IT’S OUR PARTY AND YOU’RE NOT INVITED:
THIRD PARTY BENEFICIARIES IN CONTRACT LAW
by
Michael E. Mestinsek and Matthew O. J. Synnott
Stikeman Elliott LLP
It's Our Party and You’re Not Invited:
Third Party Beneficiaries in Contract Law
A. Introduction
Parties regularly make agreements that are intended to benefit or protect one or more third parties. Limitations of liability, i.e. exclusion clauses, are a common example. Corporate parties to agreements with limitations will often seek to extend the protection of those limitations to their directors, officers, employees, etc. Indemnities are another common example. In many cases when contractual parties agree to indemnify one another, they also agree to indemnify one another’s directors, officers, employees, agents, affiliates etc. (if the parties are corporate entities) or successors, assigns, heirs, representatives etc. (if the parties are individuals). Flow-through indemnities,1 which are
increasingly common in subcontracting arrangements, are yet another example.2
It is tempting to assume that third parties can enforce or rely on agreements that are intended to benefit or protect them, but that may or may not be the case. The uncertainty results from the third party beneficiary rule, an aspect of the doctrine of privity of contract. The third party beneficiary rule provides that a contract cannot confer rights or impose obligations arising under it on any person except the parties to the contract. Put simply, the rule is that only a party to a contract may sue upon it.3 If an
exclusion clause is considered in light of this rule, the question arises as to whether an entity that is not a party to a contract can rely on a limit on its liability set out in that contract as against a party to the contract, particularly where the non-party has not provided consideration to the contractual party that it claims is subject to the limit. Indemnities present similar problems. As an example, if a corporation is party to a contract containing an indemnity in favour of it and its directors, and the directors suffer the type of loss covered by the indemnity but the corporation does not, how can the directors bring an action on the indemnity if they are not themselves parties to the contract?
Historically, a number of techniques have been used by courts in response to the perceived shortcomings of the doctrine of privity and the difficulties in applying the doctrine. These are outlined below in Section B. More recently, the Supreme Court of Canada established a generally applicable exception to the doctrine of privity referred to as the “principled exception” in its London Drugs Ltd. v. Kuehne & Nagel International Ltd. (“London Drugs”)4 and Fraser River Pile & Dredge Ltd. v. Can-Dive Services Ltd. (“Fraser
River Pile”)5 decisions. The principled exception and those decisions are discussed
below in Section C. Notwithstanding the historical techniques for avoiding the third party beneficiary role and the principled exception, the third party beneficiary rule
1 A flow-through indemnity involves an agreement by one party to assume its counterparty’s indemnity
obligation to a third party.
2 Further examples include letters of credit from banks and many insurance contracts. 3 S.M. Waddams, The Law of Contracts, 5th ed. (Toronto: Canada Law Book, 2005), at 193.
4 London Drugs Ltd. v. Kuehne & Nagel International Ltd., [1992] 3 S.C.R. 299, 1992 CanLII 41 [London Drugs]. 5 Fraser River Pile & Dredge Ltd. v. Can-Dive Services Ltd., [1999] 3 S.C.R. 108, 1999 CanLII 654 [Fraser River
continues to give rise to problems. The current situation and the remaining uncertainties are addressed below in Section D.
B. Historical Techniques
There has been widespread criticism, particularly among commentators, of the third party beneficiary rule and its ability to produce unfair, even absurd, outcomes.6
Iacobucci J. summarized it nicely in London Drugs:
These comments and others reveal many concerns about the doctrine of privity as it relates to third party beneficiaries. For our purposes, I think it sufficient to make the following observations. Many have noted that an application of the doctrine so as to prevent a third party from relying on a limitation of liability clause which was intended to benefit him or her frustrates sound commercial practice and justice. It does not respect allocations and assumptions of risk made by the parties to the contract and it ignores the practical realities of insurance coverage. In essence, it permits one party to make a unilateral modification to the contract by circumventing its provisions and the express or implied intention of the parties. In addition, it is inconsistent with the reasonable expectations of all the parties to the transaction, including the third party beneficiary who is made to support the entire burden of liability. The doctrine has also been criticized for creating uncertainty in the law. While most commentators welcome, at least in principle, the various judicial exceptions to privity of contract, concerns about the predictability of their use have been raised. Moreover, it is said, in cases where the recognized exceptions do not appear to apply, the underlying concerns of commercial reality and justice still militate for the recognition of a third party beneficiary right.7
In response, courts developed a number of techniques to avoid the application of the third party beneficiary rule. Four of the main approaches in this regard are agency, trusts, assignment and collateral contracts.
