Introduction:
Contracts are binding obligations imposed upon the parties who have entered into the agreement. The law enforces the obligations if necessary and once a party executes the agreement it is an obligation imposed whether the party changes its mind or not. A party violating a contract is said to be in breach of contract and the other party may seek to obtain damages caused by the breach.
Contracts may be written or verbal (under particular circumstances) and the average person enters into dozens of contracts each year. Every time one purchases a good or service, subscribes to a publication, enrolls in a gym, employs a person, or is employed, or engages in business in any manner, one executes numerous contracts that are enforceable.
Contractual rights and obligations are so pervasive that few stop and consider how remarkable it is that one may force another to perform mutually agreed upon duties by use of the courts. As one client wrote, “If I sign on this line, X can force me into court, may seize my assets if I don’t pay a judgment, can force me out of business and into bankruptcy. All because I sign on that dotted line.” Yes.
While contracts are clearly normally binding upon the parties executing the contract, they can also be enforceable by third parties who have not executed the contract(s) (“third party”) under particular limited circumstances. In most instances, third parties can neither enforce nor defend a contractual obligation. They do not have “privity” to the contract and, as such, do not have rights or obligations since those apply only to the parties who executed the contracts.
But under particular circumstances a person or entity who did not sign the contract can enforce the obligations contained in the contract and that is the subject of this article.
The Basic Law:
Assignments versus Third Party Beneficiaries:
Parties can and do assign (transfer contractually) their rights under a contract though the right to assign may be limited by the contract itself. Thus, if you are obligated to provide X product at Y price to me and there is no restriction on assignment in the agreement, I can assign that right to another entity and that entity steps into my shoes and can enforce the agreement if necessary. As seen below, this is not the same as being a third-party beneficiary to a contract.
Third Party Beneficiary-The Requirements:
A third-party beneficiary, in the law of contracts, is a person who has the right to sue on a contract, despite not having originally been a party to the contract and/or a signer of the contract.
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 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 vital for parties to a contract to understand that other entities or persons may be given rights but not obligations by their contracting. We once had a client who felt that the death of the other contracting party before our client’s construction company began to level a lot excused his company from performance only to find his company sued by the ex-wife of the deceased party who was a co-owner of the lot.
Our client complained bitterly that he had never even met the lady, would not have agreed to do anything for that “virago,” and that he only contracted with persons who he had met, checked out, and decided that they were “adult and reasonable.” “Not with that woman,” our client wrote.
But she sued as a third-party beneficiary and our client was bound.
One can provide in the agreement itself that no third-party beneficiaries are intended by the agreement and that all rights pertain only to the contracting parties. That simple solution was never even considered by our client. But you may be sure that said clause is a part of all the contracts he signs now…