Privity of Contract and Third Party Rights - Report 2008

A. What is the Current Situation in Canada?

[11] This part of the Working Group report addresses the first issue identified above: Is there a need for reform in Canada at the present time? The question is not whether the general principle that third parties cannot enforce contracts made for their benefit has to be reformed, since there have already been crucial changes of direction initiated by both legislatures and courts, especially, in the latter case, through the principled exception. The question is more whether there is at this time a call for clarifying and/or further expanding the current exceptions through legislation in the Canadian context. To this end, the report reviews the law surrounding privity in order to determine if the rule, as it now stands, poses the type of problem which requires legislative intervention.

1. The Privity of Contract Doctrine

[12] Two principles underpin the doctrine of privity of contract. First, only a person who is party to a contract can sue on it. Second, it is generally accepted that consideration must have been given by the promisee to the promisor.[3] In other words, a person who wants to enforce a contract must provide something of value in exchange for a promise.[4]

[13] A strict application of the privity rule would prevent a third party C from suing on a contract between A and B. C could not sue despite the fact that the contract confers a benefit upon C;[5] or extends the protection of an exemption clause to C;[6] or gives C an express right to enforce the contract.[7] Even though one of the contracting parties has already paid (or agreed to pay) to the other a price for the benefit conferred upon the third party in the contract, the third party is precluded from enforcing the promise – all because C is not a party to the contract. This could conceivably lead to the result that “a promise given for good consideration will be essentially unenforceable for all practical purposes”.[8]

[14] On the other hand, the privity of contract doctrine still has its merits. It might prevent a third party who is not an intended beneficiary of a particular contract, but only an incidental one, from suing.[9] It might also protect a third party from being held liable where an agreement purports to impose an obligation upon the third party.

[15] The privity of contract rule is still regarded as a well-established feature of law in a number of common law jurisdictions, including most of the Canadian provinces and territories. However, “its force has been significantly undermined by a growing list of exceptions to the rule”.[10] Legislators and courts have, over time, recognized various exceptions and other means to circumvent the rule.

2. Statutory and Common Law Exceptions

[16] A quick review of the various exceptions and the other means by which the rule can be avoided is appropriate at this point. The report reviews examples of when the privity rule has gotten in the way of the contracting parties’ intentions, as well as how contracting parties have been relieved from the strict application of the rule in certain circumstances.[11] Presenting a big picture of the current situation will hopefully help to answer the question of whether there is a need for reform in the Canadian context, and, if so, to what extent should the rule be reformed.

[17] Within this report, the types of cases where the privity rule has caused, or still causes practical difficulties have been loosely divided into categories: (a) Express intention to benefit a third party; (b) Third party as instrument or representative of a contracting party; (c) Chain of contracts; and (d) Rights and obligations follow the “subject matter” of the contract. Admittedly, these categories are in no way watertight. It is additionally possible to subdivide each of the categories, or even add further categories. However, using categories helps to identify the types of situations where it is often necessary to relax the privity rule.  Other legal devices commonly used to circumvent the privity rule, which are not true exceptions, are also examined in order to give an overview of all currently available tools.

a. Express Intention to Benefit a Third Party

[18] The first category deals with the “true” third party beneficiary, that is, a third party expressly identified by name or description as the intended beneficiary of the contract.[12] The benefit expressly provided for in the contract can be financial, commercial, a privilege or other advantage, as well as an indemnity, exemption or limitation of liability, or a mere right to enforce a contract.

[19] Exceptions falling in this category seem to be justified by the fact that a true or express beneficiary should have rights under the contract, and reflects the importance of giving effect to the contractual arrangements entered into by the contracting parties.[13] Examples of when the privity rule has gotten, or might still get, in the way of the parties’ intentions are numerous.[14]

[20] Common law exceptions have developed to enable courts, in appropriate circumstances, to arrive at results which conform to the express intentions of the contracting parties to confer a benefit upon a third party, such as insurance law and pension and benefit law.[15] Numerous statutory provisions also permit certain classes of express third party beneficiary to escape the consequences of the privity rule where the harsh effects of the doctrine would have thwarted the contracting parties’ true intentions. Exceptions falling within the first category are common in particular contexts, such as insurance law, as well as pension and benefit law.[16]

[21] The Supreme Court of Canada has developed the unique “principled exception” which potentially encompasses a good number of cases where true third party beneficiary rights are at stake. In Fraser River Pile & Dredge v. Can-Dive Services Ltd.,[17] the Court allowed Can-Dive, third party named as beneficiary in an insurance contract, to rely on the waiver of subrogation clause contained in Fraser River’s insurance policy in its defence against a negligence action brought by the insurer and Fraser River.

