Introduction:
The ability to enter into a legally binding contract is such a universal action that people take it for granted. But one should realize that this legal act encompasses the following:
It allows an individual who is competent (mentally competent and above a certain age) to enter into an arrangement binding both him or her and another person or entity in such a way that the state will provide its resources to enforce the agreement should either side so wish. Those resources include a court of law and the power of the legal system to enforce the judgment of the court.
So long as it is legal, the full power of the state is available to the individual to make sure the contract is enforced if the other side breaches.
In short, it allows an individual to not only bargain and enter into a legally binding arrangement, but to avail him or herself of the power of the government to enforce the arrangement.
In modern times, such binding arrangements can be verbal, written, or even arranged electronically, though various restrictions apply to the method of contracting. Thus, contracts involving the sale of land must be in writing in most jurisdictions, etc.
Such power to enforce necessarily has led to much law as to how one invokes that power legally. The doctrines of “PRIVITY OF CONTRACT” and “THIRD-PARTY BENEFICIARY” are two related doctrines that impose requirements on the act of contracting if one wishes to enforce the contract.
This article shall discuss both such doctrines and what a party must do to comply with these requirements.
Privity of Contract:
The doctrine of privity of contract is an ancient common law principle that provides that a contract cannot confer rights or impose obligations upon anyone who is not a party to that contract. Privity can be considered the “immediate connection” that is required before someone can use the right to contract effectively.
This doctrine makes good sense if one considers it. Can I make a contract you are not involved in but binding on you? The courts have long held that before a party can benefit or suffer from a contract, one must have actually agreed to its terms and actively consented to its provisions. Since contracting is a voluntary act, the act must have been performed by the parties bound to the contract.
A logical result of this doctrine of privity is that, at common law, a third party generally has no right to enforce a contract to which they are not a party, even where that contract was entered into by the contracting parties specifically for their benefit and with a common intention among all of them that they should be able to enforce it. Under common law, if I contract with X to allow a benefit to confer upon you and pay X money to make that happen, but you are not a party to the contract, you cannot enforce it. While I would still have the right to enforce the contract, what would happen if I became incompetent or died? You would have no right to make X perform.
And such situations are by no means unlikely. Assume I pay a college to allow my son or daughter to attend. The benefit is for the son or daughter, but they would have no right, under privity of contract, to make the college fulfill the contract.
This led to the need for the doctrine of Third-Party Beneficiary discussed later in this article.
Exceptions to the Rule of the Privity of Contract
At common law and in most states, there are designated exceptions to the rule that the person must be a party to the contract in order to enforce it:
Assignment of Rights: If a party in a contract transfers their rights and obligations under it to another individual, this can give a noncontracting party rights. This transfer of rights is called assignment. Once a proper assignment takes place, the third party steps into the shoes of the original person and assumes all rights to sue the contract against the other contracting person. Note that the right to assign can be prohibited in the underlying contract...and often is...and assigning the rights to the benefits does not necessarily remove the party from the obligations in the contract.
Novation: Novation means replacing one person who is tied to an agreement with another, but this only happens with consent from all concerned parties since it also removes the original contract holder from all obligations under the contract. It does not merely transfer benefits, which is an assignment, but the full obligations and releases the original contracting party. Unlike an assignment that only transfers privileges and duties from one party to another, novation changes a previous person completely. Besides that, any new party must conform to all the conditions itemized in the first agreement and take on all rights as well as liabilities, thereby effectively becoming privy to it while having no privity whatsoever with the initial contracting counterpart. They have privity to the novation.
Tortious Liability: Sometimes tort claims may ignore the rule if certain requirements are satisfied, such as proof that there was no direct contractual link between them. Yet, one suffered damages due to another’s defaulting on his side.
Statutory Exemptions: Certain jurisdictions have enacted laws that provide statutory exceptions to the privity of contract rule. Such provisions usually give rights to some non-signatories enabling them to enforce some specific terms or seek remedies under particular circumstances. The precise nature and scope of these statutory exceptions may vary significantly from one jurisdiction to another, and they are limited in their application only to certain agreements or persons.
Insurance Companies: According to the doctrine of privity, the beneficiary of a life insurance policy would have no right to enforce the contract since they were not a party to the contract and the signatory is dead. As this would be inequitable, third-party insurance contracts, which allow third parties to submit claims from policies issued for their benefit, are one of the exceptions to the doctrine of privity.
The Sale of Defective Goods: One exception to privity is manufacturers’ warranties for their products. It used to be the case that a lawsuit for breach of warranty could only be brought by the party to the original contract or transaction; so, consumers would have to sue retailers for faulty goods because no contract existed between the consumer and the manufacturer. Now, under modern doctrines of strict liability and implied warranty, the right to sue has been extended to third-party beneficiaries, including members of a purchaser's household, whose use of a product is foreseeable.
Negligence: If a personal injury occurs because of negligence, the negligent party can be sued by third parties who have not entered into a contract with the negligent party.
Restrictive Agreements: In some cases, a restrictive agreement may be enforceable against a third party. For example, assume that the owners of a house want to sell their house with the understanding that the buyer is not going to change the design of the house. If the buyer sells the house to a third party and some requirements are met, the third party may be obligated to follow the original owners' conditions.
Trusts: In some cases, a contract between a trustee and another party may affect the owner. For example, if a contract is made between the trustee of a trust and another party, the beneficiary of the trust can sue by enforcing their right under the trust, even if they are a stranger to the contract.
