6.1 General Perspectives on Illegality

Our study now turns to the legality of the underlying bargain of a contract. The basic rule is that parties can enter a contract for any lawful purpose, and therefore courts will not enforce an illegal bargain. But why should the courts refuse to honor contracts made privately by people who presumably know what they are doing—for example, a wager on the World Series or a championship fight? Two reasons are usually given. One is that refusal to enforce such an agreement helps discourage unlawful behavior; the other is that honoring such contracts would demean the judiciary. It is unclear whether such limitations discourage parties from entering unlawful agreements. For instance, a man hired to commit a murder is not in the least deterred by the fact that the courts are not open to him to collect his fee. So, the protection of the good name of the judicial institution must provide the principal reason for denial of a remedy to one who has made an illegal bargain. Implementing this rule means that a promisee who has already performed under an illegal contract can neither obtain performance of the act for which he bargained nor recover the money he paid or the value of the performance he made. The court will simply leave the parties where it finds them, meaning that one of the parties will have received an uncompensated benefit, and the other will have no lawful remedy.

Following this notion, the courts have created several exceptions to the general rule. Not surprisingly, the severity of the rule against enforcement has led courts to seek ways to moderate its impact, chiefly by modifying it according to the principle of restitution. In general, restitution requires that one who has conferred a benefit or suffered a loss should not unfairly be denied compensation. Thus, a party who is excusably ignorant that his promise violates public policy and a party who is not equally in the wrong may recover restitution. Likewise, when a party “would otherwise suffer a forfeiture that is disproportionate in relation to the contravention of public policy involved,” restitution will be allowed. Other exceptions exist when the party seeking restitution withdraws from the transaction contemplated in the contract before the illegal purpose has been carried out and when “allowing the claim would put an end to a continuing situation that is contrary to the public interest.” An example of the latter situation occurs when two bettors place money in the hands of a stakeholder. If the wager is unlawful, the loser of the bet has the right to recover his money from the stakeholder before it is paid out to the winner.

Though by and large courts enforce contracts without considering the worth or merits of the bargain they incorporate, freedom of contract can conflict with other public policies. Tensions arise between the desire to let people pursue their own ends and the belief that certain kinds of conduct should not be encouraged. Thus, a patient may agree to be treated by an herbalist, but state laws prohibit medical care except by licensed physicians. Law and public policies against usury, gambling, obstructing justice, bribery, corrupt influence, perjury, restraint of trade, impairment of domestic relations, and fraud all significantly affect the authority and willingness of courts to enforce contracts.

In this chapter, we will consider two types of illegality: (1) that which results from a bargain that violates a statute and (2) that which the courts deem contrary to public policy, even though not expressly set forth in statutes.

6.2 Agreements in Violation of Statute

Any bargain that violates the criminal law—including statutes that govern extortion, robbery, embezzlement, forgery, some gambling, licensing, and consumer credit transactions—is illegal. Thus, determining whether contracts are unlawful may seem to be an easy enough task. Clearly, whenever the statute itself explicitly forbids the making of the contract or the performance agreed upon, the bargain (such as a contract to sell drugs) is unlawful. But when the statute does not expressly prohibit the making of the contract to engage in an unlawful act, courts examine a number of factors.

It is important to remember that statutes can vary from jurisdiction to jurisdiction, and, thus, what might be unlawful conduct in one state might be lawful in another – making a contract valid in one state yet void in another.

Gambling Contracts

A gambling contract is an agreement between two or more parties to wager or bet on the outcome of a future event or contest over which the bettors have no control and which typically involves chance. These contracts are generally considered illegal due to a variety of legal and public policy concerns. Some of the concerns about these contracts include gambling addiction, financial hardship, the potential for fraud, and other social problems like potentially attracting criminal elements who are lured by the prospect of making easy money. That said, many states do have some kinds of gambling that have been legalized and regulated, including state-sponsored lotteries.

