What is a Third Party Beneficiary Contract?
While every contract involves the performance of certain obligations and the payment of a specific price, the parties to a particular contract are not always necessarily bound to each other. In other words, the fact that a contract exists between two parties within a contract does not preclude the possibility that a third party, who is not privy to the contract’s circumstances of negotiation and formation, may have the right to enforce its terms and sue for damages in the event of breach.
A third party beneficiary contract is a type of contract that allows an individual who was not a party to an agreement ("third party") to sue for a remedy if the agreement has been breached. Its most common form develops when two parties enter into a contract with the intention that a third party will benefit from it . Specifically, it is a stipulation in favor of a third party not privy to the contract, which stipulation is enforceable by such third party. In contrast, a party to the contract may have a number of obligations toward a non-party.
There are two types of third party beneficiaries: (1) a donee beneficiary who is the intended beneficiary of a gift; and (2) a creditor beneficiary who is the intended beneficiary of a loan, which occurs when a third party lends money to the promisor on the condition that he/she will use it to perform an obligation to the promisee. While in both instances the parties to the contract intend to benefit a third party, they differ in that the creditor beneficiary has no power to discharge the debt, while the donee beneficiary can decide to waive his/her right(s).
Types of Third Party Beneficiaries
There are two types of third party beneficiaries under contract law: intended and incidental. Only intended beneficiaries may enforce a contractual agreement as a third party. Incidental beneficiaries are entitled to no rights under a contract.
Intended Beneficiaries
An intended beneficiary is a third party who the parties to a contract intended to benefit by the terms of the contract. For example, if John and Sally contract for the sale of John’s car to Sue and John and Sue intend that the sale be for Sue to give the car to Sally as a gift, then Sally is an intended beneficiary of the contract. Sally would have the right to sue on the contract and recover damages for breach as the intended third-party beneficiary of the contract.
Incidental Beneficiaries
In the above example, assume that John and Sue intend for the sale of the car to Sally to be a gift; however, they do not include that language in their contract. If John and Sue then breach their contract and Sue refuses to pay John for the car because she intends to give the car to Sally for a gift, Sally would be an incidental beneficiary. Because John and Sue did not intend for Sally to benefit from the contract between them, Sally would have no rights under the contract.
Restrictions on Intended Beneficiaries
Generally, a party must intend to confer a benefit before a third party can be considered an intended beneficiary of the contract. However, there are a few notable exceptions for individuals: An example of when these exceptions might be utilized can be found in life insurance policy. Policies often provide that upon the death of the insured, a beneficiary (e.g., a spouse) shall receive a sum of money. On the face of the policy, it appears that the beneficiary would have a contractual right to sue for damages upon the death of the insured. However, courts have held that such interspousal agreements are generally unsupported by consideration. As such, the policy is one of gratuity in favor of the beneficiary rather than a contract between the insured and the beneficiary. Another important exception to these rules is the landowner whose property has been tortiously damaged by a tenant. In such situations, the landowner may recover damages from its tenant’s insurer even if the policies don’t name the landowner as an additional insured. The landowner is considered an intended beneficiary of the contracts because insurance contracts are within the contemplation of the parties such that the landowner is within the class protected by the policies. The question arises as to who is protected by the policy. The policy protects the legal rights of the tenant against claims for damages. Therefore, the insured could not have intended to protect the tortious actions of an insured or he would not have needed insurance.
Legal Standing of Third Party Beneficiaries
A party’s legal rights are often determined by the intent of the parties. Accordingly, if the contracting parties have expressed an intent to benefit a non-contracting third party by means of their contract, then the third party may be said to be a third party beneficiary. The relevant inquiry is whether the parties to the contract intended to create a right in favor of the third party and intend that the third party beneficiary could sue to enforce the terms of the contract even though the third party was not a party to the contract. Whether the third party has a cause of action for breach of contract depends on the classification of the third-party beneficiary as either a donee or a creditor beneficiary.
