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The rule of privity of contract is the principle that a third party cannot sue for damages on a contract to which he is not a party. This rule has been strongly criticized in recent times, particularly where the contract is for the benefit of the third party. Indeed civil law systems of other States recognize and enforce such contracts. Despite calls for statutory reform, the rule persists in Indian Law to prevent a third party enforcing contractual provisions made in their favour.
The common law doctrine of privity means that a “contract cannot, generally, confer rights or impose obligations arising under it on any person except the party to it”. The second part of this doctrine (under which a contract cannot impose liabilities on anyone except the parties to it) is generally regarded sensible and just as it would not be fair to subject people to contractual obligations without their consent. But the first part (under which a contract cannot confer rights on anyone except a party to it) has been subject of much criticism.
A third party beneficiary, in the law of contracts, is a person who may have the right to sue on a contract, despite not having originally been a party to the contract. This right arises where the third party is the intended beneficiary of the contract, as opposed to an incidental beneficiary. It vests when the third party relies on or assents to the relationship, and gives the third party the right to sue either the promisor or the promisee of the contract, depending on the circumstances under which the relationship was created. In order for a third party beneficiary to have any rights under the contract, he must be an intended beneficiary, as opposed to an incidental beneficiary. The burden is on the third party to plead and prove that he was indeed an intended beneficiary.
An incidental beneficiary is a party who stands to benefit from the execution of the contract, although that was not the intent of either contracting party. For example, if party A, hires party B, to renovate his house, and insists that B use a particular house painter—party C, because that house painter has an excellent reputation, then the house painter is an incidental beneficiary. Neither A nor B is entering into the contract with the particular intent to benefit C. A simply wants his house properly renovated; B simply wants to be paid to do the renovation. If the contract is breached by either party in a way that results in C never being hired for the job, C nonetheless has no rights to recover anything under the contract.
The distinction that creates an intended beneficiary is that one party - called the promisee - makes an agreement to provide some consideration to a second party - called the promisor - in exchange for the promisor's agreement to provide some product, service, or support to the third party beneficiary named in the contract. The promisee must have an intention to benefit the third party. For example, if party X, contracts with party Y to deliver certain product to party Z, for Z’s benefit, then in that case Z becomes the intended beneficiary under the said contract.
When a contract confers the status of intended beneficiary on a third party, this does not mean only the performance must be rendered to or for the benefit of the third party, it also means that the contract manifests the intent to grant the beneficiary an independent cause of action to enforce the promise i.e. Once the beneficiary's rights have vested, the original parties to the contract are both bound to perform the contract. Any effort by the promisor or the promisee to rescind or modify the contract at that point is void. Indeed, if the promisee changed his mind and offered to pay the promisor money not to perform, the third party could sue the promisee for tortious interference with the third party's contract rights.
There are three tests used to determine whether the third party beneficiary's rights have vested:
1. if the beneficiary knows of and has detrimentally relied on the rights created;
2. if the beneficiary expressly assented to the contract at the request of one of the parties; or
3. if the beneficiary files a lawsuit to enforce the contract
Where a contract for the benefit of a third party is breached by the non-performance of the promisor, the beneficiary can sue the promisor for the breach just as any party to a contract can sue the other. Because the rights of the third party are defined by the contract created between the promisor and the promisee, the promisor may assert against the beneficiary any defenses to the contract that could be asserted against the promisee. These include all of the traditional basis by which the formation of a contract may be challenged like lack of capacity, lack of consideration, etc.; and all of the traditional bases by which non-performance on the contract may be excused like failure of consideration, impossibility, illegality, etc.
It wasn’t until the mid-19th century, that a hard and fast rule developed that a third party could not enforce a contract to which he was not a party. Prior to this, there were authorities supporting both this view and the contrary view. In Tweddle v. Atkinson, the Court acknowledged the existence of contrary authorities, but held that the doctrine of privity of contract meant that third party beneficiary could not enforce against the promisor the promise that the promisor had made to the promisee. The rule was affirmed in Dunlop Pneumatic Tyre Co. Ltd. v. Selfridge & Co. Ltd where it was accepted that it was a fundamental principle of law that only a party to a contract who had provided consideration could sue on it.7 The rule has subsequently been reaffirmed in numerous cases, including Beswick v. Beswick. In Beswick, a coal merchant agreed to transfer a business to his nephew in exchange for a salary and the payment of a weekly annuity to his widow on his death. On Beswick’s death, however, the nephew refused to pay the annuity. The widow brought an action in her personal capacity as the beneficiary of the contract and in her capacity as administratrix of the estate. The House of Lords held that she was not entitled to enforce the contract in her personal capacity, but as administratrix of the estate (as her deceased husband’s representative) she was able to obtain specific performance.
