Two businesses negotiate an agreement. Both sides sign it. They perform under the agreement, exchange money, and receive benefits. Years later, a dispute arises and one side sues for breach of contract.
Then the defendant raises a very different argument: the contract itself was illegal and should never have been enforced in the first place.
Under California law, that argument can sometimes defeat an otherwise ordinary breach-of-contract claim.
But the rule is more complicated than simply asking whether some aspect of the transaction violated the law. California courts also consider the nature of the illegality, the purpose of the law that was violated, the relative responsibility of the parties, and whether denying relief would actually further the policy behind the law.
California Contracts Must Have a Lawful Object
California law starts with the principle that a contract must have a lawful object.
Civil Code section 1667 defines what is considered unlawful, including conduct contrary to an express provision of law, contrary to the policy of an express law, or otherwise contrary to good morals.
Civil Code section 1598 further provides that when a contract has a single object and that object is unlawful, the entire contract is void.
This leads to a basic principle of California contract law: courts generally will not use their authority to enforce an illegal bargain.
That can have significant consequences in business litigation.
A plaintiff cannot necessarily overcome an illegality defense simply by arguing, “But the defendant agreed to it.” The fact that both parties signed the agreement does not make an unlawful agreement lawful.
But Not Every Legal Violation Makes an Entire Contract Unenforceable
The more difficult cases arise when a transaction is not inherently unlawful but some aspect of the agreement or its performance violates a statute or regulation.
California courts have repeatedly recognized that the rule against enforcement of illegal contracts is not entirely inflexible.
A useful distinction is between a contract whose central purpose is unlawful and an otherwise legitimate business transaction involving a statutory or regulatory violation.
Suppose two parties agree to conduct an activity that the law itself prohibits. Enforcing their agreement could directly undermine the policy behind the prohibition.
Now consider a lawful business transaction in which one party fails to satisfy a licensing, documentation, or regulatory requirement.
The existence of that violation is important, but it does not necessarily answer whether the entire agreement should become unenforceable. The consequences depend heavily on the statute involved and the circumstances of the transaction.
Why the Purpose of the Violated Law Matters
One question California courts consider is why the underlying law exists.
Some statutes are designed to protect the public from dangerous or unqualified activity. Others impose procedural or regulatory requirements on transactions that are otherwise lawful.
That distinction can matter.
In Asdourian v. Araj, the California Supreme Court considered home-improvement agreements that did not comply with statutory requirements governing such contracts. The Court nevertheless permitted recovery under the particular circumstances.
Among other considerations, the property owner was a real estate investor and was not within the class of unsophisticated consumers principally requiring the statute’s protection. The underlying remodeling work itself was also not intrinsically illegal.
The Court explained that the rule against enforcing illegal contracts is not inflexible and that, in compelling circumstances, courts may consider whether nonenforcement would cause unjust enrichment and impose a disproportionately harsh result.
The case illustrates an important distinction: a violation of a regulatory statute does not necessarily produce the same result as an agreement whose very purpose is unlawful.
Were Both Parties Equally Responsible?
Another important consideration is whether the parties were equally responsible for the illegality.
California cases sometimes refer to this concept as in pari delicto, meaning that the parties are equally at fault.
When two parties knowingly participate in an unlawful arrangement, a court may refuse to assist either of them and effectively leave them where it finds them.
But the analysis can change when one party bears substantially greater responsibility for the unlawful arrangement.
In Tri-Q, Inc. v. Sta-Hi Corp., the California Supreme Court emphasized that the illegality doctrine should not always be applied mechanically. Among the considerations were the parties’ relative culpability and whether refusing relief would unjustly enrich the party bearing greater responsibility for the improper arrangement.
This can become particularly important when one party designed, proposed, or insisted upon the problematic structure and later attempts to invoke that same illegality to avoid its obligations.
Can an Illegal Contract Still Lead to Equitable Relief?
A more recent published California decision illustrates another important distinction.
