Module 5: Third Parties, Risk & Good Faith

Every contract carries an implied covenant that neither party will act to destroy or injure the other’s right to receive the benefits of the agreement. This doesn’t create new obligations out of thin air — it polices how the existing ones are performed. Common examples of bad faith: evading the spirit of the deal, willfully rendering imperfect performance, abusing a power to set or specify terms, or interfering with the other party’s ability to perform or receive what they bargained for.

Market Street Associates Ltd. Partnership v. Frey (Judge Posner) shows the covenant has real limits too, not just teeth. A lease gave the tenant an option to require the landlord to finance improvements, but only if the tenant first asked for that financing — the tenant deliberately avoided asking, knowing the landlord’s own staff had likely forgotten the clause existed, then tried to claim the lease was breached anyway once the landlord failed to volunteer financing no one had requested. Posner explained good faith doesn’t require rescuing the other side from their own oversight — but it does require not deliberately exploiting a known gap in the other party’s knowledge purely to manufacture a claim, remanding the case to sort out which one this actually was.

Example. Peter’s contract with John gives Peter the sole discretion to set the “delivery schedule” for goods John needs to resell. Nothing in the contract is technically broken if Peter deliberately schedules every delivery for the day after John’s big seasonal sales end, purely to spite him — but doing so to gut the value John bargained for is exactly the kind of bad-faith abuse of a discretionary power the implied covenant of good faith and fair dealing exists to stop, even though no express term was violated.

A contract between A and B can create real, enforceable rights in a third party, C — but only if C is an intended beneficiary, not merely an incidental one who happens to benefit without being a target of the deal. Intended beneficiaries include creditor beneficiaries (the contract pays off a debt A owes C) and donee beneficiaries (A intends the contract as a gift to C). Once an intended beneficiary’s rights vest — typically by learning of and relying on the contract, or by suing on it — the original parties generally can’t modify or rescind the deal to cut the beneficiary out without their consent.

Lawrence v. Fox (1859) is the foundational American case that created this whole doctrine. Holly lent Fox money on Fox’s oral promise to instead pay that same amount directly to Lawrence, to whom Holly separately owed a debt. When Fox failed to pay, Lawrence — who was never a party to the Holly-Fox agreement at all — sued Fox directly. New York’s highest court allowed it: since the entire point of the arrangement was to benefit Lawrence, he didn’t need his own separate contract with Fox to enforce the promise made for his benefit. This was a genuinely novel result at the time — privity of contract had traditionally been thought to require exactly the kind of direct agreement Lawrence never had.

Example. Peter hires John, a contractor, to build a swimming pool at Peter’s rental property — the whole point of the contract is to benefit Peter’s future tenant, Sam, who will actually use the pool. If Sam is an intended beneficiary (say, Peter specifically promised Sam a pool as part of the lease), Sam may be able to sue John directly if the pool is built defectively. Compare that to a random neighbor who simply enjoys looking at the finished pool from their yard — that neighbor is a merely incidental beneficiary with no enforceable rights at all, since nobody intended the contract to benefit them.

Assignment transfers the right to receive contract benefits to a third party — the assignee steps into the assignor’s shoes to receive performance. Delegation transfers the duty to perform instead. Some rights and duties can’t be assigned or delegated at all — personal-services obligations, changes that would materially increase the other party’s risk or burden, or where the contract expressly prohibits it.

Sally Beauty Co. v. Nexxus Products Co. shows the “materially increases the burden” limit actually blocking a delegation. Nexxus granted a distributor the exclusive right to sell its hair care products; that distributor was later acquired by a company that was itself wholly owned by Sally Beauty’s direct competitor in the same market. Even though the acquiring company was willing and able to perform the same distribution duties, the court held Nexxus didn’t have to accept the delegation — being forced to rely on a distributor ultimately controlled by a direct competitor materially changed what Nexxus had actually bargained for, regardless of the new party’s technical competence to do the job.

Example. John owes Peter $1,000 under a contract. Peter can assign his right to collect that $1,000 to a third party, Sam — Sam now steps into Peter’s shoes and can collect directly from John. Separately, if John (not Peter) is the one who owes performance — say, John owes Peter a custom-painted portrait — John generally cannot delegate that duty to another painter without Peter’s consent, because Peter specifically bargained for John’s personal artistic skill, not just “a portrait from someone.”

This is the distinction most people get wrong, so it’s worth being precise: delegating a duty does not automatically release the delegating party from liability — they remain on the hook as a backup unless something more happens. A novation is that something more: an agreement, with all three parties’ consent (the original obligor, the original obligee, and the new party), that substitutes the new party for the original one and completely releases the original party from further liability. The release is the defining feature — without the obligee’s express agreement to let the original party off the hook, you have a delegation, not a novation, no matter how the substitution was otherwise arranged.

Worth keeping distinct from a related idea it’s often confused with: an accord and satisfaction also resolves an existing obligation, but by substituting a different performance from the same two parties (paying a smaller sum to settle a larger disputed debt, for instance) — not by substituting a different party entirely. A novation needs a new party in the picture; an accord and satisfaction never does. And the consideration question people sometimes worry about for a novation is simpler than it looks: the new party’s promise to perform is itself real, bargained-for consideration, and the original party’s discharge from liability is what the obligee gives up in exchange for it — no separate payment is required to make a proper novation binding.

Example. Peter owes John $5,000 under a loan. Peter, John, and Sam all agree together that Sam will take over the debt and pay John instead, and that Peter is completely released from any further obligation. Because all three parties consented and John expressly agreed to let Peter off the hook, this is a true novation — if Sam later defaults, John cannot come back after Peter. Compare that to Peter simply asking Sam to make the payments for him without ever getting John’s agreement to release Peter: that’s only a delegation, and Peter remains fully liable if Sam doesn’t pay.

Contracts routinely allocate risk explicitly, through several standard tools: warranties (express promises about quality or performance, plus implied ones like the UCC’s implied warranty of merchantability, shifting the risk of defects onto the seller); indemnification clauses (one party agrees to cover the other’s losses from specified risks or third-party claims); exculpatory / limitation-of-liability clauses (attempting to limit or eliminate liability for certain harms — enforceability varies widely, and courts scrutinize these closely, especially for gross negligence, intentional conduct, or unequal bargaining power in consumer contexts); and insurance requirements, which shift risk to a third-party insurer entirely.

Tunkl v. Regents of the University of California is the real case behind courts’ close scrutiny of exculpatory clauses. A hospital patient signed an admission form releasing the hospital from liability for its own future negligence, as a condition of receiving care. The court refused to enforce it, laying out factors that still guide this analysis: the clause concerned a service affecting the public interest, the hospital held a decisive bargaining advantage over an incoming patient, and the patient had no real ability to negotiate or purchase protection against the hospital’s own carelessness. An exculpatory clause between equal, sophisticated commercial parties gets far more deference than one imposed on someone with no real bargaining power over an essential service.

Example. Peter hires John, a contractor, to renovate his store. Their contract includes an indemnification clause requiring John to cover any injury claims from John’s own workers on the site, and requires John to carry liability insurance naming Peter as an additional insured. If a worker is hurt on the job, that risk has already been allocated to John (and, practically, to John’s insurer) before anything ever went wrong — Peter isn’t left hoping a court sorts it out after the fact.