The Supreme Court has by its decision in M.C. Chacko v State of Travancore expressed itself in favor of the rule in Tweddle v. Atkinson thus clearing the ambiguities in the application of the doctrine of Privity of Contract. In this case, the appellant was the Managing Director of the Highland Bank. K, the father of the appellant, had guaranteed amounts due by Highland Bank to Kottayam Bank for an overdraft arrangement between the two banks. K had executed a deed making the appellant and other members of the family as universal donees of his properties. K’s guarantee was barred by limitation. The Kottayam Bank sued the Highland Bank and the appellant and other members of the family. The claim against the appellant rested upon the fact that he was one of the donees under the deed, which, it was claimed, created a charge on the properties mentioned.
The Supreme Court held that the deed was an arrangement binding between the members of the family for satisfaction of the debt, if any, under the guarantee. The covenant that K would either personally or out of the properties given to him satisfy the debt, was intended to confer an indemnity upon the appellant and others. It did not create a chargein favour of the bank. According to the principle that a stranger cannot sue under a contract, the Kottayam Bank could not recover under the deed. There are two aspects of this doctrine (privity of contract). Firstly, no one but the parties to the contract is entitled under it. Rights or benefits may be conferred upon a third party but such a third party can neither sue under the contract nor rely on defenses based on the contract. The second aspect is that the parties to a contract cannot impose liabilities on a third party.
Remedies Available to the promisee for the benefit of the Third PartyThird parties for whose benefit a contract has been made may not sue on the contract but the party making the contract may sue for specific performance for the benefit of the third party even where damages obtainable will be nominal. Third parties cannot be under an obligation to perform or demand performance under a contract. The general rule is that only the person entitled to the benefits or bound by the obligations of a contract are entitled to sue or be sued upon this. This is so even where it is clear from the contract that some provision in it was intended to benefit such third party. It can neither be used as a shield nor as a sword.
Exceptions to Application of Principle
If a third party gets a benefit under a contract, it does not have the right to go against the parties to the contract beyond its entitlement to a benefit. An example of this occurs when a manufacturer sells a product to a distributor and the distributor sells the product to a retailer. The retailer then sells the product to a consumer. There is no privity of contract between the manufacturer and the consumer.
But the parties can exercise a different form of action e.g. Donoghue v. Stevenson – here a friend of Ms. Donoghue bought her a bottle of ginger beer, which was defective. Specifically, the ginger beer contained the partially decomposed remains of a snail. Since the contract was between her friend and the shop owner, Mrs. Donoghue could not sue under the contract, but it was established that the manufacturer has a duty of care owed to their consumers and she was awarded damages in tort. Privity is the legal term for a close, mutual, or successive relationship to the same right of property or the power to enforce a promise or warranty. The Consumer Protection Act, 1986 makes the user of the good who has not paid consideration also a consumer which is a deviation from the general rule of privity of contract.
There are exceptions to the general rule, allowing rights to third parties and some impositions of obligations. These are:
* Collateral Contracts (between the third party and one of the contracting parties)
* Trusts (the beneficiary of a trust may sue the trustee to carry out the contract)
* Land Law (restrictive covenants on land are imposed upon subsequent purchasers if the covenant benefits neighboring land)
* Agency and the assignment of contractual rights are permitted.
* Family Arrangements and Marriage Settlements
Law commission long back on 26th September, 1958 in its thirteenth report stated that “the Preamble says, the Act of 1872 does not profess to be a complete Code dealing with the law relating to contracts. The legislature, while enacting this Act, did not intend to exhaustively codify the whole of the law of contract to be applied by the courts in India or any particular sub-division thereof”. It also explained the hardship caused by the doctrine of priviry of contract citing the case of “Tweedle v. Atkinson” and Krishna lal v. Promila and thereby recommended the enactment of a law conferring third party beneficiary rights but we have still not implemented it. It was recommended by the Law Commission “that a rigid adherence to the doctrine of privity is bound to cause hardship is obvious. The present state of law in India is not quite certain and the particular exceptions which have been acknowledged by case-law and statutes do not cover all cases of hardship and thus enhance the bewilderment of the layman.
As we anticipated in our Report on the Specific Relief Act, the better course would be to adopt the general exception to cover all cases of contracts conferring benefit upon third parties and dispense with the particular instances where the rule of privity should not apply and a separate section be incorporated on the lines thereof”. In the mean time, several other commercial leaders like U.K, U.S, Australia, Singapore, Hong Kong and New Zealand have introduced to plug this lacuna. It is high time our Parliament should take cognizance of this serious issue and enact legislation similar to the Contracts (Rights of Third Parties) Act, 1999 enacted in U.K.
