When Three’s Company, and Not a Crowd

Whether you’re building your dream vacation home, renovating an existing commercial structure, or developing a multimillion dollar mixed use project, negotiating construction contract language in 2017 can have important consequences years into the future. The obligations and rights arising from one often overlooked clause, that addressing contractual “third-party beneficiaries,” can vary considerably from state to state and even case to case. Those inconsistencies make it prudent to address the issue at contract formation in order to manage the potential risk inherent in blindly agreeing to default form contract language.

Legal dictionaries define a “third-party beneficiary” (“TPB”) as “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 as such in the contract from which it stands to benefit.  For example, if Contractor and Subcontractor agree to a subcontract that specifies Subcontractor will render some performance to a Project for the express benefit of 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 can also be granted to prime Design Professionals from subconsultants or to General Contractors from sub-subcontractors or suppliers to a subcontractor.

The benefits gained from TPB status can be substantial.  In our example above, the 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 efficiently and directly 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 it’s purely “economic loss,” i.e., not personal injury or property damage). There are risks however, as 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, “§ 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 reverse TPB situation. Also, word searches for third party beneficiary language in the AIA’s A102 and A201-2017 Owner-Contractor agreement and general conditions turn up similarly short. 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, fortunately for owner parties, the Supreme Court has 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.  Harris v. Suniga, 344 Or. 301, 310 180 P. 3d 12 (2008). 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.

To the north in Washington, the situation is different. That state’s Supreme Court decided in a pair of 2010 cases to rebrand the economic loss rule as the “independent duty doctrine.” The independent duty doctrine provides that “[a]n injury is remediable in tort [i.e., negligence], if it traces back to the breach of a tort duty arising independently of the terms of the contract.” Eastwood v. Horse Harbor Found, Inc., 170 Wn.2d 380, 387 241 P.3d 1256 (2010); see also Affiliated FM Ins. Co. v. LTK Consulting Services, Inc., 170 Wn.2d 442, 450, Fn. 3, 243 P.3d 521 (2010). In the context of a defective construction case, Washington courts have explained there is no independent duty to avoid economic loss, “defined as a mere defect in the bargained-for quality,” absent an independent duty or other risk of harm. See Eastwood, supra at 394; see also Nichols v. Peterson NW, Inc. 197 Wash. App. 491, 389 P.3d 617 (2016). 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 codified the economic loss doctrine there to make it clear that “an action for defective design or construction is limited to breach of contract,” including written and oral agreements for “both express and implied warranties.” Utah Code Ann. § 78B-4-513 (2012). 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.

Given the variety of legal applications, and the silence of default form language, the oldest advice remains the best - if you want something done right, do it yourself. At the time of negotiating your next construction contract, consider adding your own third party beneficiary clause that sets out all parties' expectations that the ultimate beneficiary of the work being performed shall have direct rights of action against downstream subcontractor or subconsultant parties in order to directly hold each party accountable for deficiencies in that party’s work. Protect your rights, and don’t leave your contracts open to default terms and the risk of unintended consequences.

Originally published as “When three’s company, and not a crowd” on November 16, 2017, by the Daily Journal of Commerce.