Under the law of agency, if a principal authorizes its agent to enter into contracts on its behalf with third parties, the result of the agent’s doing so is that the principal has a direct contractual relationship with the third party. This doctrine has thus been used by courts to avoid apparent third party beneficiary issues by finding that a promisee
6 See e.g. Great Britain Law Revision Committee, Sixth Interim Report (London: H.M. Stationery
Office, 1937); England Law Commission, Privity of Contract: Contracts for the Benefit of Third Parties, Consultation Paper No. 121 (1991); New Zealand Contracts and Commercial Law Reform Committee, Report on Privity of Contract (1981); Ontario Law Reform Commission, Report on Amendment of the Law of Contract, (Toronto: Ministry of the Attorney General, 1987).
7 London Drugs, at 135-136 (cited to CanLII). See also: London Drugs, at 136-139 (for a summary of judicial
was acting as agent on behalf of a third party beneficiary in extracting a promise from the promisor.8
A second approach to avoid the third party beneficiary rule is to find that a promisee holds a contractual promise — as a type of chose in action — in trust for the third party. The third party can therefore bring a claim in equity on the chose of action as the beneficial holder of the chose in action.9 The applicability of this technique for
avoiding the third party beneficiary rule has been greatly restricted by the legal requirement for a clear expression of intention to create a trust, however.10
A third approach, similar to the trust approach, is to find that a promisee has assigned its rights to sue on the promise to the third party. The application of this approach is also limited by the legal requirements for assigning choses in action. A chose in action, such as a contractual right, can be assigned in law or in equity. Legal assignment requires express notice of the assignment to the promisor.11 Without such
notice, no legal assignment occurs, but there may still be a valid equitable assignment. However, the law of equitable assignment requires that the assignor be added as a party with the assignee.12 This approach may be further limited by English case law which
provides that an assignee cannot sue for breach of contract, i.e. only a party who has actually suffered a loss can sue for compensatory damages.13
A fourth approach is to find a collateral contract between the third party beneficiary and the promisor. The purchase of goods from a retailer or distributor manufactured by a different entity is a useful example in illustrating this, as the purchaser is privy to the retailer/distributor, and the retailer/distributor is privy to the manufacturer, but strictly speaking there is no privity between the purchaser and the manufacturer. Nonetheless, some case law has implied a contract between the purchaser and the manufacturer, although there appears to be a requirement that the manufacturer communicated with the purchaser (either directly or through advertising).14
Difficulties with these four historical exceptions become apparent if they are applied to the earlier examples of situations raising third party beneficiary concerns (i.e. exclusion clauses, indemnities and flow-through indemnities). There is an obvious artificiality to arguing that sophisticated contracting parties drafting a limitation clause
8 See e.g. McEvoy v. Belfast Banking Corp Co. Ltd., [1935] A.C. 24 (H.L.); Midland Silicones v. Scruttons, [1962]
A.C. 446 (H.L.); New Zealand Shipping Co. Ltd. v. A.M. Scatterthwaite & Co. Ltd., [1975] A.C. 154 (P.C.) [sub nom. The Eurymedon]; McCannell v. Mabee McLaren Motors Ltd. (1926), 36 B.C.R. 369 (C.A.).
9 See e.g. Les Affrétuers Réunis Société Anonyme v. Leopold Walford (London) Ltd., [1919] A.C. 801 (H.L.).
10 See e.g. Schebsman, In re, [1944] Ch. 83 (Eng. C.A.); Fournier Van & Storage Ltd. v. Fournier, [1973] 3 O.R. 741
(H.C.J.); Vandepitte v. Preferred Accident Insurance Co., [1933] A.C. 70 (P.C.).
11 See e.g. Judicature Act, R.S.A. 2000, c. J-2, s. 20.
12 See e.g. Telus Services Inc. v. Tele-Direct (Publications) Inc. (2001), 99 Alta. L.R. (3d) 316, 301 A.R. 297, 2001
ABQB 777, at paras. 22-25 (Q.B.).
