Incapacity and contract law

11.4       The assumption underlying any contract is that each party has freely entered into a binding agreement, having assessed whether or not the terms are in their best interests. Some categories of person—including minors and people with impaired mental capacity—have traditionally been regarded by the law as being incapable of looking after their own interests, and through various rules, a ‘legal disability’ has been imposed on them.[1]

11.5       Generally, if a person with a legal disability attempts to make a contract, that contract can be declared ineffective.[2] Contract law does not, however, require a person’s ability to understand the implications of a contract to be assessed. Instead, the common law developed a complex set of rules categorising transactions, especially by minors, in terms of whether there is a legal disability.

11.6       In practice, the existing law of contract may work for the benefit of persons with impaired decision-making ability. A contract may be avoided on the ground that a person lacked the capacity to understand the consequences of entering into it. It has been said that:

This rule (probably by accident), reflects the modern realisation that mental incapacity has a wide variety of forms with very different degrees of impairment. The idea that people should be presumed to be capable unless shown to be otherwise enhances their dignity and capacity to manage their affairs. The treatment of contracts as binding unless avoided complements this approach.[3]

11.7       In order to avoid the contract on the ground of incapacity, the onus is on the party seeking to have the contract avoided to first establish that: (a) the contracting party was unable, due to mental impairment, to understand the contract at the time of formation; and (b) that the other party either knew or ought to have known of the impairment. This is said to be very similar to the law relating to unconscionable conduct[4]—which is given statutory recognition in the Australian Consumer Law (ACL).[5]

11.8       Effectively, the common law recognises a presumption of capacity—legal agency—and treats contracts as binding unless avoided. Arguably, any reform that required more scrutiny of capacity may work against the interests of persons with impaired decision-making ability to enter into contracts.

11.9       For example, introducing any new functional test of decision-making ability (as recommended in other areas of law) into contract law may be counterproductive—it would not necessarily assist people, and may deprive them of the ability to contract, or make contracting so risky for the other party, that they will refuse to enter into contractual relations.

11.10   Arguably, abolishing the common law relating to contractual incapacity in its entirety would have no adverse consequences, as questions about the validity of a contract could be dealt with satisfactorily by the laws relating to unfair and unconscionable contracts, undue influence and misrepresentation.[6]

11.11   However, in practice, such a reform may have limited benefit as the likely outcomes of legal disputes about the validity of contracts would be the same. Any reform would be constitutionally problematic as there is no head of Commonwealth legislative power dealing specifically with contract law. Reform covering all contracts would likely require the cooperation of states and territories either under a referral of power to the Commonwealth Parliament (s 51(xxxvii)) or through the enactment of model laws in all jurisdictions.[7]