The Law Reform Commission of Hong Kong

Report

Privity of Contract

This report can be found on the Internet at:

<http://www.hkreform.gov.hk>

September 2005

The Law Reform Commission of Hong Kong was established by the Executive Council in January 1980. The Commission considers for reform such aspects of the law as may be referred to it by the Secretary for Justice or the Chief Justice.

The members of the Commission at present are:

The Hon Ms Elsie Leung Oi Sie, GBM, JP,

Secretary for Justice (Chairman)

The Hon Mr Justice Andrew Li, Chief Justice

Mr Tony Yen, SBS, JP, Law Draftsman

Dr John Bacon-Shone

The Hon Mr Justice Bokhary, PJ

Professor Albert Chen, JP

Mr Anthony Chow, SBS, JP

Professor Y K Fan, BBS, JP

Mr Alan Hoo, SBS, SC, JP

The Hon Mrs Sophie Leung, SBS, JP

Professor Michael McConville

Mr Benjamin Yu, SC, JP

The Secretary of the Commission is Mr Stuart M I Stoker and its offices are at:

20/F Harcourt House

39 Gloucester Road

Wanchai

Hong Kong

Telephone: 2528 0472

Fax: 2865 2902

E mail: hklrc@hkreform.gov.hk

Website: <http://www.hkreform.gov.hk>

The Law Reform Commission

of Hong Kong

Report

Privity of Contract

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CONTENTS

Preface

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Terms of reference

1. In December 2002, the Secretary for Justice and the Chief Justice directed the Law Reform Commission:

"To examine the doctrine of privity of contract and its exceptions, and the justifications for and against its retention, and to make such recommendations for reform as appropriate."

The Sub-committee

2. In the same month, the Law Reform Commission appointed a sub committee under the chairmanship of Mr Benjamin Yu, SC, to consider the subject and to make proposals to the Commission for reform. The members of the Sub committee reflected a range of backgrounds and expertise. All were appointed in their personal capacity, rather than formally representing the particular organisations to which they belong. The membership of the Sub-committee was:

Mr Benjamin Yu, SC, JP (Chairman)	Senior Counsel
Mr Anthony Chow, SBS, JP	Partner Peter C Wong, Chow & Chow
Mr Simon Chui	Legal Counsel Consumer Council
Mr Baptista Lai	Barrister-at-Law
Mr Christopher Potts	Partner Crump & Co
The Hon Mr Justice Reyes	Judge Court of First Instance
Mr Peter Schelling	Managing Director & CEO Zurich Insurance Group (HK)
Ms Isabelle Tsang	Legal Counsel Bank of China (HK) Ltd
Ms Jessica Young	Assistant Professor Department of Professional Legal Education Faculty of Law The University of Hong Kong
Mr Byron Leung	Secretary

Meetings

3. The Sub-committee began its work on 29 January 2003 and between then and the publication of this report held a total of nineteen meetings.

What is "privity of contract"?

4. The doctrine of privity of contract ("the doctrine of privity") holds that a contract cannot confer rights or impose obligations on any persons other than the parties to the contract. The doctrine of privity is also known as the "third party rule". The doctrine has two aspects: as a general rule,

(a) a person cannot acquire and enforce rights under a contract to which he is not a party; and

(b) a person who is not party to a contract cannot be made liable under it.

The second aspect is generally regarded as just and sensible. However, the first aspect, that a third party cannot acquire rights under a contract to which he is not privy, has been criticised. The main concern of this report is therefore with this first aspect of the rule, and references to the doctrine of privity or the "third party rule" are to this.

Criticisms of the privity doctrine and reform in other jurisdictions

5. The privity doctrine has long been criticised as artificial and contrary to the parties' intention to benefit a third party. As a result, the courts have sometimes needed recourse to devices such as agency and trust to allow a third party to enforce a right conferred on him. Furthermore, legislation has made incremental inroads to the doctrine in specific cases. These legal principles at common law and in statutes circumvent the privity doctrine in some cases, but not generally.¹ It is no surprise that law reform bodies in various common law jurisdictions have critically examined the doctrine and recommended its reform.² In Australia (Western Australia and Queensland), Canada (New Brunswick), England, New Zealand and Singapore the privity doctrine has eventually been abrogated by legislation.³

6. The questions which fall to be considered are whether the anomalies of the privity doctrine are serious enough to warrant its reform and, if so, whether ad hoc reforms, either by the courts on their own initiative or by legislation, are adequate in the modern Hong Kong context, or whether an issue of this magnitude calls for comprehensive legislative reform.