In Aghaian v. Minassian, the underlying dispute involved an agreement concerning efforts to recover and sell valuable real property in Iran. The trial court determined that the contract was illegal.
That did not, however, end the litigation.
The plaintiffs pursued equitable relief based on allegations that the defendant had retained money and property for himself. Following trial, the court entered a judgment exceeding $34 million based on unjust enrichment, and the Court of Appeal affirmed.
The decision does not mean that a party can simply repackage every claim arising from an illegal contract as “unjust enrichment.”
Instead, it illustrates that there can be a meaningful distinction between asking a court to enforce an illegal bargain and asking the court to prevent one party from retaining property or benefits under circumstances in which equitable relief is independently appropriate.
That distinction can become critical in business litigation.
Can a Plaintiff Simply Sue for Fraud Instead?
Not automatically.
When a defendant argues that a contract is illegal or unenforceable, plaintiffs sometimes have other claims arising from the same transaction, such as fraud, conversion, restitution, or other equitable theories.
Those claims require their own analysis.
A genuinely independent tort or equitable claim may not necessarily fail merely because a related contract is unenforceable.
But a plaintiff generally cannot avoid an illegality problem merely by changing the label on a breach-of-contract claim.
The court may examine what the plaintiff is actually asking it to do. Is the plaintiff seeking to enforce rights created by the unlawful bargain? Or is the plaintiff seeking relief based on independent wrongful conduct or to prevent the defendant from retaining property to which the defendant is not equitably entitled?
The distinction can materially affect the outcome.
What If Only Part of the Contract Is Illegal?
Not every contract containing an unlawful provision necessarily fails in its entirety.
California law recognizes circumstances in which an unlawful provision can be separated from otherwise lawful portions of an agreement.
The practical question is whether the unlawful provision is collateral to the parties’ legitimate bargain or so central to the agreement that removing it would effectively require the court to create a different contract for the parties.
If the unlawful portion can be severed without changing the fundamental nature of the transaction, the lawful remainder may sometimes survive. If the illegality goes to the heart of the bargain, severance becomes much more difficult.
What Should Businesses Examine When Illegality Becomes an Issue?
When an illegality defense appears in a business dispute, the analysis should generally go beyond asking whether some statute or regulation was violated.
The more important questions may include:
- What was the actual object of the contract?
- Could the transaction have been performed lawfully?
- Was the violation central to the bargain or merely collateral?
- What policy was the violated statute intended to protect?
- Are the parties members of the class the statute was designed to protect?
- Did both parties know about the unlawful aspect of the transaction?
- Who proposed or insisted upon the problematic arrangement?
- Were the parties equally responsible?
- Would enforcement undermine the policy of the law?
- Would nonenforcement instead give the more culpable party an unjustified windfall?
- Can the unlawful portion be separated from the remainder of the agreement?
- Are there independent tort or equitable claims that do not depend upon enforcing the illegal bargain?
These questions can turn what initially appears to be a straightforward breach-of-contract lawsuit into a substantially different case.
The Practical Lesson
The fact that sophisticated parties negotiated and voluntarily signed an agreement does not guarantee that a California court will enforce it.
At the same time, discovering a statutory or regulatory violation somewhere in a transaction does not automatically mean that every contractual or equitable remedy disappears.
California courts consider the nature of the illegality, the policy behind the violated law, the parties’ respective responsibility, the possibility of unjust enrichment, and the particular relief being requested.
For businesses operating in regulated industries or entering unconventional transactions, these issues deserve attention before a dispute develops.
Once litigation begins, both plaintiffs and defendants should look beyond the question of whether the agreement was breached. Sometimes the more fundamental question is whether the court will enforce the bargain at all.
Legal Authorities
- California Civil Code §§ 1598, 1667
- Asdourian v. Araj (1985) 38 Cal.3d 276
- Tri-Q, Inc. v. Sta-Hi Corp. (1965) 63 Cal.2d 199
- Aghaian v. Minassian (2021) 64 Cal.App.5th 603
Related practice areas: Contracts and Business Torts · Civil Litigation