Editor’s note: This article is an excerpt from the book “Contract and Risk Management for Supply Chain Management Professionals” published by X. Paul Humbert, Esq1.
Privity of contract (“Privity”) answers the question of “Who do I have a deal with?” and “Who can I hold accountable?” In essence, privity tells you which person(s) or entity(s) you can sue if necessary. Who you can hold accountable determines whether you have any real rights and an effective remedy if things go bad.
It is absolutely crucial for anyone involved in contracting, whether at the negotiation stage or after the agreement is signed, to understand the principle of Privity. Simply put, Privity means that the contract, including all the rights, liabilities and responsibilities contained in the contract, only apply to the named parties or specified beneficiaries. Why is this so important? For several reasons.
First and foremost, only the named parties (or specified beneficiaries we’ll address later) can sue or have any rights and remedies under the agreement. Therefore, if you contract with a person or entity that has no cash or assets you may have no effective remedy in the event of a breach or failure to perform. Note that many organizations create legal entities such as corporations, joint ventures or limited liability companies simply to avoid risk by limiting the other parties’ ability to recover in the event of a claim or suit. This is not illegal but a risk to be on the lookout for.
For example, Giant XYZ Corporation could form a legal entity in the form of a subsidiary called Giant XYZ Corporation, USA, LLC. That subsidiary would in effect be a separate legal entity or “person” in the eyes of the law with its separate identity, tax payer ID number and independent status. In the event the subsidiary breached its contractual obligations, the parent would generally not be liable. By analogy, if you contract with someone’s son or daughter and they don’t perform and don’t carry out their obligations, you can’t sue and recover from the parent. The same is true for business entities.
Essentially, corporate or company liability is limited liability. Even partnerships may have one general partner (which could be a person or legal entity) with very limited assets or resources thereby shielding the limited partners from liability in the event of a breach. This is why it is so crucial for risk managers, business professionals and others involved in contracting to understand the all-important principle of “Privity of Contract”. In rare cases it is possible to “pierce the corporate veil” and get to the parent but that can be difficult and expensive. It usually requires some sort of fraudulent behavior or “alter ego” status.Privity of Contract is something to bear in mind at all phases of the transaction but it is especially important in the early negotiation and contact formation. Early on in the process do your due diligence and understand who in effect you are going to have a binding agreement with in the form of a contract and make sure that person has the deep pockets or resources to honor their commitments including any warranties or indemnities promised under the contract. We will discuss in a bit how to protect yourself in the event that you need or want to do business with an entity that has limited resources. At the outset the key is to understand who you are doing business with, what their resources and capabilities are, and not assume that if they don’t perform you can sue the parent just because they have a similar name. Remember, corporations or other entities sometimes form subsidiaries (and as noted sometimes enter into joint ventures or partnerships) to limit their liability.
Another reason to have a full and complete understanding of Privity of Contract concerns how the transaction is managed after the contract is signed. It may be tempting if things aren’t going well to go directly to the contractor’s or supplier’s sub-contractor(s) or sub-supplier(s) (Subs). Since you have no contract with the sub-contractor(s) or sub-supplier(s) you are not in “Privity of Contract” and you have no right to direct or otherwise tell them what to do or how to do what they are doing. You must respect Privity of Contract by going to the contractor or supplier with whom you have a contract and demanding conforming performance from them directly. Because of Privity of Contract, you can’t sue the sub-contractor(s) or sub-supplier(s) if they don’t perform, but instead your right is to hold the contractor or supplier, as the case may be, accountable for the performance of their Subs.
By the same token, the Subs have no contractual right against you for payment and the last thing you ever want to do is make direct or implied promises to the Subs that if the contractor or supplier, with whom they have a contract, doesn’t pay them you will. Directing or promising payment to subs will create mischief in at least two ways. First, the contractor or supplier will claim interference and be provided with an argument against being held accountable. Second, the subs may take your commands or promises and attempt to argue that they create a contractual commitment between you and them. Since you are paying the contractor or supplier for a result and to manage the subs, this is the last thing that you ever want to have happen.
Keep in mind you can be in Privity of Contract with more than one contractor at a time on a particular project. This is called being in a multi-prime arrangement. Obviously, there is more to manage when you have multiple prime contractors, all of whom are in Privity of Contract with you. By contrast, a single prime arrangement gives you a single point of accountability.ABOUT THE AUTHOR
- Paul Humbert, Esq. has over twenty years of legal experience in negotiating and structuring complex commercial transactions of all types. He heads The Humbert Group (“THG”), specializing in assisting management professionals in all phases of execution and process improvement. In addition to full-time consulting for both public and private clients, Paul lecturers at Rutgers University where he teaches Contract Management to MBA candidates. Paul’s books include:
- Contract and Risk Management for Supply Chain Professionals
- Model Contract Terms and Conditions with Annotations and Case Summaries
- Build Your Playbook for Managing Supply Chain Transactions
- How to Analyze and Negotiate Warranties for Goods and Services
The Humbert Group, LLC, provides consulting services to global procurement clients with particular emphasis on: complex negotiations, strategic alliances, process improvement, risk management techniques, project management assistance, training and coaching, as well as post-execution contract management including claims and dispute resolution. Paul holds degrees in both business and law and has extensive experience in these matters. He is an expert in structuring agreements and contract management procedures that are clear and minimize the risk of non-performance, disputes or non-conforming deliverables.
- Contract and Risk Management for Supply Chain Management Professionals by X. Paul Humbert and Robert C. Mastice