Chapter 19
Deciding Whether a Third Party Can Enforce or Interfere with a Contract
In This Chapter
Understanding how third parties may get involved
Recognizing and establishing third-party beneficiaries
Checking whether a party qualifies as a third-party beneficiary
Steering clear of tortious interference with contract
Third parties often get involved in contracts and contract disputes. For example, third parties may have an interest in enforcing a warranty (see Chapter 18 for details). If I give you food at my house and the food makes you sick, you may want to bring a claim against the seller who sold me the food, even though you’re not a party to the contract between me and the seller, making you a third party. Provisions in the UCC resolve whether you can bring such a claim.
Third parties may also get involved in other ways — by becoming third-party beneficiaries, by interfering in the performance of a contract between two other parties, or by having the rights or duties of the contract assigned or delegated to them. This chapter focuses on third-party beneficiaries and people who interfere in another parties’ contract by inducing one of them to breach. Here, you find out how to determine whether someone is a third-party beneficiary. You also see the potential consequences a third party may suffer as a result of interfering in a contract between other parties. (For more about assignment and delegation, see Chapter 20.)
Determining Whether a Party Is a Third-Party Beneficiary
In a third-party beneficiary transaction, a party who’s not a party to the contract sues to enforce a promise that one of the parties made. Contract law had trouble finding a theoretical justification to allow this but ultimately allows it as part of the role of contract law to carry out the parties’ intent.
Everyone agrees that whether a party is a third-party beneficiary hinges on whether the parties intended that party to be a third-party beneficiary of the promise. The challenge is to find that intent. The Second Restatement of Contracts (which has been around since 1981 and has become so familiar that I simply call it the Restatement) takes a somewhat circular approach to this problem. In § 302, the Restatement creates two categories of beneficiaries: intended and incidental. It goes on to say that a beneficiary of a promise is an intended beneficiary if the parties so intend and one of the following applies:
(a) the performance of the promise will satisfy an obligation of the promisee to pay money to the beneficiary; or
(b) the circumstances indicate that the promisee intends to give the beneficiary the benefit of the promised performance.
The First Restatement of Contracts, which came out in the 1920s, is somewhat more helpful because it provides names for these two categories of third-party beneficiaries:
Creditor beneficiary (a): One to whom one of the parties to the contract owed money that he arranged to pay
Donor beneficiary (b): One to whom the parties to the contract intended to make a gift
This section explores these two categories in turn, describes a third category for parties who have only an incidental interest in the contract, and introduces three key questions you can ask to determine whether a third party is likely to qualify as a third-party beneficiary. It also discusses the rights of third-party beneficiaries and whether the parties to the contract can change those rights.
Creating a creditor beneficiary by telling someone to pay your debt
The parties intend to create a creditor beneficiary when performance of the promise will satisfy the promisee’s obligation to pay money to the beneficiary. In other words, A and B make a contract in which B promises A that he’ll do something for C. They intend to make C a creditor beneficiary if B’s performance will satisfy an obligation of A to pay money to C.
For example, John owes Terry $100. John sells a widget to Peter for $100 and as part of the contract, John tells Peter to pay the $100 to Terry rather than to John. Peter doesn’t pay. Terry asks whether she can sue Peter for the $100. Terry is obviously a third party, but contract law must determine whether she qualifies as a third-party beneficiary, which she must be in order to have the right to sue.
Here’s how to determine whether the parties to a contract intended to create a creditor beneficiary:
1. Identify the promise that the third party is seeking to enforce.
In this example, Terry is seeking to enforce Peter’s promise to John.
2. Ask whether the performance of the promise will satisfy an obligation of the promisee to pay money to the beneficiary.
Yes, the performance will satisfy John’s obligation to pay Terry. Therefore, Terry is a creditor beneficiary and, as a third-party beneficiary, can sue Peter to enforce the promise.
This situation arises in many real-world transactions, such as real estate contracts. Suppose I buy a house from you, and in the process, I take out a $100,000 mortgage from the bank. I then sell the house to Terry, and she assumes the mortgage; that is, she promises me that she’ll pay the bank. However, she doesn’t pay the bank. The bank can still come after me (if you don’t understand why, see Chapter 20), but the bank wants to know whether it can go after Terry. Here’s how to decide whether the bank is a third-party beneficiary:
1. Identify the promise that the bank is seeking to enforce: Terry’s promise to pay the bank.
2. Ask whether the performance of the promise will satisfy an obligation of the promisee (me) to pay money to the beneficiary (the bank). Yes, that’s why I got Terry to make the promise to me. Therefore, the bank is a third-party beneficiary and can sue Terry to enforce the promise. (By the way, most mortgages today have a provision expressly saying that the mortgage isn’t assumable and that the balance is due on sale of the property.)
