Opportunities for Business Growth in Contractual Boilerplate
By Christian Graham, Construction Executive
A High-level Overview of Indemnity
Opportunities for business growth come in many shapes and forms. One such opportunity can be found where few prefer to venture: the contractual boilerplate of most construction contracts. Buried deep within this boilerplate, usually sandwiched between multiple other “standard” provisions, is something called the indemnity clause. At the negotiation table comparatively little time is devoted to this relatively obscure clause, but as it will be discussed below the clause can have a very significant long-term effect on the bottom line of any construction project.
It is a fact that despite their obscurity, indemnity clauses are pervasive in the industry. They can be found in construction agreements for nearly every major project. So-called “model construction agreements” published by various organizations also nearly always contain at least some version of the clause. Rarely given much thought other than by the attorneys who draft them, the clauses play a discreet but very important role.
This importance arises out of the fact, as those who have been in the industry long enough are no doubt aware, that at some point in time and in connection with some project there is a high probability a claim will arise, whether it be a construction defect claim, personal injury claim, product liability claim, etc. The costs of such a claim can be substantial, possibly exceeding the value of an entire project. And to a significant extent, the indemnity clause will likely determine the allocation of those costs. Depending on the wording of the clause, one particular party to the construction agreement may bear notably more (or less) costs than the other(s).
For general purposes of this discussion the parties to any given construction project fall into four categories: owners, design professionals, contractors and subcontractors. Frankly speaking, each party would prefer to bear as little of the expenses associated with a claim as possible, or at least no more than would be considered reasonably fair under the circumstances. But unfortunately this comes at a cost, because typically the less responsibility borne by one party, the more borne by the other parties.
Subcontractors tend to be the most vulnerable of the four categories of parties because they usually are the last to enter into a construction contract. Terms are often negotiated and drafted between the owner, the design professional(s) and/or the general contractor before the subcontractor even comes into the picture. Many of these terms may seem — at least from the subcontractor’s point of view — not very fair at all.
The aforementioned “model construction contracts” are touted, sometimes by well-established organizations, as setting the standard in the industry in many respects, including fairness. The advantage of the model construction contracts is they are readily available and inexpensive. The disadvantage is one that is held in common with one-size-fits-all pre-printed forms in general: they may not be suitable for every party and/or every project. Indeed, it can be argued that they tend to favor one party over others, i.e., the party catered to by the particular organization that drafted the form. For these reasons reliance on model construction contracts may not always be wise.
Furthermore, someone eventually is going to throw a curve ball by modifying the indemnity clause. It will take a certain amount of skill to comprehend the modification and to intelligently respond. Considering how much is at stake, it is well-worth investing the time to learn this skill.
THE NUTS AND BOLTS OF INDEMNITY CLAUSES
Two legal duties comprise essentially all indemnity clauses. The first is the namesake of the clause: the duty to indemnify. By way of definition, this is basically the obligation of one party to pay for damages incurred by another party (called the “indemnitee”). The indemnitee may be the owner in an owner-contractor agreement, or the contractor in a contractor-subcontractor agreement. For example, a general contractor may have a duty to indemnify, i.e., pay for damages incurred by, the owner in connection with a construction defect claim. In turn, a subcontractor may have a duty to indemnify the general contractor for the same claim.
The parties have great freedom to specify conditions triggering the duty to indemnify and/or delineate exceptions to the duty. It can for the most part be tailored as broadly (or narrowly) as they so choose. Needless to say, the broader the duty, the less costs the indemnitee will bear if there is a claim. In an extreme case the parties may fashion what in California is referred to as a “Type 1” indemnity clause. In a Type 1 indemnity clause there is a duty to indemnify the indemnitee for even the indemnitee’s own negligence. Although California has now banned these types of clauses, they can still be found in circulation.
The second legal duty comprising essentially all indemnity clauses is the duty to defend. This is basically the obligation to provide a defense to the indemnitee. Generally, the conditions triggering the duty to defend are in line with those triggering the duty to indemnify. It is important to note, however, that one is separate from the other. The duty to defend may arise before the duty to indemnify, or in some cases even if there is no duty to indemnify. For example, a general contractor may have the duty to defend, i.e., the obligation to hire an attorney for, the owner in connection with a construction defect claim even if the underlying allegations have not been proven or seem meritless.
