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Contractual Illegality & Public Policy: Definition, Examples & Issues

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  • 0:07 Contractual Illegality
  • 2:47 Gann v. Morris
  • 6:08 Lesson Summary
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Lesson Transcript
Instructor: Kat Kadian-Baumeyer

Kat has a Master of Science in Organizational Leadership and Management and teaches Business courses.

Contracts, in general, contain six elements that must be present. One such element is legal object. This means that the terms of a contract must be legal and not against public policy.

Contractual Illegality v. Public Policy

Contracts are legally binding agreements between two or more parties and are made up of six elements that must be present for a contract to be considered enforceable.

The six elements include:

  • Offer
  • Acceptance
  • Consideration
  • Capacity of the parties
  • Intent of both parties
  • Object of the contract

Our focus is on the sixth element of object of the contract, and it says that a contract cannot violate law or public policy. Obviously, a contract cannot contain language that binds parties to perform an illegal act, like murder for hire or the sale of illicit drugs. But, a contract also cannot violate public policy, the set of unwritten societal laws that all citizens are expected to follow. Said a different way, a contract cannot contain terms that breach law or harm society, like adultery.

The best way to think about statutory law and public policy is to think of it this way: Public policy tells us that there are certain things we ought to do for society, and in many instances, laws are created to ensure that public policy is followed. Let's use a few examples. It is not right to discriminate against others based on race, gender or sexual preference. In order to enforce anti-discrimination, the Civil Rights Act of 1964 was enacted to make it unlawful to discriminate against a protected group in employment, housing and education.

Bringing this back to contract law, sometimes a contract is written based on public policy, yet there is no law that directly enforces the policy. For example, when a person sells their business, it is public policy that they don't take their client list and start a new business that is the same as the one they just sold. This is mostly because if the previous owner takes all of his clients away, the new owner will no longer have customers. While this is not a law, it generally comes in the form of a covenant, or binding agreement, written into the business sale contract.

In cases where both the plaintiff and the defendant violated public policy or broke the law, the doctrine of in pari delicto applies. This doctrine was created to keep the courts from mediating cases where both parties acted against the law or public policy. It says a plaintiff who acted wrongfully cannot collect from the defendant. Let's see how the court ruled on an interesting case in where a covenant in the business sale was violated.

Gann v. Morris, Appellate (1979)

In Gann v. Morris, Alfred and Connie Gann, plaintiff-appellees, purchased a Tucson, Arizona, silk screening shop from the owner and defendant-appellant, Gerry Morris. When the contract for purchase of the business was written, it included a covenant restricting Morris from entering into the silk screening business for a period of 10 years and within 100 miles of Gann's shop and seizure of his client list.

Sometime after the sale of the business, Morris competed with the Ganns for silk screening business. He also elicited business from past clients - the clients that were part of the covenant both parties signed. The Ganns cried foul play and sued for breach of contract on the grounds that Morris violated the covenant by competing with Gann for business and failing to refer business under the terms of the agreement.

Morris contended that he was in the right to accept the business and that the covenant was unenforceable under the public policy of the restraint of trade doctrine. This doctrine restricts competition between parties and contains time and distance clauses by imposing a reasonable time frame for non-competition as well as a geographical distance restriction for conducting business. The parties, the type of business and the purpose for the covenant can determine the issue of what is reasonable.

For example, in an employment contract, a non-compete covenant may restrict an employee from working in a same or similar business for a period of one year, but it cannot limit an employee's ability to be gainfully employed. With business sales, the courts want to be sure that the covenant does not completely restrict business efforts of the seller.

In the case of Gann v. Morris, the covenant was deemed reasonable. Even though the covenant restricted Morris from entering into the silk screening business, there were time and distance limitations. In other words, Morris could set up shop in a city that extended past a 100-mile radius. He may also return to Tucson after the 10-year limitation expires.

On appeal, the court ruled in favor of the Ganns. The justification for the ruling relied on several things:

  • The silkscreen shop was a small business
  • The seller developed a clientele because of a highly specialized service he performed
  • Reputable small businesses generate goodwill
  • Transfer of goodwill is necessary in a specialized business

Goodwill is also a factor when considering the purchase of a business. This is the added value of a business beyond what can be seen, touched or produced. It can include employee skills, reputation of the brand, logo recognition and customer lists. It is the very character of the business. This is why courts see goodwill, amongst other things, as a part of a covenant restricting competition.

At decision, the court upheld the covenant and required Morris to pay the Ganns for lost profit from any and all business he took from them during the time they claimed Morris violated the contract terms. And, in no way were the plaintiff-appellees in violation of the doctrine of in pari delicto.

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