Illegality in performance of a contract: one of the least satisfactory areas of contract law?

If a contracting party performs an illegal act in the course of performance of a contract, what impact does that conduct have on the availability of remedies for breach of contract?  Can the “innocent” party use that illegality as a defence in order to avoid, for example, payment of damages for breach of contract?  This is the important question considered in the recent English Court of Appeal case, Parkingeye Ltd v Somerfield Stores Ltd [2012] EWCA Civ 1338. 

The parties had entered into a contract in terms of which P had agreed to provide an automated monitoring and control system for some of the S car parks.  The system read and recorded the vehicle registration numbers and times of entry and departure of vehicles using the car park.  The system was able to determine when a car had overstayed the maximum time permitted for customer use of the car park and therefore when a penalty was due.  P was also responsible for pursuing customers who failed to pay.  This might involve sending out a number of letters to the customer, and in individual cases customers received 4 different letters.  It was the terms of those letters which formed the focus of the dispute.  As further letters were sent to an individual customer, the terms of those letters escalated, becoming more aggressive.  The later letters incorporated a chequered edge in a clear attempt to mimic a police letter and indeed contained falsehoods.  P was entitled to retain the fees levied and so had an incentive to operate the fine system aggressively.  In Sir Robin Jacob’s words, the terms of the later letters were quite “crude and aggressive in fashion” (para 12). 

The contract was to endure for 15 months but was terminated early by S after 5 months.  P raised an action for breach.  S raised the defence of illegality, citing P’s unlawful actions committed in performance of the contract.  At first S alleged that P’s conduct had been both criminal and tortious in nature.  As the case progressed, the allegations of criminal conduct were dropped.  

First Instance
At first instance the judge indicated that he was not convinced that P intended to perform the contract in an illegal manner.  In fact, he suggested, neither of the individuals managing the two companies had fully appreciated the legal implications of the letters.  The judge awarded P damages of £350,000 for breach of contract by S.  He rejected illegality as a defence although he indicated that he had made a modest discount to the damages to reflect the terms of the third and fourth letters.  On appeal the sole issue before the court was whether S could resist payment of damages on the basis of illegality.     

Court of Appeal – Sir Robin Jacob
In the Court of Appeal Sir Robin Jacob began his substantive analysis by commenting “Illegality and the law of contract is notoriously knotty territory” (para 28).  In his own words he “ducked out of a comprehensive review of the cases” (para 28).  His starting point was two Law Commission papers on the subject, a Consultation Paper from 2009 (No. 189) and a Report from 2010 (No. 230).  A specific point of reference for him in the Law Commission publications was the part on illegality in performance of a contract (paras 3.27 and 3.28 of the Consultation Paper).  Para 3.27 rather depressingly commented that “…the effect of unlawful performance on the parties’ contractual rights is very unclear.”

Counsel for S had argued not only that P had performed the contract in an unlawful way, but also that P had had the intention to perform the contract illegally from the point of formation. As a result, it was argued, the contract was completely unenforceable.  Sir Robin was unconvinced that this was correct, particularly where “the intention was limited to only a partial (and minor on the facts) mode of performance” (para 31). The law is not a “straightjacket” (para 32), in other words not every illegality in performance has this draconian effect.  He rejected too the emphasis on the point of formation as the crucial point at which intention ought to be determined.  To Sir Robin this contract was not intended to be carried out in a wholly illegal manner (para 35), nor was illegal performance an object of the contract or necessary for its performance (para 36). 

In response to Counsel for S’s arguments that P’s intention was imbued by moral turpitude, Sir Robin identified unenforceablity as a disproportionate remedy (para 38).  Although the reference to moral turpitude is reminiscent of the Inner House decision in the famous Scottish case of Cuthbertson v Lowes (1870) 8M 1073, it seems unlikely that it inspired counsel.  Sir Robin was careful to indicate that, in making this decision, he was not exercising a judicial discretion (para 39).  Proportionality is something different: “It involves the assessment of how far refusal of the remedy furthers one or more of the specific policies underlying the defence of illegality” (para 39). 

