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Mental Incapacity & Contracts: Definition & Examples

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  • 0:06 Elements of…
  • 1:03 Example: Temple v.…
  • 2:53 Proving Mental Incapacity
  • 4:18 Example: Hauer v. Union
  • 5:59 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.

In contract law, capacity refers to one's legal ability to enter into an agreement. A person who lacks mental capacity cannot legally enter into a contract, thus making a contract voidable in most cases.

Who Would Sign This Contract, Anyway?

A contract has to be made up of several elements for it to be considered a legally-binding agreement. First, there must be offer and acceptance, or two or more parties agreeing to the terms. Next, both parties must be competent, or free of mental illness. All parties must mutually agree to the terms of the contract. Finally, there must be consideration, or an exchange of one thing of value for another.

Our focus is on capacity and how the law views the legality of a contract when one or more of the parties is mentally ill. In the eyes of the law, a contract is voidable if a person is proven to have mental incapacity. Mentally ill can take on a few different diagnoses. One is considered mentally ill if the person suffers from:

  • Schizophrenia
  • Senility
  • Alzheimer's disease
  • Retardation
  • Chronic drug or alcohol dependency

In a newsworthy story out of a Fort Wayne, Indiana, newspaper, a mentally-ill man visited a high-end car dealership with a late-model clunker and returned home with a shiny new car.

His sister, and holder of his power of attorney, Sandra Kay Temple, was shocked and dismayed that her brother was able to enter into a contract for a Mercedes-Benz sedan. She immediately demanded that the dealership return the old car and void the contract. Unfortunately, the family was left with an $82,000 car and a contract. Mercedes offered Temple an opportunity to return the car immediately in exchange for a voided contract and the old car.

However, Temple was unable to follow through with the demand. It wasn't until days later that she would return to the dealership. The deal to take back the car was rescinded. It was argued by the plaintiff that her brother did not have the capacity to enter into such an agreement. He suffered schizophrenia and post-traumatic stress syndrome, was off his medication, and as a result, experienced delusions of grandeur, mania, and impulsive thoughts and actions.

The dealership saw it differently. A representative for the dealership testified that the brother was aware of his purchase, the consequences of entering into the contract, and even asked that the salesperson confirm the funds to make the purchase with his bank.

In fact, there were no clear indications that Allen was mentally ill at all. When Temple asked Allen about the purchase, he told a much different story. Temple's brother truly believed that the salesman at the dealership was merely providing an even exchange - his beat-up Buick for a shiny Mercedes sedan.

While the case is pending in court and no decision has been made, the significance of this story leads us to understand the ways in which a court will determine mental incapacity.

How Can One Prove Mental Incapacity?

In order to make a contract voidable using mental incapacity as a ground, the court looks at a few things:

  • Did the person understand the nature and consequence of the contract?
  • Was the weight of the consequences of entering into a contract considered?
  • Did the other party (or parties) to the contract know of, or at least have an idea, that the party was mentally ill?

There is, however, a standard for mental capacity involving a couple of tests that are court ordered in cases where a party or interested party to a contract claims lack of legal ability. Cognitive or affective testing determines whether meaning was understood by the party in the areas of reasoning and understanding language. A motivational test can also be performed to judge one's ability to enter into a contract. This test may indicate conditions like mania or delusional thoughts and actions as a motivator to enter into an agreement.

Temple's brother gave no outward sign of mental illness. In fact, the most compelling testimony was that of the salesperson that revealed that the brother actually provided him with pertinent financial information needed to secure a lofty bank loan. A motivational test may have revealed the reason for his behavior that day.

Mental Incapacity! Who Knew?

In another case, Hauer v. Union State Bank of Wautoma (Ct. App. 1995), capacity became the forefront of a case involving a loan and a bad investment.

In Hauer v. Union, Kathy Hauer sued Union to recover the funds she lost as a result of a loan taken against her investment (mutual) fund. Eilbes, a friend of a friend of Hauer's, convinced her to take out a $30,000 loan against her mutual fund investment and give him the money to satisfy his defaulted loan. Hauer's financial representative at Union warned her against using the mutual fund as collateral because this was the only source of income she had. He further warned her that if she lost the money, she would not be able to draw the interest she relied on for day-to-day spending.

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