Andrew Wilkinson examines the anticipated reform of privity of contract doctrine in the UK.
In July 1996 the Law Commission presented its report on the reform of the privity of contract doctrine. This report, a 190 page document, contains a well thought out argument for the reform of the privity doctrine and provides full recommendations (plus draft bill) for the creation of third party rights in contracts. The Government has recently announced its intention to bring forward legislation on privity of contract, when time permits.
In January 1998 the Law Commission also published a proposal for the reform of the Third Parties (Rights Against Insurers ) Act 1930. The 1930 Act provides a limited statutory exception to the pari passu principle that the assets of an insolvent insured should be distributed to creditors pro rata by allowing a third party, who would have remained uncompensated if insurance money had simply devolved to the insolvent estate, to sue the insurer directly. The Act provides that the third party receives an automatic transfer of the insured's rights against the insurer on the happening of the insured's insolvency. The Law Commission's proposals in general seek to simplify the process by which a third party may seek redress from the insurer.
In November 1996 Mr Justice Lightman in the case NEMGIA v AGF1 decided that a 'Direct Payment Arrangement' (DPA) was lawful and could not be challenged. Following NEMGIA's insolvency, NEMIC, NEMGIA's reinsurer, paid policyholders' claims directly in return for the policyholders' assignment of claims against NEMGIA. The liquidators of NEMGIA challenged this direct payment on the basis that the payment was a breach of contract and/or tortious and also offended against the principle of pari passu distribution under the insolvency regime. The liquidators' claims that the DPA was a breach of contract or tortious failed. The insolvency claim never reached court as the case settled.
Although the Law Commission's proposals for reform should be welcomed, there is some danger that, given also such cases as NEMGIA, the insurance industry could end up with a very confused approach to third party rights in general and more particularly to cut through. In the meantime, however, for policyholders seeking more certain cut-through rights, all is not lost if they can negotiate security rights over their insurer's reinsurance receivables.
The following is a brief review of the developments already mentioned, the potential problems which might be created if all of the Law Commission's proposals are adopted in legislation and the way in which certain cut-through rights might be obtained in the meantime.
Law Commission's report on privity of contract
The English law doctrine of privity of contract or the third party rule prevents, in general terms, two parties conferring a benefit on a third party by their contract. For example, where A contracts with B for the benefit of a third party C, - C takes no rights under the contract. In other words, if A fails to perform his side of the contract and C does not receive his benefit, C cannot sue for damages or force A to perform. C is prevented from having any rights under the contract, because it is argued, English law follows a strict doctrine of consideration. The doctrine of consideration, again in general terms, provides that the law will not enforce gratuitous promises, but will only enforce promises where the promisor in return for his promise has received consideration from the promisee. In our example, as C does not provide any consideration to A for the benefit promised by A, C cannot enforce the promise. It is generally thought that the doctrines of privity and consideration combine to cause considerable injustice. For example, as in the circumstances of A, B and C outlined above; although B may sue for damages, B has suffered no loss, and although C has suffered a loss, C cannot sue - leaving neither B nor C with any real remedy.
This injustice has often been noted and commented on by the judiciary. In the seminal case of Beswick v Beswick2, decided in 1967, Lord Reid cited with approval the 1937 Law Revision Committee recommendation that:
"...where a contract by its express terms purports to confer a benefit directly on a third party it shall be enforceable by the third party in his own name . . ."
More recently Lords Goff and Steyn have joined the chorus of reform and in White v Jones3 Lord Goff stated that the law of contract is "widely seen as deficient in the sense that it is perceived to be hampered by the presence of an unnecessary doctrine of consideration and (through a strict doctrine of privity of contract ) stunted through a failure to recognise a [third party right]"
However because of the piecemeal nature of case law reform, the judiciary has considered it inappropriate to review or amend this rule, seeing such reform as a job for Parliament.
In response to this judicial cry for help the Law Commission produced the privity report.
