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Construction Law Alert: New Laws Will Limit the Enforceability of Defense and Indemnity Provisions and Create New Tender Requirements for Commercial Construction Projects Beginning in January 2013.

By: Christopher M. Cotter

Christopher's practice includes representing and advising both general contractors and subcontractors.
The advent of a new year triggers the applicability of new commercial construction laws in California. All commercial construction contracts entered into on or after January 1, 2013 will now be governed by newly created California Civil Code § 2782.05. The new law is the product of Senate Bill 474, which was signed into law by Governor Brown on October 9, 2011.

Cal. Civ. Code § 2782.05 administers a number of sweeping changes to the commercial construction landscape that every principal, contractor and insurer needs to be aware of. The most notable developments are: (1) "Type I" defense and indemnity obligations in commercial construction contracts are now void and unenforceable (as are, arguably, additional insured endorsements providing "Type I" coverage); and (2) any tender of defense from a general to a subcontractor now requires an "up front" allocation of fees and costs.

Say Goodbye to Type I Indemnity

Cal. Civ. Code § 2782.05 states that any provision in a commercial construction contract wherein a downstream subcontractor purports to insure or indemnify an upstream contractor is void and unenforceable to the extent the claims arise out of the "active negligence or willful misconduct" of the upstream contractor. This is a departure from the standard codified in Cal. Civ. Code § 2782(a) allowing for indemnity provisions covering all but the "sole negligence or willful misconduct" of the upstream contractor. It is also important to note that this new law follows Cal. Civ. Code § 2782(d), which previously implemented similar restraints on indemnity clauses in residential construction contracts entered into on or after January 1, 2009. As of the beginning of this year, all such "Type I" indemnity provisions in both residential and commercial construction contracts are void and unenforceable.

Active v. Passive Negligence

The natural inference is to read the legislature's use of the term "active negligence" as a contrast to "passive negligence." It would appear, then, that the legislature intended to allow for upstream contractors to continue to obtain indemnity from downstream contractors for passive negligence. And if this is indeed the case, we will have an epic battle on our hands in the coming years. In every construction dispute interpreting a post-2013 indemnity clause, general contractors will try to classify their negligence as "passive" while subcontractors will try to classify that negligence as "active." Each has a leg to stand on.

Generally speaking, "active" negligence refers to misfeasance, or the proactive violation of a duty, whereas "passive" negligence refers to nonfeasance, or the failure to perform a duty owed. However, the line between active and passive negligence has been blurred in the contractual context, and in particular with regard to construction contracts. Many courts interpret a failure to perform a duty owed by contract as a type of active negligence, rather than mere passive negligence. On the other hand, the duty of a landowner (and by proxy a general contractor) to maintain the land in a safe condition is usually defined as passive negligence. Quantifying risk will be tricky as the courts make these determinations on a case by case basis and only after adjudicating the particular facts at hand.

There is reason to believe, however, that the legislature did not intend for its use of the term "active negligence" to be read in dichotomy with "passive negligence." The Senate Rules Committee notes are instructive

This bill provides that provisions, clauses, covenants, or agreements contained in, collateral to, or affecting a [commercial construction contract] that requires a promisor to indemnify … another person against actual or claimed liability, damage, or expense arising from the negligence, willful misconduct, defective design, violation of law, or other fault of that person … are against public policy and are void and unenforceable.
Senate Rules Committee, Bill Analysis, Third Reading, Page 5, May 24, 2011. The Senate Rules Committee Bill Analysis attributes a broader scope to the reach of the statute than the plain language would suggest. Whatever the legislature's ultimate intention was, however, we are stuck with a statute that leaves the door open to an ongoing war in defining negligence as active or passive. The venue for these disputes will be the courts, and the battles will be costly.

But What About Additional Insured Endorsements?

You may be thinking to yourself: "So what? Many construction contracts require downstream contractors to obtain additional insured endorsements, which provide even greater coverage than Type I indemnity clauses." Not anymore they don't.

Cal. Civ. Code § 2782.05 explicitly applies to agreements "contained in, collateral to, or affecting any construction contract … that purport to insure or indemnify." The inclusion of the term "insure" was no accident. However, it must be noted that this code section only discusses agreements "contained in, collateral to, or affecting any construction contract." Is an additional insured endorsement "collateral to or affecting" a construction contract? A review of the Senate Rules Committee notes provides important insight:

This bill provides that a provision in a contract that requires the purchase of additional insured coverage, or any coverage endorsement or provision within an insurance policy providing additional insured coverage, primary or noncontributing coverage or waivers, is void and unenforceable to the extent that it requires or provides coverage the scope of which is prohibited under this bill for an agreement to indemnify, hold harmless, or defend.
Senate Rules Committee, Bill Analysis, Third Reading, Page 5, May 24, 2011. It would appear that the legislature intended for Cal. Civ. Code § 2782.05 to limit not only the scope of indemnity provisions contained within commercial construction contracts themselves, but the scope of additional insured endorsements collateral to commercial construction projects as well.

Further support for this reading of the statute can be found in Cal. Civ. Code § 2782.05(b)(6). This subsection states that Cal. Civ. Code § 2782.05 specifically does not apply to a "provision in a construction contract that requires the promisor to purchase or maintain insurance covering the acts or omissions of the promisor, including additional insurance endorsements covering the acts or omissions of the promisor during ongoing and completed operations." At first blush this would seem to actually provide for the continued inclusion of obligations that downstream contractors obtain additional insured endorsements. However, it must be noted that while this clause reserves the right to enforce such obligations, those obligations are limited to coverage regarding "the acts or omissions of the promisor" (i.e. the downstream contractor). Any provision requiring the promisor to obtain insurance which covers the acts or omissions of the promisee (i.e. the upstream contractor) is unenforceable.

