Introduction
The Contracts (Rights of Third Parties) Act provides a statutory exception to the much criticised doctrine of privity of contract. The privity doctrine originates from the 1861 case of Tweddle -v- Atkinson and provides that only the parties to a contract can enforce the terms of that contract. A stranger to the contract, generally cannot enforce the contract, even if the contract, if performed, would have conferred a benefit upon him.
The privity rule has been subject to much criticism both by Judges and academics, perhaps in the strongest terms by Lord Justice Steyn in Darlington Borough Council -v- Wiltshier Northern Limited (1995) when he criticised the lack of action taken by Parliament: “No doubt there will be a report by the Law Commission in the not too distant future recommending the abolition of the privity of contract rule by statute. What would then happen in regard to the proposal for legislation? The answer is really quite simple: probably nothing will happen”.
History of the Reform
There have been previous attempts to persuade Parliament to amend the law. A Law Revision Committee Report in 1937 recommended that a third party be entitled to enforce terms of a contract expressly conferring a benefit upon him. In 1967, the Law Commission’s Advisory Panel included in a draft codification of contract law provisions to create rights for a third party.
In 1996, the Law Commission published its report “Privity of Contract: Contracts for the benefit of Third Parties” and annexed a draft Bill, much of which was adopted in the Bill that was presented to Parliament.
The passage through Parliament of the Bill was speedy. It was introduced by the Lord Chancellor in the House of Lords on 3rd December 1998. Following the second reading, Committee stage, Report stage and third reading, it was introduced into the House of Commons on 14th June 1999. Amendments were made by the Commons to clarify the position on arbitration clauses and the Act’s application in Northern Ireland. The House of Lords approved these amendments, and the Bill received Royal Assent and became law on 11th November 1999.
The Act
The Act is relatively short, but has been referred to in the House of Commons as “immensely technical in character. Virtually every word reflects a careful policy decision by the Law Commission.” Much was said during Parliamentary debates and recorded in Hansard to clarify the intention of Parliament on troublesome aspects, particularly enforceability by third parties of benefits in a contract containing an arbitration clause.
A Question of Choice
The Lord Chancellor said “One possible way of looking at the matter would be to regard the right conferred on the third party as a donation and to say that it is right that the donors should be able to limit the extent of the gift as they choose”.
It is open to contracting parties to grant narrow or wide rights to third parties or to exclude the Act altogether. The latter approach has been adopted by the drafters of some standard form contracts, such as the Standard Form of Architects Appointment 1999, the ACE Conditions of Engagement, the ICE 7th Edition and the JCT Standard Forms (although the Joint Contracts Tribunal may change its position once it has had the opportunity to consider the Act’s provisions in more depth).
Perhaps this approach is not surprising. The construction industry lobbied for various amendments including one that would have excluded the Act from construction contracts altogether! The Lord Chancellor gave this amendment very short shrift.
The Enforceable Rights of Third Parties
Section 1 is the main enabling section. It is important to note that there are two ways in which a third party can obtain enforceable rights under a contract:
(a)if the contract expressly provides or
(b)if a term of the contract purports to confer a benefit upon a third party, unless it appears that on a proper construction of the contract the parties did not intend for the term to be enforceable by the third party. As the Lord Chancellor put it, there is a presumption that the parties intended the term to be enforceable but it can be rebutted. This means that it will be for the contracting party being sued by the third party to prove that an enforceable benefit was not intended.
It is (b) that is the subject of criticism and concern in some quarters. It is feared that this approach could give rise to considerable uncertainty. So, if you want the third party’s rights to be enforceable by him, you should say so. For example, “The parties agree that X may in his own right enforce the following terms of this Contract ...”.
Sub-section (3) provides that the third party must be expressly identified in the contract. He can be identified by name (for example, Fred Smith), as a member of the class (for example, my children, future tenants of the development, sub-contractors) or as answering a particular description (for example, the formwork sub-contractor, the Funder). The third party need not be in existence when the contract is entered into; for example, companies not yet incorporated or unborn children.
Sub-section (4) provides that the third party has to enforce his rights subject to and in accordance with any other relevant terms of the contract. Therefore the third party could be bound by a contractual limitation period, a clause providing that the parties should first refer any dispute to mediation, or a net contribution clause.
The Lord Chancellor confirmed at the report stage in the House of Lords that “the Bill’s intention is to give the third party his own right to enforce the contract in accordance with its terms, and that right is independent of the promisee’s right. As a natural progression, the contracting parties should be able to limit or place conditions on the third party’s right of enforcement, irrespective of the promisee’s rights. It is just a straightforward question of construction of the contract.”
Sub-section (5) provides that the third party is entitled to any remedy that would have been available to him in an action for breach of contract (such as damages or specific performance) and the normal rules relating to these remedies would apply. Therefore it is open to the contracting party to argue that loss suffered by the third party was too remote, that loss is excluded by another clause of the contract, or that the third party has failed to mitigate his loss. Subsection (6) is the corollary of this: the third party right can be purely defensive; so where a third party is sued he can rely upon any exclusion clauses that exist in the contract for his benefit.
