Indemnification Agreements…What’s Fair and What Can a Design Professional Agree to?

As risk managers and insurance brokers working with design professionals we review hundreds of contracts every year. Our review is from a risk management and insurance perspective. Our objective is to quantify the risk of each contract so our architectural and engineering clients can make informed decisions on what they should and should not agree to.

While many contractual provisions affect risk, two of the most important clauses are insurance and indemnification. Insurance is fairly straightforward, you meet the requirements in the contract or you don’t and if you don’t, you either negotiate the contract or purchase the coverage you need to comply. Indemnification provisions however are not as straightforward. There are two main reasons for this:

  • Every state has their own indemnity statutes
  • Courts within every state may have different interpretations of how various statutes should apply.

In a perfect world, everyone would be responsible for their own mistakes. Sounds simple. This is basically how the law works in the absence of a contract. In fact, however, every contract will usually have an indemnity agreement which seeks to transfer risk from one party to another.

In a typical contract for design services, the upstream party, commonly the owner or the prime design professional will seek to transfer risk to the downstream party. In order to determine what is fair and what you can agree to, which are two different questions, you need to have a basic understanding of how indemnities work and how your Professional Liability Insurance policy would respond in the event of a claim. Shown below is an example of a fairly common indemnity running between an Owner and its Consultant.

“To the fullest extent permitted by law the Consultant shall indemnify, defend and hold harmless the Owner, the Owners agents and employees, from and against any claims, damages, losses and expenses, including but not limited to attorney’s fees arising out of or resulting from the performance of the work except for the owner’s sole negligence.”

While this is straightforward, it isn’t fair, nor is it insurable. It’s not fair because this requires the Consultant to be responsible not only for its own negligence but the contributory negligence of the Owner. If there was a claim where the Consultant was 25% at fault and the owner was 75% at fault, the Consultant would be contractually responsible for 100% of the damages.

It’s not insurable because all Professional Liability policies written for design professionals exclude liabilities assumed contractually. In the situation above the Professional Liability insurer would only pay for 25% of the damages attributable to the Architect. *

Another problem with the sample indemnity above is the requirement that the Design Professional defend the owner. This is uninsurable. This obligation to defend would not exist in the absence of the contract and as mentioned above Professional Liability policies exclude any contractually assumed risk.

Lastly, the sample indemnity requires the design professional to indemnify unknown third parties (Owners agents). The obligation to indemnify should only run to the owner and its employees.

So, what does a fair and insurable indemnity look like? In simple terms you should only agree to be responsible for damages caused by your negligence. You should also expressly state that there is no duty to defend. Here is what a reasonable indemnity might look like:

The Consultant agrees to indemnify and hold harmless the Client against all damages to the extent determined to have been caused by the Consultant’s negligent performance of the services under this Agreement. Notwithstanding the foregoing agreement to indemnify and hold harmless, the parties expressly agree that the Consultant has no duty to defend the Client from and against any claims, causes of action, or proceedings of any kind.

Every contract needs to be reviewed and understood. Where appropriate, they need to be negotiated. An indemnity that is fair and insurable should be the goal of every contract negotiation.

A side note on Indemnity in the State of California

Historically, California has had some of the most challenging indemnity laws in the country. Unless it was expressly stated to the contrary, the duty to defend an upstream party was immediate, even if the indemnity didn’t require a defense. Courts in California had ruled that the “duty to defend” was inherent to the “duty to indemnify.” In certain situations, the Design Professional ended up being responsible for 100% of the upstream party’s legal fees even though it was determined that they did nothing wrong. As mentioned above these defense costs are not typically insured by a Professional Liability policy.

Fortunately, all that changed with the passage of SB 496. Senate Bill 496 was signed into law by Governor Brown on April 28, 2017. It amended Section 2782.8 of the Civil Code as it pertains to a Design Professional’s obligation to defend an upstream party. The new law limits the cost to defend an upstream party to the design professional’s proportionate percentage of fault. To quote from the Bill, a Design Professional will only be responsible for the legal fees of another if “the claims against the indemnitee arise out of, pertain to, or relate to the negligence, recklessness, or willful misconduct of the design professional. In no event shall the cost to defend charged to the design professional exceed the design professional’s proportionate percentage of fault.”

In addition, this section of the Civil Code now applies to both public and private contracts with the exception of contracts entered into with the State of California. Previously this section only applied to Public Contracts other than the state of California.

Like most laws there are still some grey areas. While SB 496 appears to eliminate the immediate duty to defend, it doesn’t specifically state that. An upstream party may still make a demand for defense. This will likely be denied by the insurance company and now there is a statute to back up the denial.

Another question is whether or not legal fees awarded by a court would be considered covered damages under a Professional Liability policy. While each case is different, if the awarded fees are “negligence based” they will likely be covered.

Like most laws, SB496 will have to be tested in court to determine how it will actually apply. Regardless SB 496 was a major win for California’s Design Professionals. While it is not perfect, very few laws are, it is a significant improvement over California’s previous indemnity laws.

* It should be pointed out that Professional and General Liability policies treat the contractual assumption of risk differently. A General Liability policy provides broad contractual liability and insures the assumption of another’s liability with the exception of the other parties sole liability. A contractor who signed the same contract would be insured for 100% of the damages in the example above. General Liability policies exclude liability arising out of Professional Services however so this won’t help an architect or an engineer.

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