Indemnification is a concept whereby one party contractually agrees or is otherwise legally obligated to bear the financial risks of another party. These parties are respectively known as the indemnitor and indemnitee. The construction industry relies on indemnification clauses to manage and transfer risk. Consider some of the common indemnification provisions that may be encountered in construction contracts.
- Insured Contract Clauses
The primary indemnity issue that appears in construction contracts relates to indemnity that is intended to trigger insurance coverage under the insured contract coverage part. This is found in Article III, sec. 3.18 of the A201, and states as follows:
§ 3.18.1 To the fullest extent permitted by law, the Contractor shall indemnify, defend, and hold harmless the Owner, Architect, Architect’s consultants, and agents and employees of any of them from and against claims, damages, losses, and expenses, including but not limited to attorneys’ fees, arising out of or resulting from performance of the Work, provided that such claim, damage, loss or expense is attributable to bodily injury, sickness, disease or death, or to injury to or destruction of tangible property (other than the Work itself), but only to the extent caused by the negligent acts or omissions of the Contractor, a Subcontractor, anyone directly or indirectly employed by them, or anyone for whose acts they may be liable, regardless of whether or not such claim, damage, loss, or expense is caused in part by a party indemnified hereunder. Such obligation shall not be construed to negate, abridge, or reduce other rights or obligations of indemnity that would otherwise exist as to a party or person described in this Section 3.18.
Here the contractor (indemnitor) has a duty to indemnify the owner and others (indemnitees) from the financial impacts of negligent acts in performing the work which causes personal injuries or property damage to third parties. Some issues can make this clause a point of contention when negotiating contract terms:
- Misunderstanding the purpose of this language.
Perhaps the most common reason for an indemnification clause to be a point of contention during negotiations is that one or both of the parties do not understand the purpose and effect of this language. In that sense, parties sometimes view these clauses as an attempt to unfairly shift risk from the owner to the contractor. That position is misguided.
The contractor already has a duty to indemnify the owner for the contractor’s negligence. This duty exists at common law. This means that the indemnification duty provided by this clause exists whether or not this clause is included in the contract. So, then, why does it need to be in the contract? The answer is simple.
Including this language allows for more efficient and definitive insurance coverage under the insured contract coverage part of the contractor’s commercial general liability insurance. This is part of the risk transfer scheme discussed in more detail in the earlier article Effective Risk Transfer: Key Construction Terms. The point there is that this clause is intended to transfer risk to a third-party insurer. The point here is that including this clause in the contract improves how that works. Let me explain.
Commercial general liability policies afford coverage for “those sums that the insured becomes legally obligated to pay as damages because of ‘bodily injury’ or ‘property damage’ to which this insurance applies.” Exclusion (2)(b) clarifies that “[t]his insurance does not apply to: ‘Bodily injury’ or ‘property damage’ for which the insured is obligated to pay damages by reason of the assumption of liability in a contract or agreement.” Two exceptions follow, which provide that Exclusion (2)(b) “does not apply to liability for damages: (1) that the insured would have in the absence of the contract or agreement; or (2) [a]ssumed in a contract or agreement that is an ‘insured contract’.” When read together, this language confirms that the losses that are the subject of the indemnity provision above will be covered by the commercial general liability policy.
- Indemnification of Purely Economic Losses.
These indemnification clauses can become a source of disagreement during contract negotiation when one party seeks to broaden the scope of indemnification beyond what would be covered by the insured contract coverage part of a commercial general liability policy. This frequently occurs when a party wants this indemnity clause to apply to losses resulting from a breach of contract that results in economic losses not related to personal injury or property damage to third parties. However, commercial general liability policies will not cover purely economic losses for breach of contract. Whether an indemnification provision should be broader than the related coverage is arguable. However, the purpose of these clauses is to clear the path for insurance coverage under the insured contract coverage part.
- Allocation of Fault.
Sometimes disputes arise during contract negotiations about whether the magnitude of the indemnification duty should mirror the amount of the indemnitor’s fault in causing a particular loss. This is frequently framed in the context of fairness in that the indemnitor feels that their duty should not exceed the amount of their fault. There is a common-sense appeal to that argument. In reality, this concern is somewhat misguided because all of indemnification exposure is transferred from the indemnitor to its insurance carrier. This means that the more significant risk is that the policy limits be exhausted. That is an issue best managed as part of a comprehensive insurance program.
- Misunderstanding the purpose of this language.
- Payment Indemnification
Article IX, Sec. 9.6.8 of the A201 provides another example of a common indemnification clause. There, the contractor is obligated to indemnify the owner for claims based on payment disagreements between the contractor and its subcontractors or suppliers:
§ 9.6.8 Provided the Owner has fulfilled its payment obligations under the Contract Documents, the Contractor shall defend and indemnify the Owner from all loss, liability, damage or expense, including reasonable attorney’s fees and litigation expenses, arising out of any lien claim or other claim for payment by any Subcontractor or supplier of any tier. Upon receipt of notice of a lien claim or other claim for payment, the Owner shall notify the Contractor. If approved by the applicable court, when required, the Contractor may substitute a surety bond for the property against which the lien or other claim for payment has been asserted. [Emphasis added].
Parties do not frequently disagree with these clauses. In fact, they simply mirror what the owner’s expectations would be. Namely, not having to pay twice for the same work and not having to bear the financial risk of the contractor’s business dealings with its subcontractors and suppliers. Another reason for including this language is that this requirement aligns with common statutory schemes relating to the use of project payments. Examples include: statutory trust, prompt payment, and contractor indemnification statutes.
- Indemnification for Breach of Contract.
Although not typically found in standardized construction contracts, it is common to have one party request another indemnify them from their breaches of contract or for pure economic losses, such as liquidated damages, that the indemnitee incurs relating to the indemnitor’s work. The following is an example mark-up of the clause set out in Article III, Sec. 3.18 of the A201, which illustrates the modifications needed to expand the indemnity obligation to include breach of contract:
§ 3.18.1 To the fullest extent permitted by law, the Contractor shall indemnify, defend, and hold harmless the Owner, Architect, Architect’s consultants, and agents and employees of any of them from and against claims, damages, losses, and expenses, including but not limited to attorneys’ fees, arising out of or resulting from performance of the Work or a breach of this Agreement, provided that such claim, damage, loss or expense is attributable to bodily injury, sickness, disease or death, or to injury to or destruction of tangible property (other than the Work itself), but only to the extent caused by the negligent acts or omissions of the Contractor, a Subcontractor, anyone directly or indirectly employed by them, or anyone for whose acts they may be liable, regardless of whether or not such claim, damage, loss, or expense is caused in part by a party indemnified hereunder. Such obligation shall not be construed to negate, abridge, or reduce other rights or obligations of indemnity that would otherwise exist as to a party or person described in this Section 3.18. [Added and deleted language].
Adding “or a breach of this Agreement” and deleting the qualifier relating to personal injury and property damages changes the scope of indemnity. Arguments exist for and against making this modification. However, it is important to note that this language expands the scope of indemnity beyond the coverage afforded under a commercial general liability policy.