On July 20, 1866, a little-known naval battle took place off the coast of modern-day Croatia. The battle, known as the Battle of Lissa, pitted the naval forces of the Austrian Empire against those of the Italians. It was apparently the first naval battle to involve a fleet of ironclad warships on both sides, which were mixed in with the older wooden variety. At the battle, the smaller Austrian fleet defeated the larger Italian fleet. Afterwards, the credit for the Austrian win was given to the Austrian’s aggressive ramming of the Italian ships because the cannon were ineffective against the ironclads (in one case a wooden Austrian ship rammed and sank an ironclad Italian ship). It’s not clear that giving credit to ramming was fully deserved, as there were other factors contributing to the Austrian’s surprising victory. Nevertheless, the Austrian’s success at the Battle of Lissa resulted in virtually every warship constructed for the next several decades containing a specifically designed ramming bow. But alas, ramming did not figure heavily in any future naval battles (guns eventually became more effective, along with torpedoes) and the naval ramming bow ultimately proved to be a major problem—instead of ramming the enemy, the ramming bows resulted in the accidental sinking of friendly ships that collided with one another.
So what do dangerous and unnecessary ramming bows on naval warships of the past have to do with contractual boilerplate today, particularly “no third party beneficiary” clauses? Well, more than you would think. But to fully appreciate that comparison, it is first necessary to understand how a third party can become a beneficiary to a contract between the named parties in the first place.
Nothing is more fundamental to the common law of contracts than the concept that, as a general rule, only parties to a contract have rights with respect to that contract. As with most general rules, however, there are exceptions. In particular, contract law (as it has developed in the U.S.) permits enforcement of contractual obligations by a nonparty to a contract if that nonparty is an “intended” third-party beneficiary of the contract. While most contracts contain an express provision that negates any intent by the contracting parties to benefit any third party, the absence of a “no third-party beneficiary” provision does not create any presumption that there is an actual intent to benefit a nonparty; and that is so even when the parties know that their performance of the contract will in fact benefit a third party. Instead, what the law requires to permit a nonparty to enforce a contract between the actual named parties to a contract is a clear expression of intent in that contract creating rights in favor of that nonparty. The concept that someone can be an implied third-party beneficiary is overstated and largely a myth.
A recent Texas Supreme Court case, First Bank v. Brumitt, No. 15-0844 (Tex. May 12, 2017), applied these principles to a situation that is common in private equity transactions—a financing commitment issued in favor of a prospective buyer of a target company. In this case, First Bank had issued a financing commitment letter to a proposed buyer of a technology company. The commitment letter did not contain a “no third-party beneficiary” provision. While the commitment letter identified that the proceeds of the loan were intended to finance the purchase of the company, and it seemed clear that First Bank knew that the seller of the business would obviously benefit from the closing of the loan, the court held that the seller was not a third-party beneficiary of the commitment letter. According to the court:
Although a contract may expressly provide that the parties do not intend to create a third-party beneficiary, the absence of such language is not determinative. ‘Instead the controlling factor is the absence of any sufficiently clear and unequivocal language demonstrating’ the necessary intent. … Contracts often benefit third parties, and the contracting parties are often aware that their performance under the contract will benefit third parties. Whether a third party may sue to enforce the parties agreement, however, depends not on whether the third party will benefit or on whether the parties knew that the third party would benefit, but on whether the contracting parties ‘intended to secure a benefit to [a] third party’ and ‘entered into the contract directly for the third party’s benefit.’
And, according to the court, it is the express language set forth in the contract that is determinative. While “circumstances surrounding the formation of a contract may inform the meaning of a contract’s unambiguous language[,] …courts may not rely on evidence of surrounding circumstances to make the language say what it unambiguously does not say.”
Obviously the inclusion of an express “no third-party beneficiary” provision would have likely resulted in First Bank obtaining a summary judgment at the trial court on the issue of whether the seller could enforce the commitment letter; and it is to avoid any arguments by putative third-party beneficiaries regarding their status that presumably was the motivation for the original drafter to create the “no third-party beneficiary” clause that is now so common in most M&A-related agreements. But like the naval ramming bow of the past, which was created in response to a faulty perception of need and thereafter became not only useless, but also dangerous, there are cautionary tales related to the indiscriminate use of boilerplate “no third-party beneficiary” clauses, especially in light of the law’s reluctance to conclude that a nonparty is an intended third-party beneficiary in the first instance.
The fact is that many merger or purchase and sale agreements do contain obligations that are intended to benefit persons who are not named parties. For example, it is not uncommon for a private company acquisition agreement to state that the seller’s indemnification obligations are in favor not only of the named buying entity, but also in favor of its affiliates, who may actually suffer the losses being indemnified. Similarly, the nonrecourse provision that private equity buyers include to limit exposure beyond the specific named parties to the agreement is clearly intended to benefit (and be enforceable by) persons (affiliates) who, by definition, are not the named parties. But the provisions relating to continued employment for target company employees are specifically not intended to be enforceable by those employees, who are otherwise strangers to the contract. Without careful drafting to identify which provisions are and are not intended to be excepted from the “no third-party beneficiary” clause, a conflict can be created that threatens the bargained-for benefits for nonparty affiliates (a sinking of a friendly ship if you will). After all, “where a provision in a contract expressly negates enforcement by third parties, that provision is controlling.”
Don’t solve one potential problem by potentially creating another. Carefully determine which provisions of your contract are actually intended to benefit and be enforceable by a nonparty (typically affiliates in the private equity context) and carve those provisions out from the standard “no third-party beneficiary” provision, else you may find yourself trying to explain how the “no third-party beneficiary” provision does not trump the otherwise clear intent to benefit nonparty affiliates. Think through both the benefits and detriments of that ramming bow before installing it and, even when it really is necessary to install a ramming bow, consider modifying the standard variety to avoid untoward consequences.