English Law/Contract/Cancellation

The financial crisis of 2007–08, like the Great Depression from 1929, began with contract regulation failing to ensure terms were transparent, and permitting unjust exchanges among parties of unequal bargaining power, particularly in consumer credit contracts, and derivative financial contracts.

Because contracts concern voluntary obligations, the courts employ a number of protections to ensure only people who give informed and true consent are legally bound. Before 1875, the common law courts only allowed escape from an agreement and damages if someone was induced to enter an agreement by fraud or was put under physical duress, or suffered from a lack of legal capacity. The courts of equity, however, were significantly more generous because they allowed "rescission" (i.e. cancellation) of a contract if a person was the victim of any misrepresentation, even an innocent one, and any "undue influence", beyond influence by physical threats. In these situations the victim of the misrepresentation or unconscionable behaviour has the option to avoid the contract. If avoided, the parties are both entitled to have returned whatever property they had already conveyed, so nobody remains unjustly enriched (though this terminology was not used till the 20th century). As the 20th century unfolded, the courts and statute expanded on the range of circumstances in which a person could claim damages for negligent misrepresentation, on top of fraud. As concern over the use of unfair terms grew, there were calls to recognise a positive duty on contracting parties to disclose material facts as part of a broader duty of "good faith" and some judges attempted to follow the American Uniform Commercial Code by fashioning a broader doctrine of "unconscionable" bargains, procured through inequality of bargaining power. This development was, however, stopped by the House of Lords, so that problems of unfair contract terms continued to be dealt with through targeted legislation. The courts also declare contracts void if they were for an illegal purpose, and refuse to enforce the agreement, or give any legal remedy if doing so would require a person to rely on their illegal act.

Disclosure and misrepresentation

A strict duty of disclosure and good faith applies to selling most financial products, since Carter v Boehm, involving insurance for an East India Company fort.

In a specific set of contracts, negotiating parties must conduct themselves in utmost good faith (or "uberrima fides") by disclosing all material facts to one another. In one of the earliest cases, Carter v Boehm, Mr Carter bought an insurance policy for any losses to a naval fort of the British East India Company in Sumatr], but failed to tell his insurer, Boehm, that the fort was only built to resist attacks from locals, and the French were likely to invade. Lord Mansfield held the policy was invalid, because insurance is a contract based on speculation and the special facts "lie most commonly in the knowledge of the insured only", thus good faith precluded Mr Carter "concealing what he privately knows".

The same rule was extended for the sale of shares in a company. In Erlanger v New Sombrero Phosphate Co the promoter and director-to-be of a guano mining business failed to disclose that the company was being valued at twice as much as he had paid for the mining rights on the island of Sombrero. The Law Lords held that, despite a delay in making a claim, the purchasers of the shares had a right to recover their money. Lord Blackburn held, further, that it was no barrier to rescission that the guano could not be put back in the ground. Counter-restitution (i.e. both parties giving back what they had got) was sufficient if it could be substantially done in monetary terms.

However, outside insurance, partnerships, surety, fiduciary relations, company shares, a narrow range of regulated securities, and consumer credit agreements, the duty on negotiating parties to disclose material facts does not extend to most contracts. Athough there is a duty to correct previous false statements, in Smith v Hughes, it was held that the general duty is merely to not make active misrepresentations.

Hence, in general, negotiating parties have a duty to not make false statements of fact or law, or misrepresent themselves through conduct. Statements of opinion, "mere puff" or vague "sales talk" (e.g. "this washing powder will make your clothes whiter than white!"), are generally not considered factual. However representations of people who profess special skill or knowledge are more likely to be actionable, as they warrant their opinions are based on concrete facts. Thus in Esso Petroleum v Mardon Lord Denning held that Esso's expert opinion that a petrol station would have 200,000 gallons worth of business was an actionable misrepresentation. If someone is induced to enter a contract by any misrepresentation, whether fraudulent, negligent or innocent, they are entitled to rescind the contract and recover their property. As an equitable remedy the right to rescission can be lost if the case meets one or more of the following conditions:

• Too much time has lapsed before the claim is made ("laches").
• The claimant continued with the contract despite becoming aware of a misrepresentation.
• A bona fide third party has bought the property purchaser (which means it cannot be recovered from the third party), but damages could be claimed from the second party (the misrepresentor).
• Counter-restitution must be possible (to prevent unjust enrichment).

