No-Third-Party-Beneficiary Clauses and the “Ever-Evolving Contractual Arms Race”

Buried bow first in the ocean floor, off the coast of Lebanon, with its stern pointing straight up, lies the wreck of the HMS Victoria. On June 22, 1893, the HMS Victoria was accidentally struck below the water line by the ramming bow of the HMS Camperdown. Within minutes of the collision, 357 members of its crew and the commanding admiral of the British Mediterranean fleet went down with the ship.[1] This was not the only time a ramming bow contributed to the sinking of a friendly ship rather than one of the enemy’s, as was the intended purpose of the ramming bow. Indeed, in the nearly 50 years naval warships were fitted with ramming bows, they almost always caused accidental damage to friendly ships rather than the enemy; after all, it was typically only friendly ships that could get close enough for the rams to be effective.[2] But it seems that everyone continued to assume that rams were a necessary component of sound naval warship design because of a few notable naval battles in the 1860s, even though they actually did more harm than good.

And what is the relevance of this historical reference? Well, Vice Chancellor Laster once described the contract drafting process as “an ever-evolving contractual arms race,” whereby contract drafters learn of situations in which a contractual counterparty structured around a specific contractual provision so that it failed to achieve its purported objective and, in response, contract drafters would modify that provision to better accomplish that objective in future transactions.[3] Would that it was always so. The evidence suggests, however, that, like the naval warship designers of the 19th century, some contract drafters tend to rely upon outdated and ineffective, if not self-defeating, contractual armaments, particularly when they are a part of the so-called “boilerplate” terms.[4] And nothing illustrates this phenomenon more than the frequently unexamined “no-third-party-beneficiary” clause. This is not the first time we have had occasion to examine the typically unexamined “no-third-party-beneficiary” clause.[5] But a recent Delaware decision suggests that we cannot be reminded too often of the importance of carefully modifying the standard no-third-party-beneficiary clause so that it, like the naval ramming bow of old, does not do more harm than good.

CHS/Community Health Systems, Inc. v. Steward Heath Care System LLC, C.A. No. 2019-0165-JRS, 2020 WL 4917597 (Del. Ch. August 21, 2020) involves a claim for indemnification under an asset purchase agreement (the “APA”). Pursuant to the terms of the APA, a specifically defined group of “Selling Entities,” which were indirectly owned by CHS/Community Health Systems, Inc. (“CHS”), had sold substantially all of their assets to the buyer. Those assets included certain “Assumed Contracts.” In the APA, the buyer agreed to assume and pay all future obligations under the Assumed Contracts. And in Section 11.1 of the APA, the buyer specifically agreed to indemnify “[CHS] and its Affiliates” from and against any liabilities arising from the Assumed Contracts. Following the closing of the APA, CHSPSC, LLC, a CHS Affiliate (but not itself a Selling Entity), apparently incurred and was required to pay contractual liabilities under one or more of the Assumed Contracts, and sought to recover those costs from the buyer pursuant to Section 11.1. So far so good. After all, Section 11.1 (the indemnification clause) clearly covered both CHS “and its Affiliates.” But alas, Section 12.22 of the APA (the no-third-party-beneficiary clause) stated as follows:

The terms and provisions of this Agreement are intended solely for the benefit of [CHS], [the buyer], their Affiliates and their respective permitted successors or assigns, and it is not the intention of the parties to confer, and this Agreement shall not confer, third-party beneficiary rights upon any other person other than the Seller Entities and the Buyer Entities, which the parties agree are express third-party beneficiaries of the rights of Seller and Buyer, respectively.

While the first clause of Section 12.22 is consistent with Section 11.1, the second clause isn’t. The buyer argued that notwithstanding the clear language in Section 11.1 of the APA, which extended the indemnification to CHS “and its Affiliates,” the terms of Section 12.22 limited the extent of the covered Affiliates to just the Selling Entities. Because CHSPSC was not a Selling Entity, even though it was an Affiliate, it was not entitled to indemnification. The court parsed the language of Section 12.22 and the arguments of both CHSPSC and the buyer, and concluded that Section 12.22 was ambiguous and required “extrinsic evidence to understand the parties’ agreement.” So now, instead of an issue being clearly determined by the language of the agreement, the court will determine at trial, based on extra-contractual evidence, the actual intentions of the parties.

Most acquisition agreements contain provisions intended to benefit affiliates (and officers, directors and employees, whether or not technically affiliates) of the contracting parties, who may be impacted by the sale in some manner (indemnification and the non-recourse clause are just two examples). An unexamined, boilerplate “no-third-party-beneficiary clause” can wreak havoc on those provisions if not carefully modified to make clear that the benefits of certain provisions of the agreement are indeed intended to benefit non-party affiliates (and perhaps others). And given the fact that it is exceedingly unlikely that an unintended third party actually would derive benefits under an agreement, even in the absence of a no-third-party-beneficiary clause, one may well wonder whether continuing to equip our contractual vessels with such ramming bows (even if modified) continues to be good idea. But you do not have to remove the ram to render it safe for your intended friendly beneficiaries; you just need to carefully modify it.

Endnotes    (↵ returns to text)
  1. See Ibrahim K. Msallam, The World’s only Vertical Wreck—HMS Victoria, Sea World, August 14, 2013, available here; Godfrey Holmes, How two British shipwrecks still fascinate us decades later – and what we can learn from them, The Independent, 29 May, 2018, available here.
  2. See Steven Wills, The Ram: A 19th-Century Naval Warfare Dead End, Center for International Maritime Security, April 2, 2014, available here.
  3. Wilmington Savings Fund Society, FSB v. Foresight Energy LLC, C.A. No. 11059-VCL, 2015 WL 7889552, at *9 (Del. Ch. December 4, 2015).
  4. See e.g., Stephen J. Choi, Mitu G. Gulati and Robert E. Scott, Innovation Versus Encrustation: Agency Costs in Contract Reproduction (July 18, 2020), available at SSRN, available here.
  5. See Glenn West, “Standard” Versus “Bespoke” Boilerplate—A Distinction That Can Make a Big Difference, Weil Insights, Weil’s Global Private Equity Watch, July 9, 2019, available here; Glenn West, On Naval Ramming Bows and Contractual Boilerplate—Are Standard “No Third-Party Beneficiary” Clauses Always a Good Thing?, Weil Insights, Weil’s Global Private Equity Watch, June 19, 2017, available here.