Privity of Contract – Explained

The rule of privity of contract is the principle that a third-party cannot sue for damages on a contract to which he is not a party. This rule has been criticised particularly in cases where the contract is for the benefit of the third-party. At this time there has been no statute introduced and the rule persists in Malaysian Law to prevent a third-party enforcing contractual provisions made in their favour.

The existence of this rule is the reason behind the rise in the use of collateral warranties. Collateral warranties bypass the rule by creating separate independent contracts collateral to the consultancy or construction contract. It allows future owners of developments to sue consultants or contractors for defects in the design or construction under the collateral warranty. There would be no cause of action under the original consultancy or construction contract.

A further fundamental principle is that the assessment of damages for breach of contract is meant to be compensation for damage, loss or injury suffered through the breach. It therefore allows the party to the contract to sue for his loss but does not allow him to sue for the loss caused to a third-party.

Exceptions do exist as was the ruling by the House of Lords in the case of St Martins v Sir Robert McAlpine [1993] where the court ruled that in the event that the Contractor was aware that a project would be occupied if not purchased by third parties and not the Corporation itself. It could be foreseen that the damage caused by a breach would cause loss to a later owner and not merely the original contracting party. Therefore on this basis the original contracting party could be entitled to recover damages for loss suffered by others. The exception did not apply where the third-party could themselves sue for the loss.

The case of Darlington Borough Council v Wiltshier Northern Ltd [1994]. Darlington wanted to create a recreational centre on land which it owned. Instead of borrowing and in order to provide private finance for the project, Darlington had Morgan Grenfell enter into a construction contract as employer, with Wiltshier as contractor. A collateral covenant between Darlington and Morgan Grenfell provided that Darlington would pay Morgan Grenfell all sums expended under the construction contract. The construction contract was therefore clearly a contract for the benefit of a third-party. The covenant also provided for Morgan Grenfell to assign to Darlington all rights against Wiltshier.

In this case, when Darlington sued there was no problem with the assignment. However, they were faced with the two general principles above. In other words, Morgan Grenfell the party in contractual relationship with Wiltshier had suffered no loss and could transfer no claim for substantial damages. On the other hand, Darlington, who suffered the loss, was precluded by the privity rule from claiming the damages which it had suffered. The principles therefore combined to allow a contract-breaker to go scot-free.

These cases show a weakening of the rigid principles of contract at least in so far as the measure of damages are concerned. What the above decisions mean is that even without collateral warranties, a consultant or contractor may find his is liable in damages for the loss to a third party due to defects in the design or construction.