It is unclear whether in cases at law, rather than in equity, counter-restitution must be precise (i.e. a thing received must be given back in specie) or in money, as in Erlanger. In Smith New Court Securities v Scrimgeour Vickers (Asset Management) [1994] 2 BCLC 212, 221, Nourse LJ held that precise counter-restitution was necessary, but on appeal on a different point, [1997] AC 254, 262, Lord Browne-Wilkinson disagreed. Then in Government of Zanzibar v British Aerospace (Lancaster House) [2000] 1 WLR 2333 the High Court held that a contract for the sale of a luxury jet could not be rescinded, despite misrepresentations about the plane's airworthiness, because it had already been repossessed by the Government of Zanzibar's finance company, meaning the plane couldn't be "given back". Thus in specie rescission was barred, and the court held that damages were not available under s.2(2) Misrepresentation Act 1967.

It is possible that a representation can become a contract term, and one that allows the right to rescind, entitling the misrepresentee to a simple breach of contract claim, with "expectation damages" for loss of potential profits (subject to remoteness and the duty to mitigate). If the misrepresentation is not a term, then damages may be available, but only "reliance damages" for losses that have been incurred. Until 1963, the general rule was that damages could only be claimed in cases of fraud (i.e. an intentional or reckless misrepresentation), for all losses that resulted directly from the misrepresentation. However, in its Tenth Report the Law Reform Committee recommended that damages should also be available for negligent misrepresentations. This led to the [[Misrepresentation Act 1967, and just before the Act was passed, the Lords also decided in Hedley Byrne v Heller there should be a new claim for negligent misrepresentation at common law.

While Hedley Byrne remains an important case for an independent action in tort, s.2(1) MA 1967 was more generous than the common law. It allows damages if the claimant shows a defendant has made a false representation, and the defendant cannot prove reasonable grounds for making a statement and honestly believed it was true. So while the common law places the burden of proof on a claimant to show a defendant made a negligent misstatement, s.2(1) MA 1967 shifts the burden of proof to the defendant. The measure of damages is also more generous under the Act than at common law, because just as the Law Reform Report was drafted, the House of Lords was introducing a limit on the quantum of damages for negligence to losses that are reasonably foreseeable. However, s.2(1) MA 1967]] was drafted to state the same damages were available as for fraud. So in Royscot Trust v Rogerson, the Court of Appeal held that even where a representation is negligent, and not fraud, the same quantum of damages is available as for fraud. This is controversial among academics who argue that fraud is more morally culpable than negligent behaviour, and should therefore deserve a more severe limit on compensation, though it is not entirely resolved what the proper circumstances for remoteness ought to be. Under s.2(2) the court has the discretion to substitute the right to rescind a contract for a small misrepresentation with an award of damages. Under s.3, a court has the power to strike down clauses excluding remedies for misrepresentation if they fail the reasonableness test in the Unfair Contract Terms Act 1977.

An exception to the law on misrepresentation arises when someone is induced by the fraudulent misrepresentation to enter an agreement through a written document at a distance (and not when a transaction is face to face). In Shogun Finance Ltd v Hudson a crook obtained Patel's credit details and bought a Mitsubishi Shogun on hire purchase contract from a car dealer. Patel's details were faxed to Shogun Finance who agreed to finance the purchase, enabling the crook to drive away. Subsequently Hudson bought the car from the crook, who disappeared. Shogun Finance, who had not been paid, found Hudson and sued to recover the car. In a controversial 3-2 decision, the Law Lords held that the contract between Shogun and the crook was void (as if there had never been an offer mirrored by an acceptance), to protect commercial certainty with signed documents. They had intended to contract only with Patel. Nobody can convey property they do not own (nemo dat quod non habet), so Hudson never acquired legitimate title to the car and had to return it. The minority held that this situation should follow ordinary law of misrepresentation, and should mean that the right of the finance company to rescind the contract would be barred by the intervention of Mrs Hudson's rights as a bona fide third party purchaser, just like all of Europe, the United States, and previous decisions of the Court of Appeal suggest. However, because of the majority decision the special category of "mistake about identity" cases remains a general exception to the law on misrepresentation.

