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Chapter Eleven | Legality
Generally speaking, a contract which involves a violation of a statute or an administrative regulation, or which violates public policy is not enforceable by a court of law. Such a contract is void or is a nullity. Likewise, should the subject matter of a contract involve some form of criminal activity or the commission of a tort (a civil wrong), the contract is also void and unenforceable.
When only a part of a contract is illegal, and the illegal provision or portion does not involve serious moral turpitude, the illegal portion of the agreement may be disregarded and the legal part of the contract may be enforced. The contract is said to be divisible or severable. However, if the entire contract is so completely integrated that the parts cannot be separated, the entire agreement will be void and unenforceable.
An Agreement Contrary To Public Policy
Public policy is an important rationale used for striking down or refusing to enforce a contract or a clause of a contract on grounds of immorality, unconscionability, economic policy, unprofessional conduct, and other criteria. At the outset, it must be recognized that “public policy” is a somewhat vague area of the law. Even though a contract or an agreement may not violate some formal statute or regulation, a contract may still be unenforceable if it violates public policy. Public policy is determined by assessing a wide variety of statutes, court and administrative decisions, and public attitudes and perceptions about the nature of law and society. It is essentially a “legal value judgment” concerning the nature and type of contractual relationships a society will recognize and enforce.
Laos v. Soble
503 P.2d 978 (Ariz. 1972)
This is an appeal from a judgment in favor of defendants in a lawsuit to recover from them a fee purportedly due and owing to the plaintiff.
The plaintiff’s claim was predicated upon the following document, written in longhand and signed by attorney Soble:
”The case was tried to the court, both Laos and Soble testifying as to the circumstances which gave rise to this writing. The trial court, in ruling in defendants’ favor, apparently believed Soble’s version, i.e., that the agreed upon compensation was for Laos’ services as an appraisal witness in an impending condemnation trial. Since, according to him, he did not avail himself of such services, the obligation to pay Laos did not arise.
On appeal, Laos contends that the document upon which he relied reflects that he was entitled to judgment as a matter of law. We believe that the document reflects the contrary that, as a matter of public policy, the contract is illegal and therefore void. Although illegality was neither asserted in the trial court nor on appeal, we have a duty to raise such questions sua sponte when the face of the record reflects illegality.
An agreement to pay a witness a fee contingent on the success of the litigation is against public policy and void.
Professor Corbin points out that the use of “expert” testimony has been subject to grave abuses and that bargains for obtaining same should be under close supervision by the court. A similar concern was expressed in Belfonte v. Miller:
* * * The difficulties and dangers which surround so called expert testimony are well understood by the profession and it is the manifest duty of our courts to carefully scan all special compensation in addition to the witness fees allowed by the law * * * The rule applied to such contracts is not to be affected by proof that the behavior of the parties was in fact exemplary, for it is the tendency of such contracts which serves to generate their undesirability. Improper conduct or bias can be predicted easily when the compensation of the witness is directly related to the absolute amount of an award which may in turn be dependent to a great degree on the testimony of that same witness. * * *
We are of the opinion, and so hold, that a contract providing for compensation of a witness contingent on the success of the litigation is subversive of public justice for the reason that his evidence may be improperly influenced. Public policy considerations brand such contract illegal.
Although the trial court’s denial of plaintiff’s claim was correct, but for a different reason, we affirm.
Every state has adopted a variety of vocational and professional licensing statutes that regulate the professional and business conduct of certain groups or professions in society.
Types of Licenses
A regulatory license regulates the standards of conduct of certain professionals. In order to procure a regulatory-type license, certain baseline qualifications must be met. Qualifications may include possessing special skill, special knowledge, special training, or meeting a minimum educational level. In addition, the party seeking a regulatory license may be required to demonstrate that he or she has passed a professional certification or licensure examination.
A revenue license is often no more than an occupational tax. The purpose of revenue license is merely to raise revenue necessary to monitor the underlying activity. Any applicant will be granted the license upon the payment of the proper fee. A revenue license is also called a ministerial license. In deciding whether a particular license is regulatory or revenue in nature, it is important to assess the legislative intent and legislative history of the underlying statute mandating registration or licensure.