Creating a donor beneficiary by making a gift
According to the Restatement, a third party is a third-party beneficiary if “the promisee intends to give the beneficiary the benefit of the promised performance.” This third party is referred to as a donor beneficiary (donor meaning the giver of a gift). In other words, A and B make a contract in which A gets B to promise to give something to C.
For example, John sells a widget to Peter for $100. As part of the contract, John tells Peter to pay that $100 to John’s favorite charity. Peter doesn’t pay. The charity asks whether it can sue Peter for the $100.
To determine whether the parties to a contract intended to create a donor beneficiary, here’s what you do:
1. Identify the promise that the third party is seeking to enforce.
The charity wants to enforce Peter’s promise to pay the charity $100.
2. Ask whether the promisee intends to give the beneficiary the benefit of the promised performance.
Yes, John (the promisee) said he intends to give the charity (the beneficiary) the benefit of the $100. Therefore, the charity is a donor beneficiary and, as a third-party beneficiary, can sue Peter to enforce the promise.
The most common example of a donor beneficiary is the beneficiary in a life insurance policy. I agree to pay the insurance company a premium in return for its promise to pay my beneficiary upon my death. The third party is clearly an intended beneficiary and can sue to enforce the insurance company’s promise. Notice that the beneficiary gave no consideration in return for being named as a beneficiary. As I explain in Chapter 3, this is a gift promise and is not binding. Therefore, I can generally revoke (take back) this promise to make someone my beneficiary, such as by designating a new beneficiary. However, my promise may be enforceable on a theory of reliance (see Chapter 4 for details on reliance).
Creating an incidental beneficiary: Another name for loser
After defining what qualifies someone as a third-party beneficiary, the Restatement says that if you’re not a third-party beneficiary, you’re an incidental beneficiary, which really means you’re a loser — you have no right to enforce the contract. To determine whether someone’s an incidental beneficiary, look for a third party who benefits from the contract and then ask whether the reason the parties entered into the contract was to benefit that third party. If the answer is no, then the third party is an incidental beneficiary.
For example, suppose I hire you to do some research for me for the summer. I promise that in payment, I’ll buy you a new Mercedes from Midtown Motors. Needless to say, you accept my offer. You do a fantastic job on the research, and I say, “Let’s go down and pick out that Mercedes.” You say, “Professor Burnham, I didn’t do it for the Mercedes. I did it for the love of contract law. That’s good enough for me, and you don’t have to get me the Mercedes.” You’re happy, I’m happy, but unfortunately the third party to our contract, Midtown Motors, is unhappy. They sue to enforce the contract, claiming to be a third-party beneficiary. Would they have benefitted from performance of the contract? Yes, indeed. Did we enter the contract with the intention of benefitting them? Nope. That makes Midtown Motors an incidental beneficiary — they lose.
Asking three key questions to identify third-party beneficiaries
As a quick check to determine the likelihood that a third party qualifies as a third-party beneficiary, ask the three questions I present in this section. The answers to these questions won’t give you a definitive determination, but they can be helpful in making the determination.
Is the third party named in the contract?
A third-party beneficiary is usually named in the contract. This alone isn’t enough to make someone a third-party beneficiary, however. When you name the beneficiary of an insurance policy, you most certainly intend that party to be a third-party beneficiary. But if I name Midtown Motors as the place I’ll purchase a car to pay you for your research work, I probably didn’t intend Midtown Motors to be a third-party beneficiary. The intent all depends on the context in which that party is named.
When writing a contract that names a beneficiary, consider adding that the parties expressly do or do not intend the party to be a third-party beneficiary.
Does performance run to that third party?
Another test is whether performance of the contract runs to that third party. If so, an intent to benefit that party is more likely. In a life insurance contract, the insurer will perform directly to that third party (the beneficiary) by paying that person the money. In our research contract, in which I promise to buy you a car in payment for your work, my performance runs to you, not to Midtown Motors. (We could say it runs through them but not to them.)
In a case where an insurance company promised the buyer of an automobile that it would provide liability insurance, a person injured by the buyer sued the insurance company. Obviously, the injured person was not specifically named in the contract, but the purpose of the contract was to compensate those who were injured by the buyer, so that was close enough to name the injured person as a third-party beneficiary.
This issue of who performance runs to sometimes comes up with government contracts that intend to serve a public interest. Did the government intend to benefit those directly affected by the contract or to benefit the general welfare? Courts have generally determined that such a contract wasn’t intended to benefit any particular person unless the terms of the contract provided for that.
For example, suppose the government contracts with a business to retrain unemployed workers in a particular city, and the business doesn’t do it. Do the unemployed workers have a claim against the business? Probably not. The government’s intent in contracting with the business was to serve the general good by reducing unemployment, not to benefit any particular unemployed worker.
Did the promisee intend to benefit the third party?
Questions about third-party beneficiaries all come back to intent. One way to focus on that intent is to think of the promise from the point of view of the promisee — the one to whom the promise was made. If someone is a third-party beneficiary, then the scope of the promisor’s obligation has been expanded from the promisee to the third party as well.