Because the outcome is contingent on events that lie outside the power of the parties to control does not transform a bargain into a gambling contract. For example, if a parent says to his daughter, “I’ll bet you can’t get an A in organic chemistry. If you do, I’ll give you $50,” this is not a gambling contract, but a unilateral contract, the consideration to the father being the daughter’s achieving a good grade.

Despite the general rule against enforcing wagers, there are exceptions, most statutory but some rooted in the common law. The common law permits the sale or purchase of securities: Sally invests $6,000 in stock in Acme Company, hoping the stock will increase in value, though she has no control over the firm’s management. It is not called gambling; it is considered respectable risk-taking in the capitalist system, or “entrepreneurialism.” Insurance contracts are also speculative, but unless one party has no insurable interest (a concern for the person or thing insured) in the insured, the contract is not considered a wager.

Sunday Contracts

At common law, contracts entered into on Sundays, as well as other commercial activities, are valid and enforceable. However, there are some state statutes or local ordinances that regulate or restrict certain activities, including entering into contracts, on Sundays or other specific days of the week, often due to religious or historical reasons. These laws vary significantly from one jurisdiction to another, but they often address matters such as retail sales, alcohol consumption, and recreational activities.

These laws trace to the Second Commandment which frowns on work performed on “the Lord’s Day.” In 1781, a New Haven city ordinance banning Sunday work was printed on blue paper, and since that time such laws have been known as ‘blue laws.’ The first statewide blue law was enacted in the United States in 1788; it prohibited travel, work, sports and amusements, and the carrying on of any business or occupation on Sundays. The only exceptions in most states throughout most of the nineteenth century were mutual promises to marry and contracts of necessity or charity. As the Puritan fervor wore off and citizens were, more and more, importuned to consider themselves “consumers” in a capitalistic economic system, the laws have faded in importance and have mostly repealed or unenforced. That said, New Jersey still has many Blue laws within the state and in specific municipalities. For instance, in the Borough of Paramus New Jersey, local ordinance code §391-2 provides:

Sunday activities restricted.

No worldly employment or business, except works of necessity and charity, shall be performed or practiced by any person within the Borough on the first day of the week, commonly called and hereinafter designated as “Sunday.”

Thus, many businesses located in the Borough of Paramus, including the Paramus Park Mall are closed on Sundays.

Usury

A usury statute is one that sets the maximum allowable interest that may be charged on a loan; usury is charging illegal interest rates. Formerly, such statutes were a matter of real importance because the penalty levied on the lender—ranging from forfeiture of the interest, or of both the principal and the interest, or of some part of the principal—was significant. But usury laws, like Sunday contract laws, have been relaxed to accommodate an ever-more-frenzied consumer society. There are a number of transactions to which the laws do not apply, varying by state: small consumer loans, pawn shop loans, payday loans, and corporate loans. In Marquette v. First Omaha Service Corp., the Supreme Court ruled that a national bank could charge the highest interest rate allowed in its home state to customers living anywhere in the United States, including states with restrictive interest caps. Thus it was that in 1980m Citibank moved its credit card headquarters from cosmopolitan New York City to the somewhat less cosmopolitan Sioux Falls, South Dakota. South Dakota had recently abolished its usury laws, and so, as far as credit-card interest rates, the sky was the limit. That appealed to Citibank and a number of other financial institutions, and to the state of South Dakota because it became a major player in the U.S. financial industry, creating many jobs in the state. 

Licensing Statutes

To practice most professions and carry on the trade of an increasing number of occupations, states require that providers of services possess licenses—hairdressers, doctors, plumbers, real estate brokers, anglers, egg inspectors, and, yes, lawyers are among those on a long list. As sometimes happens, though, a person may contract for the services of one who is unlicensed, either because (1) they are unqualified and conducting business without a license or (2) because for technical reasons (e.g., forgetting to mail in the license renewal application) they do not possess a license at the moment. To better understand the impact of a license or its lack, suppose that Robin calls Paul to provide legal services in drafting a contract. Paul, who does not have a license to practice law, drafts a contract for Robin’s purpose. Robin then discovers that Paul does not have a law license, and refuses to pay Paul for the contract. Is Paul entitled to collect the fee?

