California Senate Bill 474: A Step Back From The Precipice Of “Strict Liability” In Commercial Construction Contracts

Introduction

California Senate Bill 474 (SB 474) was signed into law by Governor Brown on October 9, 2011.

SB 474 provides that provisions in commercial construction contracts entered into on or after January 1, 2013 that require the parties to indemnify or defend an owner for its active fault, or require a subcontractor to defend, indemnify, or insure a general contractor or construction manager for the active fault of others, or to the extent that the claim does not arise out of the subcontractor’s scope of work on the project, are deemed to be against public policy and are null and void.

SB 474 does not quite prohibit all “Type I” indemnity obligations in California construction contracts, nor are the SB 474 amendments clear in all respects as to the respective future rights of the parties. But, with the SB 474 amendments, certainly the classic Type I indemnity obligation in commercial construction in California will be a thing of the past.

Background

To understand the context and import of SB 474, a brief discussion of the history of construction contact law and contractual indemnification in California, and the relevant language and contract terms is appropriate.

Construction contracts commonly contain provisions that attempt to transfer risk in a project from one party to another party or parties to the agreement. Historically, the most common and most onerous contractual risk transfer provisions in construction agreements have been 1) contractual indemnity and 2) insurance requirements for additional insured coverage; specifically, the contractual obligation of one party to name the other as an additional insured on the former’s general liability coverage for both ongoing and completed operations.

The California Legislature has promulgated various statutory provisions relating to indemnity generally and construction contracts in particular. The definition of indemnity and the rules for interpretation of an indemnity agreement are set forth in California Civil Code Sections 2772-2779. The provisions of the Civil Code specific to construction contracts in California are outlined in California Civil Code Sections 2782-2784.5.

Indemnity, generally speaking, is the act of making one party (the indemnitee) whole from liability that was caused by the indemnitor. The “indemnitee” is the party benefiting from the agreement. The “indemnitor” is the party assuming the responsibility, usually the one with the weaker bargaining position, i.e., subcontractor, lessee, tenant, etc. There are typically two distinct obligations associated with contractual indemnity: 1) the duty to pay or reimburse the indemnitee for liability caused by the indemnitor, and 2) the duty to defend a claim or action brought against the indemnitee.

The Obligation to Indemnify

Construction contract law in California law begins with the premise that parties to a construction contract should be free to mutually negotiate the terms of an acceptable construction agreement between them. However, for public policy reasons, the California Legislature has placed limits on this broad right. California Civil Code Section 2782 provides that no construction contract in California, commercial or residential, may require indemnification for 1) an indemnitee’s sole negligence, 2) an indemnitee’s willful misconduct, or 3) the design provided to the indemnitor. To the extent that a construction contract purports to require the indemnitor to undertake any of these three prohibited obligations, it is deemed against public policy and unenforceable.

Indemnity issues usually arise in a construction setting when a bystander or worker is injured, where property damage results from an accident or through defective construction. Typically, project owners first seek to shift the risk to general contractors, who then seek to shift the risk to subcontractors. Oftentimes the contract documents will also provide that the general contractor or subcontractors must indemnify and defend the architect or other design professionals associated with the project.

More modern indemnity provisions require that the indemnitee both defend and reimburse the indemnitor so long as the accident, claim or damage “arises out of or is in any way connected with the work” of the indemnitor, even if the indemnitor is faultless. Stated another way—and utilizing the relationship of general contractor and subcontractor—the general contractor can be 99% actively at fault, alone, or in some combination with the designer or other subcontractors on the project. But, as long as the claim is in some way causally connected with the work of the subcontractor, then the subcontractor may be contractually responsible for the entire claim as well as the general contractor’s attorneys’ fees and costs of defense.

Understandably, courts have historically struggled with the concept of finding indemnification in favor of a primarily or actively negligent indemnitee. In 1972 the court in MacDonald &Kruse v. San Jose Steel (1972) 29 Ca1.App.3d413, analyzed this troubling issue by surveying numerous published indemnification rulings and drafting an elaborate opinion in which it determined that there were three main types of indemnification:

Type I: Indemnitee covered for active and passive negligence of itself and other parties.

Type II: Indemnitee covered for its passive, but not its active negligence.

Type III: Indemnitee covered, except if negligent, actively or passively in any way.

Active negligence is an action that causes damage. In contrast, passive negligence is negligence due to inaction, omission, or the failure to do something that you are legally obligated to do. For example, if a subcontractor is actively negligent in constructing the framing for a building, and the general contractor failed to notice the defect, the subcontractor is actively negligent and the general contractor is passively negligent.