The end result is that commercial construction contracts can still require downstream contractors to obtain additional insurance endorsements which cover their upstream contractors. However, those provisions are only enforceable so long as they do not obligate the downstream contractor to obtain AI coverage beyond the downstream contractor's own negligence.

Update Your Tender Procedure or Risk Faulty Tenders

Under subdivision (e) of Cal. Civ. Code § 2782.05, regular old tender demands will not cut it anymore. More precisely, subdivision (e) states that a "subcontractor shall owe no defense or indemnity obligation to a general contractor or construction manager for a claim unless and until the general contractor or construction manager provides a written tender of the claim … that includes the information provided by the claimant or claimants relating to claims caused by that subcontractor's scope of work. In addition, the general contractor or construction manager shall provide a written statement regarding how the reasonable allocated share of fees and costs was determined."

The mandate for upstream contractors to provide a written allocation of fees and costs amongst the various downstream contractors is not new, but its timing is. General contractors were not previously expected to allocate such fees and costs until they sought payment from the subcontractors at the back-end of the litigation process. As a practical matter they often made no such allocations at all. Now, general contractors are required to make an up-front allocation during tender. The statute is unclear as to what remedy a subcontractor will have against an improper tender under Cal. Civ. Code § 2782.05(e). What is clear is that improperly tendered claims will lead to costly litigation aggressive subcontractors attempt to avoid the improper tenders altogether.

Modified Defense Obligations

Another change every player in the construction industry should be aware of is the modified defense framework outlined in Cal. Civ. Code § 2782.05(e)(1) & (2). Without getting into too much detail here, these subdivisions outline the requirements that a downstream contractor must follow in order to satisfy their defense duties once triggered by a proper tender of defense. Suffice it to say that if you or your insured have received a tender you should seek counsel immediately. For the purposes of this article, however, I would like to point out some interesting nuances that everyone should know.

Under Cal. Civ. Code § 2782.05(e)(1) the subcontractor owes the general contractor a complete defense of claims, but only to the extent that they are alleged to be caused by the subcontractor and specifically not including claims resulting from the scope of work of the general contractor. This defense duty is arguably much narrower than the defense duty that is owed by an insurer to an insured. After all, in the insurance context, a complete defense of both covered and uncovered claims is owed to the insured even if only one of the underlying claims potentially triggers coverage (a so-called "mixed" action). Buss v. Superior Court (1997) 16 Cal.4th 35, 48-49.

Practically speaking, this means that while Cal. Civ. Code § 2782.05 has limited the impact of additional insured endorsements dramatically in the indemnity context, it has not necessarily done the same in the defense context. After all, Cal. Civ. Code § 2782.05(e) discusses only defense obligations as between a subcontractor and a general contractor – it makes no mention of an insurer's defense obligations. In light of Buss and its progeny, it will be difficult for an insurer to argue that it owes only a limited defense of a properly tendered claim by an insured. Anyone that has dealt with a construction defect claim knows that the costs of defense often trump the ultimate cost of indemnity, especially for a "small player" subcontractor, and particularly when an additional insured endorsement is in play. Shifting of defense costs per an additional insured endorsement may therefore serve as the last vestige of cost-shifting in the construction context.

What Does This Mean for My Business?

General Contractors

The first thing you need to do is make sure that your construction contracts are valid and up to date. If you have not had your contracts recently reviewed by an attorney, you should do so immediately. You will also need to be prepared to work closely with your attorneys in the early stages of a dispute to ensure that you are adhering to your obligations, delivering proper tenders, and recouping maximum compensation from your subcontractors. Obtaining additional insured endorsements from your subcontractors will now, more than ever, be critical to ensuring that you are transferring as much risk as legally possible and minimizing your costs of doing business. You should therefore consult an attorney to ensure that your additional insurance obligations conform with these new laws as well.

Subcontractors

If you hire sub-subcontractors to perform a portion of your work, you need to immediately consult with an attorney to make sure that those subcontracts are valid and up to date. Additionally, you should work closely with your insurance company going forward to ensure that you understand the consequences and potential costs of additional insured endorsements, and that you are being properly compensated for obtaining them.

Architects and Design Professionals

Design professionals are specifically excluded from Cal. Civ. Code § 2782.05 and remain free to negotiate broad defense and indemnity clauses. In light of the California Supreme Court's recent holding in Beacon Residential Community v. Skidmore, Owings, and Merrill LP, design professionals now need to be more mindful of their potential liability than ever before. If you have not recently reviewed your design contracts and indemnity clauses, now is the time to do so.

Insurers and Insurance Adjusters

The two most important takeaways are to: (1) make sure you are properly tendering claims in compliance with the new construction laws; and (2) understand the importance of additional insured endorsements and how they can impact tender issues and defense costs in your cases. You should be able to discuss these issues with your defense counsel directly as claims arise, but it may be worthwhile to take the initiative and tackle these issues early.

Conclusion

The New Year brings about yet another makeover to the construction industry's defense and indemnity guidelines. It is crucial to be familiar with these complex new developments and prepared to handle the legal fallout that will inevitably arise. Whether you are an owner, general contractor, subcontractor, design professional or insurer, it is critical to contact your attorney to make sure that your construction contracts, insurance contracts and tender correspondence are up to date and in compliance with recent developments in the law.

Please contact the author of this alert or any of the attorneys in Snyder Law's Construction Law Practice Group should you desire counsel regarding these or any other construction-related issues. The attorneys at Snyder Law LLP have the experience and insight required to tackle your most pressing legal needs.