The answer to this question requires a three-step analysis. First, some occupations may be performed without a license (e.g., lawn mowing). Other occupations may be performed with or without certain credentials, the difference lying in what the professional may tell the public. For instance, an accountant need not be a certified public accountant to carry out most accounting functions. Still, some occupations require a license as a minimum requirement to perform a specific type of work. It is safe to assume that in the example above, Paul is required to hold a valid license to practice law to perform legal work for Robin.

The second step is to determine whether the licensing statute explicitly bars recovery by someone who has performed work while unlicensed. Reading the statute would be required to determine this, but many statutes do not contain a specific provision on the point. Statutes that do bar recovery would end our analysis, but let’s assume that the statute in this scenario is silent on the practice of law without a license.

When a statute is silent, the third step of the analysis is to distinguish between “regulatory” and “revenue” licenses. A regulatory license is intended to protect the public health, safety, and welfare. To obtain these licenses, the practitioner of the art must generally demonstrate his or her abilities by taking some sort of examination, like the bar exam for lawyers or the medical boards for doctors. A revenue license generally requires no such examination and is imposed for the sake of raising revenue and to ensure that practitioners register their address so they can be found if a disgruntled client wants to serve them legal papers for a lawsuit. Some revenue licenses, in addition to requiring registration, require practitioners to demonstrate that they have insurance. A license to tend bar, available to anyone 21 or older who applies and pays the required fee, would be an example of a revenue license. In our example, a lawyer’s license is a regulatory license.

If a state requires a professional license, it is necessary to determine whether the license is regulatory or revenue raising. Generally speaking, failure to hold a regulatory license bars recovery and such a contract would be void as illegal, but the absence of a revenue license does not bar recovery — the person may obtain the license and then move to recover.

6.3 Bargains Made Illegal by Common Law

Unsurprisingly, courts do not want to enforce contracts that violate established societal norms, laws, or public interests. When a contract is deemed to be against public policy, a court will typically refuse to enforce it, rendering it void. In determining whether to enforce a contract where there is no statute, courts must ordinarily balance the interests at stake. To strike the proper balance, courts must weigh the parties’ expectations, the forfeitures that would result from denial of enforcement, and the public interest favoring enforcement against these factors: the strength of the policy; whether denying enforcement will further the policy; the seriousness and deliberateness of the violation; and how direct the connection is between the misconduct and the contractual term to be enforced. After weighing these factors, if a court determines that a contract is against public policy, the bargain would be rendered unlawful under common law.

 

Common-Law Restraint of Trade

One of the oldest public policies evolved by courts is the common-law prohibition against restraint of trade. A contract in restraint of trade is an agreement in which one party agrees to limit its ability to engage in a certain trade, profession, or business activity, usually for a specific time period and within a specific geographic area. Evolving from early contracts that fixed prices or agreed not to exclusive sales territories, today these contracts are typically concerned with promises not to compete in sales of businesses and employment contracts.

Not all restraints on trade are unlawful; only unreasonable ones are. As the Restatement puts it, “Every promise that relates to business dealings or to a professional or other gainful occupation operates as a restraint in the sense that it restricts the promisor’s future activity. Such a promise is not, however, unenforceable, unless the restraint that it imposes is unreasonably detrimental to the smooth operation of a freely competitive private economy.” An agreement that restrains trade will be construed as unreasonable unless it is ancillary to a legitimate business interest and is not more restrictive than is necessary to protect the legitimate interest. Restraint-of-trade cases usually arise in two settings: (1) the sale of a business and an attendant agreement not to compete with the purchasers and (2) an employee’s agreement not to compete with the employer should the employee leave for any reason.

