James J. Sienicki and Eric Spencer – June 20, 2013
Accidents and losses unfortunately happen on construction projects. Thus, it is prudent, on the front end of a project, to prospectively determine which party or parties will ultimately pay in the event accidental damage or loss occurs.
This risk is often allocated through an interlocking set of contractual obligations between owners, design professionals, general contractors and subcontractors on a particular project, and through insurance coverage. The parties normally allocate this risk not to the party who can most afford it, but to the party that, at least theoretically, can best control whether the damage or loss occurs in the first place. Thus, for example, general contractors usually require their subcontractors to indemnify them for property losses or personal injury that result from or arise out of the subcontractor’s work. The contract also may require that the subcontractor purchase insurance, and in most cases, name the general contractor as an additional insured on the policy purchased by the subcontractor. Owners, general contractors, design professionals (e.g. architects and engineers) may have similar arrangements in their respective contracts.[1]
When entering into these agreements, it is important to understand what you are getting and what you are giving up when it comes to indemnity and insurance. These provisions often determine who will be picking up the check if something goes wrong. Therefore, these provisions should be carefully negotiated, if possible. Alternatively, if you must bear some risk of loss, it is prudent to fully understand the ramifications of the obligations that have been assumed, and also to exercise foresight to have or obtain insurance coverage to cover the risk of loss. Many parties assume they bargained for certain protection or limitations but later realize, when those contract provisions are tested in court, that their supposed protection or limitations are less than optimal.
This article summarizes Arizona law regarding key indemnity and insurance issues affecting construction projects. We can by no means comprehensively cover the subject here; however, this article covers items that can help reduce the chances of being surprised by an indemnity or insurance obligation or limitation down the line.
Contractual Indemnity Is Key. The first step of any indemnification analysis is to read the contract provisions.
If there is no contract provision addressing indemnification, a party still may be entitled to indemnity under common law legal principles. It is difficult to obtain common law indemnity because the party seeking common law indemnity cannot in any way be “actively” at fault for the damages or loss—and that is rarely the case on a construction project. A party who is merely “passively” at fault may still be entitled to common law indemnity, but drawing the line between active and passive negligence is easier said than done. Even the most diligent owner, contractor or design professional has likely made some mistake somewhere along the way. Therefore, an owner may be forced to engage in costly litigation in order to establish its common law right to indemnity, while the general contractor need only show that the owner was merely 1% at fault to avoid any common law indemnity liability. Thus, it is important to address indemnification in your contract in order to avoid this unpredictable and potentially costly scenario.
Is the Indemnity Clause Enforceable Under Arizona Law? Like most states, Arizona has set some basic parameters on what type of indemnity agreements can be enforceable. Because, as a matter of public policy, all parties should have an incentive to operate with due care, no party to a construction contract can be indemnified for its sole negligence. A.R.S. § 32-1159. In other words, if a party is 100% at fault for the loss or injury in question, that party cannot shift that loss to another via an indemnification provision. (Insurance is a different matter, however).
Parties working on a public construction project are further restricted. While a party may be indemnified for its partial negligence on a private project, one cannot be indemnified for its own fault on a public project. A.R.S. §§ 34-226; 41-2586. For example, a private owner who is 75% at fault may be fully indemnified by its general contractor under the right circumstances, and with the right indemnity provisions, while a public owner will be capped at 25% under the anti-indemnity statutes regardless of what its indemnity provisions provide.
In light of these restrictions, many indemnity clauses begin with the phrase “to the extent permitted by law” in order to enhance their ability that they will be enforceable. Thus, an indemnity provision that provides that a party is entitled to be indemnified for “all” damage or loss it suffers on a public project will probably be interpreted to only cover those damages or losses caused by the other party or parties.
Do the Indemnity Provisions Enable a Party To Be Indemnified? Rarely will you encounter a scenario where the party giving indemnity (the “indemnitor”) is completely at fault. Thus, a good indemnity provision needs to account for more complex scenarios likely to be encountered, such as when multiple parties—including the party seeking indemnity (the “indemnitee”)—are negligent to some degree.
If the indemnification clause does not specifically state that the indemnitee can be indemnified for its own negligence, then the indemnitee cannot be indemnified if it is (actively) negligent. Of course, a generalized indemnity provision is preferable over no indemnity provision because having a contract right dispenses with the necessity for a judge or jury to determine, as a matter of equity, whether you truly “deserve” indemnity. However, securing a more specific indemnification agreement is usually the goal of any party seeking to be indemnified for its own negligence on a private construction project.
In order to create the requisite level of specificity, the contract must state clearly that the indemnitee will be indemnified for damages or losses caused in part by its own negligence. For example, Arizona courts have found the following clause to be sufficiently clear: “To the fullest extent permitted by law, the Contractor shall indemnify and hold harmless the Owner . . . against all claims . . . caused in whole or in part by any negligent act or omission of the Contractor, . . . regardless of whether or not it is caused in part by a party indemnified hereunder.” Washington Elem. School Dist. No. 6 v. Baglino Corp., 169 Ariz. 58, 817 P.2d 3 (1991) (emphasis added). Thus, an owner invoking this provision may be indemnified for all damage or loss even when it is 99% responsible for the damage or loss.
Because the determination of fault is inherently unpredictable, a more specific indemnity clause provides broader protection against losses that occur on private projects. Having an attorney review indemnity provisions in a construction contract ahead of time can enhance the probability that the clause will enable a party to be indemnified as the indemnitee, or the party’s knowledge regarding what risks it is taking on as the indemnitor. That way, the party can know what changes to the clause should be negotiated before signing the contract. And, especially if the party is the indemnitor, the party should confirm that it has insurance coverage to protect itself against indemnity risks before signing the contract.
