Please Pass the Risk

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July 12, 2016
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July 12, 2016

Please Pass the Risk

Brian McMath

Indemnification Clauses in Construction Contracts and Why They Matter

By: Brian E. McMath

I. Introduction
Indemnity, at its most basic, is a method of transferring risk from one party to another. The indemnifying party (“Indemnitor”) agrees to shoulder the risk on behalf of the indemnified party (“Indemnitee”) per an indemnity clause. Generally, indemnification comes in three forms: broad form, intermediate form, and limited form.

a. Broad Form Indemnification
Broad form indemnity attempts to saddle the Indemnitor with an almost limitless array of liability, and as a consequence, is often the most problematic sort of indemnity. Broad form indemnity clauses will use language like “any and all liability” that might possibly arise out of the Indemnitor’s services, including liability arising from the Indemnitee’s negligence. Several states (including New Mexico) have outlawed such broad form indemnity in construction contracts, as will be discussed in more detail in Section II.

b. Intermediate Form Indemnification
Intermediate indemnification usually requires the Indemnitor to take on all liability that the Indemnitor contributed to in any way. This means that even if the Indemnitor and Indemnitee are equally at fault, the Indemnitor still assumes all the liability. Intermediate form clauses will typically use language like “[Indemnitor] agrees to indemnify [Indemnitee] from all liability arising out of [Indemnitor]’s performance except for the sole negligence or willful misconduct of [Indemnitee].” Typically, these types of indemnification clauses work to the extreme detriment of the Indemnitor because the Indemnitor must be completely faultless in order to avoid liability. For example, if Indemnitor was 1% at fault and Indemnitee were 99% at fault, Indemnitor would still be 100% liable under this type of clause. Luckily, several states (once again including New Mexico) have forbidden this practice in construction contracts.

c. Limited Form Indemnification
Limited form indemnification essentially mirrors New Mexico’s comparative fault standard: A party pays for the party’s own percentage of fault. If Indemnitor is 30% at fault, Indemnitor will pay 30% of the damages, and so on. Limited form indemnification simply ensures that the Indemnitor will indemnify the Indemnitee for the Indemnitor’s own negligence.

d. Why This is Important
Knowing exactly what risk you have agreed to take on is important for two reasons: First, it will determine whether the indemnity provision of the contract is legally enforceable under applicable state law. Second, it will determine whether the risk you have agreed to take on is insurable. If your insurance company has agreed to insure your company against your own negligence, that coverage does not necessarily extend to the negligent acts of a party you have agreed separately to indemnify. Your insurance carrier may not agree to insure the negligent acts of the Indemnitee, meaning that broad form and intermediate form indemnity clauses may expose you to uninsurable risks.

II. Overview of Relevant Law
Knowing the law in the jurisdiction where you are doing business is paramount, as this area of law is often different depending on which state you happen to be in. The following is a current snapshot of the relevant law in New Mexico and surrounding states.

a. New Mexico statutes and cases
Known as the Construction Anti-Indemnification Statute, NMSA 1978 Section 56-7-1 defines as unenforceable any provision of a construction contract that requires Party A to indemnify, hold harmless, insure, or defend Party B for bodily injury or damage to property arising from Party B’s own negligence, acts, or omissions. Under the statute, the Indemnitor need only indemnify the Indemnitee for the Indemnitor’s own negligence, acts, or omissions. Essentially, parties to a construction contract may not “contract away” liability for their own negligence, acts, or omissions.
While the statute does not forbid a party from requiring that another party obtain project-specific insurance, the statute does prohibit any contract clause requiring the Indemnitor to list the Indemnitee as an additional insured on the Indemnitor’s insurance policy for the purpose of saddling the Indemnitor with liability for the Indemnitee’s own negligence, acts, or omissions. In other words, an Indemnitee cannot short-circuit the statute by requiring the Indemnitor to insure it against liability arising out of its own negligence, acts, or omissions.

