Sometimes a stranger to a contract (not a party or a party’s successor or assignee) will claim the right to enforce the contract or some limited portion of it. When this happens, the arcane and sometimes confusing law of third-party beneficiaries comes into play.
Generally speaking, a non-party seeking to enforce a contract right must demonstrate that the contracting parties intended that it benefit from performance under the contract despite the fact that it neither made nor received a promise. Beyond that deceptively simple statement, however, lies a maze of rules and exceptions that are applied, sometimes inconsistently, in a variety of situations. When drafting a contract, then, it is best to follow a three-step approach to the problem of third-party beneficiaries: (1) identify situations in which the issue is likely to arise; (2) determine what the parties to the contract intend; and (3) draft a clear statement of that intention.
According to the Restatement (Second) of Contracts and the common law of most states, a third-party beneficiary must be more than a stranger to the contract who benefits in some way from the performance of the parties’ agreement. Rather, to enforce the contract, a third party must be a direct, intended beneficiary of an undertaking that one party (referred to here as “the promisor”) makes to another party (referred to here as “the promisee”). Whether this is so is a question of contract interpretation, involving consideration, first, of the plain language of the contract and, if necessary, the circumstances of its negotiation and execution. See, e.g., Cutler v. Hartford Life Ins. Co., 292 N.Y.S.2d 430 (N.Y. 1968).
A little bit of history is helpful. Because the whole idea of third-party beneficiaries is inconsistent with the core principle of privity of contract, it was born of exceptions to that general rule. Prior to the influential Second Restatement, the common law of many states grouped third-party beneficiaries into two classes: so-called donee beneficiaries (those to whom the promisee intends to confer a gift in the form of the promisor’s performance) and so-called creditor beneficiaries (those to whom the promisee owed a pre-existing duty which the promisor’s performance of its contractual obligation discharges). The Second Restatement swept away these categories and created two new, broader categories: “intended” third-party beneficiaries, who possess enforcement rights, and “incidental” third-party beneficiaries, who do not. The older classifications are rarely used anymore—because it is difficult to shoehorn myriad types of contractual relationships into one or the other—but the language does crop up in the case law now and then.
Today, in almost all jurisdictions, the sole criterion of third-party beneficiary status is the intent of the parties to the contract—the promisor and the promisee. Did the promisee intend to hand over or share enforcement rights with the third party and was it understood and agreed by promisor and promisee that this would be the case? If an exercise in contract construction results in a “yes” to both these questions, the third party may enforce the promisor’s undertaking. If the answer is “no,” the third party is an unintended, “incidental” beneficiary, without contract rights.
The promise benefiting a third party to a contract does not have to be for the sole benefit of the third party to confer third-party beneficiary status, as long as it is for the third party’s direct or substantial benefit. See, e.g., Advanced Concepts Chicago, Inc. v. CDW Corp., 938 N.E.2d 577 (Ill. App. Ct. 2010). A third party does not need to be named individually, so long as its identity is ascertainable and the intent to benefit is shown on the face of the agreement. See, e.g., In re Lehman Brothers Holdings Inc., 515 B.R. 171 (Bankr. S.D.N.Y. 2014). Conversely, it is not enough that the putative third party’s name appears in the contract: It must be clear that the contract was made expressly for the benefit of that third party. See, e.g., Fireman’s Fund Ins. Co. v Maryland Cas. Co., 26 Cal. Rptr. 2d 762 (Cal. Ct. App. 1994). Attempts to make the “public as a whole” a third-party beneficiary—particularly of public contracts—typically fail. See, e.g., McMurphy v. State, 757 A.2d 1043 (Vt. 2000) (heirs of a driver who died in a car accident on a road owned by the state but maintained by a town could not sue for breach of the town’s contractual maintenance responsibilities).
A careful draftsperson is on the lookout for situations in which third-party issues are likely to arise: There may be third parties to whom your client, as promisee, may wish to extend the right to enforce an obligation, or there may be third parties whom your client, as promisor, wants to make sure are excluded from any rights under the contract. You should have these thoughts in mind when drafting any business or commercial contract, but there are certain scenarios in which third-party beneficiary issues are the most likely to arise.
