Third Parties Gain Right To Enforce Project Contracts

Third Parties Gain Right To Enforce Project Contracts

December 01, 1999

Third parties will have an easier time in the future asserting rights under project documents that are governed by English law as a result of a new law that took effect on November 11.

The new law partly abolishes the doctrine of “privity of contract” that, until now, has prevented any person from enforcing rights arising under a contract unless he is a direct party to the agreement. This was true regardless of how clear the actual parties to the contract were in expressing their intention to create a right in favor of the other person.

The new law — called the “Contracts (Rights of Third Parties) Act 1999” — gives more freedom to contracting parties by allowing them to create enforceable rights in favor of third parties. This development has the potential to obviate to a large extent the need for direct agreements. Enforceable rights could be given to the lenders in project agreements such as construction contracts, operation and maintenance contracts or concession agreements (although these are typically governed by the law of the country where the project will be built). However, it remains to be seen whether lenders will give up the comfort of a direct contractual relationship and rely solely on a statutory right.

In the US, where common law third-party beneficiary rights have existed for many years, project finance lenders still require that consents to assignment be executed even when the underlying agreement acknowledges certain rights to the lenders. It appears from the language of the act that it would be easier to assert third-party beneficiary rights in England than in the US, where there is a requirement to show the contracting parties’ intention to create such rights.

Under the English act, if the term of the contract purports to create a third-party beneficiary right, then it is up to the contracting parties to prove that the contract, on a proper construction, does not show that they intended that term to be enforceable by the third party. In any case, the new contracts act should strengthen developers’ hands in arguing that the sometimes costly direct agreements should not be required where the underlying agreement already grants the lenders adequate protections. In this respect, project finance transactions governed by English law could become simpler. The new contracts act has already provoked a serious debate within the English construction industry on the effect it will have on collateral warranties, a form of direct agreement widely used in real estate development deals.

However, because of the way it operates, the new law also has the potential to create new hazards. Presumably, a sweeping “no third party rights” clause specifically barring application of the bill would be sufficient to show that the parties had no intention to create such rights. However, things could get more complicated in cases where the parties to the contract want the contracts act to apply with respect to a specific right in favor of a specific third party. For example, the parties may desire to create third-party rights in favor of one type of lender to the project but not others. Simply stating that a clause is intended for the benefit of the lenders to the project would potentially create rights in favor of any lender to the project, whether senior or subordinated, secured or unsecured, who was aware of the clause granting third-party rights to lenders prior to entering into the relevant loan transaction. Because of the new law’s limitations on amendments, a lack of caution could lead one to create rights inadvertently in favor of third parties without being able to do anything about it later.

The new contracts act does not apply to contracts entered into fewer than six months after it took effect on November 11, although this restriction does not apply to contracts that are entered into on or after November 11 and expressly provide for its application. It is unclear under what circumstances amending a contract in future will bring it under the statute and, perhaps, create third-party rights inadvertently.

The new law states that “a person who is not party to a contract may in his own right enforce a term of the contract if the contract expressly provides that he may.” In an effort to make things less technical by not requiring contracting parties to use any particular wording, the act provides that the third party may also enforce a term of the contract if “the term purports to confer a benefit on him” unless “on a proper construction of the contract it appears that the parties did not intend the term to be enforceable by the third party.” The third party need not be identified by name if it is a member of a class or answers a particular description. Finally, unless they have expressly retained the right to do so in the contract, contracting parties that create a right to a third party may not rescind the contract or amend it in a way that alters that right if the third party has relied on the right and the party to the contract against whom the right would be enforceable knew of or should have reasonably foreseen such reliance.