Third-party rights - Third-party beneficiaries

Learning Outcomes

This article explores the rights of third-party beneficiaries in contract law. It distinguishes between intended and incidental beneficiaries, outlines the conditions under which a third party's rights vest, and explains the enforceability of the contract by and against the third party, the promisor, and the promisee. Upon completion, you will be able to identify the type of beneficiary, determine when their rights become enforceable against the original contracting parties, and analyze the available claims and defenses in MBE scenarios involving third-party rights.

MBE Syllabus

For the MBE, you must understand when a person who is not a party to a contract can nonetheless enforce that contract. This requires analysis of the original parties' intent and the nature of the benefit conferred upon the third party. You should be prepared to:

• Distinguish between intended and incidental beneficiaries.
• Identify creditor and donee beneficiaries as types of intended beneficiaries.
• Determine when a third-party beneficiary's rights vest, cutting off the original parties' power to modify or discharge the contract.
• Analyze the rights and liabilities between the third-party beneficiary, the promisor, and the promisee.
• Recognize defenses available to the promisor when sued by the third-party beneficiary.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. A third party whose benefit from a contract is purely unintentional and who cannot enforce the contract is known as:
   1. A creditor beneficiary
   2. A donee beneficiary
   3. An incidental beneficiary
   4. An intended beneficiary
2. The rights of an intended third-party beneficiary vest when the beneficiary:
   1. Learns of the contract.
   2. Materially changes position in justifiable reliance on the promise.
   3. Is identified by name in the contract.
   4. Receives notice from the promisor that performance is due.
3. Promisor contracts with Promisee to pay Promisee's $500 debt to Creditor. Before Creditor learns of the contract or relies on it, Promisor and Promisee agree to rescind their contract. Can Creditor successfully sue Promisor?
   1. Yes, because Creditor is an intended beneficiary.
   2. Yes, because the original debt remains unpaid.
   3. No, because Creditor's rights had not yet vested.
   4. No, because Creditor was not a party to the contract.

Introduction

Generally, only parties to a contract have rights and duties under it. However, a major exception exists where the contracting parties intend their agreement to benefit a third person. This person, known as a third-party beneficiary, may be able to enforce the contract despite not being a party to its formation. The key distinction is whether the benefit to the third party was intended or merely incidental.

To analyze third-party rights, you must identify the relationship between the parties: the promisor (the party whose performance benefits the third party), the promisee (the party who obtains the promise that benefits the third party), and the third-party beneficiary (the outsider who benefits).

Identifying Third-Party Beneficiaries

The essential first step is determining whether a third party has legally enforceable rights under the contract. This depends on whether the third party is an intended beneficiary or merely an incidental beneficiary.

Key Term: Third-Party Beneficiary
A person who is not a party to a contract but stands to benefit from the contract's performance.

Intended vs. Incidental Beneficiaries

• Intended Beneficiary: Enforcement rights are granted if the contracting parties (especially the promisee) intended the third party to benefit from the promised performance. The benefit must run directly to the third party. Recognition of a right to performance in the beneficiary must be appropriate to effectuate the parties' intentions.
• Incidental Beneficiary: A person who benefits from a contract but whom the parties did not intend to benefit directly has no rights under the contract. The benefit is merely an unintended byproduct of the contract.

Key Term: Intended Beneficiary
A third party whom the contracting parties intended to benefit directly from their contract. Intended beneficiaries have rights to enforce the contract.

Key Term: Incidental Beneficiary
A third party who benefits from a contract only indirectly and unintentionally. Incidental beneficiaries have no rights to enforce the contract.

Worked Example 1.1

Developer contracts with Builder to construct a large shopping mall on Developer's land. The mall is expected to significantly increase customer traffic in the area, benefiting nearby Retailer's shop. Builder breaches the contract by failing to complete the mall. Can Retailer sue Builder for breach of contract?

Answer: No. Retailer is merely an incidental beneficiary. While the mall's construction would have benefited Retailer, the primary purpose of the Developer-Builder contract was to benefit Developer, not surrounding businesses. The benefit to Retailer was indirect and unintentional from the contracting parties' viewpoint.

Types of Intended Beneficiaries

Intended beneficiaries are traditionally classified as either creditor or donee beneficiaries, though the modern approach (Restatement Second) focuses simply on whether the beneficiary was intended.

Creditor Beneficiary

A person is a creditor beneficiary if the promisee's primary intent in securing the promisor's performance was to discharge an obligation the promisee already owed to the third party.

Key Term: Creditor Beneficiary
An intended beneficiary to whom the promisee owed a pre-existing duty, which the promisor's performance is intended to discharge.

Donee Beneficiary

A person is a donee beneficiary if the promisee's primary intent was to make a gift to the third party by securing the promisor's performance for the third party's benefit. There is no pre-existing obligation owed by the promisee to the third party. The classic example is a life insurance policy where the insured (promisee) contracts with the insurer (promisor) to pay proceeds to a named beneficiary (donee beneficiary).