Sale of a Business

A first common area where a restraint-of-trade issue may arise is with the sale of a business. Regina sells her lingerie store to Victoria and promises not to establish a competing store in town for one year. Since Victoria is purchasing Regina’s goodwill (the fact that customers are used to shopping at her store), as well as her building and inventory, there is clearly a property interest to be protected. And the geographical limitation (“in town”) is reasonable if that is where the store does business. But if Regina had agreed not to engage in any business in town, or to wait ten years before opening up a new store, or not to open up a new store anywhere within one hundred miles of town, she could void the noncompetition terms of the contract because the restraint in each case (nature, duration, and geographic area of restraint) would have been broader than necessary to protect Victoria’s interest.

Employment Noncompete Agreements

A second common restraint-of-trade issue arises with regard to noncompete agreements in employment contracts. As a condition of employment by the research division of a market research firm, Bruce, a product analyst, is required to sign an agreement in which he promises, for a period of one year after leaving the company, not to “engage, directly or indirectly, in any business competing with the company and located within fifty miles of the company’s main offices.” The principal reason recited in the agreement for this covenant not to compete is that by virtue of the employment, Bruce will come to learn a variety of internal secrets, including client lists, trade or business secrets, reports, confidential business discussions, ongoing research, publications, computer programs, and related papers. Is this agreement a lawful restraint of trade?

Here both the property interest of the employer and the extent of the restraint are issues. Certainly, an employer has an important competitive interest in seeing that company information not walk out the door with former employees. Nevertheless, a promise by an employee not to compete with his or her former employer is scrutinized carefully by the courts as it restricts the employee from future work opportunities. Moreover, these types of contracts often arise from a take it or leave it negotiation with the employer where the employee is in a weak bargaining position. For these reasons, many courts are not enthusiastic about employment noncompete agreements, and in some states courts refuse to enforce such agreements. Other states view them more favorably as long as they are reasonable.

If a covenant not to compete is ruled unlawful, the courts can refuse to enforce the entire covenant, freeing the employee to compete thenceforth. Or, the court could delete from the agreement only that part that is unreasonable and enforce the remainder of the agreement, or even rewrite the objectionable clause themselves. If a court decides to enforce a noncompete agreement, it could issue an injunction to assure that the past employee does not violate the agreement.

Unconscionable Contracts

Courts may refuse to enforce unconscionable contracts, those that are very one-sided, unfair, the product of unequal bargaining power, or oppressive; a court may find the contract divisible and enforce only the parts that are not unconscionable.

The common-law rule is reflected in the Restatement: “If a contract or term thereof is unconscionable at the time the contract is made a court may refuse to enforce the contract, or may enforce the remainder of the contract without the unconscionable term, or may so limit the application of any unconscionable term as to avoid any unconscionable result.”

And the Uniform Commercial Code (UCC) provides a similar rule in Section 2-302(1): “If the court as a matter of law finds the contract or any clause of the contract to have been unconscionable at the time it was made the court may refuse to enforce the contract, or it may enforce the remainder of the contract without the unconscionable clause, or it may so limit the application of any unconscionable clause as to avoid any unconscionable result.”

Unconscionable is not defined in the Restatement or the UCC, but cases have given gloss to the meaning, as in Williams v. Walker-Thomas Furniture Co., a well-known early interpretation of the section by the D.C. Court of Appeals.

Unconscionability may arise procedurally or substantively. A term is procedurally unconscionable if it is imposed upon the “weaker” party because of fine or inconspicuous print, unexpected placement in the contract, lack of opportunity to read the term, lack of education or sophistication that precludes understanding, or lack of equality of bargaining power. Substantive unconscionability arises where the affected terms are oppressive and harsh, where the term deprives a party of any real remedy for breach. Most often—but not always—courts find unconscionable contracts in the context of consumer transactions rather than commercial transactions. In the latter case, the assumption is that the parties tend to be sophisticated businesspeople able to look out for their own contract interests.