If a court concludes that a regulatory license is required, a party seeking enforcement of any underlying contract must prove that the proper license was in force at the time the contract came into existence. Failure to possess a regulatory license at the time any consideration is furnished prevents a court from enforcing an agreement concerning that professional activity or conduct. Where the purpose of the licensing statute is merely to raise revenue, an underlying contract may still be enforced, even though the required license had not been obtained. The individual, however, may be required to procure the proper license before any judgment is entered by the court.
Markus & Nocka v. Julian Goodrich Architects, Inc.
230 A.2d 739 (Vt. 1969)
The defendant was the principal architect on a project involving an addition to the DeGoesbriand Hospital in Burlington, Vermont. The hospital directed the defendant to engage the services of the plaintiff firm as consulting architects. The plaintiff is a Massachusetts architectural firm specializing in hospital design. The arrangement was accomplished and evidenced in an exchange of letters between the parties. The project with which the plaintiff was connected involved the development of an outpatient department, emergency department, laboratory and xray departments. The duties of the plaintiff included a study of the medical needs to be incorporated into the addition, inspection of the premises, consultation with hospital staff, preparation of construction and equipment estimates, detail drawings of specialized rooms, participation in revision of preliminary sketches, and provision of specifications for cost and bid purposes. The plaintiff’s staff made numerous trips to Burlington, consulting with hospital personnel and medical staff, and prepared plans and detailed drawings. As the matter finally wound up, the design recommendations of the plaintiff were not accepted by the hospital staff, and the new expansion was finally put out to bid and constructed on the basis of plans and working drawings of the defendant. The compensation of the plaintiff was to be 1 percent of construction cost plus travel expenses, and this 1 percent figure was the basis of the judgment in favor of the plaintiff awarded below.
It is unquestioned that these activities were carried on in connection with construction to be undertaken within Vermont. The facts show that the plans and sketches were developed based on information obtained from visits to the Vermont site and consultation with the Vermont hospital personnel. Indeed, the acts evidencing performance under the contract, sufficient at law or not, have no other relevance than to this Vermont project on its Vermont site. Thus they are within the ambit of the Vermont architectural registration statute. * * *
Architectural contracts entered into in violation of such registration statutes are held to be illegal, and the provisions for payment of commissions under them are unenforceable. The underlying policy is one of protecting the citizens of the state from untrained, unqualified, and unauthorized practitioners. It has been applied to many professions and special occupations for similar protective purposes. * * *
26 V.S.A. 121 specifically mentions consultation as one of the activities prescribed for one not registered. This is not to say that any kind of consultation between architects of different states can be contractually valid only with registration. It does mean that when the nonresident architect presumes to consult, advise, and service, in some direct measure, a Vermont client relative to Vermont construction he is putting himself within the scope of the Vermont architectural registration law. Nothing in that law suggests that the services must be somehow repetitive to be prohibited. No basis for excusing this plaintiff from its express provisions appears here. * * *
Judgment reversed and judgment for the defendants to recover their costs.
Covenants (Promises) Not to Compete
A covenant not to compete may be found in two general types of business contracts:
- A promise made by the seller of a business or of an enterprise to a buyer wherein the seller agrees not to open or be involved in a similar business in a specified geographic area for a specified period of time; or
- A clause which is part of an employment contract which restricts an employee from discussing or divulging so called “trade secrets” (special or limited insider information) or which restricts or completely forbids the employee from engaging in competition or going to work with a competitor when an employment contract is terminated.
A promise made by the seller of a business will be enforced if it is reasonable in terms of time, area, and scope. When the area is too broad or extensive or the time is too long for the reasonable protection for the buyer, a covenant not to compete will generally not be enforced.
Under a strict common law interpretation, if such a covenant “failed” in any respect (i.e., the court concluded that a covenant was unreasonable as to either time or area), the court could not enforce any part of the covenant. Nor would a court rewrite (reform) any of the provisions of a contract in order to make a provision reasonable. Why? First, courts do not really like such covenants and consider them to be in “restraint of trade.” Second, to rewrite a covenant to make it reasonable (i.e., twenty-five miles is unreasonable for a restaurant—ten miles is reasonable; 5 years is unreasonable for a barber—6 months is reasonable) would put the court in a position of actually writing the contract for the parties, subjecting the parties to an agreement they had not actually made.
