Contract Law: The Rules of Third Party Beneficiaries Enforcing an Agreement

Contract Enforcement by Third-Party Beneficiaries

When people think of contracts, they assume that there are only two parties involved. Contract law is not always that simple, though. There can be other parties that stand to benefit from a contract’s performance and can be hurt by its breach. The outside party is known as a “third-party beneficiary.”[1]

As early as 1806, American courts started recognizing that third-party beneficiaries have legal rights.[2] In the seminal case, Lawrence v. Fox, Holly loaned $300 to Fox and Fox agreed to pay the $300 to Lawrence to satisfy a debt that Holly owed Lawrence.[3] The New York Court of Appeals found that Lawrence was an intended third-party beneficiary of the contract who had rights and could enforce the contract between Holly and Fox to recover the $300.

Categories of Third Party Beneficiaries

A third-party beneficiary is either a donee or a creditor. A donee beneficiary benefits from a contract gratuitously; that is, not in exchange for a service he has provided. For example, assume that John enters into a contract with Robert, a landscaper, providing that Robert will shovel the snow off John’s elderly neighbor, Bob’s, driveway every time it snows more than three inches. Bob is not a party to the contract, but he is an intended third-party beneficiary who will gratuitously benefit from John’s contract with Robert.

A creditor beneficiary is a person to whom an obligation is owed by the promisee. In the previous example, imagine that Bob had paid Robert to shovel his snow. So, if Robert hires John to shovel Bob’s snow, he is doing so to offset his own contractual obligation. Bob is therefore an intended third-party creditor beneficiary.

Contract Rights of a Third Party Beneficiary

Both donee and creditor beneficiaries can enforce contract rights, but to do so, both must be intended beneficiaries. The named beneficiary on a life insurance policy (the person who is to receive the death benefit upon the death of the insured) is a classic example of an intended beneficiary under the life insurance contract.

In general, an intended beneficiary is one who is[4]:

1)      Identified in the contract: All of our examples express cases in which the third-party beneficiaries were named in the contract. Bob was identified by the parties in our snow-shoveling cases and the beneficiary of a life insurance contract is named in the agreement (though it can typically later be changed)[5]

2)      Receives performance directly from the promisor; or circumstances demonstrate that the promisee will give the beneficiary the benefit from the contract.[6]

For example, in a 2012 case from New York, Logan-Baldwin v. L.S.M. General Contractors, Inc., homeowners hired LSM to restore their home. LSM hired Henry Isaacs, a subcontractor, to help with roofing. Henry Isaacs then hired Hal Brewster for assistance with the project, but Brewster caused damage to the home, forcing the homeowners to fix the damage themselves. The homeowners sued LSM and Isaacs for breach of contract. Isaacs argued that the homeowners did not have standing to enforce its subcontract with LSM because the homeowners weren’t intended third-party beneficiaries of the subcontract. The court disagreed and held that the homeowners were intended third-party beneficiaries to the contract, and therefore had standing against the promisee Isaacs. The court rooted its opinion on the circumstances of the contract. Isaacs knew that the purpose of the contract was to restore a home for the homeowners. The court reasoned that circumstances may indicate that there is an intended third-party beneficiary by looking at the contract as a whole.[7]

Vesting of the Rights of the Third Party Beneficiaries

For a third-party beneficiary to enforce a contract, his rights under the agreement must have vested, which means that the right must have come into existence.

Aside from the fact that the contract becomes enforceable by the third party upon vesting, the timing of the vesting is important for another reason. Before the third-party beneficiary’s rights vest, the original parties to a contract can modify their contract in any way they see fit. Once rights vest, the original parties cannot discharge or modify contractual rights without the beneficiary’s agreement to a change to the contractual rights.[8]

            A third-party beneficiary’s rights vest when any of the following three things happen[9]:

1)      The beneficiary assents to the promise in a contract in the manner requested by the parties:

2)      The beneficiary sues to enforce the contract’s promise; or

3)      The beneficiary materially changes position in justifiable reliance on the contract’s promise.

As an example of the first scenario, assume Adam owes Carla $200. Adam and Bertha agree that Adam will paint Bertha’s car and, in exchange, Bertha will pay Carla $200 on Adam’s behalf. Adam notifies Carla by email that Bertha will be paying her to satisfy Adam’s debt. Carla responds to the email by saying “sure, that’s fine with me.” At this point, Carla’s rights as an intended third-party creditor beneficiary in the agreement between Adam and Bertha have vested. As such, Adam and Bertha can no longer rescind or change the agreement to Carla’s detriment unless she consents.[10]

            An example of the third scenario would be where Sandy pays Joan to mow Jane’s lawn. Upon hearing of the agreement, Jane calls her usual landscaping company and tells them that she won’t be needing their services for the next two weeks. Because Jane has relied on Joan’s promise to Sandy to her detriment, she is vested as a beneficiary. Sandy cannot now let Joan out of the agreement without Jane’s consent.

A third-party beneficiary is more than a mere outsider to a contractual arrangement. A third-party beneficiary is often a legally protected entity with rights who can enforce the agreement to which she is a beneficiary.