Contract Law: Basic Principles (privity, novation, termination)

Basic Rules of Contract law

After a contract is formed, legal principles apply to govern the legal relationship.

These fundamental principles underlie all contracts. 

The basic principles of contract law include:

• Formation - making a contract
• Consideration in contract law
• Privity of Contract
• Variations: Changing legally binding contracts
• Novation: Assignment - Transfer of Contractual Rights
• Entire Contracts and Divisible Contracts
• Termination: How Contracts End
• Remedies for Breach of Contract

Once a person signs a contract, the basic rule of law is that they are bound by their signature, whether they have read the contract or not, or understood the document - or not. It's known as the doctrine of freedom of contract.

 

Privity of Contract: Exclusivity of Legal Relationship

The starting point doesn’t get more fundamental than this.

The doctrine of privity of contract consists of two general rules:

• a third party to a contract - someone who didn't sign it - cannot be sued under it.
  As a consequence a third party to the contract:
  • can't be required to perform the contract, and 
  • can't incur liability under it.
• A person who is not a party to a contract cannot sue on the contract to obtain the promised performance.

Privity of contract is required to give rise to a legal obligation to perform it or be sued on the contract. In the usual case, the person must be a party to the contract. The right to sue is acquired by being a party to the contract.

The usual cases are:

• for a written contract, the legal person that signed it
• in an oral contract case, it will be the legal person that agreed its terms.

Exception to the Rule of Privity of Contract

The rule on privity was altered with the introduction of the Contracts (Rights of Third Parties) Act 1999.

The Contracts (Rights of Third Parties) Act allows a third party to enforce a contract where:

1. it states that they can,
2. a term confers a benefit on them: the benefit can be conferred on them by name, as a member of a class of people, or by falling within a description.

Any remedy under the contract is available to the third party: on the same terms as that they are available to a named party to the contract.

Law of Agency & Privity

Privity of contract still applies when an agent operates to create a contract on behalf for the principal.

An agent can make a contract for its principal with a third party, by making a contract between:

• the third party and the principal, without the agent becoming a party to the same contract.
  The agent signs as agent only of the principal. Only the principal can sue or be sued under the contract
• the third party and the principal, with the agent also becoming a party.
  Either the agent or the principal can be sued under the contract
• the third party and the agent, but without the principal being a party to the same contract

Third Party Rights Clauses in contracts can establish a situation to include or exclude the rights granted by the Third Party (Contract Rights) Act. Agency clauses make it expressly clear that third parties do not have authority to make contracts on behalf of another person.

 

Variations: Changing the Contract

As you know, contracts are legally binding.

That means that they can’t be changed by the parties without agreement of both parties.

Changing a contract - known as a "variation" - requires another legally binding agreement to change the original legally binding agreement. This means that the elements required to form a contract must be satisfied again to vary the terms. That is, a new:

• offer
• acceptance
• fresh consideration (fresh consideration is something that a party is not already required to do), and
• intention to be legally bound.

Unless the existing contract says so, there are no formal requirements that must be satisfied for the variation to constitute a binding contract. That is, it doesn’t have to be in writing - it could be agreed over the telephone. It can also be changed by conduct.

Amendments to Agreements: Form of Variations

The existence of a separate agreement must be able to be proved.

If you're familiar with the perils of verbal contracts, you'll know that written variations are the way to maximise certainty of what is agreed.

As you can imagine, variations to legally binding commitments are best recorded in writing and signed by the parties.

There are two options:

• new contract: preparing and signing a completely new agreement.
  It replaces the first.
  The original contract is ended in its entirety and replaced with a completely new contract.

• new contract, vary clauses: signing a new agreement which varies specific provisions of the first contract.

Attempts to Force a Variation

When an existing contracting party, without the consent of the other party:

• insists on performance of the contract which is not consistent with the agreed terms (with express or implied), or
• tries to impose different terms of performance than what the contract states and requires,

then it’s a breach of contract and potentially a repudiation of the contract.

Sometimes, businesses (usually the paying party) “notify” their contracting partners that the terms of the contract have changed. 

If the supplier starts performing to that new way under the contract, then it may be taken to have:

• • agreed to the variation by its conduct, or

• • affirmed the contract after the breach.

The result is that the right to terminate the contract - or any ability to negotiate the terms of the variation are lost.

In business contracts, often variation clauses are built in, which change these general principles.

 

Novation: Assignment & Transfer of Contractual Rights

The legal obligations under a contract cannot be "assigned" or transferred to another person, without agreement from the other contracting party(ies).

To transfer (or “assign”, which is a misnomer) contractual obligations the requirements of novation must be satisfied.

In novation, there is no assignment of rights and obligations: a new contract is created with new rights and obligations, with a new contracting party.

What can - and can't - be done without agreement

But then the benefit of a contract - rather than the burden, which are the legal obligations - can be transferred without the permission of the other contracting party.