An agreement by a person to refrain from exercising his or her trade or profession is generally viewed unfavorably by courts because it is “inimical to the interests of society in a free and competitive market and to the interests of the person restrained in earning a livelihood.” (See United States v. Addyston Pipe & Steel Co., 85 F. 271 (1898)). However, the covenant is enforceable if it is reasonable. In all cases, the covenant must be a part of a larger contract of employment, supported by consideration, or it may be termed as a “naked covenant” and denied enforcement by a court.
A covenant not to compete in a contract of employment is closely scrutinized by courts and will be strictly construed when enforcement is sought. The burden of proof is placed on the party seeking to enforce the covenant. Courts may ask the following questions when determining whether such a clause in a contract of employment will be enforceable:
- Is the restraint reasonable in the sense that it is no greater than necessary to protect the legitimate business interests of the employer in such areas as protection of trade secrets or other confidential information?
- Is the restraint unreasonable and unduly harsh on the employee in terms of time or area (especially extending into an area or territory in which the employee did not work)?
- Would the employee’s work for a competitor irreparably injure or harm the employer’s business or threaten such irreparable injury (especially with regard to an intangible such as “good will”)?
- Is the employment of a unique, extraordinary, or unusual type?
Courts are sometimes reluctant to enforce a covenant where the public will be denied a necessary or essential service. In this case, the court might in fact prefer to award monetary damages for the breach of the covenant instead of issuing an injunction or a restraining order. An example might be where a veterinarian agrees not to compete against his former associates for a period of three years. In the small farming community where the vet lives, there are no other vets. In these circumstances, a court might be reluctant to enforce the covenant because the public might be denied an important service. The court might instead award money damages against the vet for breach of the covenant, the amount to be determined as a matter of proof during a trial.
In recent years, some courts have in fact become more proactive concerning restrictive covenants. Several courts now follow the “blue pencil” rule, which permits the court to “strike out” any unreasonable provisions from an agreement and to modify the time or area to provide reasonable protection to the parties. The “blue pencil” rule has its origins in the doctrine of severability as applied to illegal contracts.
It should be noted that in a few states (most notably, California), an employer cannot restrict a regular employee, not in possession of any specialized information or “trade secrets,” from engaging in employment when the term of a contract ends, holding that such restrictions are void and a violation of public policy as a matter of law. In general, however, properly drawn covenants are enforceable and provide important protections in business relationships. One other exception occurs in the case of a covenant not to compete applicable to an attorney. Depending on the jurisdiction, such covenants may be judged as per se illegal on public policy grounds.
Read Frederick v. P.B.M. and consider the application of the rules discussed to the facts of the case. Did it surprise you that the lower court granted the injunction?
Frederick v. Professional Bldg. Main. Indus. Inc.
Court of Appeals of Indiana , 168 Ind. App. 647; 344 N.E.2d 299 (1976)
In 1967, appellee (PBM) employed Frederick as a management trainee in PBM’s contract cleaning and maintenance business. In 1972, Frederick resigned. When he then sought to engage in the contract maintenance business on a part time basis, PBM brought this action to enforce a covenant against competition. The trial court enjoined Frederick and he appeals. The issue is whether the covenant given by Frederick is enforceable.
It reads as follows:
James Frederick hereby covenants that he will not engage in contract maintenance business, including, but not limited to, janitorial services, window cleaning, floor cleaning, commercial or residential cleaning, either as a sole proprietor, partner, or agent or employee of a corporation or other business organization in the following localities:
The counties of Lake, Porter, La Porte and St. Joseph in Indiana; of Will and Cook, in Illinois, except Chicago; and the counties of Berrien and Van Buren in Michigan.
This covenant shall extend for a period of ten years from the date of termination of this contract.
Such covenants are in restraint of trade and are not favored by the law. However, they will be enforced if they are reasonable. * * * This determination must be made upon the basis of the facts and circumstances surrounding each case. It depends upon a consideration of the legitimate interests of the covenantee which might be protected, and the protection granted by the covenant in terms of time, space and the type of conduct or activity protected.
While the burden of proving the facts and circumstances rests with the party seeking to enforce the covenant, the ultimate determination of whether the covenant is reasonable is a question of law for the courts.
