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    Managing RISK in Your Contracts

    Sept. 1, 2007
    They say risk is unavoidable in life, and thats probably true. However, risk is not necessarily unavoidable when it comes to the contracts you enter into.

    They say risk is unavoidable in life, and that’s probably true. However, risk is not necessarily unavoidable when it comes to the contracts you enter into.

    Risk allocation in the construction industry is established through the construction contract. Accordingly, when drafting their standard agreements with subcontractors, general contractors frequently incorporate multiple provisions that have the effect of transferring liability to the subcontractors.

    The logic expressed by the general contractors is that risk should be allocated to the party that is in the best position to manage it. In reality, it frequently happens that the party with the strongest bargaining position gets to allocate the risk in a contract.

    Let’s take a look at some of the most common mechanisms general contractors will employ in this risk allocation process:

    • Indemnification clauses
    • Additional insured requirements
    • No damage for delay clauses
    • Pay-if/when-paid clauses.

    Indemnification Clauses
    One of the most common risk allocation devices utilized by “upstream” parties in the construction contract is the indemnification/hold harmless agreement. Indemnification may be simply described as the obligation of one party (the indemnitor) to reimburse a second party (the indemnitee) for the losses that second party incurs, or the damages for which it may be held liable.

    In the construction context, indemnification clauses are used to shift risk from upstream parties to subcontractors. Through contractual provisions the subcontractor is often required to indemnify not only the general contractor and the owner, but also the architect and the engineers.

    Indemnification clauses are used to transfer liability for damages and/or judgments, transfer the duty to defend, and transfer or allocate the duty to insure. The indemnification clause is usually found in its own section of the contract.

    Today, most states designate, by statute or judicial ruling, the types of liability that can be transferred contractually and the type of language required for such transfers to be enforceable.

    The modern indemnification provisions can be grouped into three different categories: broad form, intermediate form, and limited form.

    1) Broad form indemnification clauses.
    The broad form (also called no fault) indemnification clause requires the subcontractor to assume any and all liability for the project regardless of fault, even if the liability arises from the sole negligence of another. Since this type of clause shifts the entire risk of loss, the subcontractor who agrees to this provision absorbs massive amounts of liability for the project. Today, most states either prohibit broad form indemnification clauses by statute, or simply refuse to judicially enforce these agreements.

    2) Intermediate form indemnification clauses.
    With this type of clause, the subcontractor is required to assume all liability for the project except that which is due to the sole negligence/fault of the indemnitee. Under the intermediate form, the subcontractor will have to indemnify from all liability and damages, so long as it does not arise from the sole fault of the general contractor, the owner, or anyone else the subcontractor has agreed to indemnify.

    This type of indemnity imposes on the subcontractor liability for its sole negligence, as well as for the joint negligence of itself and the indemnitee, without regard to the indemnitee’s proportion of fault. Therefore, a subcontractor can find itself responsible for all liability resulting from an accident in which the general contractor was 99% at fault. This type of indemnification poses the same problem that broad form indemnification creates; having a subcontractor with a relatively low financial net worth taking on the financial risks of the large general contractor and owner.

    Even though this intermediate form does not allow for zero fault indemnification, it offers only a modicum of protection more than the broad form and should be avoided if possible by a subcontractor.

    Today, several states ban these types of clauses in at least some contexts. However, 18 states ban only broad form clauses.

    3) Limited form indemnification clauses.
    Limited form indemnification clauses are the least stringent on the subcontractor. Limited form indemnification is the basic concept of comparative fault. Under this form, the subcontractor assumes liability only to the extent of its own negligence or fault.

    This form of indemnity is simply a restatement of the common law principle that an entity should be held liable for only those circumstances over which it exercises control. In order to control risk and limit potential liability, all subcontractors should try to ensure that any contract entered into contains only a limited form indemnification agreement.

    Additional Insured Requirements
    Additional insured requirements are often used to reinforce indemnification agreements, and in some cases to circumvent anti-indemnity statutes.

    Construction contracts typically require all general contractors and subcontractors to carry a certain amount of liability insurance to pay any defense costs, settlements, or judgments arising out of claims related to that contractor’s work. The named insured is the person or business to which the commercial general liability policy is issued, and also is the one who pays the premiums and deductibles, has the power to cancel the policy, and receives any notice of cancellation.

    With the rise of anti-indemnity statutes, it has become a common risk management technique in the construction industry for the general contractor to require the subcontractor to grant both the general contractor and the owner additional insured status on the subcontractor’s commercial general liability (CGL) policy.

    The effect of the additional insured status is similar to the effect achieved by an indemnification agreement. Essentially, the general contractor obtains a direct contractual relationship with the subcontractor’s insurance carrier, but is under no obligation to pay either the policy premium or deductibles.

    There are several reasons general contractors require subcontractors to grant them additional insured status.

