Client Alert – California Law on Type I Indemnity Provisions in Construction Contracts Changes January 1, 2013

Since the Mayan Apocalypse didn’t occur on December 21, 2012 – though perhaps like construction projects the apocalypse is merely delayed – we need to be concerned about changes in California law that become effective on January 1, 2013.  

One important change for construction industry professionals is Senate Bill 474. SB 474 substantially changes the law applying to indemnity provisions in construction contracts. This change does not affect existing construction contracts. However, this change will apply quite soon, as in a few days from now, to construction contracts entered into starting January 1, 2013. You need to know about these changes because:

• This change in the law likely will require the rewriting of indemnity provisions in most construction contracts, including yours, as well as those of others which you sign.
• This change in the law also may affect the type of insurance you require in your construction contract, or is required of you.
• Understanding this change in the law can help you better evaluate whether a construction project will be profitable, as the degree of risk-shifting involved in indemnity provisions can make a large dollars and cents difference.
• Understanding this change in the law also can help you react correctly when problems arise on a construction project, as they almost inevitably do, that trigger the operation of an indemnity provision.

Before discussing the changes, I’ll explain Type I indemnity provisions, which are affected by the change in the law. If you’re already a Type I indemnity guru, just skip over the following sections to the one titled “Changes in Law – Indemnity.”   

What is an Indemnity Provision?

Indemnity means to pay for the liability of another. Your auto insurance policy is a contract of indemnity. If you’re liable for an automobile accident, your insurance company will (hopefully) indemnify you by paying any judgment or settlement against you.   

Indemnity usually also includes the obligation to “hold harmless.” This means to pay the expense (usually attorney’s fees) in defending the claim. Accordingly, the auto insurance company usually hires and pays for an attorney to defend you if you are sued by the other party to the automobile accident.   

Indemnity in a Construction Contract   

The insurance company does not agree to indemnify you out of the goodness of its heart. Instead, you pay the insurance company a premium for this protection.  

However, not everyone who agrees to indemnify someone else is directly compensated as is an insurance company. Traditionally, those higher on the construction food chain (owner as opposed to general contractor, general contractor as opposed to subcontractor, first-tier subcontractor as opposed to lower-tier subcontractor or supplier) seek to transfer liability downstream to the party lower on the chain via an indemnity provision.  

Taking as an example a contract between a general contractor and a subcontractor, an indemnity provision often requires that if there is a claim against the subcontractor that involves the subcontractor’s scope of work, and the general contractor is sued, then the subcontractor will pay for the general contractor’s defense. Additionally, if there is a judgment against the general contractor, or a settlement of the lawsuit, the subcontractor will pay the amount of the judgment or settlement.

For example, the general contractor is sued by a visitor who was injured on the jobsite after he tripped over equipment left overnight by the mechanical subcontractor. Under the subcontract indemnity provision, the mechanical subcontractor would defend the general contractor from the personal injury lawsuit. Additionally, the mechanical contractor would pay any judgment against the general contractor, or a settlement of the lawsuit.

Type I Indemnity Provision

So far the indemnity provision doesn’t sound too bad, perhaps even fair. However, disputes which arise on a construction project often are more complicated than in the example just given. To illustrate, let’s switch to another, more complicated example.  

Goliath School District, the project owner, sues Samson Construction, the general contractor, to recover liquidated damages for a project which finished late for a number of reasons. The work which finished late included the mechanical work, performed by the mechanical subcontractor, Tiny Mechanical. The complicating factors include:

• The mechanical work was not the only work which finished late. Many other scopes of work (e.g., electrical, plumbing, masonry) also finished late. 
• Samson Construction’s terrible mismanagement of the project substantially contributed to the project finishing late.

Does Tiny Mechanical owe Samson Construction a defense and indemnity from the delay claim? The answer, as so often in the law, is: It depends. Specially, it depends on the type of indemnity provision in the subcontract between Samson Construction and Tiny Mechanical.