While the statute broadly defines the term “construction contract” as an agreement “relating to construction, alteration, repair or maintenance of any real property in New Mexico,” the statute is not without limits. For example, the statute “does not apply to indemnity of a surety by a principal on any surety bond or to an insurer’s obligation to its insureds.” The statute also does not prohibit contractual caps on a party’s liability for its own actions or omissions. In Fort Knox Self Storage, Inc. v. Western Technologies, Inc., an engineering firm sought to cap its liability for its own acts and omissions at $50,000 via a clause in the contract with the owner. The owner sued the firm for $350,000. The New Mexico Court of Appeals held that as long as such caps on liability are “reasonable and not so drastic as to remove the incentive to perform with due care,” such caps on liability were enforceable even though they might result in a negligent party being partially indemnified for its own negligence.

In February 2016, the New Mexico Supreme Court issued an opinion in Safeway, Inc. v. Rooter 2000 Plumbing and Drain SSS which analyzed the enforceability of a contractual indemnity provision under the 1971 version of Section 56-7-1. In Safeway, the Supreme Court found that even though a contractor’s duty to indemnify an owner is separate and apart from the contractor’s duty to insure and defend the owner, a contractor could not be required to insure and defend an owner for liability arising from the owner’s own negligence. In 2003, the statute was expanded to prohibit contractual provisions that require one party to “indemnify, hold harmless, insure or defend” another party against liability for the other party’s negligence, acts, or omissions. Essentially, the current form of the statute reflects the Safeway court’s reading of the older version of the statute, arguably rendering the 2003 amendment as superfluous.

b. Surrounding areas

i. Texas, Colorado, and Utah
These states each have their own analogue to New Mexico’s construction anti-indemnification statute. There are differences between the language of each, however, and it is always a good idea to have a contract reviewed by an attorney licensed in the jurisdiction whose laws will control any disputes.

ii. Oklahoma
Oklahoma law contains no statutory prohibitions against construction contracts that “contract away” a party’s liability. In fact, an Indemnitee is allowed to saddle an Indemnitor with liability arising from the Indemnitee’s own negligence as long as “the contract makes it unequivocally clear that that is what the parties intended.”

iii. Arizona
Arizona’s construction indemnity statute, published as A.R.S. § 32-1159 (1993), essentially allows intermediate form indemnification in construction contracts. Arizona’s statute prohibits only contract provisions that seek to saddle an Indemnitor with liability “resulting from the sole negligence” of the Indemnitee, meaning that if an Indemnitor contributed in any way, the Indemnitor can contractually be held liable for the entire loss.

c. AIA Model Language
The American Institute of Architects (“AIA”) has created very useful contract templates that are widely used in the construction industry. The AIA’s model indemnity clause reads as follows:

The Architect shall indemnify and hold the Owner . . . harmless from and against damages . . . to the extent they are caused by the negligent acts or omissions of the Architect . . . . The Architect’s duty to indemnify the Owner under this provision shall be limited to the available proceeds of insurance coverage.

Essentially, the AIA model language requires the architect to indemnify the owner for the architect’s own negligence, acts, or omissions; a classic limited form indemnification agreement. However, the AIA language also places a cap on the architect’s liability as “the available proceeds of insurance coverage.” In New Mexico, such a cap on liability is only enforceable if it is “reasonable and not so drastic as to remove the incentive to perform with due care” per Fort Knox Self Storage. Therefore, the amount of insurance proceeds will likely determine whether or not the liability cap is enforceable. For example, if the “available proceeds” are zero, this type of cap on liability might be unenforceable because it is not reasonable under the circumstances. If you use the AIA template or something similar, you should be aware of the insurance proceeds and whether or not such an amount would be considered reasonable under the circumstances.

III. Conclusion
Indemnity is a good thing, and it ensures that parties to a construction contract can apportion out risk in a number of different ways. However, indemnity clauses that are contrary to state statutes are often unenforceable and can result in major (and often uninsurable) liability. It is usually worth the investment to have a legal professional review a contract prior to execution in order to alleviate some of these issues.