In addition, if the covenant as written is not reasonable, the Courts may not enforce a reasonable restriction under the guise of interpretation, since this would amount to the court subjecting the parties to an agreement they had not made.
In the case before us, the evidence discloses that Frederick was employed by PBM at a management level. Through his employment, Frederick acquired skills related to the performance of janitorial services provided by PBM and to the technique of surveying a proposed job and computing a competitive and profitable bid. However, the potential use by a former employee of merely skill and ability he has acquired will not justify a restraint.
Frederick was also privy to bidding and cost analysis which PBM considered confidential. While there was no evidence that this information was novel or unique, so as to construe it as a trade secret, it is apparent that it might be used in an effort to undercut PBM’s bids. * * *
The evidence disclosed that PBM conducted its operations in the eight counties enumerated in the covenant. However, it was not established that Frederick worked in all eight counties. * * * The covenant restraining him from engaging in the contract maintenance business was unreasonable in prohibiting activity in counties where he had not worked. * * *
No evidence was introduced bearing directly on the reasonableness of the covenant’s ten year term. * * *
Bringing these factors together, it appears that Frederick was to be restrained from acting not only as a proprietor but also as an employee in furnishing janitorial services by contract. The geographic area of the restriction was more broad than the area in which he worked. He was not in possession of any trade secrets, but did have pricing information which in the immediate short term, might enable him to undercut PBM. On this basis, he was to be restrained for ten years. Such a restraint is unreasonable, and the covenant is therefore void.
Usury involves a contract that carries an excessive and illegal rate of interest. Most states regulate the rate of interest by a specific statute. Such statutes typically provide for a “legal rate” where no rate has been stated in a contract, and a maximum rate that is the most that can be legally charged under all circumstances.
If a court determines that an agreement is usurious, a number of remedies are available. The majority of states today will deny recovery of any and all interest on usurious loans. Some states require the forfeiture of both principal and interest; other states permit the borrower to recover double or triple the interest previously paid. Still other states may permit the charging of a “legal rate” where the interest rate charged “inadvertently” surpassed the legal rate.
An exculpatory clause is a provision of a contract that relieves a party of liability for its own ordinary negligence. Exculpatory clauses are not favored by the courts and will be strictly construed against the party writing them.
At common law, courts would enforce exculpatory clauses on the ground of “freedom of contract,” especially where a contract was entered into by two private parties, and no gross negligence, fraud, willful injury, or violation of a law was involved. Later, courts modified their views and began to refuse to enforce an exculpatory clause in an employment relationship, so that an employer would be liable to employees for any negligence, despite the existence of an exculpatory clause.
However, where there is a public interest involved, an exculpatory clause will generally be held to be void and against public policy. A public interest is established where one of the parties is a public institution—one owned or operated by the government or some subsidiary or branch of the government, i.e., a public hospital, a public school, or a municipally owned parking facility. In recent years, some courts have significantly narrowed the number of parties who may exculpate themselves from liability and have created a new category, termed a “quasi-public” institution, which can not exculpate itself from liability based on its own negligence. A quasi-public institution may be defined as a private party or business entity that:
- Deals with a large number of people;
- Solicits the public business;
- Deals in a necessary and/or vital service (i.e., transportation, education, banking, etc.).
Read the case of HyGrade Oil v. New Jersey Bank. How did the court reach its conclusion that HyGrade Oil could not absolve itself from liability based on its own negligence? Do agree you with this view or do you subscribe to the notion of absolute “freedom of contract”? What was the decision of the court? What did Hy-Grade Oil actually win?
Hygrade Oil Co. v. New Jersey Bank
350 A.2d 279 (Super. Ct. N.J. 1975)
HyGrade Oil Company (plaintiff) brought this action against New Jersey Bank (defendant), which refused to credit HyGrade’s account with an amount assertedly deposited by HyGrade in the bank’s night depository box.
BISCHOFF, Judge. The resolution of this appeal requires us to determine whether a clause in a “night depository agreement” between a bank and a customer, providing that “the use of the night depository facilities shall be at the sole risk of the customer,” is valid and enforceable.