Note that the duty to defend may seem to take the backseat to the duty to indemnify. But in reality the cost of defense is often on par with the cost of indemnification, and tends to increase/decrease in proportion to the size of the claim. It can even exceed the size of the claim in many cases. So from a dollars and cents standpoint, the duties are equally important.
THE ART OF NEGOTIATION
Those who master the art of negotiation of these very important clauses can reap significant long-term benefits. And although the art can be difficult in the mastery, it is not necessarily difficult in the application. There is no need to negotiate a substantial amount of legalese to create a substantial amount of value. The negotiation of as little as two or three words can make all the difference. By way of example, here is sample indemnity language with redline revisions shown:
“Indemnity. The Contractor shall indemnify and defend the Owner, the Architect, and their agents and employees from and against any and all claims, damages, and expenses arising out of any act or omission by the Contractor in connection with the performance of this Contract, unless such claim, damage, or expense is caused in whole or in part by a party indemnified hereunder.”
The revision affects only several words, but the before and after is night and day in terms of the legal effect. Under the original language prior to the revision the contractor has a duty to indemnify the owner even if a claim is entirely the result of the owner’s negligence. Under the revised language the contractor has no duty to indemnify the owner whatsoever if the owner played any role in causing the claim. This could be a multi-million dollar swing, depending on the size of the claim.
The duty to indemnify is ripe with similar opportunities for negotiation. Absent agreement, there is no dollar limit to the duty. This means liability may run to the indemnitee for an untold sum. The negotiation of indemnity caps can, therefore, be very worthwhile. For example, an indemnity cap can specify that ‘the duty to indemnify shall not exceed the contract price.’
In the same vein, the parties may agree to limit the types of damages. So-called consequential damages, such as business interruption, can run rampant and amount to a very sizeable part of any claim. Punitive damages can also be a very sizeable part of any claim. Consequently, the negotiation of any limitation or exclusion of these types of damages can, again, be very worthwhile.
As mentioned in the foregoing section the duty to defend can be just as important as the duty to indemnify, and is equally ripe with opportunities for negotiation. One such opportunity is the timing of the duty. Generally speaking, it can begin at the inception of the claim or at the inception of the duty to indemnify. It probably goes without saying that the former is much more desirable for indemnitees because it requires the payment of defense costs to begin immediately. If payments do not begin immediately, they may never begin because insurance carriers often settle claims prior to trial. This can be as costly (or as valuable, depending on which side of the negotiation table a party in on) as the cancellation of the duty to defend altogether.
Another closely related aspect of the duty to defend is the right to select defense counsel. The right may be granted to the indemnitee, but this can be expensive for the other parties. Knowledge of the right to select, but not the obligation to pay for, defense counsel arguably drives costs in only one direction (up). And it doesn’t necessarily resolve claims more efficiently. This aspect of the duty therefore should be negotiated very carefully.
Claims are unfortunately inevitable. The cost of the claims, however, can be managed through the intelligent negotiation of these very important clauses. Parties who understand the value of these negotiations, and who know how to undertake them will ultimately be more successful.
As generally the last to sign a contract, subcontractors in particular should take heed. By the time they become involved the owner and the general contractor may seem to present a united front against the negotiation of contract terms they have already agreed upon and drafted. However, indemnity clauses are too important to pass over. Subcontractors should maintain a checklist of items to negotiate in every indemnity clause. The items discussed in the section above may serve as a good starting point.
Conversely, the parties drafting the contract (usually the owner or the general contractor) shouldn’t rely too heavily on model construction contracts, and should take the time to ensure that an indemnity clause is in place to meet their goals. The cost of preparation of a custom clause is nominal in comparison with the value it can potentially yield.
The fruits of these efforts may not provide the same immediacy of gratification as other business dealings, but they are too substantial to ignore. Business leaders should seize this opportunity for growth. With the right initiative construction projects can be more profitable.