This report, despite its wide review of legislation in other jurisdictions and its clear case for reform, has in our view, underestimated the wider implications of its proposed reforms. In our view these reforms if implemented will affect not just the parties to contracts (and third parties) but will also have a substantial effect on the regulatory frameworks (such as the insolvency rules and capital adequacy rules) within which commercial entities operate.
The effects of the privity rule pervades more than contract law; for example it is not clear how the existence of third party rights will affect the interpretation of the requirement for 'mutuality' in Rule 4.90 in the Insolvency Rules, such mutuality being required before parties can set off obligations during insolvency. As a knock on effect of this uncertainty there may be further difficulties for banks and insurance companies to work out their margins of solvency or capital adequacy purposes.
In our view the wider implications of the proposed reforms will lead to a high degree of legal and therefore commercial uncertainty.
The Law Commission however, did not feel that a wider statutory and regulatory review was necessary. According to the Law Commission no consequential amendments were required to a number of major enactments because:
"either the enactments are sufficiently widely worded to apply to claims by third parties under [the proposed statute] and it is appropriate that they should apply; or, if that is not so, amendment to render the enactments applicable to claims by third parties under [the proposed statute] is unjustified in terms of policy at least in this project."
There was no further justification of this view in the report. Given the wealth of material reviewed by the Law Commission on privity of contract it is easy to see why a further lengthy review of statute did not seem appealing. However, although we can understand why the Law Commission would not wish to become embroiled in this further review, nevertheless we do not believe that such a fundamental change in the nature of contract law could fail to have unintended effects on the interpretation of statutory provisions. One can only hope that the Government will take on these concerns before introducing legislation.
Law Commission's Report on the Third Parties (Rights Against Insurers) Act 1930 (the Act)
The Act grants third parties statutory cut-through rights against an insured's insurer in circumstances where they have an established claim against the insured which has subsequently become insolvent. The Act does not, however, apply to reinsurance contracts.
This report was produced pursuant to the Law Commission's recommendation in the report on privity, that the Act should be subject to separate review.
The main recommendations centre on when the rights of the third party against an insurer, faced with an insolvent insured, crystallise. The Law Commission has provisionally recommended the abrogation of the requirement that the third party should be required to establish and quantify the assured's liability as a precondition for commencing proceedings under the Act against the insurer. The third party is at present required to bring two sets of proceedings, one against the insured, and then against the insurer. This obviously causes delay and an increase in costs and in the light of the general climate of the Woolf Report, was deemed to be inappropriate.
The Commission has also proposed that the Act should continue to not apply to reinsurance contracts.
This report is interesting for a number of reasons. First, despite the fact that it could be argued that the Act grew out of the general injustice caused by the privity doctrine, it fails to refer to the privity report at all. Secondly, the decision to exclude reinsurance contracts from the reformed Act's ambit and the absence of any reference to the privity report, brings into question whether it is intended that reinsurers will be caught by the reforms to the privity doctrine. It would seem (without further clarification) that contracts of reinsurance, where the necessary elements for the existence of third party rights (as suggested by the Commission in the privity report) are in place, may be caught by rules providing for third party rights. Again this is uncertain. Thirdly, if, as is stated to be the case in the privity report, the Act is a statutory exception to the rule on privity, this begs the question how this "exception" will be interpreted when the "rule" has disappeared.
NEMGIA v AGF - cut through
The NEMGIA case is a potent reminder of the potential for complexity when both the rules on contract, in particular privity, and the rules of insolvency are engaged in ascertaining the rights of policyholders, cedants and reinsurers.
We do not wish to say anything further on this case, except to comment we believe that those who have used this decision to justify the belief that the widespread use of Direct Payment Arrangements will increase, are mistaken. This case was decided on narrow contract and tort issues and it is likely that had this case not settled, the liquidators' argument that the direct payment was a breach of the pari passu principle would have succeeded. Any reinsurer attempting to implement a DPA in reliance on this case may find himself facing a "double-dip" payment; once to the policyholders and then to the liquidator.