[22] The Court rejected a narrow interpretation of the principled exception first articulated in London Drugs v. Kuehne & Nagel Investments which would have limited the principled exception to cases where parties to contract understood that the services could only be supplied by employees or agents of the supplying party.[18] Instead, the Court held that the principled exception applies to situations that meet the twofold test it had previously put forward:

In terms of extending the principled approach to establishing a new exception to the doctrine of privity of contract relevant to the circumstances of the appeal, regard must be had to the emphasis in London Drugs that a new exception first and foremost must be dependent upon the intention of the contracting parties. Accordingly, extrapolating from the specific requirements as set out in London Drugs, the determination in general terms is made on the basis of two critical and cumulative factors: (a) Did the parties to the contract intend to extend the benefit in question to the third party seeking to rely on the contractual provision? and (b) Are the activities performed by the third party seeking to rely on the contractual provision the very activities contemplated as coming within the scope of the contract in general, or the provision in particular, again as determined by reference to the intentions of the parties?[19]

The Court then affirmed that the principled exception has an open-texture, that is, it is not restricted to a particular class of agreement.[20]

[23] Although Fraser River confirms that the principled exception is not restricted to a particular kind of contract, the twofold test may be more hazardous when the contracting parties expressly confer a direct benefit upon a third party beneficiary who does not have to perform any particular activity coming within the scope of the initial contract or provision.[21] For instance, one could wonder how the twofold test would be met in a case where an individual A agrees to pay a landscaper B to take care of A’s parents’ property. Would the principled exception apply to cases where third parties are not engaged in the “very activity” envisaged by the agreement? However, it is possible that distinguishing between cases where the third party is engaged in the very activity contemplated and cases where the third party does not have to perform any particular activity envisaged by the agreement may not, in itself, be a satisfactory argument to deny the application of the principled exception.

[24] In addition, it is still not clear whether the reach of the principled exception can extend to situations where an express third party beneficiary brings a claim to enforce a contract; or whether its application is restricted to situations where a third party beneficiary relies on a provision of a contract intended for its benefit as a defence against a claim brought by one of the contracting parties. In other words, can the principled only be used as a shield or can it also be used as a sword?

[25] There are, on the other hand, arguments that weigh in favour of using the principled exception both as a shield and a sword. The Supreme Court has opened the door to using the principled exception as a sword by overruling Preferred Accident Insurance Co. of New York v. Vandepitte.[22] Vandepitte had refused a claim by a third party, a named insured, because the latter was not privy to the insurance contract. While one might argue that such an exception had already been recognized in the insurance context prior to Fraser River, it still remains that overruling of Vandepitte could support a claim brought by a plaintiff seeking to enforce a contract or a term of a contract.[23] Furthermore, as McCamus pointed out:

[I]f, as the Court states in Fraser River, the purpose of the exception is to withhold application of the privity doctrine in cases where consideration of ‘common sense and commercial reality’ suggest that the doctrine should be ignored, there appears to be no convincing basis for assuming that such considerations could apply only in the context of third-party reliance on limitations of liability or waiver of subrogation provisions.[24]

[26] Nonetheless, lines of authority are in direct conflict on whether the principled exception can be used as a sword.[25] There is no acknowledged common ground at present.[26] Nor is it clear whether the principled exception has established a “principle” that third parties can enforce contracts made for their benefit or only an “exception” to the common law principle that they cannot. If the expansive view prevailed, the principled exception would be closely equivalent to the civil law principle of “stipulation for another” that allows contracting parties to confer a benefit on a third party which will be directly enforceable by the beneficiary.[27] The option of stipulating for another or conferring to a third party a right to enforce contractual arrangements bargained for its benefit creates a major inroad into the civil law principle of privity of contract which has at times mistakenly lead to the belief that privity is specific to common law jurisdictions.[28]

b. Third Party as Contracting Party’s Instrument or Representative

[27] Sometimes a contract will not expressly identify an intended third party beneficiary. However, there are cases where a contract implicitly benefits a third party.[29] The intentions to benefit a third party can be, among other things, implied from the specific relationships linking the contracting party and the third party. Consequently, the second category embraces situations where a third party is an instrument (vicarious performance/liability) or a representative of a contracting party (implicit agency).