    General contractors require subcontractors to name the GC as additional insured in order to protect the GC’s own insurance policies. A general contractor would generally prefer not to use its own insurance to defend a claim, when another option is available.

    Many jurisdictions have held that by tendering its defense to the subcontractor’s insurer, the general contractor keeps its own insurance company out of the suit. If the general contractor uses the subcontractor’s carrier for defense and does not seek indemnification from its own insurer, the subcontractor’s carrier cannot sue the general contractor’s insurer for reimbursement of any money paid out on the general contractor’s behalf. Therefore, the general contractor’s premiums will not increase and no deductibles will need to be paid.

    Furthermore, a carrier has no right of subrogation against an insured. Thus, additional insured status prevents the subcontractor’s insurer from bringing suit against the general contractor for damages, even if the general contractor caused the loss.

    Additional insured status can also be used to circumvent anti-indemnity statutes, since many antiindemnity statues make exceptions for insurance contracts. Using additional insured status, a general contractor can shift the burden of liability to the subcontractor just as in broad form or intermediate form indemnification; yet not have the provision be declared void as against public policy. In addition to the requirement that the subcontractor include the owner and contractor as additional insured on its CGL policy, there will likely also be a provision containing a waiver of subrogation. This is a contractual term that waives a subcontractor’s rights of subrogation for loss payments and expenses made by the subcontractor or covered by the subcontractor’s general liability insurance.

    No Damage for Delay Clauses
    Construction owners are increasingly placing “no damage for delay” clauses in their contracts, and general contractors are in turn including similar terms in their subcontracts. These clauses provide that the contractor will be entitled to an extension of time for delays, but no additional compensation to the subcontractor is required.

    The no damage for delay clause is utilized to protect the owner and general contractor from liability for unanticipated additional costs associated with delay to, disruption of, or interference with the subcontractor’s work. Many construction delays result from the acts and omissions of the owners, its design professionals, or the general contractor. These delays result in higher overhead and construction costs which impose a significant financial burden upon subcontractors.

    The treatment of no damage for delay clauses is varied among the states. Some states have declared that for both private and public contracts clauses which disallow remedy for delay caused by the owner or contractor are void as being against public policy. Other states have declared that no damage for delay clauses are only void when incorporated into a public contract. Some jurisdictions have allowed these clauses to be enforced in both public and private contracts, but there are numerous exceptions to that enforcement. And yet other states enforce no damage for delay clauses as written, but strictly construe them against those seeking their benefit.

    Be aware of the local law, and review the construction contract to make sure that it does not require you to waive your rights to remedies for costs associated with delays in construction caused by the general contractor or owner.

    Pay If/When Paid Clauses
    Time of payment clauses are generally considered either pay-if-paid or pay-when-paid. In the majority of jurisdictions, these clauses will generally be construed as pay-when-paid clauses and therefore serve only to determine the time of payment. A pay-when-paid clause is the standard provision and will be found in most construction contracts. However, pay-if-paid or contingent payment provisions have become increasingly popular with general contractors, so you should carefully scrutinize all payment provisions.

    A pay-if-paid clause actually shifts the risk of owner insolvency from the general contractor onto the subcontractor. A true pay-if-paid clause places a subcontractor in the position of working on a contingency basis, where the subcontractor only gets paid for the work performed if the owner makes payment.

    These types of clauses place a subcontractor at risk for nonpayment by the owner for reasons created by the general contractor and/or other subcontractors.

    Therefore, you should be ever vigilant as to the specific wording of the payment provisions of contracts, so as to ensure that they have not without knowing absorbed the risk of owner insolvency.

    Risks may indeed be an unavoidable part of life, but when it comes to the contracts your company signs, there are ways to minimize them. Read contracts carefully, and know your state’s laws. If in doubt, get matters clarified in writing.Be on your toes, and do your homework upfront, because after a contract is signed isn’t the time to realize it has unfavorable provisions.

    Philip A. Franco has more than 25 years experience with the law firm of Adams and Reese LLP, New Orleans, LA, as one of the firm’s most experienced commercial trial lawyers. He can be reached at 504/585-0291, or philip. [email protected]

    This article is based on the presentation Managing Risk With Contracts, that Philip Franco gave at the 2006 Commercial Contracting Roundtable, held in Atlanta, Oct. 25-26, 2006. The Commercial Contracting Roundtable, which also incorporates the Design/Build Seminar, is co-sponsored by the Air Conditioning Contractors of America (ACCA) and Contracting Business magazine. The 2007 Commercial Contracting Roundtable, to be held Oct. 24-25 in Baltimore, MD, will feature 15 business management and technical sessions specifically tailored for commercial HVAC and Design/Build contractors, For more information about the 2007 Commercial Contracting Roundtable, contact Richard Ware at ACCA, 703/824-8843, or visit www.contractingroundtable.com.