Sir Robin Jacob rejected S’s entitlement to the illegality defence, Lord Justice Laws agreeing both with this conclusion and Sir Robin's reasons.   

Court of Appeal – Lord Justice Toulson
Referring to Sir Robin Jacob’s description of this area of the law as “knotty”, Lord Justice Toulson raised the stakes: “That is a mild way to describe it.  It is one of the least satisfactory parts of the law of contract” (para 43).  The reason why it is so difficult is because it involves questions of public policy (para 44).  He also acknowledged the difficulties inherent in “weighing” the respective illegalities on the part of the contracting parties:

“But where, as in this case, both parties were complicit in the illegality, denial of one party’s claim on that ground will be to give an unjustified benefit to the other.  The rule that where both parties are equally at fault the defendant should prevail may be right in more serious cases (on the ground that the court should, in effect, wash its hands of the dispute), but may be a disproportionately severe response in less serious cases” (para 45). 

Lord Justice Toulson also referred to the Law Commission work in this area, noting their conclusion on the possible creation of a statutory discretion, i.e. that this “…was not the best solution to the problems of illegality in the law of contract, because of the difficulties which close study showed that such a scheme would itself present” (para 48).  He also noted the relatively high standard that the Law Commission suggested ought to be adopted.  In essence, the Law Commission suggested that the court should identify the policies involved and base their decisions “transparently on these policies” (Consultative Report, para 3.140, quoted by Lord Justice Toulson at para 50):
“If this approach were adopted, we consider that the illegality defence would succeed in only the most serious of cases.  That is, we believe that the policy issues underlying the defence would have to be overwhelming before it would be a proportionate response to deny the claimant his or her usual contractual rights” (Consultative Report para 3.141, quoted by Lord Justice Toulson at para 50). 

The Law Commission suggested that “…the courts should consider in each case whether the application of the illegality defence can be justified on the basis of the policies that underlie that defence.  These include: (a) furthering the purpose of the rule which the illegal conduct has infringed; (b) consistency; (c) that the claimant should not profit from his or her own wrong; (d) deterrence; and (e) maintaining the integrity of the legal system.” (para 3.142, quoted by Lord Justice Toulson at para 51.)  Those policies could not be looked at in isolation: “Against those policies must be weighted the legitimate expectation of the claimant that his or her legal rights will be protected.” (para 3.142, quoted by Lord Justice Toulson at para 51).  Whilst endorsing this approach Lord Justice Toulson did not see it as a complete substitute for the rules on illegal contracts developed in the case law (para 53), “…rather that those rules are to be developed and applied with the degree of flexibility necessary to give proper effect to the underlying policy factors” (para 53).  He also recognised the unusual nature of cases of this type:

“In some parts of the law of contract it is necessary in the interests of commercial certainty to have fixed rules, sometimes with exceptions.  But in the area of illegality, experience has shown that it is better to recognise that there may be conflicting considerations and that the rules need to be developed and applied in a way which enables the court to balance them fairly” (para 54). 

In applying the law to the facts of the case, Lord Justice Toulson referred to the seminal case on illegality in performance of a contract, namely St John Shipping Corporation v Joseph Rank Ltd ([1957] 1 QB 267).  A distinction drawn in that case which Lord Justice Toulson supported was between, on the one hand, a party who deliberately sets out to break the law in performance of a contract and, on the other, a person who breaks the law without meaning to do so or in a minor way (para 61).  He quoted Devlin J:

“Persons who deliberately set out to break the law cannot expect to be aided in a court of justice, but it is a different matter when the law is unwittingly broken.  To nullify a bargain in such circumstances frequently means that in a case – perhaps of such triviality no authority would have felt it worthwhile to prosecute – a seller, because he cannot enforce his civil rights, may forfeit a sum vastly in excess of any penalty that a criminal court would impose…” ([1957] 1 QB 267 at 288).

