Law: Privity in Contracts

Introduction

The basic principle followed in the interpretation of a contract is that it is a contract drawn up for the benefit of two parties.1 It is a legal document that spells out the obligation that both parties are supposed to perform to produce a certain action or benefit.2 The contract made is also the assurance that in the event of breach or non-failure to provide what was promised, the parties can seek legal remedy in a court of law.3 To protect contracting parties and third parties not part of the agreement, the law created the doctrine of privity. But in recent times it became clear that commercial transactions involve complex and multipartite agreements.4 Thus, there is a need to create exemptions to the rule of privity of contract.5 The following is a discussion on why it is difficult to enforce a promise made in favour of a third party.

In a typical contract, there are only two parties involved. In a contract “each agrees to perform stipulated obligations.”6 This claim is based on a fundamental contract principle and therefore each party may enforce the promise made by the other.7 It is a challenge for third parties to seek legal remedy using a contract entered into by two parties. The underlying principle is based on the concept that “a contract creates personal rights and duties and not real rights and as a result, a contract cannot impose obligations or create rights for a third party.”8 The principle was established to protect the contracting parties as well as third parties who are made a part of a contract without their consent.

Privity of Contract

Even if a third party finds justification to seek legal remedy the court of law does not automatically grant the request even if an exception to the rule does exist. Aside from the privity doctrine that will be discussed in detail later, the law provides a narrow framework that must be used to determine if a contract is enforceable or not. Thus, the contract must not only exist but the law will determine if it is valid and can be enforced.9

It seems that the privity contract creates a wall of protection that prevents a third party from interfering with the legal rights and obligations created by two contracting parties. It is therefore important to clarify the meaning of privity of contract. According to one definition “privity of contract is a legal relationship between two parties based on contract, estate, or another lawful status, that confers certain rights or remedies. For example, parties that are in privity of contract can enforce the contract or obtain remedies based on it.”10 There seems to be a creation of a closed-loop that does not permit access and interference from third parties.

The doctrine of privity is concerned with the determination of who will enforce a promise made in the context of a contract. In the case Dunlop Pneumatic Tyre Co Ltd v. Selfridge and Co Ltd the Lord Chancellor, Viscount Haldane stated that “only a person who is a party to a contract may sue on it.”11 This assertion is easy to understand. A third party simply means that this person or this entity is not part of the contracting parties. Therefore, the third party had no rights to the benefits that will be incurred as the result of the said contract. In the same manner, the third party cannot be liable for the consequences that resulted from the said contract.

When the privity doctrine is invoked, “a person may not enforce a contractual promise, even when that promise is made in his favour, if he is not a party to the contract.”12 The principle can be seen in Dunlop v Selfridge wherein Selfridge made a promise in favour of D but the promise was made not between Dunlop and Selfridge but between Selfridge and another supplier. The problem was that a supplier bought the tyres from Dunlop and resold them to Selfridge and in that particular transaction Selfridge entered into an agreement with that supplier that it will not sell the tyres below a certain price, however, Dunlop was not a party to that contract. Thus, Dunlop cannot enforce the promise made.

The case Dunlop v. Selfridge can be used as an example to highlight the point that the privity doctrine is applicable even when two parties made a contract expressly to confer a benefit on a third party.13 A closer examination of the privity doctrine will reveal that it can cause problems for businesspeople. It must also be pointed out that this doctrine has a second rule. The second rule states that “a person claiming damages for breach of contract can only recover compensation in respect of losses he suffered.14 It, therefore, creates another layer of protection that separates an erring party from answering the demands made by a third party that is not privy to a contract.

Consider for instance the difficulty of dealing with complex and multipartite arrangements in the following examples. A and B agreed wherein A is required to pay money to C. The application of the privity doctrine makes it impossible for C to sue A if the latter defaulted on the promise made to B. It is clear that C was not part of the contract made between A and B, however, it is also clear that the exact purpose of the contract was to compel A to pay to C.

The problematic nature of the privity contract can also be seen from the perspective of the third party because it can be interpreted that B can sue C for the non-delivery of a particular product or service. But C cannot rely on B because of C of the lack of privity between C and B.

Exceptions to the Rule

There are, however, exceptions to the rule. An example of an exception can be seen in the Road Traffic Act 1988.15 In this particular example, one can see a general reform to the doctrine of privity and grants that third parties have the right to enforce contracts made for their benefit.16 It is an example of how the law understands the importance of the rights of people even if they are not part of the agreement between two parties.