13 Angela Swan, Canadian Contract Law, 2nd ed. (Markham, Ont.: LexisNexis Canada Inc., 2009), at 177
[Canadian Contract Law]; Albacruz (Cargo Owners) v. Albazero, [1977] A.C. 774 (H.L.).
or an indemnity intend to appoint a third party their agent, create a trust or assign contractual rights but chose not to expressly say so in negotiated agreements.
C. The Principled Exception
The more recent exception to privity is known as the principled exception. The principled exception was established by the Supreme Court of Canada in London Drugs and Fraser River Pile. Geoff Hall, quoting Fraser River Pile, explains it this way:
The principled exception first appeared in London Drugs Ltd. v.
Kuehne & Nagel International Ltd. and was elaborated upon and
extended in Fraser River Pile & Dredge Ltd. v. Can-Dive Services Ltd. Fraser River Pile set out a two-part test for the availability of the principled exception…Noting that the exception is dependant on the intentions of the contracting parties, which is determined on the basis of two cumulative factors:
(a) Did the parties to the contract intend to extend the benefit in question to the third party seeking to rely on the contractual provision? and (b) Are the activities performed by the third party seeking to rely on the contractual provision the very activities contemplated as coming within the scope of the contract in general, or the provision in particular, again as determined by reference to the intentions of the parties?15
The principled exception thus allows a third party beneficiary to rely on a contractual provision if two factors are met. There is some uncertainty surrounding the scope of the principled exception, however, as it has received mixed treatment in case law subsequent to London Drugs and Fraser River Pile:
A few cases have held that the principled exception should be applied judiciously. For example, some decisions have refused to apply it after noting that London Drugs and Fraser River Pile
should be taken as representing incremental changes to the law rather than a wholesale change to the doctrine of privity of contract, while others have held that the principled exception can only be used as a shield to defend an action and cannot be
used as a sword to bring one. On the other hand, Cheong v.
Futuma [[2002] B.C.J. No. 2214 (B.C.S.C.)] applied the principled
exception to found a cause of action, allowing a non-party to an escrow agreement to enforce it on the basis that the parties to the escrow agreement had intended the investors whose money was being held to enjoy the benefit of the agreement. A number of cases have shown no reluctance to apply the principled exception where it is appropriate to do so…16
15 Canadian Contractual Interpretation, at 121, quoting from Fraser River Pile, at para. 32.
16 Canadian Contractual Interpretation, at 122; see also Canadian Contract Law, at s. 3.5; The Law of
It is useful to consider the facts in London Drugs and Fraser River Pile and to more closely assess what the Court actually said in those cases (in relation to the principled exception) in order to determine the proper scope of the principled exception.
1. London Drugs
The facts in London Drugs were straightforward. London Drugs purchased a new 7,500 pound transformer and arranged for storage with Kuehne & Nagel International Ltd. (“KNI”), a warehouse company. The parties used KNI’s standard form contract, which included a limitation of liability clause that read as follows:
LIABILITY - Sec. 11(a) The responsibility of a warehouseman in the absence of written provisions is the reasonable care and diligence required by the law.
(b) The warehouseman’s liability on any one package is limited to $40 unless the holder has declared in writing a valuation in excess of $40 and paid the additional charge specified to cover warehouse liability.
London Drugs was aware of the clause and fully understood it, but chose not to obtain additional insurance from the warehouse company and instead arranged for its own all-risk coverage. While attempting to move the transformer onto a truck for delivery back to London Drugs, two of KNI’s employees were negligent and caused $33,955.41 in damage to the transformer.
London Drugs commenced an action against KNI and its two employees for damages for breach of contract and negligence. At trial, the employees were found personally liable for the full amount of the damages, but KNI’s liability was limited to $40 pursuant to the exclusion clause. The British Columbia Court of Appeal reduced the employees’ liability to $40, either by implying a term into the exclusion clause extending the limitation to cover KNI’s employees and by applying the agency exception to the doctrine of privity (as per Lambert J.A.), or by taking into account the “contractual matrix” between KNI and London Drugs, including the exclusion clause, so as to qualify the employees’ duty of care and their ensuing liability to $40 (as per McEachern C.J.B.C. (as he then was) and Wallace J.A.). London Drugs appealed this decision and the employees cross-appealed, arguing that they should be completely free of liability.