Third-Party Beneficiary of a Contract
In the United States, the doctrine of third-party beneficiary has been greatly expanded to allow third-party beneficiaries of a contract to have their own cause of action to enforce the contract even if no privity exists. Note that the doctrine of third-party beneficiary normally benefits the third party and does not always transfer the obligations to the third party. There are also restrictions on when this right can arise.
There are two kinds of third-party beneficiaries: an “intentional or intended” beneficiary and an “incidental” beneficiary.
When a non-party to a contract receives benefit from the agreement directly, this is known as an intentional beneficiary. Essentially, this means that contracts create rights, obligations, and liabilities only in the parties who negotiated and signed the contract. The third-party beneficiary must be referred to or named in the contract and the intent to provide a benefit to this third party must be irrevocable. (A typical example: a father pays tuition and enrolls his son in a college, signing the enrollment forms since his son is out of the country in the military. The son is the one mentioned as the student, but the father is the one paying and enrolling him. The father dies. The son returns. As a third party named beneficiary, the son can demand access to the school.) An intended beneficiary is explicitly promised certain benefits in a contract, but they are still not party to the contract itself.
An incidental beneficiary is a person or legal entity that is not party to a contract and becomes an unintended third-party beneficiary to the contract. An incidental beneficiary is a third party who benefits from a contract between two other parties, but it is not intended that the third-party benefit. This type of third party does not have any legal rights under the contract.
Categories of Intended Third-Party Beneficiaries
A third-party beneficiary is either a donee or a creditor. A donee beneficiary benefits from a contract gratuitously, not in exchange for a service he/she/it has provided. For example, assume that you enter into a contract with Ed, a painter, providing that Ed will paint Uncle Pete’s home. Uncle Pete is not a party to the contract, but he is an intended third-party beneficiary who will gratuitously benefit from your contract with Ed.
A creditor beneficiary is a person to whom an obligation is owed by the promisee. In the previous example, imagine that you had paid Ed to paint the home. So, if Ed is painting to offset his own contractual obligation. Uncle Peter is therefore an intended third-party creditor beneficiary.
Contract Rights of an Intended Third-Party Beneficiary
Both donee and creditor beneficiaries can enforce contract rights, but to do so, both must be intended beneficiaries. The named beneficiary on a life insurance policy (the person who is to receive the death benefit upon the death of the insured) is a classic example of an intended beneficiary under the life insurance contract.
In general, an intended beneficiary is one who is:
1. Identified in the contract:
2. Receives performance directly from the promisor or circumstances demonstrate that the promisee will give the beneficiary the benefit from the contract.
Vesting of the Rights of the Third-Party Beneficiaries
For a third-party beneficiary to enforce a contract, her/his/its rights under the agreement must have vested, which means that the right must have actually come into existence. Thus, if the contract is breached before a condition precedent has been met, the right may not have vested. (You contract to supply product X but only if available from Y. Y does not make it available due to bankruptcy of Y. The right has not vested.)
Aside from the fact that the contract becomes enforceable by the third party upon vesting, the timing of the vesting is important for another reason. Before the third-party beneficiary’s rights vest, the original parties to a contract can modify their contract in any way they both wish. Once rights vest, the original parties cannot discharge or modify contractual rights without the beneficiary’s agreement to a change to the contractual rights.
A third-party beneficiary’s rights also vest if any of the following three things happen:
1. The beneficiary assents to the promise in a contract in the manner requested by the parties:
2. The beneficiary sues to enforce the contract’s promise; or
3. The beneficiary materially changes position in justifiable reliance on the contract’s promise.
As an example, assume Uncle Pete above cancels his own contract to have his house painted knowing you paid Ed to paint it. Or, assume Uncle Peter, upon hearing of the agreement, let you and Ed know he had canceled another painter since he wanted to have Ed do it. Because Uncle Pete has relied on Ed’s promise to you to his detriment, he is vested as a beneficiary. You can no longer let Ed out of the agreement without Uncle Pete’s consent.
It is vital to note that a third-party beneficiary is more than a mere outsider to a contractual arrangement. A third-party beneficiary is often a legally protected entity with rights who can enforce the agreement to which he/she/it is a beneficiary.
The Rights in the Contract That Go to the Third-Party Beneficiary
When the third-party beneficiary has rights under the contract, those rights usually include all the rights that exist under the contractual document. For example, our office successfully argued in the California appellate courts that an arbitration clause in the contract could be enforced by the third-party beneficiary to the contract. The third-party beneficiary steps into the shoes of the party seeking to benefit the third party.
Conclusion:
It is apparent that the ancient doctrine of privity of contract, developed to protect parties from being bound by agreements that they did not participate in, has been eroded in numerous ways and mostly to protect the rights of third parties. It is tempting at times to assume that privity of contract is not a remaining viable doctrine.
That would be an error. The exceptions above and the doctrine of third-party beneficiary are exceptions to an all-pervading rule and minus those exceptions, privity is required. Again, this is good law. Strangers or even people known to you should normally not have the ability to bind you to an agreement even if they consider it a benefit to you. An example that rings true to the writer involved a parent signing his adult son up for a year-long course in higher mathematics at a school abroad with the ulterior motive being to separate that son from a romantic connection the father abhorred.
As the son told the father, the father had no right to obligate his son who was not a party to the contract. Indeed, the agreement between the school and the father obligated the father to pay whether or not the son elected to attend...he was a beneficiary of the contract, not an obligated party.
As it should be.