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Law Reform Commission Report on Privity of Contract and Third Party Rights

PRACTICE AREA GROUP: Corporate
DATE: 20.06.2011

Last year, the Law Reform Commission (the “LRC”) published a Final Report entitled “Privity of Contract and Third Party Rights” (the “Final Report”). The report was launched by the Minister for Enterprise, Trade and Employment, Mr. Micheál Martin, at the offices of the LRC. This Final Report follows the LRC’s initial Consultation Paper on this issue which was published in November 2006. The Commission examines the arguments for and against the reform of the doctrine of privity of contract (the “Doctrine”) taking into consideration the views of many legal commentators and practitioners that the Doctrine is too harsh and that the Doctrine in Ireland should follow other jurisdictions, including England, that have amended the Doctrine significantly. As the law currently stands in Ireland (subject to some limited exceptions discussed below) the effect of the Doctrine is that only the parties to a contract can enforce its terms. Even in circumstances where a third party is stated to have the benefit of a provision of a contract in some way, such third party cannot enforce any such provision against the party who confers such a benefit on them.

The Doctrine of Privity of Contract

Accordingly, the Doctrine is a rule which prevents a contract from being enforceable in favour of, or against, someone who is not a party (or, in legal terms, “privy”) to that contract. Specifically this means that: (i) a person is unable to enforce any rights under a contract to which such a person is not a party; (ii) a person who is not a party to a contract will not have any contractual liabilities imposed on them; and (iii) contractual remedies are only available to compensate parties to a contract and not third parties.

While the Doctrine exists, a number of exceptions have developed over time. Some of the recognised exceptions include:

(i) Agency

An agency is created in circumstances where one person (called the agent) is appointed by another person (called the principal) to act as its representative in commercial arrangements. Any contracts entered into by the agent (within the scope of the agency granted) on behalf of the principal will be legally binding on the principal and the principal is entitled to enforce the contract despite it not being a direct party to the agreement.

(ii) Assignment

Unless the contract precludes it, a party to a contract is free to assign the benefit, but not the burden, of a contract to a third party. The third party is then able to enforce the contract and the party that assigned the benefit is no longer entitled to enforce or vary that contract.

(iii) Trusts

In cases where a completely constituted trust is created in a third party’s favour by a contract, then such a third party is able to enforce that contract.  The courts, however, are reluctant to find that there is a trust in place unless it is clear that this was the intention of the parties.

(iv) Collateral Contracts

A collateral contract is a contract that co-exists alongside another (or the main) contract. Essentially, a collateral contract amounts to the creation of a contract between persons who are not parties to the main contract in order to impose liability (e.g. for statements/promises made).

(v) Tort of Negligence

Third parties who are prevented from suing in contract due to the Doctrine may be able to rely on the tort of negligence. To make a successful case under the tort of negligence there is no requirement for a contract to have been entered into between the parties.

(vi) Legislative Exceptions

There are a number of other exceptions to the Doctrine that have been implemented by means of legislation. Third parties may be able to enforce insurance contracts, consumer contracts and section 25 of the Companies Act 1963 entitles shareholders to bring proceedings against one another despite the contract being between the company and the shareholders.

A harsh doctrine?

The Doctrine has been criticised in the past for being harsh, too restrictive and in need of reform for a number of reasons and these include the following:

1. The Doctrine may prevent the contracting parties' intentions. A third party is unable to enforce a contract made for their benefit, even in situations where the contracting parties agree that the third party should be able to do so. It is arguable that the refusal of the courts to give full effect to such a contract undermines the principle of freedom of contract.

2. The Doctrine may produce the unreasonable result that the third party who suffers a loss is unable to sue to enforce its rights, while the contracting party who can sue has not suffered a loss, and thus may only be entitled to nominal damages. As a general rule it is not possible for the promisee to recover damages in contract for the loss suffered by a third party although an order of specific performance of the contract may be available in limited circumstances. However, it is of course up to the promisee to decide whether it wishes to bring such a claim and it is completely out of the third parties hands. Where a third party finds itself in such circumstances it clearly causes that third party an injustice as they may have had a reasonable expectation that the contract would be enforced. This situation is highlighted even more where the third party has relied on the contract to its detriment.

3. While a number of exceptions to this rule already exist, it is not particularly fair or reasonable that these exceptions do not, and will not, cover every situation where an unjust or illogical result is caused by the Doctrine. There is great difficulty caused by the variety of exceptions to the Doctrine because it can be unclear whether the courts will apply the privity rule or an exception to the Doctrine.

4. Legal practitioners have developed methods of avoiding the Doctrine (eg. by using agency and trusts, assignments or collateral warranties) but this can involve a degree of commercial inconvenience and expense. A number of cases have been heard by the courts on this issue and this indicates that the legal devices used to avoid the Doctrine are not definitive or certain and if such a legal device was contested instead by one contracting party it would involve unexpected litigation costs.