Another example of an exception can be seen in the case of an agent representing a client. A person or entity can be held liable on contracts made on his behalf.17 This assertion is based on statutes with regards to the use of an agent. The privity doctrine cannot be used to default on an agreement made by the person’s agent. For example, a movie star’s agent agreed on his behalf. Even if the agreement was made between the agent and another party, the movie star cannot evade the responsibility to perform the promise made by his agent on his behalf. The exception to this rule was strengthened by a pronouncement that “a court may be prepared to find an implied agency even where there is no formal agency agreement, to circumvent the privity of contract doctrine.”18

Another exception to the rule can be seen in the awarding of a benefit to a third party. However, it is not automatic that the burden of the contract can be assigned to a third party that has a claim to the said benefit. A good example is an agreement made by a creditor and a third party wherein the creditor assigns to a third party the right to recover payment. However, the exception to the privity doctrine can only be achieved if the assignment of the said benefit was done in writing and a notice has been given to the party “against whom the assigned rights are to be enforced.”19 Another exception to the rule can also be achieved when a contract is modified to add a new party. However, the effective change in the contract requires the consent of all the parties involved in the said agreement.20

It has been mentioned earlier that even if two parties agreed to specifically confer a benefit to a third party, the third party cannot enforce the contract. But the common law rule of privity of contract can be circumvented because of the Contracts Act 1999. This law is also known as the Rights of Third Parties. The focus of this law is to provide an exception when a contract was made for the benefit of the party who was not part of a contract drawn between two parties.

It must be pointed out that the Contracts Act 1999 does not automatically nullify the privity doctrine but it clarifies that there are exceptions to the legal assertion that even if two parties entered into a contract that will benefit a third party, the third party cannot enforce the said contract. According to the said doctrine, the third party cannot enforce the promise made because the parties in the agreement did not provide a clear indication that they agreed to provide a benefit to a third party. Thus, the third party is a mere indirect beneficiary of the said contract.

The Contracts Act of 1999 significantly modified this rule because if two parties entered into a contract that expressly provides the intention to confer a benefit on a third party. Thus, if A and B entered into an agreement that requires A to pay to C and the contract specifically provides that the parties “intended for that person to be able to enforce the contract” then the third party can enforce the contract”21 However, there are provisions that protect A from double liability.

There are other exceptions albeit it does not benefit the third party. In the case of Total SA v. Bekker NO, a third party intervened to undertake to pay the debtor’s debt for him.22 In another exception that favours the parties in agreement, a third party cannot ignore the existence and validity of a contract. Thus, in a case that involves A and B, a third-party C cannot induce A to breach the contract. If C induces A to breach the contract then B can sue for damages from C. Another exception is the doctrine of notice wherein a creditor may enforce “performance of a contractual obligation from a third party if the third party received the performance while he was aware of the creditor’s contractual right about that performance.”23

An example of the exception of the privity contract can be seen in the following case. A sells his yacht to B and subsequently claims transfer of ownership of the said yacht. But in the process, A was able to sell the same property to C. A was in breach of the contract with B. However, B cannot claim performance from A because A is no longer the owner of the yacht, the ownership was transferred to C. Nevertheless, B can claim performance from C if B can prove that C was aware of the earlier contract made between A and B. On the other hand, C has no choice but to claim damages from A because it created a contract between that person and not C.

In a similar example, X and Y agreed to lease a flat. Y agrees to lease the flat from X for 2 years. But after a year, X sells the said flat to Z. The privity of the contract says that Z has nothing to do with the agreement between X and Y. But if Y can prove that Z knew of the existing lease agreement then Z will be made to respect the said contract.

There are other exceptions such as the beneficiary of a trust “can enforce a trust’s terms against the trustee even if the beneficiary has provided no consideration.”24 Another exception is collateral contracts. A third party can enforce the rights of a person that entered into a particular contract even if the third party is not part of that agreement. The exception is made possible through the principle called the operation of law.

An example is when a company goes into liquidation and the party to an agreement with the company can seek the assistance of a third party to enforce his rights under the contract. In a similar vein, the spouse or children of an insured person is not exactly a party in the original agreement made between a person and an insurance company. But after the death of the wife, husband, parent or spouse, the beneficiary can enforce the contract even if they are considered as a third party to the agreement.