The consultation process

7. The Sub-committee published a consultation paper on Privity of Contract (the "consultation paper") in June 2004, with a consultation period until the end of August 2004. The Sub-committee received responses to the consultation paper from those listed at Annex 1. We are grateful to all those who responded to the consultation paper.

8. The recommendations in the consultation paper were in general supported by the majority of respondents. Nevertheless, some respondents did have specific comments and reservations on both the recommendations and the issues discussed in the consultation paper. Apart from written comments, the Hong Kong Construction Association Ltd also met the Sub-committee and presented the consolidated views of the Association itself, the Hong Kong Federation of Electrical & Mechanical Contractors, the Hong Kong Institute of Surveyors, the Hong Kong Institute of Architects and the Association of Consulting Engineers. We will deal with the various comments and reservations in the following chapters.

Layout of this report

9. This report is the result of careful consideration of the initial recommendations in the consultation paper in the light of the responses we received. Chapter 1 of this report further examines the doctrine of privity as well as the common law and statutory principles which have the effect of circumventing the doctrine. Chapter 2 discusses the arguments for and against reforming the doctrine, while Chapter 3 examines a number of options for reform and concludes in favour of recommending reform by means of a detailed legislative scheme. Chapter 4 examines the legislative schemes in other major common law jurisdictions and considers various options before making our provisional recommendations for a legislative scheme for Hong Kong. Chapter 5 summarises all our recommendations.

Chapter 1 - The current law in Hong Kong

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The doctrine of privity

1.1 In this chapter, we further explain the doctrine of privity and illustrate its effect with some real-life examples. We then examine common law and statutory principles which have the effect of circumventing the doctrine and allowing a third party to enforce a jus quaesitum (a right conferred on him by the contractual parties). The last part of the chapter looks at judicial developments in other common law jurisdictions and discusses how those developments have been received by the Hong Kong courts.

1.2 As explained in the Preface, the doctrine of privity has two aspects. The first aspect, which is the crux of our present discussion, is that, as a general rule, a person cannot acquire and enforce rights under a contract to which he is not a party. The doctrine of privity at common law is generally considered to have been established in Tweddle v Atkinson.¹ The court in that case held that, in the words of Wightman J, "no stranger to the consideration could take advantage of a contract though made for his benefit." ² That is to say, a third party to a contract, not having provided consideration himself, cannot enforce the contract even if it has been entered into for his benefit. The rule was affirmed in Dunlop Pneumatic Tyre Co Ltd v Selfridge & Co Ltd ³ when the House of Lords accepted that it was a fundamental principle of law that only a party to a contract who had provided consideration could sue on it.⁴ This "consideration" rule is related to the doctrine of privity and is regarded as a possible explanation for the doctrine.⁵

1.3 When considering the effect of the privity doctrine, account needs to be taken of the remedy rule: the need to prove loss in an action for breach of contract. When a plaintiff sues for breach of contract, he must prove that he has suffered actual loss as a result of the alleged breach. Otherwise, he will only be entitled to nominal damages. This, when combined with the privity doctrine, could lead to unjust results in some circumstances. For example, suppose a contract is entered into between a parent company and a contractor for the benefit of a subsidiary company. If the subsidiary company subsequently suffers loss as a result of the contractor's breach, the subsidiary company cannot sue the contractor because it is not a party to the contract. The parent company, even though it is a party to the contract, will only recover nominal damages because it has suffered no actual loss. Hence it is not a viable option for a promisee (the parent company) to sue the promisor (the contractor). The decision of Alfred McAlpine Construction Ltd v Panatown⁶ is a good example of the rule that a person can only recover nominal damages unless he has suffered actual loss.

