The Importance of Third-party Beneficiary Clauses in Contracts

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In resolving construction contract negotiations and disputes, we’ve seen a number of overlooked clauses carry significant importance: a 20-year roof warranty limited to material replacement costs (no tear-out, no install) and only if the owner gives notification of a defect within 60 days; limitations of liability clauses that cap damages significantly below insurance coverage the owner paid for; and, in perhaps the most egregious example, an attorney’s fees clause written in reverse that had the winner pay the loser’s legal fees!

Whether you’re building your dream vacation home, renovating an existing commercial structure, or developing a multimillion-dollar mixed-use project, construction contract terms matter. Interpretations of one often overlooked clause—addressing contractual “third-party beneficiaries”—varies considerably from state to state. Consistent inconsistency makes it prudent to address the issue at contract formation to manage the risk inherent in blindly agreeing to default form contract language.

A third-party beneficiary (TPB) is a person or entity who, though not a party to the contract, stands to benefit from the contract’s performance. Typically, the TPB needs to be expressly named in the contract from which it stands to benefit. For example, if a contractor and a subcontractor agree to a subcontract that specifies the subcontractor will render some performance to a project for the express benefit of the owner as a TPB, then that owner is a third-party beneficiary of the subcontract, even though it is not a party to the subcontract. TPB status may exist up and down the contractual chain.

TPB status carries substantial benefits. In the preceding example, an owner may assert claims directly against the subcontractor for breach of the subcontract, breach of warranty, negligence, or other claims arising out of the subcontracted work for the project. This allows the owner flexibility to pursue the potentially liable parties rather than having to first seek recourse from its prime contractual partner—the general contractor. These direct rights can also help avoid an economic loss rule defense by the offending party (the economic loss doctrine generally provides that a party cannot recover in negligence for purely “economic loss”—i.e., not personal injury or property damage). There are risks, however, because if not drafted correctly, a TPB clause could grant unintended rights, such as giving a subcontractor direct claims against the owner, or a general contractor direct claims against a project lender.

Interestingly, default form contract language is largely silent on the TPB issue. The AIA’s B101-2017 Owner-Architect agreement states at section 10.5, “Nothing contained in this agreement shall create a contractual relationship with or a cause of action in favor of a third party against either the owner or architect,” but does not address the desired TPB situation. This means the parties are left to the applicable law of the place in which the project is located, which can vary considerably from state to state.

In Oregon, to the benefit of owners, the Supreme Court ruled that where an owner, even as a remote purchaser, can demonstrate actual property damage rather than purely economic loss, the economic loss rule does not bar a negligence claim for construction defects. Thus, even if an owner is not a TPB of a subcontract in Oregon, that owner may have direct rights of recovery against a subcontractor for actual property damage to the owner’s property.

In Washington, the situation is different. Washington’s Supreme Court rebranded the economic loss rule as the independent duty doctrine. It provides that an injury is remediable on a negligence theory if it traces back to the breach of a duty arising independently from the contract terms. In the context of a defective construction case, Washington courts have explained there is no independent duty to avoid economic loss—i.e., the bargained-for quality, absent an independent duty or other risk of harm. These cases suggest that in Washington, without a TPB clause, the upstream party needs to show an independent duty or harm separate from the construction defect in order to maintain a direct action against a non-contracting construction party.

And in Utah, we find the rule directly opposite to that in Oregon. There, the Utah Legislature has actually codified the economic loss doctrine to make it clear that an action for defective design or construction is limited to breach of contract. Absent a TPB clause in a Utah contract then, an owner has little recourse against a construction party with whom it lacks privity of contract.

Legal interpretations vary and construction contract terms matter. The oldest advice remains the best: If you want something done right, do it yourself. When negotiating your next construction contract, consider adding your own TPB clause clarifying the upstream parties benefiting from the work have direct rights of action against downstream parties in order to equitably hold each party accountable for deficiencies in each party’s work. Protect your rights by not leaving your contracts open to default form contract terms and the law of unintended consequences.

Originally published as an Op-Ed by the Oregon Daily Journal of Commerce on September 15, 2022.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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