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Third-party clauses in a contract

August 21, 2021
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This article is written by Satendra Pratap Singh, pursuing a Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from Lawsikho.

Introduction

The case for establishing a contract for the benefit of a third party is simple and straightforward. The basic principle of following the footprints of the intentions of the parties to the contract is highly desirable from the adjudicators. The general principle standing from centuries is that there should not be any burden imposed on the third parties. Among various principles of contract, one such principle is the Doctrine of Privity which laid down that a contract does not confer rights on someone who is not a party to a contract. However, one question which has troubled many eminent jurists since the 16th and 17th century is, “whether or not a third party enforced a contract that benefited him?” 

Until the mid-19th century, there was no clarity on this question and the position had to be clarified in the case of Tweddle v. Atkinson where only the party to the case who had provided consideration could sue on it. The same principle was later acknowledged in various cases like Gandy v. Gandy and Dunlop Pneumatic Tyre Co. Ltd. v.  Selfridge and co. Ltd. The courts of equity wanted to mitigate the hardships by applying the doctrine of consideration trust but the device failed as the judges wanted the strict application of fiction. In India there had been a conflict of judicial opinion however the preponderance view is that the English doctrine of privity applies in India notwithstanding Section 2 (d) of the Indian Contract Act, 1872 which lays down that consideration must proceed from the promisee, in conformity with the English rule. 

Exceptions to the Doctrine of Privity

It is well accepted by various legal jurisdictions across the globe including India that strict adherence to the Doctrine of Privity is bound to cause hardships. However, the present state of the law in  India is quite certain and the particular exceptions formulated by the laws and statutes do not cover all the problems and thus enhance the bewilderment of the laymen. As observed by the U.K. Law Commission report (1996) various topics like trusts of the promise, covenants concerning land, Tort of Negligence, Agency Assignment, collateral contracts, etc. are some exceptions to the Doctrine of Privity. 

What is a subcontract clause?

A subcontract is a contract between a firm (the original party who is employed to do a job) and a firm (a third party who agrees to do part of a job). The general law allows the original parties to subcontract out or delegate- services that are contracted to supply to its customers without taking prior consent from the other party.  However, subcontracting out any work would not enable the original party to pass- on the liability to the subcontractor or third party. In the event of shoddy work or any incompetency done by the subcontractor or third party, the liability would be on the original party and the client or customer can claim damages from him for a breach of contract. However, it is important to note that the original party can sue the subcontractor or third party for substandard work depending on the terms of the contract for the subcontract. Generally, customers require the service providers not to subcontract out any work without their prior consent and make sure to insert a subcontracting clause as per their business needs. One such example of such clause is;

“The service provider shall not without the prior written consent of the client subcontract any of the services to be supplied by the service provider to the client.” 

Also, a better way of dealing with this clause is by listing out activities in an exhibit that cannot be subcontracted and the terms required to be fulfilled to engage any subcontractor like years of experience, reputation, area of specialization, etc. 

What is an assignment clause?

‘Assignment’ means a transfer of contractual rights or liability by a party to the contract to a stranger who is not a party to the contract. Under Section 37 of the Indian Contract Act, 1872 the parties to a contract can dispense with a performance by way of assignment. As per Indian law, any type of contract can be assigned if it has consent from the party at risk. However, if two parties have entered into a contract relying on the personal skills of the promisor then the said type of contract cannot be assigned. Also, there are few more exceptions of assignment like a contract of personal nature, incapable of assignment under law or terms of the agreement. Hence it is highly recommended to state the intent in the contract expressly with due care and caution to avoid adverse consequences. 

The general principle in contracts that “an obligation cannot be transferred to the third party without his consent” affects the Assignment clause the most. “As a rule, obligations under a contract cannot be assigned except with the consent of the promisee, and when such consent is given, it is a novation resulting in a substitution of liabilities”. Assignment of contractual rights or benefits arising out of a contract is a very important tool available with the lenders to secure its rights against the borrower. Assignment of contractual rights or benefits arising out of the contract is the most important tool available with the lenders to secure its rights against the borrowers. 

Collateral contracts

Collateral contracts are contracts that are in addition to the original or main contract. They are an exception to the Parol Evidence Rule which says that anything other than the words are written in the contract can not affect the terms of the contract. Any extrinsic evidence will not have any value unless it is written and it was agreed between the parties that the contract shall never be in one place and was never intended to be completely written. To prove an oral statement to be a part of an oral contract, the plaintiff must prove that the said statement was promissory and was not an opinion or an informal statement. An example of a Collateral Contract clause:

 Collateral Agreement means any separate agreement between Borrower and Lender and any other party (if applicable) for the establishment of any other fund, reserve or account related to the Mortgage Loan or the Mortgaged Property.”

When is the Himalaya clause inserted?

A Himalaya clause is inserted to benefit the parties who are strangers to the contract mostly in contracts of the carriage like bills of lading. The intention is to exempt the servants, agents, and independent contractors as far as possible from any possible liability from the parties like the shipper, consignee, or holder of the bill of lading. The idea is to put an obligation on the other parties not to sue the agent, servant, subcontractor of the contractual carrier, etc. employed for the performance of the original contract. The example of a Himalaya clause is 

“It is hereby agreed that under no circumstances the merchant shall undertake any allegation or claim against any servant, agent, subcontractor whether arising in tort, bailment or contract of carriage.”  

Conclusion

It is very important to express the intentions of the parties to the contract in case of third-party rights or else it might lead to huge loss to the party because allowing third party rights in a contract expands the horizons of risks as anyone benefiting from the clauses can sue the contracting parties. The drafting of third-party clauses requires precise skills to grant rights (as opposed to excluding them). It also depends on the rights to be granted, to whom they’re to be granted and limitations attached thereto. It is open to the contracting parties to grant narrow or wide rights to third parties or to eliminate them altogether. The latter approach is generally found in the standard form of contracts.  In 1996, the Law Commission of the U.K. published its report “Privity of Contract: Contracts for the Benefit of Third Parties” and annexed a draft Bill, subsequently being passed by the House of Lords in 1999. There has been a wave of clarity in the said topic of law as various nitty-gritty has been solved by the codified provisions of the Act.  There are two ways as per Section 1 of the amendment Act by which third party rights can be granted firstly it expressly provides and secondly if a term of the contract purports to confer a benefit on the third party. The provision for identification of the third party is highly applauded as it helps to eliminate uncertainty and risk extraordinarily. Also, the third party is entitled to any possible remedy that would have been available in case of breach of contracts like suit for damages, injunction, or specific performance. 

Under the new Act, the third parties are not kept safe from potential legislation by exclusion or limitation clauses. As per Section 3(6), any third party can take benefit of any clause only if he could have done so if he were a party to the contract. In India, there is a need for such an amendment to avoid ambiguity and bring certainty in contract-related disputes. Although the Law Commission of India has recommended the government from its report twice that they completely agree with the changes proposed by the Law Commission of the U.K. in 1996 still there is no movement as of now but the judiciary has time and again alarmed the legislature for such need in the current market and hopefully, there shall be a green signal soon. 

References


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