Shareholders, employees, and creditors of an acquired company can become third-party beneficiaries of M&A agreements, typically because such agreements often include provisions that specifically benefit persons and entities in those categories. Acquisition agreements thus commonly include no-third party beneficiary provisions, or provisions that tailor the rights extended to any such third parties. See, e.g., Merzin v. Provident Fin. Group, Inc., 311 F. Supp. 2d 674 (S.D. Ohio 2004) (former target company shareholders’ claims for breach of merger agreement dismissed inter alia due to a no-third-party beneficiary clause); but see In re Enron Corp., 292 B.R. 507 (S.D.N.Y. 2002) (claims of target company shareholders survived despite no-third-party beneficiary provision).
Contractual indemnification may extend to a larger group than just the parties to an agreement (for instance, the directors, employees, agents, parents, and subsidiaries so often included in contract boilerplate clauses). An indemnitee may wish to expand the class, while being careful to retain some specificity, while the indemnitor will want to ensure that the language does not expand the group too broadly. For instance, in Melvin Green, Inc. v. Questor Drilling Corp., 946 S.W.2d 907, 911 (Tex. App. 1997), an undertaking to indemnify a party’s “officers, directors, employees, and joint owners” was specific enough to be enforceable but would not be read to include the party’s non-employee consultant.
A very common example of a contract for the benefit of a so-called “donee” beneficiary is a life insurance policy. As a result of a long history of recurring case law, insurance decisions involving third-party beneficiaries form a class by themselves, and in most jurisdictions a beneficiary under a life insurance policy is often named or otherwise described in the policy and has standing to enforce the policy, generally by direct action.
Attempts by persons affected by negligently performed personal services to sue as third-party beneficiaries of a professional service contract are most common in jurisdictions in which the economic loss doctrine bars tort claims for negligence in the absence of physical or personal injury. See, e.g., Raritan River Steel Co. v. Cherry Bekaert & Holland, 407 S.E.2d 178 (N.C. 1991) (creditor of corporation not a third-party beneficiary of corporation’s audit contract with negligent accounting firm); Futrell v. Payday California, Inc., 190 Cal. App. 4th 1419 (2010) (employee could not sue employer’s payroll company as third-party beneficiary). Attempts to make persons affected by an attorney’s malpractice third-party beneficiaries of the lawyer’s contract with his client tend to fail, largely because of policy considerations arising from the attorney-client relationship and conflicts of interest. See, e.g., Estate of Agnew v. Ross, 152 A.3d 247 (Pa. 2017).
Third-party issues arise with some frequency in the realm of construction contracts because the performance rendered by general and subcontractors can impact so many others involved or with an interest in a project, including property owners, tenants, lenders, materialmen, employees, and government agencies. Precise drafting of contract documents is needed to exclude all these additional prospective claimants. See, e.g., Valdez v. Cillessen & Son, Inc., 734 P.2d 1258 (N.M. 1987) (whether an injured employee was a third-party beneficiary of general contractor’s agreement with subcontractor to carry workers’ compensation insurance created a genuine issue for trial); De Groot v. Standley Trenching, Inc., 338 P.3d 536 (Idaho 2014) (dairy owner not a third-party beneficiary of a bid contract between general contractor and manure-handling system installer; contract only identified dairy as the place where the work was to be done).
Security services contracts between a security firm and a property owner or a commercial landlord and tenant spawn frequent claims by victims of crimes or violence that they were intended third-party beneficiaries of the security firm’s promises. The results are mixed and difficult to reconcile. Compare L.A.C. ex rel. D.C. v. Ward Parkway Shopping Ctr. Co., L.P., 75 S.W.3d 247 (Mo. 2002) (mall patron, sexually assaulted on premises, was third-party beneficiary of contract between mall and security firm) with Wood v. Centermark Prop., Inc., 984 S.W.2d 517 (Mo. Ct. App. 1998) (employee of mall tenant, abducted and murdered at mall, was at best an incidental beneficiary of provision in lease between mall owner and tenant requiring mall owner to provide security).
