Privity of contract is a concept stating that contracts should not give rights or obligations to entities other than those who are parties to the contract. The principle helps to protect third parties to a contract from lawsuits arising from that contract. There are some exceptions to the privity principle and these include contracts involving trusts, insurance companies, agent-principal contracts, and cases involving negligence.

The Privity Principle

Privity is sometimes used as a defense in business litigation. The principle has its roots in England and was developed to reduce individuals and entities being caught up in lawsuits. The principle can help protect innocent third parties from contracts that they may not even know about. Consider, for example, a new tenant who settles into a house after making a lease agreement with the landlord. 

The tenant finds out that, contrary to the contract she signed with the landlord, the house's air conditioning system is faulty. The new tenant raises the issue with the landlord who tells him that the AC fault is the responsibility of the previous tenant. The new tenant cannot sue the previous tenant because the previous tenant was not a party to the new tenant's lease agreement with the landlord. 

If the new tenant wants to take legal action, it has to be against the landlord. The privity principle also applies when a tenant subleases a property he is renting. The landlord may not be able to sue the tenant to whom the property was subleased.

In contract law, privity and consideration are closely related and any contract that does not follow both principles is not enforceable. Any contract with privity, but without consideration, is not valid. For example, a contract made between two friends Andrew and John. Andrew promises to pay John a monthly fee because John is such a nice person.

In such a contract there is no consideration, there is nothing John is giving back in return for the payments from Andrew.  If Andrew defaults on his payments and John sues him for breach of contract, courts would likely not enforce the contract. This is because, although the contract is in line with the privity concept, there is no consideration in the contract.

Types of Privity 

  • Horizontal Privity
    Horizontal privity can be brought up if benefits in a contract are given to another party that is not a party to the contract.
  • Vertical Privity
    This may be raised when another contract is made arising from one of the parties to another contract.

Exceptions to the Privity Principle

In modern times, situations have arisen that have necessitated the relaxing of the privity principle.

  • Collateral Contracts and the Sale of Defective Goods
    A third party may sue the seller over defective goods if the third party is affected by the flaws in the goods. 
  • When an Agent Is Involved
    An agent may enter a contract with another party on behalf of a principal. In this case, the principal may not be able to be released on grounds of the privity principle because he was represented in the contract. 
  • Trusts
    In some circumstances, an agreement between a trustee and another party may affect the owner.
  • Restrictive Agreements
    In some cases, a restrictive agreement may be enforceable against a third party. This may be the case when owners of a house sell to another person with the understanding that the buyer would not change the design of the house. If the buyer sells the house to a third party and some requirements are met, the third party may be obligated to follow the original owners' conditions.
  • Negligence
    In the case of personal injury resulting from negligence, the negligent party may generally be sued by third parties who are not parties to any contract with the negligent party.
  • Assignment of the Contract
    In some cases, benefits from a contract may be assigned to another party.
  • Insurance Companies
    A third party involved in an automobile accident with an insured vehicle may, in some cases, sue the insurance company when he gets a favorable court ruling against the vehicle owner.

Another legal principle similar to privity is issue preclusion. Issue preclusion, also known as collateral estoppel or res judicata, prohibits an entity from litigating an issue more than once.

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