Managing Risks: Indemnity and Defense Obligations

By Joseph Dirik

An important purpose of contract negotiations is to assign or shift risks between parties. We recently discussed the Texas Legislature's attempt last session to address an important risk-shifting technique - contingent pay or pay-if-paid clauses. This session, the Legislature has turned its attention to construction contracts again.

In January Rep. Joe Deshotel, D-Beaumont, introduced House Bill 490, a far-reaching bill proposing to restrict construction contracting parties' ability to shift risks using indemnification and defense provisions for contracts entered into after the effective date of the bill. The bill would not apply to construction contracts entered into by municipalities, counties or school districts.

Indemnity, or "hold harmless," agreements are often negotiated between owners and contractors and between contractors and subcontractors. Such agreements protect one person (the "indemnitee") against certain losses by having someone else (the "indemnitor") assume those risks. The indemnifying party's liability depends on the agreement because under Texas law, indemnity is a matter of contract and is governed by what you agreed to, not by what you did. Defense and indemnity agreements are similar. Instead of protecting against losses, a party may agree to defend another party against certain claims. This obligation often involves providing legal representation to defend against claims.

Indemnity and defense clauses generally address risks of bodily injury and property damage inherent in the construction process. Some provisions protect the person being indemnified from their own negligence, so long as the indemnitor is also at least partially negligent. In many cases, however, the indemnitor finds they are responsible for more than expected and may include losses that were not their "fault." This happens if the parties bargain for a hold-harmless agreement that protects the indemnitee from varying degrees of liability, including sole negligence, joint or concurrent negligence or strict liability.

Texas law currently applies the "express negligence rule" to indemnity provisions involving the indemnitee's sole or partial negligence. The rule requires that such indemnification provisions be set forth conspicuously in the contract so as to provide the parties with fair notice. If the parties' intent is clear, these provisions are valid and enforceable, absent a violation of public policy. The parties may also negotiate the types of losses, damages and liabilities that are covered including not only bodily injury or death and property damage, but also breach of warranty, breach of contract, patent, trademark or copyright infringements, willful misconduct and criminal behavior.

Another method of shifting risks involves contracts and subcontracts containing provisions that require the owner or contractor be named as an additional insured under the contractor or subcontractor's general liability policy. Coverage, of course, depends on the terms of the agreement and the language of the policy's endorsement. Texas law permits owners and contractors to obtain additional insured status on their contractors' and subcontractors' general liability policies to cover for loss or liability caused by the owner or contractors' sole or concurrent negligence, including strict liability. As a result, the insurance company that issued the policy for the named insured becomes responsible for the additional insured's actions.

An example of risk-shifting using insurance policies is highlighted in McCarthy Bros. Co. v Continental Lloyds Ins. Co., a case involving a standard additional insured endorsement. A subcontractor's employee was injured in a fall at a construction site. The injured employee sued the general contractor for negligently allowing a dangerous condition to exist. The general contractor asked its subcontractor's insurer, Continental Lloyd's, to provide its defense as an additional insured on the sub's general liability policy. But Lloyd's refused to defend because the suit sought damages for the general contractor's own negligence and because the suit did not allege that the subcontractor (the named insured) was negligent. The court agreed with the general contractor's argument that because the plaintiff was injured while in the course and scope of his employment with the named insured, the general contractor's liability "arose out of" the named insured's work. This brought the claim within the policy language. And the court held that the general contractor was covered by the policy as an additional insured even though the claim was based on the general contractor's negligence.

Under Deshotel's bill, contract provisions in contracts and subcontracts providing the indemnitee with protection in the form of defense or indemnity against loss or liability caused by the sole or concurrent negligence, including strict liability, of the indemnitee would be void and unenforceable under Texas law. The restriction would also apply to contract provisions requiring an insurance policy that would "frustrate the prohibitions" of the law. Furthermore, under the introduced version of the bill, parties could not waive these restrictions by contract.

If the bill passes, an important risk-shifting tool will be removed from the toolboxes of construction contracting parties.