Exculpatory Clauses

The courts have long held that public policy disfavors attempts to contract out of tort liability. Exculpatory clauses that exempt one party from tort liability  for harm to the other caused intentionally or recklessly are unenforceable without exception. A contract provision that exempts a party from tort liability for negligence is void under two general circumstances: (1) when it “exempts an employer from liability to an employee for injury in the course of his employment” or (2) when it exempts one charged with a duty of public service and who is receiving compensation from liability to one to whom the duty is owed.  Contract terms with offensive exculpatory clauses may be considered somewhat akin to unconscionability.

To be enforced, exculpatory clauses must be reasonable. Exculpatory clauses will generally be held valid if (1) the agreement does not involve a business generally thought suitable for public regulation (a twenty-kilometer bicycle race, for example, is probably not one thought generally suitable for public regulation, whereas a bus line is); (2) the party seeking exculpation is not performing a business of great importance to the public or of practical necessity for some members of the public; (3) the party does not purport to be performing the service to just anybody who comes along (unlike the bus line); (4) the parties are dealing at arms’ length, able to bargain about the contract; (5) the person or property of the purchaser is not placed under control of the seller, subject to his or his agent’s carelessness; or (6) the clause is conspicuous and clear.

Obstructing the Administration of Justice or Violating a Public Duty

It is well established under common law that contracts that would interfere with the administration of justice or that call upon a public official to violate a public duty are void. Examples of such contracts are numerous: to conceal or compound a crime; to pay for the testimony of a witness in court contingent on the court’s ruling; to suppress evidence by paying a witness to leave the state; or to destroy documents. Thus, in a case in Arkansas, a gambler sued a circuit court judge to recover $1,675 allegedly paid to the judge as protection money, and the Arkansas Supreme Court affirmed the dismissal of the suit, holding, “The law will not aid either party to the alleged illegal and void contract…‘but will leave them where it finds them, if they have been equally cognizant of the illegality.’” Also in this category are bribes, agreements to obstruct or delay justice (jury tampering, abuse of the legal process), and the like.

Family Relations

Another broad area in which public policy intrudes on private contractual arrangements is that of undertakings between couples, either prior to or during marriage. Marriage is a relationship defined by statutory law, and individuals have limited ability to change its scope through legally enforceable contracts. Moreover, marriage is an institution that public policy favors, and agreements that unreasonably restrain marriage are void. Thus, a father’s promise to pay his twenty-one-year-old daughter $100,000 if she refrains from marrying for ten years would be unenforceable. However, a promise in a postnuptial (after marriage) agreement that he will provide his wife with a fixed income for as long as she remains unmarried after his death if he predeceases her is valid because the offer of support is related to the need. Property settlements before, during, or upon the breakup of a marriage are generally enforceable since property is not considered to be an essential incident of marriage. But agreements in the form of property arrangements that tend to be detrimental to marriage are void—for example, a prenuptial (premarital) contract in which the wife-to-be agrees to leave the marriage on demand of the husband-to-be and to renounce any claims upon the husband-to-be at any time in the future in return for which he will pay her $100,000. Separation agreements are not considered detrimental to marriage as long as they are entered after or in contemplation of immediate separation; but a separation agreement must be “fair” under the circumstances, and judges may review them upon challenge. Similarly, child custody agreements are not left to the whim of the parents but must be consistent with the best interest of the child, and the courts retain the power to examine this question.

The types of contracts or bargains that might be found illegal are innumerable, limited only by the ingenuity of those who seek to overreach.

6.4  Exceptions to Illegality

As stated in the outset of this Chapter, the general rule is that courts will not enforce illegal bargains. The parties are left where the court found them, and no relief is granted: it’s a hands-off policy. The illegal agreement is classified as void, and that a wrongdoer has benefited to the other’s detriment does not matter. For example, suppose a specialty contractor, statutorily required to have a license, constructs a waterslide for Plaintiff, when the contractor knew or should have known he was unlicensed. Plaintiff discovers the contractor is unlicensed and refuses to pay the contractor $80,000 remaining on the deal. Under the general rule of non-enforcement, the contractor will not get paid. 