Duress

While the law on disclosure and misrepresentation aims to make contracting parties informed (or not disinformed), the law also says agreements may be avoided when, in a very general sense, a person's free will was impaired. Complete exercise of "free will" is rare for most people, because they make choices within a constrained range of alternatives. The law still holds people to nearly all contracts (if consumer, employment, tenancy, etc. legislation is not activated) except where someone was under duress, unduly influenced or exploited while in a vulnerable position. Like misrepresentation, the victim may avoid the contract, and the parties restore their property to reverse unjust enrichment, subject to the victim's claim for damages, so long as none of the four equitable bars to rescission lie (i.e. no excessive lapse of time, affirmation of the contract, intervention of an innocent third party's rights and counter-restitution is possible).

The most straight forward claim, for duress, involves illegitimate threats. The common law long allowed a claim if duress was of a physical nature. So long as a threat is just one of the reasons a person enters an agreement, even if not the main reason, the agreement may be avoided.

Only late in the 20th century was escape allowed if the threat involved illegitimate economic harm. A threat is always "illegitimate" if it is to do an unlawful act, such as breaking a contract knowing non-payment may push someone out of business. However, threatening to do a lawful act will usually not be illegitimate. In Pao on v Lau Yiu Long the Pao family threatened to not complete a share swap deal, aimed at selling their company's building, unless the Lau family agreed to change a part of the proposed agreement to guarantee the Paos would receive rises in the swapped shares' prices on repurchase. The Laus signed the guarantee agreement after this threat, and then claimed it was not binding. But the Privy Council advised their signature was only a result of "commercial pressure", not economic duress. The Laus' considered the situation before signing, and did not behave like someone under duress, so there was no coercion amounting to a vitiation of consent.

However, contrasting to cases involving business parties, the threat to do a lawful act will probably be duress if used against a vulnerable person. An obvious case involving "lawful act duress" is blackmail. The blackmailer has to justify, not doing the lawful act they threaten, but against a person highly vulnerable to them, the demand of money.

Undue influence

Third parties, particularly banks, will not see their security cancelled over undue influence claims if they ensure people seeking mortgages have independent advice.

Parallel to the slow development of common law duress, the courts of equity allowed escape from a contract if any form of undue influence was used against a contracting party. "Actual undue influence" is now essentially the same thing as duress in its wider form. In these "class 1" cases, a claimant proves they were actually put under undue influence. Most relevant are the cases on "presumed undue influence", of which there are two sub-classes. "Class 2A" cases involve someone being in a pre-defined relation of trust and confidence with another, before which they enter a very disadvantageous transaction. In Allcard v Skinner, Miss Allcard joined a Christian sect, the "Protestant Sisters of the Poor", run by her spiritual adviser, Miss Skinner. After taking vows of poverty and obedience she gave the sect almost all her property. Lindley LJ held that if she had not been barred from the claim by letting 6 years lapse, it could be presumed that Miss Allcard was unduly influenced and she would have been able to rescind the transfer.

Other class 2A relationships include doctor and patient, parent and child, solicitor and client, or any fiduciary relation (but not wife and husband). Where the relation does not fall into one of these, it stands with "class 2B" cases. Here, a claimant may first prove that there was in fact a strong relation of trust and confidence. If that is done, and there is a disadvantageous transaction, it will be presumed to result from undue influence. It will then be up to the recipient of the property to rebut the presumption. This takes on greatest significance in cases involving banks typically lending money to a husband for his business, and securing a mortgage over the husband and wife's jointly owned home. Significant problems arose, particularly after the early 1990s housing, stock market and currency crashes, where the husband's business failed, the bank attempted to repossess the house, and the wife claimed she never understood the implications of the mortgage or was pressured into it.

