privity of contract

Last modified: Thu Feb 23 16:37:37 2006

A well-established principle of contract law (see: Contract) is that only the parties to the
contract can make claims against it. The archetypal case is Dunlop v Selfrige in which
Dunlop took action against Selfridge for breach a contract with an intermediary (see:
Dunlop V Selfridge1945). The House of Lords ruled that Dunlop were not a party to the
contract that was breached, and could therefore not enforce it.

Clearly it is fair that people should not incur obligations in respect of contracts to which
they are not party and which offer them no benefits. However the principle of privity
does mean that it is difficult to enter a contract that benefits a third party without taking
out a separate contract with the third party. For example, in Woodar v Wimpey see:
Woodar Investment Development Ltd V Wimpey Construction Ltd 1980 Wimpey
contracted to pay £850,000 for land to Woodar, and £150,000 to a third party. When
Wimpey tried to back out of the deal, they claimed that they could not be sued for the
£150,000 because of privity. This claim was upheld by the House of Lords. The case of
Tweddle v Atkinson rested on the same issues (see: Tweddle V Atkinson 1861).

While there have long been specific statutes allowing third-party rights under contracts
(motor insurance, for example) there were repeated calls for the law on privity to be
reformed to extend the abilities of third parties in general to enforce a contract for their
benefits The Contracts Rights Of Third Parties Act 1999 goes some way towards this.

Briefly, a third party can enforce a contract if:

 the contract specifically provides for this, and

 the contract benefits the third party, and
 the allowed third parties must be identified in the contract, and
 the contracting parties consent to the provision for third-party enforcement.

The doctrine of privity poses particular problems for exclusion clauses in contracts (see:
Privity And Exclusion Clauses).

privity and exclusion clauses

Last modified: Thu Feb 23 16:37:37 2006

In general an Exclusion Clause in a Contract acts to defend one of the parties, usually for
consequences of a Breach Of Contract or Negligence. The clause describes a relationship
between the contracting parties. It is sometimes desirable to extend an exclusion clause to
parties outside the contract. For example, a company may wish to protect contractors that
it employs. On the whole, however, Privity Of Contract acts to restrict the effect of such
clauses on third parties.

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The courts usually try to enforce a contract in the way the contracting parties intended.
For example, if I sign a contract to the effect that I indemnify you and your agents, and I
do so of my own free will, then clearly I have an obligation to do so. In some cases the
courts are able to find ways to enforce the parties' intentions without offending any legal
principles, although tortuous logic may be required (see: The Eurymedon 1975).

The Eurymedon (1975)

Last modified: Thu Feb 23 16:37:38 2006

This case (The Eurymedon [1975] AC 154) demonstrates that although an existing
contractual obligation cannot usually be consideration (see: Consideration) in an
agreement between the contracting parties, it is possible for an obligation to a third party
to be so deemed. There is some rather tortuous reasoning in the judgement; this probably
arises because in fact the intentions of all the contracting parties were clear; the court
strove to find terms under which it could deliver a judgement that reflected these
intentions.

The case concerns a carrier of goods by sea, the owners of the goods (the plaintiff) and
the stevedors (defendents). The owner contracted with the carrier to deliver a piece of
machinery. The contract contained an exemption clause to the effect that the owners
could not sue for damages in respect of negligence after one year, and that the owners
would extend the same exemption to the carriers' agents at the docks (the stevedors, in
this case).

The stevedors damaged the machine at the dock; that this was a result of their negligence
is not in dispute. However, the owners did not bring suit until the time set out in the
exclusion clause had elapsed. They could not sue the carrier, as the exclusion clause
would have defeated their suit. So they sued the stevedors. The owners argued that there
was an implied contract between themselves and the stevedors, and under the terms of
this implied contract the stevedors should have exercised due care in the unloading.
Because they did not, they were liable for damages.

This seems on the face of it to be a good case. However, it is clear that when the owner of
the goods contracted with the carrier, they fully consented to exempt the carriers and their
agents from liability for negligence. It hardly seems fair that they should wriggle out of
this exemption on a technicality.

Now, the stevedors could not rely on the exemption clause as a term in the original
contract itself, as this would be contrary to the principles of Privity Of Contract, even
though the clause was for their benefit. So the problem for the court was to find a way in
which there was an implied agreement between the stevedors and the owners that did
include this clause. The reasoning goes like this:

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  in contracting with the carriers, the owners of the goods made a unilateral offer to
the effect that a party (as yet unknown) could unload the goods at dockside with
the benefit of the exclusion clause.
 the stevedors accepted this offer; acceptance was signalled by their performing
the requested action (as per Carlill v Carbolic Smoke Ball Co, see: Carlill V
Carbolic Smoke Ball Co 1893)
 this acceptance formed a valid implied contract, because all the required
provisions for validity were in place (see: Contract); the only tricky one was
consideration, which was deemed to be the process of unloading the goods.
 therefore the stevedors had a contract with the owners, in which they were
exempted from liability after one year.
 therefore the stevedors were not liable.

Although the reasoning is strained, the judgement gives effect to the original intentions of
the contractees, and does not offend against any other precedents.

However, it is interesting to ask what the situation would have been if the stevedors had
damaged the goods before fulfulling their consideration, e.g., on ship itself. Then,
presumably, there would no consideration and no contract.