Statutes Conferring Rights or Imposing Liabilities on Third PartiesIn Australia, it has been held that third-party beneficiaries may uphold a promise made for its benefit in a contract to which it is not a party in Trident General Insurance Co Ltd v. McNiece Bros Pty Ltd case. Although damages are the usual remedy for the breach of a contract for the benefit of a third party, if damages are inadequate, specific performance may be granted as described in Beswick v. Beswick case. Section 11 of the Western Australian Property Law Act 1969 enables the enforcement of a contract by the third party on whom benefit is conferred expressly by the contract.
New Zealand has enacted the Contracts Privity Act 1982, which enables third parties to sue if they sufficiently identified as beneficiaries by the contract, and in the contract it is expressed or implied they should be able to enforce this benefit.
Since the New York Court of Appeals decision in Lawrence v. Fox, it has been generally accepted in the U.S. that a third party is able to enforce a contractual obligation made for his benefit. The First Restatement of the Law of Contract in 1932 restricted third party rights to those who fell in one of two categories i.e. donee beneficiaries and creditor beneficiaries. The courts however found these two categories overly restrictive and eventually adopted the “intention to benefit test”.
The Second Restatement of Law of Contract in 1981 adopted the intention to benefit test. The Second Restatement addresses other issues including variation and termination and defences. The well established rule in Illinois is that if a contract is entered into for the direct benefit of a Third person, the third person may sue for a breach of the contract in his or her own name, even though the third person is a stranger to the contract and the consideration. This principle of law is widely accepted throughout the United States, because allowing a third party beneficiary to sue the promisor directly is said to be manifestly just and practical. In cases it increases judicial efficiency by removing the privity requirement, under which the beneficiary must sue the promisee who then in turn must sue the promisor.
The common law did not recognize third party beneficiary rights. The leading authority was “Beswick V. Beswick”. The U.K. recently adopted detailed legislation, the contracts (Right of Third Parties) Act 1999, abrogating the rule of privity of contract for third party beneficiaries. The U.K.’s 1999 Act was modeled in part on the New Zealand Contracts (Privity) Act 1982.Calls for reform in the area; however, date back to at least 1937 with the recommendations of the English Law Revision Committee. This earlier call for reform was not implemented. In 1991, the Law Commission (for England and Wales) put forward for discussion in a consultation paper proposals for reforming the privity rule and subsequently recommended a detailed legislative scheme in its final report in 1996.An important consideration behind its recommendation for detailed legislative reform was the fact that although the House of Lords had been highly critical of the third party rule in English law it had declined on a number of occasions to reconsider it.
The U.K’s 1999 Act essentially replicates the recommendations in the Law Commission’s 1996 report. The 1999 Act has been generally well-received. In contrast, the U.K. Act offers a greater balancing of third party interests with those of the contracting parties. It provides that where a third party right arises under the terms of the contract, the parties to the contract may not vary or rescind it without the consent of the third party once: (i) the third party has communicated his assent to the term to the promisor; or (ii) the promisor is aware that the third party has relied on the term; or (iii) the promisor could reasonably foresee that the third party would rely on the term and the third party has relied on the term.
The Law and Revision Division of the Attorney-General’s Chambers, Singapore introduced legislation that is virtually identical to that of the U.K.
On 25th October 2005, the Law Reform Commission of Hong Kong released a report on proposals to reform the doctrine of Privity of Contract. The report recommends that the doctrine should be reformed by means of a detailed legislative scheme which would provide comprehensive, systematic and coherent solutions. It also recommends that all the major issues arising from their proposed statutory exception should be dealt with in the new legislation. In a nutshell the proposed reform should be regarded as a general and wide-ranging statutory exception to the privity doctrine.
The working group for the Preparation of Principles of International Commercial Contracts of UNIDROIT, the international institute for Unification of Private Laws also developed draft articles to recognize third party beneficiaries. The draft articles included provisions addressing the identification of third parties, exclusion and limitation clauses, defenses, revocation and renunciation.
Thus from the above statements we can conclude that where a contract is made for the benefit of a third person there may be an equity in favour of the third person to sue upon the contract, and it has been suggested that a person who takes a benefit under a contract may sue on the contract. Thus, a stranger having beneficial interest under a contract can sue in equity to enforce although he himself is a stranger to the contract.
The rigid adherence to the doctrine of privity of contract under the present state of law in India should be done away with to remove the hardship caused by the same. This can be done by dispensing with the particular instances where the rule should not apply and by incorporating a separate section with similar instances under the laws adopted by other countries mentioned above.
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