Two mains issues arose in London Drugs: (i) whether the employees owed London Drugs a negligence-based duty of care; and (ii) whether the employees could obtain the benefit of the exclusion clause. The second issue is the most relevant for the purposes of this paper and was recognized by Iacobucci J., writing for the majority, as being concerned simply with privity:
The appellant [London Drugs] has never argued, understandably in the circumstances of this case, that s. 11(b) of the contract of storage was not wide enough to cover the respondents' negligence, that it had not been brought to the appellant's attention prior to the execution of the contract, or that it would be unconscionable to permit the respondents to rely on
the limitation clause. The main obstacle to the respondents' claim, as pointed out by the appellant, is the doctrine of privity of contract.17
The majority of the Court found that the exclusion clause applied to the employees, but on different reasons than those articulated by the British Columbia Court of Appeal. Instead, the Court, noting that “the doctrine of privity should not stand in the way of commercial reality and justice”,18 articulated a new exception to privity:
In the end, the narrow question before this Court is: in what circumstances should employees be entitled to benefit from a limitation of liability clause found in a contract between their employer and the plaintiff (customer)? Keeping in mind the comments made earlier and the circumstances of this appeal, I am of the view that employees may obtain such a benefit if the following requirements are satisfied:
1) The limitation of liability clause must, either expressly or impliedly, extend its benefit to the employees (or employee) seeking to rely on it;
and
2) the employees (or employee) seeking the benefit of the limitation of liability clause must have been acting in the course of their employment and must have been performing the very services provided for in the contract between their employer and the plaintiff (customer) when the loss occurred.19
On the facts, the majority of the Court found that the employees had satisfied these two requirements, as the language in the standard form warehousing contract was intended to apply to KNI’s employees and the employees were acting the course of their employment and performing the very services contracted for under the standard form warehousing contract.20
It is clear from the majority’s reasons that they intended to articulate a new exception to the doctrine of privity in London Drugs. Iacobucci J. expressly noted that the trust and agency exceptions to the doctrine of privity remained available and were not affected by the majority’s decision.21 His Lordship further stated:
In my view, the respondents were third party beneficiaries to the limitation of liability clause found in the contract of storage between their employer and the appellant and, in view of the circumstances involved, may benefit directly from this clause notwithstanding that they are not a signing party to the contract. I recognize that such a conclusion collides with privity of
17 London Drugs, at 124. 18 London Drugs, at 19 London Drugs, at 162-163. 20 London Drugs, at 166. 21 London Drugs, at 165.
contract in its strictest sense; however, for reasons that follow, I believe that this Court is presented with an appropriate factual opportunity in which to reconsider the scope of this doctrine and decide whether its application in cases such as the one at bar should be limited or modified. It is my opinion that commercial reality and common sense require that it should.22
However, the scope of the new exception was qualified in several regards in London Drugs:
• the majority appears to have limited the exception to employees seeking to rely upon their employers’ contractual limitations of liability as against third party claims;23
• Iacobucci J. stated that “[n]othing in these reasons should be taken as affecting in any way the law as it relates to the imposition of obligations on third parties”;24
• Iacobucci J. made it clear that the exception in London Drugs was intended to be an incremental change to the common law;25 and
• Iacobucci J. justified the exception on the basis that it was being used as a defence, and not to found a cause of action:
Moreover, recognizing a right for a third party beneficiary to rely on a limitation of liability clause should have relatively little impact on the rights of contracting parties to rescind or vary their contracts, in comparison with the recognition of a third party right to sue on a contract.26
On the other hand, it is unclear to what extent the holding that “the doctrine of privity should not stand in the way of commercial reality and justice” left a door open to continue to find new circumstances in which the third party beneficiary rule may be properly avoided.