Privity of Contract
© Daniel Atkinson 1999

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 criticised in recent times, particularly where the contract is for the
benefit of the third party. Indeed civil law systems of other members of the European Union recognise and
enforce such contracts. Despite calls for statutory reform, the rule persists in English Law to prevent a third
party enforcing contractual provisions made in their favour.

The existence of the rule is the reason behind the rise in the use of collateral warranties. Collateral warranties
bypass the rule by creating separate independent contracts collateral to the consultancy or construction
contract. It allows future owners of developments to sue consultants or contractors for defects in the design or
construction under the collateral warranty. There would be no cause of action under the original consultancy
or construction contract.

A further fundamental principle is that the assessment of damages for breach of contract is meant to be
compensation for damage, loss or injury suffered through the breach. It therefore allows the party to the
contract to sue for his loss but does not allow him to sue for the loss caused to a third party.

Two decisions establish an exception to these principles. The first of two court decisions to examine these
principles was St. Martin's Corporation Ltd v Sir Robert McAlpine (1993). McAlpine was the contractor for
a development for the Corporation. After completion the Corporation passed the development to Investments,
a sister company. The Corporation also assigned the full benefit of the construction contract to Investments,
with the intent that Investments could sue McAlpine should any defects occur. Defects were found after the
assignment which were alleged to be due to breaches of contract by McAlpine under the construction
contract. It cost Investment £800,000 to put right the defects.

Investment sued under the above action. The House of Lords held that the action failed. The assignment of
the benefit under the contract had no effect because McAlpine's consent to the assignment had not been

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obtained as required under the contract with the Corporation. It was considered that the reason for including
the contractual prohibition from the contractor's point of view was that the contractor wished to ensure that he
dealt, and dealt only, with the particular employer with whom he has chosen to enter into a contract.

"Building contracts are pregnant with disputes: some employers are much more reasonable than others in
dealing with such disputes".

So the action failed under the first of the above principles, the privity of contract between the Corporation and
McAlpine prevented Investments suing on the contract.

However the Corporation was also a party to the action. Since the assignment had failed the Corporation
argued that it was entitled to judgment against McAlpine for any breach of contract. The problem the
Corporation faced was that they had parted with the property at full value and were not liable to their sister
company for the defects. Where therefore was their loss? On the basis of the second principle above, the
Corporation could not sue for the loss suffered by a third party, in this case £800,000 incurred by Investments.
The Corporation was therefore entitled only to nominal damages under the above principles.

Having found that McAlpine were not liable to the extent of the loss of £800,000, the House of Lords then
proceeded to find an exception to the second principle described above, namely that a plaintiff can only
recover damages for his own loss. The basis of this exception was that it was known by McAlpine that the
development would be occupied if not purchased by third parties and not the Corporation itself. It could be
foreseen that the damage caused by a breach would cause loss to a later owner and not merely the original
contracting party. Therefore on this basis the original contracting party could be entitled to recover damages
for loss suffered by others. The prohibition on assignment was crucial to this exception. The exception did not
apply where the third party could themselves sue for the loss.

The decision has made uncertain some of the boundaries of contract. Nor is it clear on what basis an original
contracting party would hold damages won in such an action. In the above case the Corporation had already
paid its sister company the £800,000 as part of the Group reorganisation, so that the problem did not arise.

Some answers are found in the Court of Appeal decision on 28 June 1994 Darlington Borough Council v
Wiltshier Northern Ltd (1994). Darlington wished to create a recreational centre on land which it owned.
Instead of borrowing and in order to provide private finance for the project, Darlington had Morgan Grenfell
enter into a construction contract as employer, with Wiltshier as contractor. A collateral covenant between
Darlington and Morgan Grenfell provided that Darlington would pay Morgan Grenfell all sums expended under
the construction contract. The construction contract was therefore clearly a contract for the benefit of a third
party. The covenant also provided for Morgan Grenfell to assign to Darlington all rights against Wiltshier.

In this case, when Darlington sued there was no problem with the assignment. However, they were faced with
the two general principles above. In other words, Morgan Grenfell the party in contractual relationship with
Wiltshier had suffered no loss and could transfer no claim for substantial damages. On the other hand,
Darlington, who suffered the loss, was precluded by the privity rule from claiming the damages which it had
suffered. The principles therefore combined to allow a contract-breaker to go scot-free.

The exception in St. Martin's Corporation Ltd v Sir Robert McAlpine was applied and Darlington was held
to be entitled to recover. In an important judgment, the wider exception was recognised, namely that if a party
engages a contractor to perform specified work, and the contractor fails to render the contractual service the
party suffers a loss of bargain. That loss can be recovered on the basis of what it would cost to put right the
defects. It was held that it was no pre-condition to recovery of substantial damages that the party should
undertake to use the damages awarded to carry out the necessary repairs. It followed that if the party is sued
for damages before assignment, then it would hold such damages for the third party and would be
accountable to them for the sum awarded.

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These cases demonstrate a weakening of the rigid principles of contract at least in so far as the measure of
damages are concerned. The full extent of the exception as it applies to construction contracts still needs to
be worked out. What the above decisions mean is that even without collateral warranties, a consultant or
contractor may find his is liable in damages for the loss to a third party due to defects in the design or
construction.