Key Term: Donee Beneficiary
An intended beneficiary to whom the promisee intended to make a gift through the promisor's performance.

Worked Example 1.2

Father contracts with Painter for Painter to paint Daughter's house as a birthday gift. Painter fails to perform. Is Daughter a creditor or donee beneficiary? Can she sue Painter?

Answer: Daughter is a donee beneficiary. Father (promisee) intended to confer a gift upon Daughter. There was no pre-existing debt from Father to Daughter that the painting was meant to discharge. As an intended (donee) beneficiary whose rights have likely vested (see below), Daughter can sue Painter (promisor) for breach.

Vesting of Rights

An intended third-party beneficiary's rights are not automatically secure. The original contracting parties (promisor and promisee) generally retain the power to modify or rescind the contract, thereby altering or eliminating the third party's rights, until those rights have vested.

Key Term: Vesting
The point at which a third-party beneficiary's rights under the contract become secure against modification or discharge by the original contracting parties.

Vesting occurs when the beneficiary:

1. Manifests assent to the promise in a manner invited or requested by the parties; OR
2. Brings suit to enforce the promise; OR
3. Materially changes position in justifiable reliance on the promise.

Until one of these occurs, the promisor and promisee are free to change their agreement. Once vesting occurs, their power to vary the third party's rights without the third party's consent terminates.

Rights and Liabilities

Once an intended beneficiary's rights have vested, specific enforcement rights and liabilities arise among the three parties.

Third-Party Beneficiary vs. Promisor

The intended beneficiary may sue the promisor directly for breach of the contract.

• Promisor's Defenses: The promisor can assert against the beneficiary any defenses that the promisor has against the promisee arising from the contract (e.g., lack of consideration, failure of a condition, illegality). The promisor generally cannot assert defenses that the promisee might have against the beneficiary relating to any separate transaction between them, unless the promise was merely to pay whatever the promisee owed the beneficiary.

Third-Party Beneficiary vs. Promisee

• Creditor Beneficiary: A creditor beneficiary can sue the promisee on the pre-existing debt that the promisor was supposed to discharge. The beneficiary can sue both the promisor (on the contract) and the promisee (on the original debt), but is entitled to only one satisfaction.
• Donee Beneficiary: A donee beneficiary generally has no right to sue the promisee if the promisor fails to perform, as there was no existing obligation between the promisee and beneficiary. However, if the donee beneficiary detrimentally relied on the promisee's arrangement, a suit based on promissory estoppel might be possible against the promisee.

Promisee vs. Promisor

The promisee may sue the promisor for breach of contract. If the breach involves failure to perform for a creditor beneficiary, the promisee can sue for specific performance to compel the promisor to pay the beneficiary, thereby discharging the promisee's debt. If the promisee has already paid the debt himself, he can sue the promisor for damages. If the breach involves a donee beneficiary, the promisee's damages are often nominal, so specific performance is the preferred remedy.

Modification and Discharge

As noted under Vesting, the original parties can modify or discharge their contract by mutual agreement up until the intended beneficiary's rights vest. After vesting, modification or discharge typically requires the beneficiary's consent.

Defenses

When sued by an intended third-party beneficiary, the promisor may raise any defense against the beneficiary that the promisor could have raised against the promisee. This includes defenses related to contract formation (e.g., mistake, fraud, lack of consideration) and conditions of performance.

Exam Warning

Do not confuse third-party beneficiary rights with assignment or delegation. Third-party beneficiary rights are created by the original contract itself, intending to benefit an outsider from the outset. Assignment and delegation involve the transfer of rights or duties after the contract is formed.

Summary

Third-party beneficiaries are non-parties who benefit from a contract between others. Only intended beneficiaries (creditor or donee) have rights to enforce the contract. Incidental beneficiaries do not. An intended beneficiary's rights vest upon assent, suit, or material reliance, after which the original parties cannot typically modify or discharge the contract without the beneficiary's consent. The beneficiary can sue the promisor, who can raise defenses available against the promisee. Creditor beneficiaries can also sue the promisee on the original debt.

Key Point Checklist

This article has covered the following key knowledge points:

• Only intended beneficiaries, not incidental beneficiaries, can enforce a contract.
• Intention is determined primarily by the promisee's purpose: to discharge a debt (creditor beneficiary) or confer a gift (donee beneficiary).
• Rights vest when the beneficiary assents, sues, or materially relies on the promise.
• Prior to vesting, the original parties can modify/discharge the contract.
• After vesting, the beneficiary's consent is generally needed for modification/discharge.
• Beneficiary can sue the promisor directly.
• Promisor can assert defenses against the beneficiary that promisor has against the promisee.
• Creditor beneficiary can sue the promisee on the original obligation.
• Donee beneficiary generally cannot sue the promisee (unless detrimental reliance).
• Promisee can sue the promisor for specific performance or damages.

Key Terms and Concepts

• Third-Party Beneficiary
• Intended Beneficiary
• Incidental Beneficiary
• Creditor Beneficiary
• Donee Beneficiary
• Vesting