Hong Kong has introduced draft legislation that will allow certain third parties to enforce contracts to which they are not a party.  This heralds an alignment with other major jurisdictions, including the United Kingdom.  This alert describes the changes and how they may impact your contractual arrangements.

Introduction

On 28 February 2014, the Contract (Rights of Third Parties) Bill (the Bill) was introduced to the Legislative Council. The Bill has been a work in progress since the initial report by the Law Reform commission of Hong Kong in 2005.

If passed, the Bill will serve to bring Hong Kong into line with the United Kingdom and a number of common law jurisdictions including Australia, Canada and Singapore which have all enacted similar legislation in recent years. The Cayman Islands is also in the process of enacting legislation on the rights of third parties in contract.

But what does the Bill actually mean for the doctrine of privity?

Recap of basic principles

The doctrine of privity states that a person cannot acquire and enforce rights under a contract to which he is not a signatory or party. The principle of privity, first formalised in Dunlop v Selfridge1, operates on the premise that a third party, who is not a signatory to a contract has not:

  1. provided any consideration or value for the rights which are allegedly conferred on it under the contract; or
  2. evidenced its intention to be bound to the terms of the contract, through signature of the contract.

However, complications arise where the parties have clearly intended to grant third party rights under a bilateral contract but the third party has been unable to exercise them under a strict interpretation of privity.

How will the law change?

If passed, the Bill will vary the common law rule of privity of contract by enabling a third party to enforce a term of a contract where the contracting parties intend to create a legal obligation enforceable by a third party. The underlying principle of the Bill is to avoid potential injustice to third parties and to give effect to the intention of contracting parties wishing to benefit third parties.

The Bill contains a two-limb test under which a third party who is not a party to a contract will be able to enforce it if:

  1. The contract contains an express term to that effect; or
  2. The contract contains a term which purports to confer a benefit on the third party UNLESS on proper construction of the contract, the parties to the contract do not intend that the third party have a right to enforce it.

What does “purport to confer a benefit” mean?

While it may seem that the reform of the law is primarily intended to protect third parties and their acquired rights, in fact the provisions will enable the proper protection of the intention of all contracting parties.

The qualifications around the two-limb test all go to correctly evidencing the intention of the contracting parties and identifying what the phrase purports to confer a benefit actually means:

1. Opting-out

Importantly, parties may expressly exclude the application of the Bill (or ordinance as it will be once it becomes effective) and maintain the common law position if they choose.

2. Identity of the third party

The third party must be expressly identified by name, class or as answering a particular description.

3. Contract Rescission and Variation

In order to preserve the rights of third parties, the Bill contains restrictions on the rights of contracting parties to rescind or vary the contract by agreement without consent of the third party (section 6(1)). Importantly though, this restriction can be overridden by an express term to the contrary or an express term specifying circumstances in which the third party’s consent is required. For such an express term to have effect, the third party must be aware of it or, in the absence of awareness, reasonable steps have been taken to notify the third party of the express term before the third party’s rights are crystallised (section 6(4)(a) and (b)).

These provisions are intended to strike a balance between the contracting parties’ freedom to alter the terms of the contract in accordance with their intentions on the one hand, and the interests of a third party who may suffer as a result of such alteration, on the other.

 

It should be noted though that if the Bill is enacted in its current form the Court will have discretion and power (under section 7) to rescind or vary a contract without the consent of the third party if it thinks it is just and practicable to do so. In making an order to dispense with the third party’s consent, the Court may impose conditions which include payment of compensation to the third party.

4. Protection against Double Liability

The Bill contains a provision to protect the promisor under a contract from double liability in circumstances where a promisor has performed his obligations (wholly or partly) to the third party.  In these circumstances the promisor will be discharged from his or her obligations to the promisee to the same extent. Further, it provides that if the promisee has recovered from the promisor a sum in respect of the third party’s loss or the promisee’s expense in making good the promisor’s default, the court (or arbitral tribunal) must reduce any award to the third party to an appropriate to the extent to which it considers appropriate to take account of the sum.

5. Arbitration Agreement

Under section 12 of the Bill, a third party will be treated as a party to an arbitration agreement for the purpose of the Arbitration Ordinance (Cap. 609) provided that the third party’s right to enforce a term of the contract is subject to an arbitration agreement. This ensures that the third party is not only entitled to arbitration, but is also bound by arbitration.

However, a significant limitation of the this arbitration provision is where a third party wishes to enforce an award other than a Hong Kong domestic arbitration award in Hong Kong. This is because under the New York Convention, which concerns enforcement of foreign arbitral awards, only signatories to the arbitration agreement, i.e. the contracting parties, may enforce an award. This lacuna has been aired in cases brought before the courts in several jurisdictions including Canada, Germany and Spain, but remains unresolved (see: LCIA “Arbitration International” Volume 27, Number 4, 2011 for discussion on these cases).

Scope

In essence, the Bill (if enacted) will allow greater freedom for contracting parties to confer rights on a named third party but the caveat remains throughout that if on “proper construction” of the contract it is clear that the contracting parties did NOT intend to confer rights upon a third party, then these provisions will not apply.

Further, the new legislation will not apply:

  1. To contracts entered into before the commencement of the legislation. This means that there is no need to amend existing contracts;
  2. If a third party already has an enforceable right under existing rules or convention or where allowing third parties a right to enforce a contract would conflict with certain areas of law e.g. a bill of exchange;
  3. If there are sound policy reasons for maintaining privity of contract in certain areas e.g. a contract of employment.

Conclusion

If the Bill is enacted then it will significantly change the legal nature of relationship between contracting parties and third parties interested in a contract. The changes are likely to be widely welcomed and would bring Hong Kong into line with comparable common law jurisdictions.

In practical terms the introduction of the Contracts (Rights of Third Parties) Act 1999 in the United Kingdom has not had major practical impact as most commercial contracts now contain an opt-out clause to prevent application of the legislation. As a result, there has been little case law on the interpretation of the two-limb test and the all-important phraseology around a contract which “purports to confer a benefit”. However, if contracting parties do wish to confer third party rights in their contracts, then clear wording should be included in order to avoid potential disputes concerning purported rights.

The aim is not to abolish the concept of privity, rather to ensure clarity and protection of the intentions of contracting parties where a third party is involved.  Further readings of the Bill are scheduled for March 2014 and it is anticipated the legislation will be passed by the end of this year.