As always in the law, there are exceptions, and this is true even when discussing illegal contracts. There are limited instances where a court might permit one party to recover, but those instances do exist, and are discussed below.

Party Withdrawing before Performance

A party that has withdrawn from a contract prior to performance in an illegal bargain may be entitled to seek restitution. For example, Samantha and Carlene agree to bet on a soccer game and deliver their wagers to the stakeholder. Subsequently, but before the game, Carlene discovers the wager is unlawful and decides she no longer wants the bet. She notifies Samantha and the stakeholder. In this case, a court may permit her to get her money back from the stakeholder.

Party Protected by Statute

When a party is protected by a statute, it can have a significant impact on the legality or enforceability of a contract. In contract law, statutes and regulations can override or modify the terms of a contract and may provide protections to one or both parties. For example, securities laws forbid the sale or purchase of unregistered offerings—such a contract is illegal. Yet even with the illegality, the statute allows the purchaser of the unregistered offerings the right of rescission (return of the money paid), so there is still a contract remedy.

Party Not Equally at Fault

When both parties to a contract are equally responsible for the illegal conduct, called ‘in pari delicto‘, the court is more likely to refuse to enforce the contract for both parties. Neither party is favored since both have “unclean hands.” However, there are situations where one party is less culpable or less involved in the illegal conduct than the other party. In such cases, the court may be more lenient toward the party with lesser fault. If one party induces another to make an illegal contract by undue influence, fraud, or duress; the party with lesser fault in the illegality can recover their consideration.

Excusable Ignorance

Excusable ignorance occurs when one party to the contract was genuinely unaware of the contract’s illegal nature. This ignorance may arise due to a lack of knowledge about specific laws or regulations, misrepresentation by the other party, or other reasonable factors that prevented the party from recognizing the illegality. For example, a laborer is hired to move sealed crates, which contain illegal drugs. Although it is unlawful to sell and ship these drugs, the laborer can still be payed for services due to excusable ignorance.

Partial Illegality

Partial illegality in contracts refers to a situation where only a portion of a contract is illegal, while the remainder of the contract is lawful and enforceable. In cases of partial illegality, the court may choose to sever or remove the illegal portion while upholding the valid portions of the contract, provided that the legal and illegal aspects are distinct and separable. For example, a six-page employment contract contains two paragraphs of an illegal noncompete agreement. The illegal part is thrown out, but the legal parts are enforceable.

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References

Article IV, Section VII, paragraph 2 of the New Jersey

California Business and Professions Code, Section 16600.

Harold C. Havighurst, review of Corbin on Contracts, by Arthur L. Corbin, Yale Law Journal61 (1952): 1143, 1144–45.

Henrioulle v. Marin Ventures, Inc., 573 P.2d 465 (Calif. 1978).

Marquette v. First Omaha Service Corp., 439 U.S. 299 (1978).

Pacific Custom Pools, Inc. v. Turner Construction, 94 Cal. Rptr. 2d 756 (Calif. 2000).

Raimondo v. Van Vlerah, 325 N.E.2d 544 (Ohio 1975).

Ransburg v. Haase, 586 N.E. 2d 1295 (Ill. Ct. App. 1992).

Thomas M. Reardon, “T. M. Reardon’s first-hand account of Citibank’s move to South Dakota,” NorthWestern Financial Review, September 15, 2004.

Restatement (Second) of Contracts, Section 178.

Restatement (Second) of Contracts, Section 186(a).

Restatement (Second) of Contracts, Section 195.

Restatement (Second) of Contracts, Section 197(b).

Womack v. Maner, 301 S.W.2d 438 (Ark. 1957).

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