1.4 The effect of the first aspect of the doctrine of privity on everyday life can best be illustrated by some real-life examples.

(i) Contracts to pay money to a third party

1.5 A and B enter into an agreement under which A agrees to pay a sum of money to C. Both parties fully intend that C should take the benefit of A's promise. If A defaults, C cannot sue A because of the doctrine of privity. It does not help for B to sue A for damages since B would be unlikely to have suffered any damage himself. Sometimes, the Court may be able to prevent an injustice to C if B is prepared to sue A for specific performance and the Court is prepared to make an order compelling A to perform his promise.

(ii) Contracts to purchase real property

1.6 A property developer enters into a building contract with a contractor under which the contractor promises to use good workmanship and sound materials. The contractor warrants that he would make good any defects in the building within a stated period of, say, twelve months. Shortly before completion of the building, the developer sells individual units to purchasers. If a purchaser of a unit discovers a defect in his flat, he has no direct recourse against the building contractor. This is still the case even though the developer may have obtained the building contractor's warranties specifically for the benefit of purchasers, since purchasers are not "privy" to the building contract. In practice, a developer may withhold part of the payment to the building contractor to ensure that the building contractor honours its promise. The developer may also contract with the purchaser that the developer would exercise its best endeavours to enforce all defects and maintenance obligations under all contracts relating to the construction of the development.⁷ Nevertheless, a purchaser may find himself in a poor bargaining position because his only direct recourse, if any, is against the developer. Even that would depend upon the terms of his contract with the developer and on whether the developer is still around to honour its promise. In certain circumstances⁸, the contract between a developer and the purchasers may provide that where the developer is wound up, all warranties and guarantees under all contracts relating to the construction of the development would be assigned by the developer to the owners' corporation incorporated under the Building Management Ordinance (Cap 344) or, if no such corporation exists, to the manager of the development for the time being to be held in trust for purchasers of the units in the development. This recourse against the contractor is indirect, however, and an individual purchaser may encounter difficulties in compelling the owners’ corporation or the manager of the development to sue the contractor.

(iii) Insurance contracts

1.7 B is a sub-contractor of A. B takes out an insurance policy to cover his and A's liability to employees' compensation with an insurer (C), without joining A as a party. An employee of B is injured in the course of employment because of the negligence of A's employee. A pays the required compensation to B's employee. A, however, will have difficulties in seeking indemnity from C, since A is not a party to the insurance contract even though the parties intend to benefit him.

Legal principles which have the effect of allowing third parties to enforce rights

1.8 As illustrated in the above examples, strict adherence to the privity doctrine can prove artificial and contrary to the parties' intention, and can lead to injustice and inconvenience. There are, however, circumstances in which the doctrine does not apply, either because of supervening principles of common law or because of specific statutory provisions which allow a third party to enforce a right conferred on him by the contracting parties. The following paragraphs will first explain the principles at common law, followed by those in statutes. The merits and limits of employing these common law and statutory principles as options for reforming the privity doctrine are discussed under "Option 1" and "Option 2" respectively in Chapter 3 where other possible options for reform are also considered.

Common law

(i) Covenants concerning land

1.9 Covenants in a lease can benefit third parties who later acquire an interest in the property. Hence, a person may be able to enforce a covenant affecting land made by his predecessor in title even though he was not a party to the covenant, and a covenant may be enforced against someone acquiring land with notice that it is burdened with a covenant.⁹

(ii) Trusts

1.10 A trust is an equitable obligation to hold property on behalf of a beneficiary. A chose in action may be the subject matter of a trust. For example, if A makes a promise to B to pay a sum of money to C, a trust of that promise can be construed as created by B in equity in favour of C. In that case, B would be the trustee while C would be the beneficiary under the trust. If this agreement is construed by the court as a properly constituted trust, C can, in his capacity as beneficiary, sue A to enforce the promise. Though C is not a party to the promise made by A to B, C could nonetheless enforce the promise in equity.