“Type I” is perhaps the most common in construction contracts, and certainly the most one-sided. Taking our example of a contract between a general contractor and a subcontractor, the subcontractor is responsible to indemnify and hold harmless the general contractor even if the claim against the subcontractor relates only partially (think less than 10%) to the subcontractor’s work, and the general contractor’s negligence is the major (think over 90%) cause of the claim, unless the claim arose solely from Samson Construction’s active negligence (or willful misconduct). Even if Samson Construction terribly mismanaged the project, it is unlikely that its active negligence was the sole (think 100%) cause of the project finishing late. The indemnity provision doesn’t seem so fair now, at least from Tiny Mechanical’s perspective.  

Tiny Mechanical’s obligation to indemnify and hold harmless Samson Construction may not be a practical problem if Tiny Mechanical has insurance that will satisfy the indemnity and defense obligations. But if it doesn’t – and that may happen for a variety of reasons even if the subcontractor carries the usual required insurance – Tiny Mechanical may be directly liable for damages and attorney’s fees for claims that it did nothing to cause and largely may not even concern its work, and have to pay the very party whose negligence substantially contributed to the problem. Other subcontractors may have a similar obligation, but what if they’re insolvent, or didn’t obtain adequate insurance? Then Tiny Mechanical could be left holding the proverbial bag.

Changes in Law – Indemnity

California law changes this result for all contracts entered into starting January 1, 2013 on public construction projects, and private construction projects other than residential construction (where the law similarly changed, but earlier, effective 2009). In the Goliath School District vs. Samson Construction vs. Tiny Mechanical example:

• Tiny Mechanical would owe indemnity and defense only to the extent its work was involved. If the other trades which also may owe indemnity and defense were insolvent and did no have adequate insurance, that would be the problem of Samson Construction, not Tiny Mechanical. 
• Tiny Mechanical would not owe indemnity or defense to the extent Samson Construction’s active negligence contributed to the problem. Tiny Mechanical no longer would have to show that Samson Construction’s active negligence was the sole cause of the problem. 
• Tiny Mechanical also would not owe indemnity or defense to the extent design deficiencies contributed to the problem (as they so often do).

That’s a lot better for Tiny Mechanical (though not so good for Samson Construction).

Here’s a summary of the specific changes to indemnity provisions:

• Indemnity provisions by a general contractor, subcontractor or supplier in favor of the owner of a private project are unenforceable to the extent the claims arise from the owner’s active negligence. (Civil Code § 2782 (c)). Comment: Previously the indemnity provision was unenforceable only if the claim arose solely from the owner’s active negligence. 
• Indemnity provisions by a contractor, subcontractor or supplier in favor of the public entity owner are unenforceable if they permit indemnity for claims arising from the public entity’s active negligence. (Civil Code § 2782 (b)). Comment: General contractors were previously protected from having to indemnify a public entity for the latter’s active negligence. The change is to extend this protection to subcontractors and suppliers. One consequence of extending this protection to subcontractors and suppliers is that a general contractor, in its contract with a subcontractor, may not require the subcontractor to indemnify the public entity for the latter’s active negligence. 
• For all public and non-residential private projects, indemnity provisions by a subcontractor in favor of a general contractor, construction manager, or other subcontractor are unenforceable to the extent the claims (1) arise from the active negligence or willful misconduct of the upstream party, (2) involve defects in design, or (3) do not arise from the subcontractor’s scope of work. (Civil Code § 2782.05). Comment: Here too, previously the indemnity provision was unenforceable only if the claim arises solely from the upstream party’s active negligence or willful misconduct or was entirely unrelated to the subcontractor’s scope of work.

Insurance Exceptions

The new law does not apply to “Any wrap-up insurance policy or program” (Civil Code § 2782.05 (b) (4)); in other words, owner controlled insurance programs (“OCIPs”) and contractor controlled insurance programs (“CCIPs”).  Another exception is for provisions which require the subcontractor to make the general contractor an additional insured. (Civil Code § 2782.05 (b)(6)).  