Section 1(7) of the Act defines the terms of promisor and promisee used in the Act. The promisor “means the party to the contract against whom the term is enforceable by the third party”. The promisee “means the party to the contract by whom the term is enforceable against the promisor” . To take an example, if A and B agree that A should pay £500 to C, A would be the promisor and B would be the promisee. C is the Third Party.
Recission and Variation; Third Party Consent
Section 2 was the subject of some concern in the construction industry. It provides that where a third party has a right to enforce a term of the contract, the contracting parties “may not, by agreement, rescind the contract, or vary it in such a way as to extinguish or alter his entitlement under that right, without his consent”. The third party’s protection only applies where
- the third party has assented to the term (by words or conduct)
- the promisor is aware that the third party has relied on the term or
- the promisor could reasonably be expected to foresee that the third party would rely on the term and the third party has in fact relied upon it.
The construction industry was concerned that Section 2 could limit the right to instruct or agree variations to the contract works. Reassurance has been given by David Lock of the Lord Chancellor’s Department in the House of Commons where he explained that Section 2 only referred to variations in a strict legal sense, i.e. a variation to the
terms
of the agreement which requires new “consideration”. He said that Section 2 does
not
apply to variations of
work
under the contractual variations machinery.
The Lord Chancellor also stated in the House of Lords at report stage that:
“the Bill uses the expression “variation” in its strict and correct legal meaning - a variation of the terms of an agreement by further agreement between the parties to the original agreement. Contracts conferring powers unilaterally exercisable by one party to require changes are of a wholly different character. I assure your Lordships that it is not our intention that the Bill should impact on such provisions. We do not believe that it does or that further clarification is necessary. The contract industry’s confusion, if I may put it in that way, arises because the Bill uses “variation” to mean a variation agreed by both parties but when the construction industry uses the term “variation” it often refers to alterations to what is being built which the contract allows one of the parties to require unilaterally. The Law Commission was aware of the way in which the construction industry uses the term when it produced its report and made it clear that such variations would not be covered by the restrictions in Clause 2. .... As Clause 2 does not apply to such variations, the third party’s rights will be subject to any provisions in the contract which allow what has been built to be varied unilaterally”.
There are limited circumstances where a term conferring a benefit on a third party can be varied without the third party’s consent, following application to a Court or Arbitrator. The Court or Arbitrator will allow this to happen where the third party’s whereabouts cannot be ascertained or where the third party is mentally incapable of giving his consent. The Court can also dispense with consent if satisfied that it cannot reasonably be ascertained whether or not the third party has in fact relied upon the term. Where the Court dispenses with the third party’s consent it can order that compensation be paid to the third party or impose any other conditions it thinks fit.
The parties can agree to contract out of the fetter of obtaining third party consent e.g. by including a term in the contract stating that they can vary the contract without the consent of the third party or that the third party’s consent is only required in certain specified circumstances.
The Promisor’s Defences
Provisions of Section 3 apply where the third party has brought proceedings to enforce a term of the contract. In those circumstances, the promisor can rely upon any defence or set off relevant to the term being enforced had he been sued by the promisee. The promisor may also rely on a defence or set off, or bring a counterclaim, where this would have been possible had the third party been a party to the contract. For example, the promisor could rely on a breach by the third party of a separate contract and seek to raise a counterclaim against the third party.
In summary, the position is:
- if the contract is void, discharged or unenforceable (for example, because of a failure of consideration), the third party cannot enforce his rights under it;
- if the promisor can claim damages for breach of the contract by the promisee, the promisor can also assert a set off against the third party (in other words, set off arising from the contract);
- the contract might provide that the promisor can set off against its obligation to the third party an amount due to it from the promisee under a wholly unrelated contract; and
- the promisor can invoke any rights of set off or counterclaim it happens to have in relation to the third party.
Again, it is a question of choice; the parties can agree a waiver of the promisor’s rights and expressly exclude rights of set off, defence or counterclaim.
Restrictions on the Third Party
Section 3(6) provides that where proceedings are brought against a third party, he may only take advantage of any clause of the contract (such as a limitation or exclusion clause) if he could still have done so had he been a party to the contract. This means, for example, that if the contracting party could not have relied upon an exclusion clause because it was invalid (for example, induced by fraud, or it falls foul of the Unfair Contract Terms Act), the third party will also be unable to rely upon the clause.
The Promisee’s Rights; the Promisor’s Protection
Section 4 is intended to preserve the status quo and allow a promisee to enforce any term of the contract, independently of the right of a third party to bring proceedings.
Section 5 is designed to protect the promisor from paying out the same sum twice; i.e. once to the promisee and again to a third party who has an enforceable benefit. If a contract is enforceable by a third party and the promisee recovers from the promisor a sum in respect of the third party’s loss or has recovered the expense of making good to the third party the promisor’s default, when the third party brings proceedings, the court or arbitrator is to reduce the award to the third party to the extent it thinks appropriate to take account of the sum recovered by the promisee.
Exclusions
Section 6 contains a list of exceptions where the Act will not apply. Notably, it will not apply to bills of exchange, contracts of employment or some categories of carriage of goods. The rationale for this was that Parliament did not intend to alter areas of law where there are already provisions to protect third parties, nor did Parliament intend to change existing labour law.