2. Fraser River Pile
The facts in Fraser River Pile were also straightforward. Can-Dive Services Ltd. (“Can-Dive”) chartered a barge from the defendant, Fraser Rive Pile & Dredge Ltd. (“Fraser River”) then sank it. Fraser River’s insurance policy extended coverage to additional insureds, including charterers like Can-Dive, and included the following waiver of subrogation:
17. SUBROGATION AND WAIVER OF SUBROGATION
CLAUSE
In the event of any payment under this Policy, the Insurers shall be subrogated to all the Insured’s rights of recovery therefor, and the Insured shall execute all
22 London Drugs, at 126.
23 See e.g. London Drugs, at 126 and 155. 24 London Drugs, at 128.
25 London Drugs, at 163-165. 26 London Drugs, at 154.
papers required and shall do everything that may be necessary to secure such rights, but it is agreed that the Insurers waive any right of subrogation against:
. . .
(b) any charterer(s) and/or operator(s) and/or
lessee(s) and/or mortgagee(s). . . .
The insurance company paid Fraser River $1,128,365.57, the fixed amount stipulated in the policy for the loss of the barge. Fraser River then made a further agreement with their insurance company to pursue a negligence action against Can-Dive and to waive any right to the waiver of subrogation clause. Accordingly, the insurance company sued Can-Dive.
Can-Dive was held liable at trial in the amount of $949,503. This decision was overturned by the British Columbia Court of Appeal. The issue before the Supreme Court of Canada on appeal from that decision was whether Can-Dive, a third party beneficiary, could rely on the waiver of subrogation clause to defend against a subrogation action of the basis of the principled exception to the privity of contract doctrine.
The Court restated the exception from London Drugs as follows:
In terms of extending the principled approach to establishing a new exception to the doctrine of privity of contract relevant to the circumstances of the appeal, regard must be had to the
emphasis in London Drugs that a new exception first and
foremost must be dependent upon the intention of the contracting parties. Accordingly, extrapolating from the specific
requirements as set out in London Drugs, the determination in
general terms is made on the basis of two critical and cumulative factors: (a) Did the parties to the contract intend to extend the benefit in question to the third party seeking to rely on the contractual provision? and (b) Are the activities performed by the third party seeking to rely on the contractual provision the very activities contemplated as coming within the scope of the contract in general, or the provision in particular, again as determined by reference to the intentions of the parties?27
Applying that analysis, the Court found that the parties to the insurance contract intended to extend the benefit of the waiver of subrogation clause to Can-Dive, as it was expressly mentioned as a charterer.28 The Court rejected Fraser River’s argument that its
further agreement with the insurers to pursue legal action against Can-Dive effectively deleted the third party benefit from the insurance contract, as the further agreement was concluded after Can-Dive’s inchoate right under the contract had crystallized into an actual benefit (in the form of a defence against an action in negligence by Fraser River’s insurers). When Can-Dive’s rights crystallized, they became a party to the initial contract for the limited purpose of relying on the waiver of subrogation clause. Therefore, Fraser River could not unilaterally revoke Can-Dive’s rights once they had developed into an
27 Fraser River Pile, at para. 32. 28 Fraser River, at paras. 35, 36.
actual benefit without negotiation and agreement among all of the parties, including Can-Dive.29 The Court also found that the second factor was met since the relevant
activities arose in the context of the relationship of Can-Dive to Fraser River as a charterer, the very activity anticipated in the insurance policy pursuant to the waiver of subrogation clause.30 As a result, the Court found that Can-Dive satisfied both of the
threshold requirements for the purposes of introducing a new, principled exception to the doctrine of privity of contract as it applies to third party beneficiaries.31
The Court recognized the sound policy reasons for relaxing the doctrine of privity in the circumstances:
When considered in light of the Court’s discussion of the necessary interdependence of various contractors involved in a common construction enterprise, the comment reflects the Court’s acknowledgment that the rule of privity set out in
Vandepitte was inconsistent with commercial reality. In a similar
fashion, Fraser River in the course of this appeal has been unable to provide any commercial reason for failing to enforce a bargain entered into by sophisticated commercial actors. In the absence of any indication to the contrary, I must conclude that relaxing the doctrine of privity in these circumstances establishes a default rule that most closely corresponds to commercial reality as is evidenced by the inclusion of the waiver of subrogation clause within the contract itself.