It is not unreasonable to predict increased reliance by owners and general contractor on OCIPs and CCIPs, as well as additional insured provisions, under which they may be able to achieve indirectly that which they no longer can achieve directly, being contractually indemnified for their active negligence. Consequently, I expect a greater focus on how insurance is structured on a construction project and the drafting of insurance provisions in construction contracts.   

Changes in Law – Defense

Since the obligation to “hold harmless” (provide a defense) goes hand in hand with the obligation to indemnify, changes in the law on providing a defense conform to the changes to the law on indemnity. Specifically, the subcontractor only has to provide or pay for a defense to the extent its work is involved, and need not be concerned if other subcontractors don’t honor their defense obligations for their work.

Additionally, the California Legislature provides, in Civil Code § 2782.05 (e), some much-needed clarity to the previously ambiguous process for demanding a defense and responding to such a demand:

1. A subcontractor’s defense obligation to a general contractor or construction manager does not begin until the general contractor (or construction manager) provides a written tender of its defense.
2. The written tender must include (a) the information provided to the general contractor or construction manager relating to claims caused by the subcontractor’s scope of work and (b) how the general contractor (or construction manager) determined its allocation to the subcontractor of a share of the overall defense costs.
3. The subcontractor then has two options: (a) defend the claim with counsel of its choice, or (b) pay the allocated share of the overall defense cost.
4. If the subcontractor elects to defend, it must provide written notice of its election no later than 30 days following receipt of the tender. The subcontractor then must provide a “complete defense” of all claims or portions to the extent alleged to be caused by the subcontractor. However, the subcontractor has no obligation to defend claims resulting directly from the general contractor’s scope of work of others, such as other trades.
5. If the subcontractor does not elect to defend, while the claim is pending, it must pay its reasonable allocated share of the defense fees and costs. Payment is due within 30 days of receipt of an invoice.
6. The allocated share of defense fees and costs that the subcontractor is to pay is subject to reallocation, including any amounts reallocated when the claim is resolved by settlement or judgment.

The California Legislature also has spelled out in Civil Code § 2782.05 (f) the process for enforcing these rights.

1. If a subcontractor elects to defend but fails to do so, the general contractor or construction manager may pursue a claim against the subcontractor for any resulting compensatory damages, consequential damages, and reasonable attorney’s fees.
2. If the subcontractor elects to pay an allocated share of defense fees and costs but fails to pay, the general contractor or construction manager may pursue a claim for any resulting compensatory damages, interest on defense and indemnity costs (at 2% per month), consequential damages, and reasonable attorney’s fees incurred to recover these amounts.
3. A subcontractor has a right to request the general contractor or construction manager to reallocate defense fees and costs. If the general contractor or construction manager does not reallocate within 30 days of final resolution of the claim, the subcontractor has the right to pursue a claim for any resulting compensatory damages with interest (at 2% per month). This provides the general contractor (or construction manager) incentive not to get greedy in allocating to the subcontractor.

Comment: The law still permits the contracting parties to agree on the “timing or immediacy of the defense” and “provisions for reimbursement of defense fees and costs,” so long as they are not otherwise prohibited. (Civil Code § 2782.05 (e)). Thus, a subcontractor may request a contract provision which requires sooner the determination of a proper allocation, such as in a quick mini-arbitration. Such issues likely will be the new battleground in disputes over contract provisions on defense obligations.

Conclusion

This alert summarizes the changes, but certainly is not a complete explanation of sweeping changes on a very complex subject, and of course does not address specific indemnity provisions in your contracts, or contracts drafted by the other party which you sign. Accordingly, you should consult with your legal counsel. Hopefully that’s us, but even if not, you should talk with your attorney about this change in the law.