1.11 However, the use of this trust device to circumvent the doctrine of privity has its restrictions. A promisee (ie B in the example quoted above) is not a trustee for a third party unless he manifests an intention to create a trust.¹⁰ Where the word "trust" or "trustee" is not used, there may be difficulties in determining whether or not there is the requisite intention to create a trust. Moreover, there must be an intention to benefit the third party. If the promisee intends the promise to be for his own benefit, there will not be any trust created in favour of the third party.¹¹ The main difficulty of using the trust device is that the court has confined its usage within narrow limits. The trust device has so far been applied only to promises to pay money or to transfer property.¹² According to Sir Guenter Treitel, the trust device has therefore been treated as an exception to the doctrine of privity but is of limited and uncertain scope.¹³

(iii) Tort of negligence

1.12 A contract between A and B may, in addition to creating contractual obligations between the parties, impose on B a duty of care towards a third party, C, under the law of tort. Breach of a duty of care on the part of B may render him liable to C for negligence.¹⁴

(iv) Collateral contracts

1.13 A contract between two parties may be accompanied by a collateral contract between one of them and a third party. For instance, A may enter into a contract of repair with B which specifies the use of the paint manufactured by C because of its special quality. If the paint supplied does not have that quality, A cannot sue C on the contract of sale of the paint to B because A is not privy to the contract.¹⁵ The Court may, however, resort to the device of a collateral contract between A and C under which C would be held to have warranted to A the quality of the paint in consideration of A's agreement with B to buy the paint.

(v) Assignment

1.14 A person who is entitled to the benefit of a contract may transfer the benefit to another person who is not a party to the contract. This process is known as assignment, and the consent of the party liable under the contract is not needed. An assignment may be seen as a circumvention of the privity doctrine because the person bearing the burden of the contract becomes liable to a person with whom he had no contractual relationship and whom he may not have intended to benefit.

(vi) Agency

1.15 Agency is the relationship between two persons, by agreement or otherwise, where one (the agent) may act on behalf of the other (the principal). One consequence is that the principal acquires rights and incurs liabilities under the contract made by the agent on his behalf with third parties, even though the principal is not a party to the contract. Agency is sometimes looked upon as only an apparent exception to the doctrine of privity because in an agency the agent is only the instrument of the principal, who is the real contracting party.¹⁶ This view may be true if the agent acts within his actual authority, but where, for example, the principal's identity is not disclosed, an established agency is a clear exception to the doctrine of privity.¹⁷

Statutory provisions

(i) Conveyancing and Property Ordinance (Cap 219)

1.16 Section 41 of Cap 219 provides that a covenant is enforceable not only by the parties but also by the convenantee's successors in title, assigns, lessees and mortgagees. Section 26 of Cap 219 provides:

"[a] person may take an immediate or other interest granted to him in land or the benefit of any condition, right of entry, covenant or agreement granted to him over or in respect of land, although he may not be named as a party to the instrument."

(ii) Third Parties (Rights against Insurers) Ordinance (Cap 273)

1.17 Under Cap 273, a third party may in specified circumstances step into the shoes of the insured and enforce his rights under the policy by suing the insurance company directly. According to section 2, where a person who is insured against liabilities to third parties under a contract of insurance becomes bankrupt, makes a composition or an arrangement with his creditors, or is wound up, his rights under the contract of insurance are transferred to the third party to whom the liability was incurred. In other words, the third party has a direct cause of action against the insurer.

(iii) Marine Insurance Ordinance (Cap 329)

1.18 A person with a limited interest in property may insure and recover its full value, holding any amount above his own interest on account for others similarly interested. Section 14(2) of Cap 329 provides that:

"A mortgagee, consignee or other person having an interest in the subject matter insured may insure on behalf and for the benefit of other persons interested as well as for his own benefit."

(iv) Bills of Exchange Ordinance (Cap 19)

1.19 A bill of exchange is defined in section 3(1) of Cap 19 as:

"an unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed or determinable future time a sum certain in money to, or to the order of, a specified person or to bearer."