In general, a third party may assert a claim under a contract when it appears from the terms of the agreement that the contracting parties meant to make the third party a direct promise to it to do some particular thing. The question whether a mutual intention to benefit a third party can be found depends on an examination of the parties’ contractual intent.
As a rule, only a creditor or third party donee has an action for breach of contract. An incidental beneficiary lacks standing to sue. A third party is only an incidental beneficiary if it does not satisfy the legal test for a creditor beneficiary or donee beneficiary.
For example, to prove the existence of a creditor beneficiary relationship, the third party beneficiary must demonstrate that it was a creditor beneficiary, where the benefit to the third party which the promisor intended to create a duty enforceable against the promisor either was a debt which the promise owed to the third party, or a claim against the promise which the promise asserted to be enforceable only against the promise, and that the promise prevailed.
Third Party Beneficiary Contract Examples
In the insurance industry, an insured may name a third party (such as a domestic partner or an estranged spouse) as a beneficiary. If the insured dies and the third party is denied the proceeds, anyone with an interest in the deceased insured may sue the insurer for specific performance under the policy, and the court may award the proceeds to that third party. C.I.T. Corp. v. Universal Bonding Ins. Co., 234 So. 2d 1, 7 (Fla. Dist. Ct. App. 1970) ("As long as the recognized vested interest of the two remaining beneficiaries in obtaining the proceeds of the policy could [be] protected, there could be no damage sufficient to bar recovery in this cause of action."); Restatement (Second) of Contracts § 302 cmt. b. (1981) ("[T]he third party beneficiary is created when the promisee and promisor agree that performance under the contract is meant to benefit the third party. The beneficiary has a right to bring an action to enforce the promise if the beneficiary is an intended beneficiary."); Florida Power Corp. v. Gulf Power Co., 403 So. 2d 616, 619 (Fla. Dist. Ct. App. 1981) ("The plaintiffs clearly had an interest in having their contract performed and had a right to sue for its breach."). In one case, a stranger sued an insurer for an insured’s life insurance policy proceeds, alleging the insured did not have a beneficiary at the time of his death. Stowers v. Pac. Mut. Life Ins. Co. of Cal., No. C-75-1208-JB (D. Alaska Jan. 26, 1976). The court granted the motion to dismiss because it was "unable to find any authority in either the statutes or case law of the state of Alaska for the proposition that a third party has a compensable interest in insurance proceeds until he has been designated as a beneficiary by the insured." Id. at *2. In the area of real property, a landlord may enter into an agreement with a real estate agent and provide a third party beneficiary clause in order to benefit from the duties of the agent and the agent’s commission fees. Rychnovsky v. Regan, 911 F.2d 643, 645-46 (10th Cir. 1990) ("Although both parties dispute the creation of a third party beneficiary contract, the conduct of the parties clearly indicates that Rychnovsky intended to make Regan an intended beneficiary of the transaction. . . As an intended third party beneficiary, Rychnovsky was entitled to enforce the obligations of the agreement between Regan and Hill."); see also Morgan Stanley Group Inc. v. Newberg, 256 B.R. 182, 186 (Bankr. S.D.N.Y. 2000) (under New York law, a "landlord who expressly avails itself of a retail tenant’s leasehold improvements and/or is identified as a beneficiary . . . may bring an action directly against the contractor or subcontractor."); Breece Memorial v. 550 Grand LLC, No. 601248/06, 2008 NY Slip Op 51580, at ¶ 3 (N.Y. Sup. Ct. 2008) (under New York law, "a nonnegotiable [commercial lease] clause that makes [the tenant’s] landlord, the owner of the subject commercial building, a third-party beneficiary of the [tenant’s] contract with its construction manager is valid and enforceable.").
How to Write a Third Party Beneficiary Contract
A key consideration in drafting a third party beneficiary contract is to reflect accurately the intention of the contracting parties, thereby avoiding prolonged disputes with respect to the rights of the parties. In this regard, the parties should not only be aware of the rights of third party beneficiaries under the state law applicable to the contract, but also use language that is likely to give rise to enforceable rights in favor of the third parties, if that is indeed the intent.