Even If the Indemnity Provisions Enable the Party To Be Indemnified, To What Extent Will It Be Indemnified? Unfortunately, drafting an indemnity provision that specifically addresses a party’s own negligence still may not be sufficient to provide the desired indemnity protection. The fact that a party is able to be indemnified despite its own negligence has nothing to do with how much it is entitled to be indemnified.
The above example from the Baglino case involved an agreement where the owner was entitled to indemnification for damages “caused in whole or in part” by its own negligence. This language would permit an indemnitee to recover all its damages. Thus, an owner 25% at fault can be indemnified for 100% of its damages or losses under such a broad agreement.
However, using a different example, an indemnification clause that requires a subcontractor to indemnify the general contractor for damages and losses only “to the extent caused by negligent acts of the subcontractor” has a narrowing effect, such that the subcontractor is only obligated to provide indemnification for that portion of the loss that was caused by the particular subcontractor. MT Builders, L.L.C. v. Fisher Roofing Inc., 291 Ariz. 297, 197 P.3d 758 (App. 2008). Thus, a general contractor that uses this narrower clause in its contract indemnity provisions could not be indemnified for the damages or losses it caused.
Right-Sizing the Indemnity Obligations. It is important to understand how indemnity obligations dovetail with other indemnity obligations assumed by others on the project.
For example, assume that a private project owner enters into an agreement with its general contractor that specifically states the owner is to be indemnified despite its own negligence, but the general contractor enters into an indemnification agreement with its subcontractor that doesn’t state that the general contractor is entitled to indemnity for its own negligence. A third-party suffers a loss and sues the owner, general contractor and relevant subcontractor. A jury determines that all three parties were actively negligent according to the following percentages: owner 40%, general contractor 10% and subcontractor 50%.
In light of the more specific indemnification agreement between owner and general contractor, the general contractor will be obligated to indemnify the owner for the 40% of damages attributable to the owner. However, the general contractor will not be able to seek any indemnity from the subcontractor.
Thus, agreeing to a mismatched indemnity obligation can potentially be very costly for the contracting party caught in the middle, as it may find that it has liabilities passed on to it, but it cannot pass these liabilities on. This same caught in the middle scenario can apply to subcontractors who further subcontract their work or architects who contract with engineer subconsultants, for example. Therefore, a party should strive to reduce the indemnity coverage it is giving and/or strive to get as much indemnity coverage as it is giving.
Insurance Coverage—A Necessary Backstop. Who will be legally responsible according to an indemnity agreement is only the first part of the inquiry when a loss has occurred. Insurance coverage is equally critical. Insurance is important not only as a potential source to pay an indemnity obligation, but it can be used as a back-door way to achieve indemnity-type protection that would otherwise be unavailable.
An owner, for example, may have purchased a general liability policy and may also have additional insured status on the policy purchased by another party (the general contractor for example). The first place the owner will look for coverage will be the general contractor’s policy because the loss, if paid by the general contractor’s policy, is less likely to affect the owner’s future insurance premiums. That is why a party would want another’s policy to be the primary policy, and the insurance provisions in a contract should state whose policy is primary.
To determine whether a party is covered under another’s insurance policy, obtaining a copy of the certificate of insurance is helpful, but keep in mind that certificates are not binding on the insurance company unless an endorsement is issued identifying the party as an additional insured. Thus, at the time of contracting, especially if this is the first time you have contracted with this party, you should request the actual policy—including all endorsements—from the party who purchased the insurance.
Even if a party is covered by another’s policy, it is certainly possible for that policy to fall short in covering the indemnification obligations. This can leave a party with significant financial exposure. It is prudent to discuss this issue with an insurance broker before signing a contract. The reverse can be true as well: the insurance coverage may exceed or supplant the indemnity duty. Thus, for example, if an owner is not entitled to indemnity from its general contractor for one reason or another, insurance coverage under the general contractor’s policy nonetheless may be triggered due to the owner’s additional insured status. In other words, the owner may end up with some recourse after all if the general contractor’s insurer is obligated to defend the owner and/or contribute insurance proceeds towards a settlement or judgment.
Whether any insurance (yours or another policy) will cover the loss depends on the breadth of the indemnification clause and the breadth of the insurance coverage. If one agrees to indemnify another party only for claims arising from death, personal injury, or property damage, for example, a commercial general liability (CGL) insurance policy will likely cover such damages or losses. If, on the other hand, one agrees to indemnify the other party for additional economic losses, such claims will likely not be covered by a CGL policy. Thus, indemnitors should consider excluding this up front (before signing the contract). In fact, the safest approach would be to attempt to delete any indemnity obligations for which there is not going to be insurance coverage to back-up the indemnity obligations.
Conclusion. Whether you are an owner, general contractor, subcontractor or design professional, you will almost always seek indemnity from, or be asked to provide indemnity to, another party on a construction project. It is therefore important to carefully address indemnity obligations through contracts and insurance policies. Attorneys and insurance brokers can help with these issues. As with any significant business endeavor, careful review of all indemnity and insurance obligations and limitations on the front end is a worthwhile “ounce of prevention” to take in order to avoid incurring “a pound of cure” on a construction project.
[1] One notable exception is that one cannot be named as an additional insured on a design professional’s Errors & Omissions (E&O) policy, but can be named an additional insured on a design professional’s Commercial General Liability (CGL) policy.