[28] In certain cases, circumstances may allow the inference that the contracting parties recognize that the contractual obligations could only be performed by servants, employees or agents of the supplying party. Here, the third party is a mere vehicle through which one of the contracting parties carries on business or performs its contractual undertakings.[30] In other words, there is a sufficient identity of interests between the corporation and its officers or between the employer and its employees as far as the performance of the employer’s contractual obligations is concerned.

[29]  Contracting parties may also have contracted on behalf of third parties, whether the contracting party and the other parties have an identity of interests or not.[31] In this latter type of case, the contracting parties are the representatives of the third parties, by contrast to the former type of case where the third parties are an instrument of the contracting party.

[30] Common law or statutory exceptions developed in this second category are mainly motivated by considerations of fairness or equity and often require the court’s intervention to prevent contracting parties from evading the agreed contractual obligations. However, this result is often also underpinned by practical and commercial realities, as well as special considerations which arise from certain types of contractual relationships.

[31] The principled exception in London Drugs v. Kuehne & Nagel Investments now provides a remedy for many of these types of cases. Nonetheless, this inroad on the doctrine of privity conveys some analytical difficulties. As mentioned above, the twofold test requires looking at the questions of (1) whether the contracting parties intended to extend the benefit to the third party seeking to rely on the contractual provision, and (2) whether the activity performed by the third party is the very activity contemplated in the contract.[32] Here again, the second branch of the test can be slightly problematic. Problems might indeed occur when liability does not arise from the direct performance of a specific contract which contains the clause that would protect a third party, but instead from the negligence of an employee, agent or servant acting in the course and scope of their general duties.[33]

[32] The problems regarding the second branch of the test might be more apparent than real, however. The second branch requirement that the third party be “engaged in the very activity envisaged by the agreement” essentially allows the inference that the contracting party impliedly intended to extend the benefit to its employees, agents or servants, even though the contract does not expressly say so. Indeed, “a better view of the content of the second branch of the test is that it applies only in cases where the third-party beneficiary is not explicitly referred to in the agreement and it applies in support of an inference that the agreement implicitly so provides”.[34]

[33] Further, as previously noted, there is no consistent case law holding that the principled exceptions can be used as a sword. The shield/sword dichotomy is even more challenging when the third party is an implied beneficiary. Additional concerns arise when the issue is not to prevent a party from evading its contractual obligations, but rather to grant a claim to a third party who is a mere implied beneficiary, because of the risks related to potential double recovery.[35] Moreover, while it might seem fair to allow third parties to rely on a limitation clause impliedly intended for their benefit, it might on the other hand appear unfair to permit implied third parties to recover damages when there is no reciprocity, that is, allowing third parties to sue for breach of contract when they cannot themselves be sued for breach.[36] However, despite some courts’ reservations, nothing in London Drugs or Fraser River plainly limits further judicial developments of the principled exception for use by third party beneficiaries to enforce contractual arrangements both by suit (sword) or defence to a suit (shield).

[34] Moreover, it is not clear whether the principled exception can be used by other implied beneficiaries to make up for a technical lack of privity when it appears to be a sensible conclusion.[37] Is the application of the principled exception justified in cases where there is a community of interests between the third party and one of the contracting parties, or practical necessity?[38] If so, one could argue that we might be on the way towards abolition of the existing doctrine of privity, rather than incremental changes to the common law.[39]

[35] In addition to the principled exception, a number exceptions have also been created to relieve against the consequences of the privity rule in cases where third parties are instruments or representatives of contracting parties, such as insolvency law, will and estate law, mercantile agent law, partnership and corporation law and union law. Moreover, contracting parties can also work around the privity rule by explicitly providing for the use of a separate legal device, such as a trust or agency, and hence escape the undesirable effects of the rule.[40]

c. Chain of Contracts

[36] Another class of third party beneficiary can be added when third parties are not express beneficiaries or even implied beneficiaries of a contract or term of a contract, but simply relational third party beneficiaries. The third category covers cases where a contracting party subcontracts with a “third party” who might also engage in further contractual relationships with another “third party” and so on. Chains of contracts are common in commercial contexts where a contracting party will often chose to subcontract in order to fulfill its contractual obligations.

