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Keep in mind third-party-beneficiary issues

A recent U.S. court decision reminds us of the importance of considering potential third-party-beneficiary issues when drafting contractual indemnity provisions in Canada. On March 3, the New York Supreme Court (Appellate Division) upheld a lower court decision giving Diamond Castle Partners, a U.S. private equity firm, the right to sue IAC/InterActiveCorp. for damages for breach of representations IAC made in connection with the sale of its subsidiary, PRC LP, in late 2006. Diamond Castle was not a party to the purchase agreement. Instead, the representations were made to Panther/DCP Acquisition LLC, an affiliate of Diamond Castle formed for purposes of completing the acquisition. After the deal closed, PRC and Panther merged. In January 2008, PRC filed for bankruptcy and Diamond Castle’s equity interest in PRC was extinguished as part of the ensuing reorganization.

Diamond Castle sued IAC claiming it was entitled to the benefit of the indemnity extended to the buyer and its affiliates under the purchase agreement and sought to recover losses suffered due to alleged inaccuracies in statements made by IAC about the financial impact of PRC’s customer contracts. IAC asked that the claim be dismissed on the grounds that Diamond Castle was not a signatory to the agreement, which contained a no-third-party-beneficiaries clause limiting enforcement of the agreement to the parties. The court rejected IAC’s position on the basis that, although Diamond Castle was not a signatory, the agreement “plainly intended to give the buyer and its affiliates enforceable rights,” and the undefined term “parties,” as used in various clauses in the agreement, referred to more than just the signatories. As each clause within a contract must have meaning, the court construed the limitation clause to exclude only persons who were not signatories or buyer or seller indemnified parties. The court also noted that interpreting the purchase agreement in the manner IAC suggested would be inequitable, leaving Diamond Castle without any remedy.

While the court referenced the 1998 New York District Court decision Control Data Systems Inc. v. Computer Power Group Ltd., it distinguished Diamond Castle’s case based on the wording of the applicable no-third-party-beneficiary clause. In that case, Control Data sought the benefit of an indemnity extended under an agreement with a no-third-party-beneficiary clause and the court ruled that Control Data’s parent company, as the signatory, should more properly bring the claim on behalf of its subsidiary. In its reasons for judgment in Diamond Castle Partners IV PRC L.P. v. IAC/InterActiveCorp., the court indicated that the third-party-beneficiaries clause applicable to Control Data’s case prevented “any person who was not a signatory” from enforcing any rights, and was therefore a broader restriction.

In Canada, the general rule (known as privity of contract) is that only a signatory to a contract may sue upon it. In the leading cases of London Drugs Ltd. v. Kuehne & Nagel International Ltd. and Fraser River Pile & Dredge Ltd. v. Can-Dive Services Ltd., the Supreme Court of Canada created certain principled exceptions to when a third party may obtain the benefit of protections extended under a contract (effectively, using the contract as a “shield”), but was reluctant to overthrow the rule entirely or give third parties the right to enforce a contract to claim a benefit, thereby using the contract as a “sword.” Given the SCC’s statement in London Drugs that the decision conformed to “commercial reality and justice,” it is possible that a Canadian court may have adopted the same position as the New York Supreme Court in Diamond Castle. However, Canadian courts have generally taken the view that any major reform to the established principles on privity of contract must come from the legislature, not the courts. To date, New Brunswick is the only province that has adopted this approach, enacting legislation that abolishes the third-party-beneficiary rule unless the contract provides otherwise. The U.S., United Kingdom, and a number of other Commonwealth jurisdictions have adopted similar approaches.

Comparable legislative reform does not appear on the horizon in the remaining Canadian provinces. As a result, it is important to be mindful of the risks of not including an intended beneficiary of rights under a contract as a signatory, and ensure that a suitable mechanism is put in place to ensure the beneficiary can have those rights enforced should the need arise. While in Diamond Castle’s case the court ultimately reached the commercially intended result, the litigation over whether Diamond Castle was entitled to bring a claim for breach of contract could have been avoided had the no-third-party-beneficiaries clause in the purchase agreement specifically carved out Diamond Castle’s rights to bring a claim for indemnity, and any other rights that it was to receive personally under the agreement.  

Cheryl Satin is a partner at Blake Cassels & Graydon LLP in Toronto practising in the business group. She can be reached at cheryl.satin@blakes.com. The opinions expressed in this article are those of the author alone.

  • Lawyer

    André Roothman
    The time has come for Canadian law to get rid of the doctrine of privity of contract as well as the requirement of consideration. A contract is all about the intention of the parties. We are long past the days of irrational formalistic requirements of seal, consideration and what knows. It is the 21st century, so let us advance to where the Romans were 2000 years ago, namely the intention of the parties and concensus. That includes making a promise enforceable.