Michael A. Diamond, Esq. of Gary Altman and Associates, LLC, also points out that while "the rights of an intended beneficiary can only be enforced by him or on his behalf," there is no prohibition on the contracting parties from reserving the right to "waive the benefit without the consent of the beneficiary." See Diamond, Interestingly, in order for a third party to have a right to enforce such a waiver, it must not contravene the intention of the promisee. Miller v. Keithley Instruments, Inc., 153 P. 3d 994, 1001 (Or. App. 2007). For example, an intended beneficiary has no right to enforcement where his status arises from the express language of the contract or the manner and circumstances of its performance, and his mere fact of existence is insufficient without more. While a third party may not have enforcement rights , he may have the right to protection against interference, which in some states can be enforced against anyone who interferes, not just the promisor.
It should also be noted that the naming of the intended beneficiary in the contract does not automatically entitle him to enforce the contract. Rather, enforcement of a contract by a third party beneficiary only occurs once he accepts the agreed-upon conditions and obligations of the contract, and agrees to be bound. As Attorney Diamond explains, "where no request is made or other action taken on the part of the promisor evidences an intention to dispense with the need for the approval or assent by the promisee to the requested change in obligation, the general rule is that the promisee’s assent is required even though the modification is one for the benefit of the third person." See Diamond, In addition, a party granting authority to another must be careful to omit any grant of authority not provided in the contract’s terms, so as not to expose itself to potential liabilities for "respondeat superior" actions. Such exposure could include a breach of fiduciary duties – arising out of an agent’s willful misrepresentation, or the taking of advantage of the principal’s disability.
How Third Party Beneficiaries Can Enforce Their Rights
When a third party beneficiary has been granted rights under a contract, that party typically has the ability to enforce those rights through legal means. The ability of a third party beneficiary to sue to enforce a contract depends on what type of beneficiary they have been classified as. For instance, if the third party beneficiary is a creditor or donee beneficiary, the third party beneficiary may sue to enforce a contract where the promisee has no remaining obligation. If the third party beneficiary is a mere incidental beneficiary, the third party beneficiary will not be allowed to bring a suit. Instead, only the promisee can enforce the contract.
There are two main types of enforcement actions available for third party beneficiaries: a creditor beneficiary action and a Donee (or gift) beneficiary action. A third party beneficiary may bring an action if they are a creditor beneficiary and deal with a party to a contract in a way which explicitly shows the creditor beneficiary was intended to receive a benefit resulting from the performance of a contract. A creditor beneficiary will have the ability to enforce as "incidental" beneficiary even without any intent to have the benefit pass to oneself if making such a benefit part of bargain was essential to the creditor’s consideration for the agreement. Though, a creditor must be owed a debt by the promisor (the promissor being the party to a contract who made the promise) before they can bring an action against them. A "Donee/Grace" beneficiary action, however, is initiated when a party to a contract intends to make a gift to the third party beneficiary. Essentially, a Donee beneficiary may sue if the promisee makes it clear to the promisor that allowing a certain non-party to continue receiving a benefit is essential to the contract they made. If a donnee beneficiary proves such, it is irrelevant if the donor has also received a benefit under the contract. These rules would suggest that the primary bar to enforcement by a third party beneficiary is being able to reasonably prove their status as one who was clearly intended to directly benefit from a contract between two other parties.
The most common challenges to enforcement by third party beneficiaries to a contract is a lack of standing or the fact a contract was performed, or at least attempted to be performed, according to its terms. A third party beneficiary may even not be able to enforce a contract where the contract has been explicitly terminated due to anti-diversion clauses (where a contract provides a certain breach or violation of the contract will not permit a third-party beneficiary to enforce their right to it). An additional avenue that may prevent a third party beneficiary from enforcing contract provisions is if there is a plan to divert the contractual benefit from the third party, or if a third party beneficiary is found to be an incidental beneficiary.