[37] One of the main arguments for relaxing the privity rule for chains of contracts is that there is no good reason to preclude parties that are integrated in a chain of contracts, thus not complete strangers to the head contract, from recovering or protecting themselves against subrogated lawsuits when it is not at odds with the general intentions of the parties or the object of the contract. Commentators have also suggested that such an exception would help to reduce wasteful transaction costs, as well as some of the practical difficulties which may occur when all parties cannot be identified by name or class at the time the head contract is entered into.[41]

[38] It is true that the principled exception in London Drugs and Fraser River could apply to chain of contracts if the twofold test is met. However, unless the contracting parties intended to benefit a third party and the third party was performing the activities envisaged in the contract, it would be impossible to alleviate the consequences of the privity rule through the principled exception.[42]

[39] Again, however, a small number of exceptions have developed to relieve against the strict application of the doctrine of privity of contract in certain contexts, such as intellectual property law, shipment and carriage law and construction law.[43]

[40] Some commentators have suggested that expanding the current exceptions in other commercial contexts would be cost and time efficient, but also “consistent with modern notions of commercial realty and justice”.[44] Anyway, it is likely that chains of contracts are better dealt with on a piecemeal basis through both judicial and legislative intervention in accordance with the circumstances of each case.

d. Rights and Obligations Follow the “Subject Matter”

[41] The fourth category embodies cases where a contractual right or obligation follows the specific “subject matter” of the contract whether it is the intention of the parties or not. In certain circumstances, particular rights or obligations “attach” to the goods, real property, chattel or document of title which is the subject of the contract. The “ownership” of the contractual right or obligation is contained in the “subject matter” of the contract itself.

[42] Certain rights and obligations may indeed pass to successors if these rights or obligations are incidental to or directly related to the property.[45] Courts and legislators alike have long accepted that practical realities could compensate for the lack of privity in appropriate circumstances.

[43] Hence, commercial convenience and efficiency have prompted the development of common law and statutory exceptions in particular contexts, such as real estate law, landlord and tenant law, merchant law, surety law, merger, acquisition and other changes of corporate control law and consumer law.

3. Legal Devices Ousting the Privity of Contract Rule

[44] In addition to the categories of exception discussed above, there are other means of working around the privity rule. These legal devices are not, per se, exceptions to privity. However, they are established devices designed to help parties structure their contracts to avoid the detrimental effects of the rule, or they offer another course of action to third parties who have no contractual rights owning to the lack of privity.

a. Other Means of Circumventing the Privity Rule

[45] A number of separate means of circumventing the privity rule have been extensively used to facilitate legal transactions, such as agency, trust, assignment, novation, as well as collateral contract and collateral warranty.[46] In most cases, such relief will, however, require the evidence of a real intention to create a trust or an agency or the use of a specific wording, or the compliance with certain formalities and restrictions to assign contractual rights, or the construction of a collateral contract or warranty.

[46] Nonetheless, one should not forget that all these recognized legal devices carry their own specific requirements, and should not be used lightly, or made up for the mere purpose of escaping the consequences of privity after the fact.

b. Other Causes of Action

[47] Third parties who are not permitted to bring an action in contract may base their claims on other available courses of action. For example, a contracting party may also be independently liable in tort to a third party for physical injury, property damage, and even economic loss in certain circumstances.[47] There are also a number of sui generis causes of action available, such as breach of confidence and fiduciary relationship, as well as additional remedies in restitution, such as unjust enrichment, promissory estoppel and damages for third party beneficiary loss (contracting party enforcing third party beneficiary rights in particular contexts).

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