Third party rights: behind the times

Scots law on third party rights in contract is widely thought to be problematic. This article explains why, and looks to how this situation might change in the future. The related issue of damages for “transferred loss” is also addressed.

In a typical contract in favour of a third party, the contracting parties will provide that one of them is bound to confer a benefit upon a third party who is external to the contract. The Scots law third party right, or jus quaesitum tertio, is generally thought to be problematic: even the Latin name of the doctrine has been criticised as outdated and inappropriate for modern usage, as have the terms “debtor” (the contracting party who is bound to make a payment or other performance to the third party) and “stipulator” (the other party to the contract, who requires that the debtor perform to the third party).

The current situation in Scotland is unfortunate, as contracts in favour of third parties are of great economic importance, particularly with regard to life insurance and contracts of annuity. The alternative to using third party rights to create enforceable rights in a single transaction is to confer the rights on one of the contracting parties and then transfer them to the third party by way of a second, separate transaction. The former is clearly more efficient.

In England, the Contracts (Rights of Third Parties) Act 1999 was adopted as a means of sidestepping the privity doctrine, which provides that only the parties to a contract may enforce its terms. The 1999 Act is thought to be generally successful (although perhaps underutilised), and its terms have been used in a number of contexts. Indeed, Mark Macaulay of Maclay Murray & Spens LLP has suggested that 1999 Act should either be extended to Scotland to offer certainty in the field of third party rights, or, preferably, the existing law should be clarified; and Douglas Mathie of Brodies LLP has previously reported that clauses in favour of third parties in Scots law documents are often made subject to English law, as the 1999 Act is seen as superior to the jus quaesitum tertio.

Additionally, there are third party rights provisions in the Draft Common Frame of Reference (DCFR II. – 9:301), the Unidroit Principles of International Commercial Contracts (PICC Article 5.2.1-6) and the Common European Sales Law (CESL Article 78), and a number of jurisdictions outwith Scotland have provided for statutory third party rights, for example New Zealand’s Contracts (Privity) Act 1982 and the Singaporean Contracts (Rights of Third Parties) Act 2001. There are thus several models to which Scotland can turn in the reform of this area of law.

Which aspects of Scots law are most problematic?

Collateral warranties are generally preferred in Scotland due to the perceived weaknesses of the jus quaesitum tertio doctrine. These are usually contained in documents supporting the primary contract, where a third party who is not party to the primary contract requires rights stemming from the primary contract, and are frequently found in the context of construction contracts and commercial developments. It would be preferable for parties to have a realistic choice between collateral warranties and third party rights, as the latter are often advantageous. For example, where a group of companies rents a building, separate warranties are required to be issued for every tenant. This process is both time consuming and easily overlooked, whereas a third party right can be built into the lease and applied to each tenant without any further action.

A further issue concerns the inability of groups of companies to rely on third party rights to deal with “group loss”. Essentially, this problem arises where a company operates using a complex group structure and suffers loss due to problems caused by a supplier’s failure to provide a particular service (for example, IT support). The supplier can, in the absence of a clearly defined third party right, state by way of defence that they were only contracting with one member of the group. It is commercially inefficient for every company within a group to contract individually with a supplier of services, but parties tend not to feel secure in relying on third party rights in Scots law. This “group loss” problem is thought to be easily avoidable under the English 1999 Act, which would allow for a single company to contract for a particular service with the intent that the benefits incurred under the contract are to be enjoyed not just by itself but by all the companies in the group.

Irrevocability is a key concern – whilst variation of the agreement by the contracting parties to the extent that the rights of the third party are not affected is permissible under Scots law, it is generally thought that a third party right in Scots law cannot be revoked once made in favour of the third party. But it is not clear which steps are required to be taken before the third party right is irrevocable. This is thought to be a fundamental flaw of the jus quaesitum tertio, because irrevocability has long been a crucial aspect of the doctrine.

The 1999 Act provides at s 2(1) and (2) that the contracting parties may rescind or vary the contract unless the third party has communicated their assent (by words or conduct) to the promisor (the party who is obliged to perform in favour of the third party), the promisor is aware that the third party has relied on the term, or the debtor can reasonably be expected to have foreseen that the third party would rely on the term and the third party has in fact relied on it. However, under the 1999 Act the contracting parties may rescind the contract despite any of these factors applying if they have expressly provided so (s 2(3)). There are similar provisions in the DCFR, PICC, CESL and the 1999 Act concerning the circumstances in which third party rights can be revoked, and such provisions could be enacted in Scotland in place of the current rules on irrevocability.

Finally, it is not currently clear whether a third party can reject or revoke their right, or how they would do so, and there is no consensus regarding which remedies are available to third parties (including whether the third party can pursue the stipulator if they do not fulfil their contracting obligations enabling the debtor to perform).

Transferred loss

The “transferred loss” doctrine does not involve traditional third party rights scenarios. Instead, this refers to the situation where the losses of one party are treated as the losses of another in order to advance a valid claim in respect of those losses against a third party. For example, a housing developer may build a street of houses, and sell the new builds to their respective first purchasers. Within a few years of these transactions, one of the purchasers may sell their house on to a second buyer. The second buyer may find that the foundations of the home have not been adequately structured. However, there is no contractual link between the developer and the second buyer – the requisite link only exists between the developer and the first purchaser.

In such cases, it is desirable that the second buyer’s claim does not disappear into a damages “black hole”, and that the loss is capable of being viewed as transferring from the first to second purchaser.

However, the law on the transferred loss doctrine is not fully developed, and consequently somewhat unclear. The case law is not entirely coherent. It has been said in the sheriff court in Clark Contracts Ltd v The Burrell Co (Construction Management) Ltd, Sheriff J A Taylor, 1 October 2002 (accessible at www.scotcourts.gov.uk/opinions/a7038_00.html) that the transferred loss doctrine is not needed in Scots law because the jus quaesitum tertio doctrine already covers cases where “black hole” losses arise, although in other Scottish cases the principles of transferred loss have been applied (for example, McLaren Murdoch v The Abercromby Motor Group 2003 SCLR 323). Clarification on the matter would be useful in defining the positions of all relevant parties in situations in which transferred loss may arise, in terms of liability to each other, and the remedies available to the party on whom the losses fall.

Could legislation resolve these issues?

Statutory provisions enacting a reformed third party right suitable for modern commercial usage is the fastest, most effective method of modernising Scots law in these areas, the alternative being to rely on the courts to gradually alter the doctrine to bring it into line with current commercial requirements. But the cases may never come, especially if parties wishing to create third party rights are making their contracts subject to English law in order to do so. Similarly with transferred loss, where it is now a decade since the last significant case on the subject. Scotland could, however, be the first jurisdiction to offer statutory clarification of a generally applicable transferred loss doctrine.

Future work in the area

I will be undertaking an LLM by research on third party rights in Scots and German contract law in the coming academic year at the University of Edinburgh. I have also recently completed a placement as a legal assistant at the Scottish Law Commission, where a great deal of my time was spent conducting research on third party rights, as the SLC is currently examining the law on the topic to ascertain whether reform in the area is needed.

Any views on the extent to which issues raised in this article are problematic in legal practice would be gratefully received, as would notice of any other practical problems arising from the current state of the law on third party rights in Scots law. These views would, with permission, be passed along to the contract team at the Scottish Law Commission to assist them in coming to a view on whether the Commission should devote further time to third party rights.

Views on any of the issues raised in this article or comment on any aspect of third party rights in Scots law can be directed to lorna.j.macfarlane@gmail.com.