He indicated that Lord Devlin’s decision certainly did not suggest that any element of minor illegality in performance would render a contract unenforceable, the position argued by counsel for S (para 63-64). 

Lord Justice Toulson then proceeded to consider the case under the following headings: object and intent of the claimant; centrality of the illegality; and nature of the illegality.  In relation to the first, he noted that the judge at first instance had decided that P did not have a fixed intention to use letter 3, nor did P appreciate its legally objectionable aspects (para 68).  In relation to the second, he referred again to Devlin J’s decision, in which he had suggested that the a contract might be found unenforceable only where what was prohibited was a contract which had at its centre the prohibited act ([1957] 1 QB 267 at 289, quoted by Lord Justice Toulson at para 70).  By contrast the most important part of the service supplied by P was the installation of the system in 17 car parks, a service which was perfectly lawful.  The misrepresentation in letter 3 was “hardly central to the performance of the contract” (para (71).  Finally, in relation to the nature of the illegality, the only form of illegality at issue here was in tort.  Nor was commission of a tort the object of the contract (para 73).  Given that P had no fixed intention of acting unlawfully and that the illegality was incidental to part of the performance of the contract rather than central to it, Lord Justice Toulson concluded that S’s illegality defence ought to be rejected. 

This case usefully illustrates the fact that illegality arguments can be raised where the conduct is minor, and not even criminal in nature.  Here the most serious allegations were the commission of a tort.  “Illegality” does not always mean a breach of the criminal law.  Lesser degrees of culpability can, in theory, have an impact on the availability of normal contract remedies.      

It is questionable whether the first instance judge’s approach of applying a “discount” to damages awarded is a useful one.  It is true that the calculation of damages is an art rather than a science and that the court often has access to different methods of calculation (for example a reliance as opposed to an expectation measure).  Nevertheless, this “discounting” approach has little to commend it.  It might involve the courts having to grade degrees of illegal conduct, something courts have tended to avoid in the past. 

The Court of Appeal is to be commended for its close analysis of and adherence to the approach advocated by the Law Commission.  This is as it should be: recommendations were made by the Law Commission after painstaking scrutiny of this area of the law.  It is heartening to see those recommendations being given such weight. Nevertheless, Lord Justice Toulson, having noted the five policies that the Law Commission had suggested underlie the defence, did not seem to apply them to the facts of the case.  Rather, he adopted three different headings (object and intent; centrality of the illegality and nature of the illegality).  Again, confusion reigns.    

Sir Robin Jacob’s “disproportionality” test deserves further comment.  Is it accurate to describe it as such? To recap, he stated “Proportionality…involves the assessment of how far refusal of the remedy furthers one or more of the specific policies underlying the defence of illegality.”  This is surely less about proportionality, and more simply a policy-based approach.  South African law is a good example of a legal system which adopts a policy based approach: only where non-enforcement of the contract furthers an important policy should the court refuse to enforce the contract (see, for example, Jajbhay v Cassim 1939 AD 537).  To create a new proportionality test only populates this already busy area with one more test.

More broadly the Court of Appeal decision is to be welcomed.  It reminds us of the importance of policy in this area.  It moves us father from a “knee-jerk” response which might dictate, as counsel for S appears to have suggested, that any degree of illegality should lead to non-enforcement of the contract.  This is clearly not correct, and certainly not in a case such as this where the conduct involved was relatively minor.  The fact that this case went as far as the Court of Appeal suggests that parties continue to consider it worth trying to use the illegality defence even where the conduct in question is minor in nature.  Perhaps the clear statements made by the judges might act as a disincentive to such an approach in the future.  Finally, the  case reminds us how many factors are potentially relevant in a case of illegality.  In such a “knotty” area, simplification seems unlikely.