Reported Cases Involving Third Party Beneficiary Contracts
The area of third party beneficiary contracts has produced several cases of considerable significance in the development of the law. These include the following notable examples. On rare occasions, the government will enter into a contract with a person or entity to benefit another person or entity. In a case decided by the U.S. Supreme Court in 1944, the Court set out in detail the genesis of this concept of the third party beneficiary. United States v. McDonnell Douglas Corp., 375 U.S. 236 (1944). In that case, the Court described the logic of the doctrine and reaffirmed a long history of third party beneficiary contracts involving the United States. In 1971, the California Supreme Court issued a generally-cited opinion in which it had to determine the rights of beneficiaries after a breach of a third party made in bad faith. In the case, the court held that a beneficiary’s right to recover damages does not depend on whether the breach was in bad faith or in good faith. At the same time, the court held that the breaching party could be liable for consequential damages if there is evidence of bad faith in the breach. Farber v. County of Los Angeles, 3 Cal.3d. 875 (Cal. 1971). A case decided by the Third Circuit Court of Appeals gave the name to the so-called venture capital "exception." Under the exception, a party may not enforce a third-party beneficiary contract if the accrual of rights under the contract would be inconsistent the goal of the contract. In the case, the court held that à venture capital organization which financed several enterprises could not sue to enforce the terms of a contract between its counsel and the trade creditors of one of the enterprises for settlement of that enterprise’s debts. The court defined the venture capital exception as the proposition that the rights of third-party beneficiaries should be subordinate to the purpose and goal of the contract if there is a possibility that such enforcement could have significant adverse impact on the purpose of the agreement. In its analysis, the court stated that "inherent in the economic relationship among a parent corporation and its wholly-owned subsidiaries, their officers, and the attorneys who represent them is the right to a full and frank disclosure of each other’s affairs, particularly with respect to pending or threatened litigation." The court held that allowing the enforcement of the trade creditors’ attorney-fee contract would have created a conflict between the joint venturers and its attorney, thereby undermining the attorney-client privilege. Philadelphia v. Lead Industries Association, 919 F.2d 1311 (3d Cir. 1990). The ability of third-party beneficiaries to recover damages as economic losses – as opposed to non-economic damages – for breach of a third-party beneficiary contract can defeat claims for the recovery of consequential damages. In one case, the court set out a distinction between damages for the loss of a contractual or tortious expectation interest that arises out of breach of a third-party beneficiary contract and damages for emotional harm. As the court argued, the latter type of loss is more predictable. It is logistically superior to rely on the former type of loss to measure consequential damages, both in the interests of the parties and the judicial system: "It is far more predictable for contracting parties to deal explicitly with the extent to which they are prepared to pay consequential damages that result from the breach of their contract than it is for a trial court to predict the possibility of emotional harm to third parties, who are not the parties to the contract, as a consequence of the breach." In re Estate of William L. Wilson, 759 A.2d. 1132 (Pa. Super. Ct. 2000).
Common Mistakes and Confusions
One of the most common pitfalls in drafting a third party beneficiary contract is to make the provision for the third party too vague. A vague third party beneficiary provision may end up being interpreted in a way that was not intended by the parties, which can be disastrous because the third party could be allowed more rights than the parties intended. Therefore, it is essential when drafting a third party beneficiary provision to make it as clear as possible so there is no room for doubt about the identity of the third party or the extent of his or her rights.
Another common misunderstanding is that the third party has to be named in the contract. In some situations, such as where a minor child is the third party and a divorce is the basis of the contract, naming the third party may be inadvisable . For example, naming the minor child of the parties may later allow the other spouse a stronger argument to gain full custody by keeping the child away from their parents.
Many people also believe that a third party must be the direct object of the contract. However, as previously mentioned, a third party can be an incidental beneficiary even if he or she is not the direct object of the contract. For example, if two divorcing spouses split a vehicle and later the engine fails, the ex-spouse to whom the engine belonged would be an incidental beneficiary of the contract even though the contract splitting the vehicle did not mention the engine specifically. There are many ways in which a person can become a third party beneficiary other than directly being listed in the contract.