A plain reading of the waiver of subrogation clause indicates that the benefit accruing in favour of third parties is not subject to any qualifying language or limiting conditions. When sophisticated commercial parties enter into a contract of insurance which expressly extends the benefit of a waiver of subrogation clause to an ascertainable class of third-party beneficiary, any conditions purporting to limit the extent of the benefit or the terms under which the benefit is to be available must be clearly expressed. The rationale for this requirement is that the obligation to contract for exceptional terms most logically rests with those parties whose intentions do not accord with what I assume to be standard commercial practice. Otherwise, notwithstanding the doctrine of privity of contract, courts will enforce the bargain agreed to by the parties and will not undertake to rewrite the terms of the agreement.32
The majority decision in London Drugs was qualified in several regards. Fraser River Pile abandoned at least one of these qualifications, as the Court rejected the notion that the exception in London Drugs could only be relied upon by an employee to benefit from its employer’s contractual limitations of liability as against third party claims:
As a preliminary matter, I note that it was not our intention in
London Drugs, supra, to limit application of the principled
29 Fraser River, at para. 36.
30 Fraser River, at para. 39. 31 Fraser River, at para. 39. 32 Fraser River, at paras. 41-42.
approach to situations involving only an employer-employee relationship. That the discussion focussed on the nature of this relationship simply reflects the prudent jurisprudential principle that a case should not be decided beyond the scope of its immediate facts.33
3. Subsequent Treatment of London Drugs and Fraser River Pile and the Current Situation
As noted above, London Drugs and Fraser River Pile have received mixed subsequent treatment. There is little question that the principled exception will assist a third party beneficiary that seeks the benefit of a contractual limit on liability which expressly applies to the third party and is not in conflict with another term in the contract like a “No Third Party Beneficiaries” clause. It is uncertain how much further the doctrine may be applied, however.
One of the main issues is whether or not a third party beneficiary can use the exception to found a cause of action. The weight of authority suggests that the principled exception can only be used as a shield, but not as a sword.34 However, there
are cases citing London Drugs and Fraser River Pile in support of a third party’s ability to advance a claim on a contract:
• The British Columbia Supreme Court has applied the principled exception to allow a non-party to an escrow agreement to enforce it on the basis that the parties to the agreement had intended the investors whose money was being held in escrow to enjoy the benefits of the agreement.35
• The Ontario Superior Court of Justice has relied upon Fraser River Pile to find that senior debt holders could enforce a note indenture between a debtor company and its other noteholders which subordinated the other noteholder’s debt to the senior debt holders’ debt.36 The Ontario Court of Appeal left the issue open,
instead applying trust law to decide the matter.37
• The Court of Queen’s Bench of Alberta has, in obiter dictae, found that an agreement between a developer and a financier relating to a store to be operated by a third party may or may not be enforceable by the third party, but could be enforced by the developer on behalf of the third party (with the developer then being liable to account to the third party).38
The first requirement of the principled exception — whether the parties intended the third party to benefit from the contract — gives rise to further uncertainty. As noted by Angela Swan, the concept of intention cannot itself be principled because no one
33 Fraser River, at para. 31.
34 See e.g. Fenrich v. Wawanesa Mutual Insurance Co., 2005 ABCA 199; RDA Film Distribution Inc. v. British
Columbia Trade Development Corp., 2000 BCCA 674; Kitimat (District) v. Alcan Inc., 2006 BCCA 75, at paras. 69-71; 375069 Alberta Ltd. v. 400411 Alberta Ltd., 2000 ABQB 29.
35 Cheong v. Futuma, [2002] B.C.J. No. 2214 (S.C.).
36 Re Stelco Inc. (2006), 20 B.L.R. (4th) 286 (Ont. S.C.J.), over’d (on other grounds) Re Stelco Inc., 2007 ONCA
483, at para. 16.
37 Re Stelco Inc., 2007 ONCA 483, at para. 16.
really knows what parties’ intentions are.39 In some circumstances where the parties’
intention to benefit one or more third parties is clear, such as indemnity which is expressly applicable to third parties, that intention may still be defeated by the inability to use the principled exception as a sword. In many more circumstances, the parties’ intention will be less clear, and the determination will be highly fact specific — not exactly the hallmark of a truly principled approach.
The question also remains what is to be made of Iacobucci J.’s statement in London Drugs that “the doctrine of privity should not stand in the way of commercial reality and justice.” At least one decision has seized on this language and rejected an attempted claim by a third party on a contract in part because disallowing the claim would not be standing in the way of commercial reality and justice.40 However, this
language might equally be used to further extend the principled exception.
39 Canadian Contract Law, at 196.