The "benefit" of the contract is the "burden" of the other contract party.

Let me explain.

Benefit and the burden of a contract

In the majority of business contracts, one party will have the obligation to pay money.

Benefit

Where a seller is entitled to be paid money under the contract, that right will be the benefit of the seller under the contract. The counterparty, the buyer, will have the benefit of receiving goods or services.

The “benefit” of the contract can be assigned without the permission of the other contracting party unless:

1. the contract is one for personal services, such as contracts of employment
2. an express term or implied term of the contract prevents it

Burden

The burden of a contract are the obligations that the party itself must perform. For:

1. the buyer: the burden of the contract is to pay money.
2. the seller: the burden of the contract is to deliver the service.

 

How does Novation work?

Novation takes place when:

1. all the contracting parties to an existing contract
2. agree that:
   1. one of them will no longer be bound by the contract, and
   2. a new contracting party will replace one of them
3. an incoming contracting party agrees to take on the burden of the contract for one of the parties
4. both (or all) of the parties to the existing contract agree that the incoming contracting party will perform the contract (and replace one of the parties).

The end result is that a new contract is created between the remaining contracting parties and the incoming contracting party. The exiting contracting party is no longer bound to the contract.

The contractual rights between the existing parties before the novation remain in force. After the novation, it is the remaining parties and the incoming party who are contractually bound.

As at the date of the novation (ie the transfer of rights), it is the future benefits of the contract which are transferred. Accrued rights prior to the transfer remain with the original (outgoing) contracting party.

The new contract is identical to the old contract. It just has different parties.

 

Why is Novation required to transfer rights?

1. Assignable contractual rights are choses in action.
   Chose in action are intangible rights to sue for enforcement of the contract. They are personal property.
   As with any other personal property, a chose in action can be transferred to a third party in accordance with the formal rules governing their transfer
2. It is not legally possible to assign the burden of a contract (ie the obligation to render performance), it may be possible to assign:
   1. the entire benefit of a contract (i.e. the right to receive performance)
   2. if a right under a contract is separate and severable, that separate and severable right
   3. if only some of the rights under a contract are assignable, those rights.
3. Assignment clauses may expressly or impliedly:
   1. authorise assignment of rights in a contract which would not otherwise be assignable, or
   2. prohibit assignment of rights which would otherwise be assignable.
4. While the product to be derived from a contractual performance may be assigned (ie the benefit), the right to that performance may, nonetheless, not be assignable because:
   1. the identity of the person to perform is material to the contractual relationship itself
   2. the nature of the contract prevents it, such as contracts requiring personal performance. Employment contracts require personal performance
   3. the contractual performance to be rendered, such as where the contract requires a party to act on the other’s instructions.

A contractual right will not be personal if it can make no difference to the other party who delivers the products or services

6. An assignee of a contractual right under a legal assignment is entitled to sue for enforcement of the right.
7. Novation will ordinarily require the agreement of the original and the substituted party.

Assignment clauses can set up a situation where novation is pre-agreed.

Entire Contracts and Divisible Contracts

Some contracts are categorised as:

• “entire contracts”, and others as
• “divisible contracts”.

The difference between the two types of contracts increases when disputes arise - that it, when you need to rely on the contract.

In an entire contract:

• one party must perform all of its obligations before the other party comes under an obligation to perform, and
• performance is a precondition to liability under the contract.

Most contracts are prepared so as to be divisible contracts.

But when it is an entire contract it affects legal rights of the parties. The categorisation of the contract affects:

1. rights to insist on performance,
2. rights to be paid, and
3. rights to terminate.

Significance of Entire Contracts

In an entire contract the entire performance of the contract must be completed before the right to be paid arises.

For example, when a contract requires goods or services to be supplied prior to the entitlement to be paid, the supply of the goods or services is a condition precedent prior to the right to payment arising. Likewise in a contract for building works for a lump sum to be paid when the works are complete.

The reason for the distinction is that where there is an entire obligation to perform, courts cannot allocate the consideration to be paid for part performance of the contractual work.

Termination of an Entire Contract

Categorisation as an entire contract also is relevant to when a contract may be terminated.

Lump sum contracts, which fix a single sum to be paid are not necessarily entire contracts. When a contract provides for a specific sum to be paid on completion of specified work, courts favour an interpretation that the contract is a divisible contract. Otherwise, a contractor would be deprived of any payment simply because there are some defect or omission in the work performed.

Unless the breach is a repudiatory breach – and goes to the root of the contract - the paying party must pay the price for the work performed. The contract price is paid subject to:

1. a cross-claim for the defects and omissions, or
2. alternatively set them up in diminution of the price by a set-off.

The amount of damages is the amount which the work is worth less by reason of the defects and omissions, and is usually calculated by the cost of making good the defects.

Not every breach of that term which absolves the employer from his promise to pay the price of an entire contract, but only a breach which goes to the root of the contract.