Under section 38(a), a holder of a bill of exchange may sue on the bill in his own name. A holder of a bill of exchange means a payee or an indorsee of a bill who is in possession of the bill, or a bearer of the bill (section 2).

(v) Bills of Lading and Analogous Shipping Documents Ordinance (Cap 440)

1.20 Where goods sold are to be delivered by sea, the seller will enter into a contract of carriage with the carrier, which is evidenced by a bill of lading. The goods are then consigned to the buyer, to whom the bill of lading is endorsed. At common law, a buyer of goods carried by sea cannot sue the carrier on the contract of carriage because there is no privity between them. However, under section 4(1) of Cap 440 a lawful holder of a bill of lading has "all rights of suit under the contract of carriage as if he had been a party to that contract". In other words, the buyer can sue the carrier direct, notwithstanding that he was not a party to the contract of carriage.¹⁸

How the Hong Kong courts have received judicial developments in other common law jurisdictions

1.21 There have been recent judicial developments in Canada and Australia relaxing the strict doctrine of privity. Although these overseas judicial developments are not binding on courts in Hong Kong, the fact that they represent the judicial opinion of the superior courts in other major common law jurisdictions may have some impact on local judicial thinking. In the following paragraphs, we first explain these overseas judicial developments, and then discuss how the Hong Kong courts have received them.

Canada

1.22 Two recent judgments of the Supreme Court of Canada have modified the law relating to privity: London Drugs Ltd v Kuehne & Nagel International Ltd ¹⁹ and Fraser River Pile & Dredge Ltd v Can-Dive Services Ltd ²⁰. In the Fraser River case, a third party beneficiary sought to rely on a contractual provision so as to defend against an action brought by one of the contractual parties (the insurer). The court held that the third party beneficiary was entitled to rely on the waiver of subrogation clause whereby the insurer expressly waived any right of subrogation against the third party beneficiary. Iacobucci J emphasised that in appropriate circumstances the courts should not abdicate their judicial duty to decide on incremental changes to the common law which were necessary to address emerging needs and values in society.²¹ In the London Drugs Ltd case, employees of a warehouseman sought to rely on the limitation of liability clause in the contract between their employer and the client (the bailor) when the employees were sued by the bailor. The Supreme Court held that the privity rule could be relaxed where the parties to the contract had, expressly or by implication, intended the relevant provision to confer a benefit on the third parties (the employees), and the action taken out by the third parties came within the scope of the agreement between the initial parties. The employees fulfilled these two conditions, and thus could benefit from the limitation clause, despite the privity doctrine. The court recognised a limited exception to the doctrine in the circumstances of the case so as to conform to "commercial reality and justice".²²

Australia

1.23 The decision of the High Court of Australia in Trident General Insurance Co Ltd v McNiece Bros Propretary²³ has relaxed the strictness of the doctrine. The importance of this case is its implications for the privity doctrine in Australia generally.²⁴ In this case, the respondent (McNiece) was the principal contractor for construction work being carried out at the limestone crushing plant of a company which took out a public liability insurance policy with the appellants (Trident) covering itself and all contractors and sub contractors. A person injured at the construction site recovered damages from McNiece, which in turn brought an action against Trident to seek indemnity for the amount of damages paid. The High Court of Australia held that McNiece was entitled to seek indemnity form Trident even though McNiece was not a party to the insurance contract.

1.24 In the High Court of Australia, three of the Justices criticised the doctrine of privity. Mason CJ and Wilson J (who delivered their judgment jointly) were of the view that there was "much substance" in the criticisms directed at the doctrine of privity.²⁵ Toohey J considered that:

"the law which precludes him [ie a non-party assured] from doing so [ie suing the insurer] is based on shaky foundations and, in its widest form, lacks support both in logic or in jurisprudence".²⁶

1.25 Mason CJ, Toohey and Wilson JJ decided the case on the basis of a specific abrogation of the privity rule in relation to insurance contracts. Mason CJ and Wilson J put forward their arguments as follows:

"In the ultimate analysis the limited question we have to decide is whether the old rules [of privity] apply to a policy of insurance. The injustice which would flow from such a result arises not only from its failure to give effect to the expressed intention of the person who takes out the insurance but also from the common intention of the parties and the circumstances that others, aware of the existence of the policy, will order their affairs accordingly … In the nature of things the likelihood of some degree of reliance on the part of the third party in the case of a benefit to be provided for him under an insurance policy is so tangible that the common law should be shaped with that likelihood in mind."²⁷

Hong Kong courts

1.26 The Trident case was considered in B + B Construction Ltd v Sun Alliance and London Insurance Plc,²⁸ the facts of which were similar to those of the Trident case. Pak Kee, a sub-contractor, took out an insurance policy with an insurer (the defendant), and the "insured" was described in the contract as "Pak Kee and his contractors". An employee of Pak Kee was injured because of the negligence of an employee of the principal contractor (the plaintiff), which was then held liable to pay damages for negligence and to reimburse Pak Kee for employee's compensation. The plaintiff brought an action against the defendant as the insurer for an indemnity. Since the defendant did not take the point that the plaintiff was not a party to the insurance contract, the Hong Kong Court of Appeal proceeded on the footing that the plaintiff's claim, if otherwise good, was enforceable in the usual way. Hence, at issue was whether the scope of the indemnity extended to the plaintiff.²⁹ Godfrey VP (with whom Ribeiro JA agreed) nonetheless stated incidentally:

"[the court is] aware of the judicial abrogation of the rule effected in Australia by the decision of the High Court (split 4 to 3) in [the Trident case], a case the facts of which bear many similarities to our own. …But here, in Hong Kong, the law remains as magisterially stated by Viscount Haldane LC in Dunlop Pneumatic Tyre Co Ltd v Selfridge & Co Ltd [1915] AC 847 at 853: '… only a person who is a party a contract can sue on it. Our law knows nothing of a jus quaesitum tertio…' ".³⁰

1.27 No Hong Kong case can be found in which the Fraser River case has been considered. The Privy Council in Re the Mahkutai³¹ mentioned both the Trident case and the London Drugs Ltd case. Lord Goff of Chievely of the Privy Council stated in an obiter dictum:

"the time may well come when, in an appropriate case, it will fall to be considered whether the courts should take what may legitimately be perceived to be the final, and perhaps inevitable, step in this development, and recognize in these cases a fully-fledged exception to the doctrine of privity of contract, thus escaping from all the technicalities with which courts are now faced in English law. It is not far from their Lordships' minds that, if the English courts were minded to take that step, they would be following in the footsteps of the Supreme Court of Canada (see [the London Drugs Ltd case]) and, in a different context, the High Court of Australia (see [the Trident case]). Their Lordships have given consideration to the question whether they should face up to this question in the present appeal. However, they have come to the conclusion that it would not be appropriate for them to do so, first, because they have not heard argument specifically directed towards this fundamental question, and second because, as will become clear in due course, they are satisfied that the appeal must in any event be dismissed."

The Privy Council here raised the possibility of "a fully-fledged exception" to the privity doctrine. Nevertheless, as Godfrey VP reiterated in the B + B case, the privity doctrine is still part of the Hong Kong law.

Chapter 2 - Should the privity doctrine be reformed?

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2.1 We examined in the last chapter the current law on the privity doctrine. This chapter examines the arguments for and against reforming the doctrine, and sets out the reasons for our conclusion that the doctrine should be reformed. In identifying the arguments for and against reform, we have been greatly assisted by the detailed examination of those arguments in the consultation paper on privity of contract published in 1991 by the Law Commission in England and Wales (the "Law Commission"), and we make extensive reference to that paper in this chapter.¹

Arguments against reforming the privity doctrine

Third party should not be able to sue in the absence of consideration

2.2 The idea that a contract requires consideration leads naturally to the view that a stranger to a contract cannot take advantage of its terms because he has not provided consideration. To put matters another way, since a promisee must provide consideration, it would be unreasonable to place a third party who has not provided consideration in a better position than a promisee who has not provided consideration.² In commenting on the Sub-committee’s consultation paper, the Hong Kong Federation of Insurers also subscribed to this