In a similar case the parent enters into a contract for life insurance and names a child as the beneficiary, the child did not pay a single shilling to the insurance company but the child qualifies as a done beneficiary.25 Thus, the child can enforce the contract. A person can also enter into a similar agreement but this time the purpose is to extinguish an obligation owed to a third party. The third party becomes the creditor beneficiary and in the same vein can enforce the contract.26

Conclusion

It can be argued that the purpose of the privity of contract is to protect the contracting parties from outside interference such as a claim from a third party that is not part of the original agreement. At the same time, it aims to protect third parties against the consequences of contracts that are concluded between other parties. The modifications made to the law on contracts can help third parties seek legal remedy but it has been made clear that the law still favours the original parties involved in a particular contract. The law is biased towards the two parties that agreed. It is therefore important that the contract must be drafted correctly to protect the rights of the contracting parties as well as the third party.

Bibliography

Bhana, D, E Bonthuys & M Nortje, Student’s guide to the law of contract, Cape Town, Juta Law, 2007.

Bradgate, R & F White, Commercial law, Oxford, Oxford University Press, 2007.

Burrows, A, Understanding the law of obligations, Oxford, Hart Publishing, 1998.

Cafaggi J, Contractual networks, inter-firm cooperation and economic growth, Cheltenham, Edward Elgar Publishing, 2011.

Carpenter, D, J McKinsey & B West, Understanding the law, Mason, Cengage Learning, 2008.

Cartwright, P, Consumer protection and the criminal law, Cambridge, Cambridge University Press, 2004.

Hill, G, Nolo’s plain-English law dictionary, Nolo, San Francisco, 2009.

Keilhack, K, Third Party Rights, London, Grin Publishing, 2002.

MacQueen, H & R Zimmerman, European contract law, Edinburgh, Edinburgh University Press, 2006.

Mead, L, K Bampton & W Allan, CIMA official exam practice kit fundamentals of ethics, Oxford, Elsevier, 2010.

Miller, R & W Hollowell, Business law: text & exercise, Mason, Cengage Learning, 2008.

Murdoch, J, & W Hughes, Construction contracts: law and management, Oxon, Taylor and Francis, 2008.

Tillotson, J, Contract law in perspective, London, Cavendish Publishing, 1995.

Footnotes

  1. J Cafaggi, Contractual networks, inter-firm cooperation and economic growth, Cheltenham, Edward Elgar Publishing, 2011, p.180.
  2. R Miller, & W Hollowell, Business law: text & exercise, Mason, Cengage Learning, 2008, p.184.
  3. K Keilhack, K, Third Party Rights, London, Grin Publishing, 2002. p.6.
  4. A Burrows, Understanding the law of obligations, Oxford, Hart Publishing, 1998, p. 166.
  5. P Cartwright, Consumer protection and the criminal law, Cambridge, Cambridge University Press, 2004, p.14.
  6. J Tillotson, J Contract law in perspective, London, Cavendish Publishing, 1995, p.96.
  7. J Murdoch & W Hughes, Construction contracts: law and management, Oxon, Taylor and Francis, 2008, p.12.
  8. D Bhana, E Bonthuys & M Nortje, Student’s guide to the law of contract, Cape Town, Juta Law, 2007, p.199.
  9. R Bradgate & F White, Commercial law, Oxford, Oxford University Press, 2007, p.27.
  10. G Hill, Nolo’s plain-English law dictionary, Nolo, San Francisco, 2009, p.12.
  11. Tillotson, p.96.
  12. Ibid.
  13. Bradgate & White, p.27.
  14. Ibid, p.28.
  15. Tillotson, p.97.
  16. Ibid.
  17. Bradgate & White, p.29.
  18. Ibid.
  19. Ibid.
  20. Ibid.
  21. Ibid.
  22. Bhana, Bonthuys & Nortje, p.199.
  23. Ibid.
  24. L Mead, K Bampton & W Allan, CIMA official exam practice kit fundamentals of ethics, Oxford, Elsevier, 2010, p.31.
  25. D Carpenter, J McKinsey & B West, Understanding the law, Mason, Cengage Learning, 2008, p.373.
  26. H MacQueen & R Zimmerman, European contract law, Edinburgh, Edinburgh University Pres, 2006, p. 205.