5. The Doctrine was developed through the common law. However, the majority of European civil law systems have rules which determine when a third party may bring a claim for performance of a contract or damages for breach. Additionally, a number of common law jurisdictions including England, New Zealand and Australia have modified the doctrine of privity through statutory intervention.

The LRC’s proposal

In the Final Report, the LRC identifies and recommends that a third party should be able to enforce its rights under a contract in three situations discussed below and also appends a draft bill entitled Contract Law (Privity of Contract and Third Party Rights) Bill 2008 (the “Bill”). The LRC acknowledges that there ought to be a limit to when and how a contract can be enforced by a third party. The three situations in which a third party should be entitled to enforce the Contract are as follows:

1. When the term expressly confers a benefit on the third party, provided it was the intention of the contracting parties that the third party ought to be able to enforce the term and in circumstances when a contract expressly confers a benefit on a third party, there ought to be a presumption that the parties intended for the third party to be entitled to bring an action to enforce a term if the situation arose.

2. When that contract expressly states that the third party has a right of enforcement, even in situations where the contract does not benefit the third party. The LRC, accordingly, recommends that provision should be made in legislation enacting the Bill to give effect to the contracting parties' intentions that a third party is to have a right of enforcement. If the parties have drafted this term into the contract, both parties clearly intend that the third party ought to have a right of enforcement.

3. When the term permits a third party to rely on exclusions or limitations on liability, provided that it was the intention of the contracting parties. The normal rules on the incorporation and construction of exemption clauses shall apply to these circumstances too.

The LRC makes a number of other recommendations and these include:

  • if possible, the contracting parties should identify the third party by name in the contract and if it is impossible to name that third party prior to the execution of the contract, then the contract must expressly identify the third party as being a member of a particular class or as answering a particular description;
  • a third party should be able to enforce a term of a contract even if that third party has not provided any consideration;
  • the contracting parties should not be able to cancel or vary the contract in a way that would affect the rights of the third party once either contracting party is aware that the third party has assented to the contract. After this point, the contracting parties are required to obtain the consent of the third party if they wish to cancel or vary the contract. If consent is not obtained then the third party may bring an action based on the terms of the contract which existed before the variation. However, the LRC proposes that the contracting parties should be able to include an express term in the contract providing for variation or termination. The LRC also acknowledges that the contracting parties can expressly agree to reserve an unlimited right to vary or terminate the contract and while this would reduce the rights of the third party it remains the choice of the contracting parties. The LRC also provides that where a contract jointly benefits more than one third party then each third party must assent to the contract in order for the crystallisation of that third party’s rights to occur;
  • the proposed legislation should also apply where the third party is a consumer;
  • the third party will bring all actions against the promisor (ie. the contracting party who promised the benefit to the third party) only;
  • the existing exceptions should not be abolished; and
  • the contracting parties should be able to expressly exclude the proposed legislation.

The LRC recommends that a number of contracts should be excluded (either because third parties already have enforceable rights or for policy reasons) and the creation of additional rights could cause uncertainty and undermine the policy behind the existing rules. The proposed legislation should not give third parties a right to sue an employee through any contract of employment.  The LRC recommends that the proposed legislation should not apply to section 25 of the Companies Act 1963 (as noted above).

A comparison of the approach taken in England and Wales with the LRC’s proposal

The Contract (Rights of Third Parties) Act 1999 (the “1999 Act”) was introduced into England and Wales in 1999 and is a very similar reform to that proposed by the LRC. In 1996, the Law Commission of England and Wales issued its final report recommending changes to the Doctrine. The Law Commission recognised that a number of bodies had made calls for the reform of the privity rule including the judiciary, academics and other law reform bodies in England and Wales and also in other jurisdictions.  The Law Commission looked to other jurisdictions that had already reformed the privity rules and decided that the most effective way of reform would be through legislation. The 1999 Act provides that a third party can enforce a contract, or a term of a contract, which is made for their benefit if the contract expressly states that they may do so, or if the term purports to confer a benefit on them and the contracting parties cannot show that they did not intend the term to be enforceable by the third party. Comparing the 1999 Act with the draft Contract Law (Privity of Contract and Third Party Rights) Bill 2008 which the LRC appended to the Final Report it is clear that the LRC has taken a similar review and suggested reform similar to that of the Law Commission of England and Wales. The Bill almost replicates the 1999 Act with some minor additional provisions inserted. One extra provision that is in the Bill but not in the 1999 Act which is worth noting is that a third party may enforce a term of a contract (provided the contract expressly provides that the third party may do so and that the term expressly confer a benefit on that third party) even in circumstances where the third party has not provided consideration for that contract. This provision is of course without prejudice to the requirements for consideration between the promisor and promisee.

Conclusion

If the LRC's proposals are accepted and the Bill is adopted, it will have a huge impact on the area of contract law and on commercial agreements going forward in Ireland.

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