Even though a bank may have played no illegitimate role, if it had "constructive notice" of undue influence (i.e. if it was aware that something was potentially wrong) the bank would lose its security and could not repossess the house. In Royal Bank of Scotland plc v Etridge the House of Lords decided that in such situations a bank should ensure that the spouse has been independently advised by a solicitor, who in turn confirms in writing there is no question of undue influence, before giving out a loan.

As opposed to duress and actual undue influence, where illegitimate pressure is applied, or presumed undue influence which depends on a relationship of trust and confidence being abused, further cases allow a vulnerable person to avoid an agreement merely on the basis that they were vulnerable and exploited. In The Medina the Court of Appeal found that a group of pilgrims shipwrecked on a rock in the Red Sea did not need to pay £4000 they promised to a rescue ship, because the "rescuers" had exploited the pilgrims vulnerable position. To prevent unjust enrichment, the Court substituted an award of £1800. Similarly, in Cresswell v Potter, Ms Cresswell conveyed her ex-husband her share of their joint property in return for release from mortgage repayments, later making him £1400 profit. Megarry J held the agreement was voidable because Potter took advantage of Ms Creswell's ignorance of property transactions.

One potential exception to this pattern, and now very heavily restricted, is the defence of "non est factum", which originally applied in favour of illiterate people in the 19th century allowed a person to have a signed contract declared void if it is radically different from what was envisaged. In Lloyds Bank Ltd v Bundy, Lord Denning MR proposed it was time that all cases be placed into one unified doctrine of "inequality of bargaining power". This would have allowed escape from an agreement if without independent advice one person's ability to bargain for better terms had been heavily impaired, and would have essentially given courts broader scope to change contracts to the advantage of weaker parties.

The idea of a general unified doctrine was disapproved by some members of the House of Lords from 1979. However, specific legislation, such as the Consumer Credit Act 1974, the Landlord and Tenant Act 1985, or the Employment Rights Act 1996 creates targeted rights for contracting parties who lack bargaining power, in the same way specific legislation circumscribes a duty of disclosure and good faith. Thus, just as there is no unified theory of bargaining power, a unified doctrine of freedom of contract was dismantled long ago where the parties are not making commercial deals in the course of business.

Incapacity

Contract law includes three main exceptions that enable a party to leave a contract on the basis of incapacity, resulting in agreements becoming unenforceable and the recovery of propertyenforcement of agreements. The first exception is that children cannot be bound by large or onerous contracts, although they can enter contracts for "necessaries" and pay a reasonable price. While the adult contracting party is bound, the child has the option to rescind the contract, as long as one of the four equitable bars (lapse of time, affirmation, third party rights, counter-restitution possible) is not present.

The second exception is for people who are mentally incapacitated, for instance because they are sectioned under the Mental Health Act 1983 or they are completely intoxicated. A counter-exception is that such a person is bound to agreements when the other party could not or did not know they lacked mental capacity.

Third, companies can generally bind themselves to any agreement, even though many (particularly older) companies have a limited range of objects that their members (in most companies this means shareholders) have consented that the business is for. Under s.39-40 Companies Act 2006, if a third party contracting with the company in bad faith takes advantage of a director to procure an agreement, that contract will be wholly void. This is a high threshold, and in practice no longer relevant, particularly since 2006 companies can choose to have unrestricted objects. It is more likely that a contract ceases to be enforceable because, as a matter of the law of agency the third party should have reasonably known that the contracting person lacked the authority to enter an agreement. In this situation a contract is voidable at the instance of the company, and could only be enforced against the (probably less solvent) employee.

In a fourth case, the consequences of incapacity are more drastic. Although the Crown Proceedings Act 1947 made it possible for the government or emanations of the state to be sued on contracts in the same way as a normal individual, where statute confers power on a public body to do certain acts, actions by representatives beyond that power will be ultra vires and void. The result is the same as it was for companies before reform in 1989, so that whole chains of agreements could be declared as non-existent.