Miscellaneous
Section 7 contains a number of supplementary provisions. Firstly, subsection (1) states that the Act does not affect any rights or remedies available to a third party apart from the Act. This preserves what are sometimes known as the “holiday cases”, where one member of a family has recovered costs for a spoilt holiday notwithstanding that he has only suffered loss for his own disappointment.
Subsection (2) provides that section 2(2) the Unfair Contract Terms Act 1977, which restricts the scope of exclusions of liability for negligence, shall not apply when the third party is enforcing a term and complains of negligence by the promisor. Therefore, the third party cannot complain that such an exclusion clause is unreasonable.
Subsection (3) preserves the normal limitation periods of 6 years for a simple contract and 12 years for a contract executed under seal, and makes these periods applicable to third parties enforcing their rights under a contract. However, the parties can expressly agree to limit these rights and impose a shorter limitation period.
Subsection (4) confirms that the third party is not to be treated as a party to the contract for the purposes of other legislation. So, for example, a third party cannot purport to rescind the contract or claim damages under the Misrepresentation Act.
Arbitration Clauses
During the passage of the Act, there was much debate about whether a third party would be bound by an arbitration clause in a contract. The original Bill and its explanatory notes suggested that a third party might be bound, but comments by the Lord Chancellor indicated that Parliament had no intention to force a third party to submit to an arbitration clause.
However, the House of Commons proposed Section 8 to clarify the impact of an arbitration clause in the contract, and the House of Lords approved this.
The intention of Section 8 is to allow a third party to take advantage of an arbitration clause where the arbitration agreement is an agreement in writing for the purposes of Part I of the Arbitration Act 1996. Where the right conferred on the third party to enforce a term is made subject to an arbitration clause, the Act provides that the third party is to be treated as a party to the arbitration agreement for the purposes of any dispute between the third party and promisor relating to the third party’s enforcement of a term of the contract. The new clause may have important consequences for the promisor; the Lord Chancellor’s Secretary has suggested that “the promisor ... will be able to seek a stay of [legal] proceedings under section 9 of the Arbitration Act.” The previous draft of the Bill would not have allowed the promisor that right had the third party chosen to litigate.
The wording of Section 8(2) is more difficult. It is intended to apply in
“situations where the ‘conditional benefit’ approach will not apply - for example, where the contracting parties give the third party a right to arbitrate a dispute other than one concerning a right conferred on the third party under clause 1, such as a tort claim made by the promisor against the third party. We do not believe that such situations will occur often, but to require the third party to arbitrate where there is no other benefit to him would be to impose a pure burden on him, which would be contrary to the policy of the Bill. Subsection (2) therefore brings in the Arbitration Act only where the third party has chosen to exercise the right to arbitrate.”
Application and Commencement
Section 9 provides for the applicability of the Act to Northern Ireland. There, the Act will have effect with minor modifications. The Act will not apply to Scotland.
Immediately on Royal Assent being granted, the new legislation came into force. However it does not apply to contracts entered into before the end of 6 months from the date on which the Act was passed (Section 10). In other words, only contracts entered into after 10th May 2000 will be subject to the Act. This is to ensure that the Act will not have retrospective effect, and to give people time to consider the effects of the Act and to amend the terms of proposed contracts and standard form contracts accordingly.
However, Section 10(3) does allow parties to “opt in” to the provisions of the Act so that a contract made before 10th May 2000 can include a term providing for the application of the new Act.
The Lord Chancellor’s Department has also confirmed in the House of Commons that the Act will not apply to a contract entered into after the Act is in force where that contract is entered into pursuant to an agreement made before the Act was in force. An example of this would be an agreement for lease which provided that the lease itself would be entered into 2 years later.
Points to Consider when Drafting
- The Act can simply be disapplied. This is the approach taken by many of the standard forms.
- Alternatively, the Act can be applied/disapplied selectively.
- Where it is applied, the Act can be modified.
If you do want the Act to apply:
- identify the third party, perhaps by name or address, or describe the class of third party as clearly as possible. If you want the third parties who come into existence at a later date to be able to enforce terms, consider using the phrase “from time to time.”
- include a statement that the third party can enforce the relevant term to avoid any doubt that this was your intention.
- consider whether there should be any prohibition or restriction on assignment.
- consider whether the promisor’s rights of set off against the third party should be restricted.
- consider where and in what circumstances the third party’s consent should be sought before altering his rights.
- if the contract is to be entered into before 10th May 2000, consider whether you want to “opt in” and expressly state that the Act applies.
- if the third party rights are to governed under the contract in place of a collateral warranty, the contract should create step in rights for funders, extend the benefit of some rights to funders, purchasers and tenants (for example, the right to claim for breach of design and workmanship obligations, but perhaps not delay), restrict the third party’s (but not the promisee’s) rights of recovery by a net contribution clause and consider to what extent third party consent is to be excluded before rights can be varied.
For further information, please contact Caroline Cummins on
0171 367 3000 or by e-mail at cxc@cms-cmck.com.