Once again our concern is that the general review of third parties' rights has not been carried out in the context of reviewing what effect the creation of such rights will have on creditors' rights, especially in circumstances similar to the facts of NEMGIA. If such circumstances were to arise again, and certain policyholders, pursuant to the changes in the law of privity, were deemed to have direct third party rights against the reinsurer for payment, it is clear that the existence of such rights would leave other creditors and policyholders in a position of considerable disadvantage. Such creditors would be left with a (possibly worthless) claim in the liquidation of the cedant. How such third party rights can be reconciled with the principle of pari passu distribution in insolvency is a question that in our view needs to be addressed.
Obtaining interim certainty
Notwithstanding the difficulties mentioned above, interim certainty can be achieved by policyholders taking proprietary rights over their insurer's reinsurance recoveries.
The easiest way to achieve this is by way of a security assignment and there has been at least one major US insurance group which has entered into such an arrangement with a substantial policyholder due to the policyholder's concerns over the thin capitalisation of one of the group's primary insurance companies.
In essence the insurer assigns to the policyholder its rights to collect in reinsurance receivables from its reinsurer in order to secure the policyholder's rights under the underlying insurance contract.
In the event that the insured becomes insolvent this solution avoids the problems that would be faced by policyholders who had entered into a Direct Payment Arrangement. While under a Direct Payment Arrangement certain unsecured creditors would be obtaining priority over other unsecured creditors - which must be anathema to the pari passu rule - no such issues arise with the security assignment because, by definition, the pari passu rule does not apply to secured creditors. Equally, all of the problems which may arise out of a general reform on privity - for example, in relation to insolvency set-off rights - will also be inapplicable. Further, policyholders with such a security right will not need to rely upon statutory cut-through under the Act and, if such a security arrangement is used further up the chain, that is, between cedants and retrocessionaires, the Act 1930 will not apply in any event.
Therefore, while the developing strands of cut-through rights in the UK may be in somewhat of a confused state, certainty can always be achieved by taking (if it is possible) a security assignment over reinsurance receivables.
For at least a century the common law has been predicated on the basis of the bilateral nature of contracts. It would hardly, therefore, be surprising if, given that the existing statutory laws would also have been drafted on this predicate, that there may be difficulties in applying and interpreting existing statutory provisions if the doctrine is abolished.
In the same way as the year 2000 problem has led to wide implications for the computer industry, the movement away from this bilateral assumption and the movement to the general acceptance of the existence of third parties' rights, we believe may lead to wider implications for commerce. If the privity doctrine is to be abolished, it will be necessary for all commercial entities to review first, the way in which they contract with their counterparties; standard contracts used in commerce will need to be reviewed to see if they create third party rights; and secondly to seek advice on whether the abolition of privity will affect the application of any statutory provisions on which they rely. For example if the existence of third party rights affects insolvent set off.
Additionally and perhaps of more immediate concern to the insurance industry, is the concern that neither of the Law Commission's reports provide any analysis of the effects of both sets of proposals on the insurance industry. This is of concern given that the insurance industry has been built, perhaps more particularly than anywhere else, on the edifice of the bilateral contract.
It is therefore proposed that the insurance industry should undertake a separate review of the Law Commission's proposals on privity and the Third Party (Rights Against Insurers) Act in the light of the current case and statute law, to see how the creation and extension of third party rights may affect the industry.
In the meantime, if certainty is what is required, we would recommend that policyholders and ceding companies seriously consider entering into security assignments with their insurers and reinsurers.
Andrew Wilkinson has been a corporate partner at Cadwalader, Wickersham & Taft's London office since February 1998. Mr Wilkinson is an experienced corporate insolvency practitioner with a particular interest in the solvency of financial institutions. Mr Wilkinson pioneered the use of schemes of arrangement for the workout of troubled insurance companies.
1.  2 BCLC 191.
2.  A.C. 58, 72.
3.  2 A.C. 207.