After that’s been established, ask whether the promisee bargained for that expanded obligation. In the case of the auto insurance policy, that answer is easy, because the promisee sought the promise of the insurance company to benefit the injured party in case of an accident. But if you agreed to be my research assistant in return for a Mercedes, did you intend for me to promise to benefit Midtown Motors? Probably not. You were most likely looking after yourself.
Changing a third-party beneficiary’s rights
The parties to a contract are generally free to modify their contract, changing their duties to each other, as I explain in Chapter 12. Similarly, the parties are generally free to change the beneficiary of a contract. However, exceptions arise when the rights of the beneficiary are said to have vested, meaning they can’t be changed without her consent.
The rights of a beneficiary usually vest in the following situations:
Express agreement: A term in the contract provides that the beneficiary can’t be changed.
Reliance: The beneficiary changes her position in reliance on the promise.
Changing a named beneficiary can be an issue with life insurance policies. If the beneficiary of a life insurance contract has relied on the promise, the insured may not be able to change the duty to the beneficiary — for example, by changing the person named as beneficiary. In many jurisdictions, courts found that the insured was unable to change the beneficiary unless he or she reserved that power in the policy. Most policies now provide that the insured party has the power to change the beneficiary.
Interfering with Someone Else’s Contract: A Big No-No
Tortious interference arises when a third party induces one of the parties to the contract to breach the contract. This gives the injured party a couple of options: She can sue the party to the contract for breach of contract, and she can sue the third party for tortious interference with contract.
Tortious interference is a tort claim, not a contract claim. Some describe it as a “business tort,” and maybe because tortious interference is less common than other torts, it’s often not studied in Contracts or Torts classes. But it’s important because a person may not be aware that he’s setting himself up for a tort claim when he induces a party to breach a contract. Of course, the tort is committed only when the interference is “improper,” and the problem that usually arises is in trying to determine whether the person’s interference was improper or justified.
This section explains how to recognize tortious interference with a contract and how the courts determine whether such interference is improper.
Finding the tort of tortious interference with contract
A party can’t get punitive damages for a breach of contract claim. However, a party may be able to get punitive damages for proving an intentional tort (wrongful act resulting in injury), such as tortious interference with contract.
In fact, one of the biggest judgments in U.S. legal history came when Pennzoil sued Texaco for tortious interference with its contract to buy Getty Oil. The jury found Texaco liable for tortious interference and assessed damages of more than $10.5 billion (reduced to a mere $8.5 billion on appeal), forcing Texaco into bankruptcy.
Restatement of Torts § 766 describes tortious interference:
One who intentionally and improperly interferes with the performance of a contract (except a contract to marry) between another and a third person by inducing or otherwise causing the third person not to perform the contract, is subject to liability to the other for the pecuniary loss resulting to the other from the failure of the third person to perform the contract.
The most difficult of these elements to prove is that the interference was improper, because the party who interfered usually claims that its interference was justified. The next section tackles that issue.
Considering claims that the interference is improper
The defendant in a tortious interference claim usually defends by saying that if it did interfere, its interference was not improper but justified. For example, not long ago, every night people across America got annoying phone calls at dinnertime with offers from long-distance services. Everyone already had a long-distance service, so if you accepted one of these offers, you had to break your existing contract with another service. Although the calls may look like tortious interference, they were probably not heavy-handed enough to qualify as improper. The company offering the service could claim that its action was justified by free enterprise, with competing parties free to offer their wares to customers, who could then decide whether they wanted to get out of their existing contracts in order to accept.
A more heavy-handed example was dramatized in the movie The Insider. Jeffrey Wigand was a scientist employed by Brown & Williamson Tobacco Company. In his contract, he promised not to divulge corporate secrets to anyone. Nevertheless, he made some disclosures to the CBS team that produces 60 Minutes. Brown & Williamson could’ve sued Wigand for breach of contract, but they went after the deeper pocket: They threatened to sue CBS for tortious interference. CBS’s defense would’ve been that they’re in the news business and the public had a right to know this information. Nevertheless, the threat worked, and 60 Minutes didn’t air the episode.
The case of Phillips v. Montana Educational Association (MEA) is not an important one, but it nicely illustrates the analysis of a claim for tortious interference with contract. Phillips was an employee of the MEA who was fired. Instead of suing his employer for breach of contract, he sued the Board of Directors of the Association for tortious interference with contract. Clearly he and the Association had a contract, and the directors had caused it to be terminated. The only issue was whether their action was improper.
The court found that the duty of the board of directors of a corporation is to act in the best interests of that corporation. It may be in the best interests of the corporation to breach a contract the corporation has with some other party. As long as they were acting in good faith, then the board of directors was justified in inducing the corporation to breach the contract with Phillips.