In February, 1974, in order to protect the increasing cash supply generated by operations of its fuel business, plaintiff’s manager, Flaster, signed a night depository agreement with defendant bank. This agreement (in printed form and apparently used by other banks in the area) contained the following provision:
* * * it is hereby expressly understood and agreed that the use of the night depository facilities is a gratuitous privilege extended by the bank to the undersigned for the convenience of the undersigned, and the use of the night depository facilities shall be at the sole risk of the undersigned.
It is clear that where a party to the agreement is under a public duty entailing the exercise of care he may not relieve himself of liability for negligence, and unequal bargaining power or the existence of a public interest may call for the rejection of such clauses.
The Uniform Commercial Code contains many provisions protecting banks in their daily operations. We find it significant that the Legislature provided in the same statute, that a bank may not, by agreement, disclaim responsibility for “its own lack of good faith or failure to exercise ordinary care” in the discharge of the duty imposed upon it by that statute.
A review of the cases in other states considering the validity of similar exculpatory clauses in night depository contracts indicates that the majority rule is to give full force and effect to the clauses.
The basic theory underlying these and other similar cases is that the absence of an agent of the bank when the night depository facilities are used creates the possibility of dishonest claims being presented by customers. In New Jersey we have rejected such a thesis in other situations and have held that the possibility of fraudulent or collusive litigation does not justify immunity from liability for negligence.
Other courts have refused to recognize the validity of such clauses. In holding such a clause inimical to the public interest, the court in Phillips Home Furnishings, Inc. v. Continental Bank (1974) said:
We find the public need for professional and competent banking services too great and the legitimate and justifiable reliance upon the integrity and safety of financial institutions too strong to permit a bank to contract away its liability for its failure to provide the service and protections its customers justifiably expect, that is, for its failure to exercise due care and good faith. * * *
We therefore hold that a bank cannot, by contract, exculpate itself from liability or responsibility for negligence in the performance of its functions as they concern the night depository service.
Judgment for New Jersey Bank reversed.
How did the court reach its conclusion that HyGrade Oil could not absolve itself from liability based on its own negligence? Do agree you with this view or do you subscribe to the notion of absolute “freedom of contract?” What was the decision of the court? What did Hy-Grade Oil actually win?
Under what circumstances should a court involve itself in re-writing a covenant not to compete when the court determines the time period of the restraint is unreasonable?
At what point should a court permit a party to rescind a bid when it has made a clerical error in putting forth its bid? What about the case where there has been a major increase in the price of an underlying component in a contract which has skyrocketed in price because of something over which a party had no control? If the court permits a rescission of a contract, what does this say about the “sanctity of contracts?” And, what about the rights of the other party to the contract?
Laos v. Soble
- What defense did Soble raise at the trial?
- What standard did the court apply on appeal? How was this issue raised?
- What was Professor Corbin’s view of such circumstances?
- Why did the court affirm the lower court’s decision?
- What is “public policy”?
- What is “expert testimony”? What type of testimony can expert witnesses offer that other witnesses cannot offer? Do some research about the Daubert Rule.
Marcus & Nocka v. Julian Goodrich Architects
- What service was the plaintiff to perform?
- Why was that fact critical?
- What was the basis of the judgment of the lower court?
- What is the policy behind a registration statute?
- The defendants were able to recover their costs. What are such “costs”?
Frederick v. Professional Building Maintenance Industries, Inc.
- What was the time period and area provided in the covenant?
- What is such a covenant called?
- What view does the court take of such covenants? Why?
- When might such a covenant be enforced by a court?
- Where will we usually find such covenants?
- What is the usual remedy sought in such cases?
- Why doesn’t the court simply rewrite a covenant to make it reasonable?
- What is the “blue pencil” rule?
- Who bears the burden of proof concerning such covenants?
- What are “trade secrets”? What is “good will”?
Hy-Grade Oil v. New Jersey Bank
- What Why did Hy-Grade Oil sue its bank?
- How did the bank defend? What was the basis of its defense?
- How did the court arrive at its decision?
- What was the decision? Did that mean that Hy-Grade Oil will have its account properly credited?
- What is a public institution?
- What is a quasi-public institution?
- What is an exculpatory clause?
- How can a party legally limit its liability for its own negligence?