The importance of careful drafting can be seen in many of the reported decisions involving third-party beneficiaries because the court will first examine the four corners of a contract to determine whether the parties unambiguously stated an intent to create or exclude third-party rights.
For instance, parties may wish to state explicitly that a contract should not be read to create any third-party rights, and plain language does this best:
Nothing contained in this Agreement shall be deemed to confer any right or benefit on any person who is not a party to this Agreement.
See, e.g., Bowman v. Int’l Bus. Mach. Corp., 853 F. Supp. 2d 766 (S.D. Ind. 2012).
Parties may even wish to call out a class of potential third-parties explicitly to reinforce their intent in the context of a blanket exclusion of third-party rights:
This Agreement is not intended to confer any benefits on any third parties, including but not limited to the customers of Broker.
See, e.g., Katz v. Pershing LLC, 672 F.3d 64 (1st Cir. 2012).
To create enforcement rights in third parties, it is also helpful to be as clear as possible, and in situations in which a challenge to third-party rights can be foreseen, your agreement may—and should—recite the parties’ intent explicitly:
Except as provided in Section 2, no right or benefit is conferred on any person not a party to this Agreement.”
See, e.g., MBIA Ins. Corp. v. Royal Indem. Co., 519 F. Supp. 2d 455 (D. Del. 2007).
Wording may be closely examined when the parties have not clearly stated their intention. In Choate, Hall & Stewart v. SCA Servs., Inc., 431 Mass. 57 (1979), a settlement agreement provided that the defendant would pay the plaintiff’s legal fees, and plaintiff’s counsel succeeded in suing the defendant directly to collect them. The defendant argued that the law firm was no more than an incidental beneficiary of the settlement agreement and the decision rested on a provision providing that payment of the fees would be made “directly” to plaintiff’s counsel.
Above all, be consistent when drafting. A surprising number of cases arise when one clause of a contract creates third-party rights while a boilerplate “no third-party beneficiaries” clause purports to exclude them. In such cases, the more specific provision (typically the one creating the third-party enforcement right) will prevail. For instance, an intergovernmental agreement between a village and its fire protection district included specific terms concerning the salary, pension, vacation and sick time of the village fire marshal—as well as a standard “no third-party beneficiary clause.” The specificity of the discussion of the fire marshal’s employment rights rendered the broader “no-third-party beneficiary” clause inoperative—at least against the marshal. Barba v. Village of Bensenville, 29 N.E.3d 1187 (Ill. App. Ct. 2015).
Finally, a careful draftsperson is aware that the law of third-party beneficiaries may affect the interpretation and enforceability of other so-called boilerplate provisions. The majority rule is that a third-party beneficiary is bound by other provisions of the contract, including, for instance, an arbitration clause. See, e.g., Penn. Cement Co. v. Bradley Contracting Co., 7 F.2d 822 (2d Cir. 1925). But this is not a universal result. In Mendez v. Hampton Court Nursing Center, LLC, 203 So. 3d 146 (Fla. 2016), the Florida Supreme Court ruled that a nursing home resident, who was a third-party beneficiary of a contract between the nursing home and the resident’s son, was not bound by the arbitration clause in that agreement because the third-party beneficiary doctrine “enables a non-contracting party to enforce a contract against a contracting party, not the other way around.”
This same issue may arise in connection with other contract provisions, such as forum selection clauses, see, e.g., Osprey-Troy Officentre LLC v. World Alliance Fin. Corp., 822 F. Supp. 2d 700 (E.D. Mich. 2011) (third-party beneficiary must abide by forum selection clause); or clauses governing the amendment of the agreement, see, e.g., Lunceford v. Houghtlin, 363 S.W.3d 53 (Mo. Ct. App. 2010) (discussing limits on parties’ discretion to amend contract to detriment of third-party beneficiaries).
The law of third-party beneficiaries is arcane and sometimes unpredictable. The best way to avoid an unpleasant surprise is to consider during the drafting process whether third-party rights need to be addressed and then ensure that the executed agreement provides a clear statement of the parties’ intent.
