illegality from the situation.

If you need commercial legal advice from a law firm that advises on businesses disputes, call us on +44 20 7036 9282 or email us at contact@hallellis.co.uk.