Towing the third party line

The Contracts (Rights of Third Parties) Act 1999 reforms the rule of "privity of contract" under which a person can only enforce a contract if it is a party to it. This rule meant that, even if a contract was made with the purpose of conferring a benefit on someone who was not a party to it, that person (a "third party") had no right to sue for breach of contract.

A simple example of this would be where a father contracts with a builder to carry out work on his daughter's flat. The builder fails to carry out the work. The rule of privity of contract prevents the daughter, who is the third party, from enforcing the contract because she is not a party to it, and the father, who can enforce the contract, has not sustained any loss as a result of the builder's breach as he was not intended to receive the benefit of the contract. Therefore he cannot recover damages for breach of the contract.

The act now means that the third party – the daughter – has a right to enforce the contract and, if necessary, sue the builder for breach of contract and recover damages.

Section 1: right of the third party to enforce contractual terms

Third parties do not automatically acquire any rights under a contract. Section 1(1) sets out two alternative circumstances where a third party may of its own right enforce a term of a contract: (a) the contract itself expressly provides that the third party may enforce a term of the contract, or (b) the contract "purports to confer" a benefit on the third party.

Section 1(2) states that, if on the proper construction of the contract, it was not intended to grant the third party a right to enforce a term of the contract, then section 1(1)(b) will not apply. Thus the third party's right to enforce depends entirely on the contracting parties' intention when they entered into the contract. The parties' intention should, wherever possible, be stated clearly in the contract. If it is not, then it will be for the courts to determine if the contract "purports to confer" a right of action on the third party.

There are a number of practical solutions to overcome this uncertainty. First, include a clause expressly stating that the contract does not intend to confer a benefit upon the third party. In these circumstances, the third party will need to continue to rely on collateral warranties. Conversely, include a clause expressly conferring certain benefits upon a third party, and identifying exactly what the benefits are.

Section 1(3) requires that for a third party to be able to enforce its rights under the act, the third party must be expressly identified in the contract by name, class or description. The third party need not be in existence when the contract is made. In practical terms, for the construction industry, it will be necessary to carefully describe the intended third parties.

A third party's right of enforcement is subject to the contract's terms and conditions and, consequently, the contracting parties are also able to limit or place conditions upon the third parties' right of enforcement.

If a third party does seek to enforce its rights under section 1(1), then, subject to any express limitations, all the remedies that are available to the parties to the contract, if they were bringing a claim for breach of contract, are also available to the third party. The normal rules of law will be applicable to those remedies, including the rules relating to causation, remoteness and the duty to mitigate one's loss, together with any other limitations that the contract contains.

Section 2: variation and recision of the contract

This particular section caused considerable concern in the construction industry because building contracts by their very nature require variations to the works as the project proceeds. The Lord Chancellor has, however, clarified that the expression "variation" is used in its strict legal sense as a variation to the terms of the agreement and not in the sense used by the construction industry.

Section 2(1) makes it clear that the parties are not entitled to rescind the contract without the third party's consent: (a) where the third party has communicated his agreement to the term, (b) where the party to the contract is aware that the third party has relied upon the term, or (c) where the party to the contract can reasonably be expected to have foreseen that the third party would rely on the term and the third party has in fact relied upon it.

To avoid difficulties, the parties to the contract should expressly state that they may by agreement rescind or vary the contract without the consent of the third party, or specify when a third party's consent is required.

Section 3: defences

At this point it is worth explaining the terms "promisor" and "promisee". These are used throughout the act and are defined in section 1(7). The "promisor" is the party to the contract against whom the term or clause of the contract is enforceable by the third party. In the example of the father contracting with a builder for the benefit of his daughter, the contractor is the promisor. The "promisee" is the party to the contract by whom the term or clause of the contract is enforceable against the promisor; that is, the father.

Section 3(2) states that the promisor shall have available to him by way of defence or set-off any matter that arises from or in connection with the contract and is relevant to the term, which effectively means that the third party cannot enforce a void, discharged or unenforceable contract any more than the parties to the contract could. It also states that the promisor shall have available to him by way of defence or set-off any matter that would have been available to him by way of defence or set-off if the proceedings had been brought by the promisee rather than the third party.

For example, an employer (promisor) and main contractor (promisee) contract that the contractor will carry out the works and the employer will pay direct to the mechanical and electrical subcontractor (third party) the contract price in respect of the M&E works. The subcontractor is a domestic subcontractor of the main contractor, carrying out the M&E works on behalf of the main contractor.

In breach of the contract between the employer and the contractor, the works the subcontractor carries out are not to the standard required by the contract and, consequently, the employer does not pay the subcontractor. In an action brought by the subcontractor for the value of the works, the employer is entitled to reduce or extinguish the subcontractor's claim by reason of the damages for breach of contract, even though the subcontractor is not party to the contract between the employer and the main contractor.

Section 3(3) states that the promisor shall have available to him by way of defence or set-off any matter if an express term of the contract provides for it to be available to him in proceedings brought by the third party, and it would have been available to him by way of defence or set-off if the proceedings had been brought by the promisee.

Again, it is easier to explain this by way of example. Two developers, Developer A (promisor) and Developer B (promisee), contract that Developer A will pay the surveyor (third party), who was the agent on Developer B's property, if Developer B transfers the property to Developer A. In a totally unrelated transaction, Developer B owes Developer A money and, consequently, Developers A and B agree an express term in the contract that provides that Developer A could raise against a claim made by the surveyor any matter that would have given Developer A a defence or set-off to a claim made by Developer B.

The result is that, if the surveyor attempts to make a claim against Developer A for his agency fees, then Developer A is entitled to reduce or extinguish the surveyor's claim by reason of the money owed to Developer A by Developer B. This may appear harsh for the surveyor, who has only attempted to get his agency fees; however, the surveyor still has a contract with Developer B and, consequently, could mount a claim for those fees from Developer B rather than Developer A. The act has merely given him two choices of potential defendant, rather than one.

Section 3(4) makes it clear that the promisor also has available any defence or set-off and any counter-claim not arising from the contract that is specific to the third party. For instance, a main contractor (promisor) contracts with a subcontractor (promisee) to pay the subcontractor's supplier (third party) £10 000, being the value of the work that the subcontractor has subcontracted to carry out. The supplier, in fact, supplies both the subcontractor and the main contractor. The main contractor's account with the supplier is in credit by £6000. The main contractor therefore has a set-off against the supplier's claim for £10 000. The main contractor is only bound to pay the supplier £4000 despite the contract with the subcontractor stipulating that the main contractor should pay £10 000.

Section 3(5) makes the defences or set-offs available under section 3(2) or the defences, set-offs or counterclaims available under section 3(4) subject to the express term of the contract. The parties to the contract can, by express provisions in the contract, reduce the number of defences, set-offs or counter-claims available to the promisor.

Section 3(6) provides that where proceedings are brought against a third party and the third party seeks by virtue of section 1 to rely on a term of the contract, such as an exclusion clause, then the third party may not avail himself of that defence if he could not have done so if he had been a party to the contract. The most obvious example is where the promisee is prevented by an express term of the contract from relying upon a net contribution clause to reduce his liability. It would appear by virtue of section 3(6) that the third party in any proceedings brought against it would also be unable to rely on the net contribution clause to reduce its liability as well.

Section 4: enforcement of contract by promisee

This makes it clear that the third party's rights to enforce the contract are in addition to any rights that the promisee has to enforce any term of the contract against the promisor.

Section 5: protection of promisor from double liability

This section protects the promisor from double recovery; where the money has already been recovered on behalf of the third party by one of the contracting parties. The remaining three sections deal with miscellaneous matters.