We do not live in a risk free world, so sophisticated parties to construction projects attempt to shift their risk from the project to another party. There are various ways of potentially shifting at least part of this risk by including in contract and/or general conditions limitation of liability or remedy clauses, insurance requirements that include appropriate additional insured endorsements, and accelerated/modified statutes of limitations. They all have limitations and, at times, are only partially effective. Historically, however, the primary risk shifting contractual provision is the indemnification clause.
Indemnification is the obligation of one party to pay or compensate another for losses, damages and defense costs incurred by another party to the contract or to a third party. The indemnification obligation can be implied by law (equitable), statutory or, as is most common, contractual. This article will focus on contractual indemnification.
The language utilized in an indemnification clause is limited only by the imagination of the drafter. However, each clause typically has the same basic features:
1. The description of the obligation,
2. The entities or persons who are to benefit from the indemnification obligation,
3. The risks to be indemnified against,
4. The scope of the obligation, and
5. Any additional conditions or limitations on the obligation.
A. The Description Of The Obligation
A typical indemnification clause begins with a statement that that the indemnitor (the party providing the indemnification) will “indemnify, hold harmless and defend” the indemnitees (the party or parties to receive the benefit). Each word has its own special legal meaning and effect when used together or independently, and must be analyzed in conjunction with the balance of the indemnification clause to ascertain the true scope of the obligation. What are you to indemnify against? Loss or liability? From what are you obligated to hold someone harmless? Defend at what point in time and to what extent? These are all critical considerations that have to be identified and addressed.
B. The Entities To Receive The Benefit
The persons or entities to receive the benefit are the indemnitees. The list can be short, including only the other party, or comprehensive, including additional parties, such as agents, consultants, lenders, affiliates, parent companies, bonding companies, governmental agencies, etc. It almost always also includes boilerplate language which will expand the obligation to include “their directors, officers, agents, consultants, and employees.” Some of the “laundry list” of indemnitees are obvious and appropriate. However, sometimes the clause tries to include an indemnitee that is inappropriate. Examples include a developer who wants its architect or engineer included, or a contractor seeking indemnification for a subcontractor. Review the list carefully, and strike the inappropriate entities. Unless there is an overwhelming reason to include a specific indemnitee, as long as the other contracting party secures its indemnification rights, this aspect is the easiest part of the clause to negotiate.
C. The Indemnified Risks
This is where these clauses become tricky. The words used may have a special legal meaning, may be overbroad, or simply inappropriate. The subject matter of the indemnity obligation has to be expressly set forth in the language of the clause. Each word has to be analyzed in light of the specifics of the contractual obligations. Types of exposure usually in an indemnification clause include “all losses, costs, claims, expenses (including but not limited to attorneys’ fees and costs), judgments, fines, penalties, liabilities, and damage of every nature and description.” Your counsel has to analyze the language carefully in light of the attendant risks. A good example of the impact that a single word or phrase may have is the standard indemnification provision of the American Institute of Architects Form A 201 “General Conditions of Construction” which provides indemnification for certain damages but limits covered damages to “other than the work itself.” This caveat essentially eliminates a significant portion of the claims the indemnitee would have expected to be included.
Another example is the distinction between “tangible property damage” and “property damage.” Tangible property damages requires actual physical harm to real or personal property. It does not typically include strictly economic losses such as the cost of repair of construction. Each party has to be cognizant of the subtle differences.
D. The Scope Of The Obligation
A party to a contract does not usually object if obligated to indemnify another to the extent the indemnitor is at fault. The problem arises, however, when the language of the clause tries to expand the obligation. Prior to 2013, with limited exceptions, indemnity clauses in California could not include indemnity for the indemnitee’s sole negligence or willful misconduct, or risk being declared unenforceable under the California anti-indemnity statutes (“Type I” indemnity clauses). As of January 1, 2013, the statutes were expanded to require that the language preclude indemnification for the indemnitee’s “active” negligence. (Civil Code Section 2782 et seq.) This amendment was in reaction to the significant problems encountered by construction subcontractors and suppliers who found themselves liable for full indemnity even when their fault was minimal. What constitutes “active” negligence is not defined by statute and often has to be determined based on the facts on a case-by-case basis. There are nuances to the statute depending on the type of contract, whether it is a private or public work, and your role on the project which have to be addressed by counsel.
E. Other Considerations
This is where the clauses can become truly creative. Each project is unique and has its own dynamic. You can insert “carve outs” and exclusions. You can limit the types of damages under the indemnification obligation such as excluding liquidated or consequential damages. The clause can limit the obligation to claims only over a certain dollar threshold, individually or in the aggregate. The language can include pro rata return of defense costs, cut off the obligation after contract completion or termination, or preclude direct claims. The possibilities become endless.
Indemnification clauses are complex, tricky, and have subtle nuances that impact the scope of the obligation, as well as the insurability of the clause itself. Case law is continually evolving as the courts wrestle with the newer statutory language and refine how the definition of the term “active” negligence will be applied. The legal implications are significant and input from counsel should be sought. Remember, it is a lot easier to prevent a problem than to extricate you from a problem after the fact.
Hal G. Block is a partner in Musick Peeler’s Orange County office. He has an architectural background and has practiced exclusively in construction litigation and transactional matters for 33 years.
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