Until 1987, California courts generally interpreted and applied indemnity agreements according to the MacDonald v Kruse formulaic analysis. More recent court decisions have rejected the mechanical application of the MacDonald v Kruse rules and have instead focused on a reasonable interpretation of the contract in light of the circumstances of the injury and the parties’ intent. Morton Thiokol/Morton Salt Division v. Metal Bldg. Alteration Co. (1987) 193 Cal. App. 1025, 1030.

The impact on, for example, a subcontractor of the duty to contractually indemnify an owner or general contractor can be financially ruinous to the subcontractor. California case law is replete with examples where a party to a construction contract was contractually required to compensate or reimburse the other party even though the indemnitor was neither negligent nor at fault. The seminal case in California interpreting “no fault” indemnity provisions is Continental Heller Corp. v. Amtech Mechanical Services, Inc. (1997) 53 Cal.App.4th 500. In Continental Heller, Amtech, as a subcontractor on a project, installed a valve that failed and caused an explosion that injured employees and damaged property. The agreement required Amtech to indemnify the general contractor, Continental, for loss “which [arose] out of or [was] in any way connected” with Amtech’s “acts or omissions” in the performance of its work. Although the court found that Amtech was not at fault for the accident, following the explicit language in the agreement, the court found that Continental nevertheless was entitled to indemnity because Continental’s loss was connected to Amtech’s act of installing the valve, and Continental did not need to establish fault to recover indemnity. The Continental court also remarked on the commercial context of the case as well as issues concerning public policy. Both Amtech and Continental were large, sophisticated firms that had carefully negotiated their indemnity agreement. Thus, the court felt that Amtech had ample opportunity to negotiate the terms of its indemnity obligations. Moreover, Amtech’s subcontract was worth $1.2 million, while it was only required to indemnify Continental for $20,000. The court seems to have relied upon these factors to support its broad interpretation of the indemnity agreement.

Likewise, in Centex Golden Construction Co. v. Dale Tile Co. (2000) 78 Cal.App.4th 992, Centex, the general contractor, sued Dale Tile, the subcontractor, for indemnity based on defective tile work on a commercial building. At trial, the jury found that Dale Tile had not been negligent in its work on the project, but the court ruled in favor of Centex on its indemnity claim. As in Continental Heller, the Court of Appeal agreed that under the agreement, Centex did not need to show fault on the part of Dale Tile to prevail. The indemnity agreement stated that all work performed by Dale Tile “shall be at the risk of SUBCONTRACTOR exclusively.” The court found that this expression by the subcontractor was sufficient to provide indemnity in the absence of fault.

The Obligation to Defend

In addition to the obligation to indemnify, most indemnity clauses also include an express duty to defend the indemnitee. The duty to defend obligates the indemnifying party to pay for all legal costs and expenses (including attorneys’ fees and expert fees) required to defend against the liability in question. The duty to defend can be even more onerous for the indemnitor than the duty to indemnify. It can be particularly troubling to indemnitors when they are being asked to defend a claim for which they believe they share absolutely no responsibility and must pay substantial attorneys’ fees and costs to attorneys whom they did not select and over whom they have no control. Yet, owners and general contractors are increasingly including provisions that obligate the indemnitor to defend claims based on mere allegations within the scope of the indemnity clause. Pursuant to these clauses, the duty to defend is triggered once allegations are made, regardless of whether the indemnitor is ultimately found to be at fault for the potential liability. California courts have approved these clauses and held that the indemnitor is obligated to defend claims for which it was ultimately held blameless. Crawford v. Weather Shield Manufacturing, Inc. (2008) 44 Cal. 4th 541.

The Obligation to Obtain Additional Insured Coverage

Finally, most construction contracts contain provisions obligating one party, for example the subcontractor, to procure an endorsement providing that the other party (the general contractor or owner) will be a named additional insured on the subcontractor’s general liability insurance. The required coverages usually include both ongoing and completed operations (coverage during the project and after completion of the project). The legal effect is that the general contractor stands in the shoes of the subcontractor for insurance purposes and has the same or similar rights against the subcontractor’s insurer as would the subcontractor. The practical effect, particularly in bodily injury claims, is that the subcontractor’s insurer is called upon to defend and indemnify the general contractor even though neither the subcontractor nor its injured employee may have been at fault for the accident—-the insurance is triggered because, by definition, the claim arises from the scope of work of the subcontractor since it is that subcontractor’s worker who has brought the claim. And, to add insult to injury, the subcontractor may then be billed by its insurer for a deductible or self-insured retention amount incurred by the insurer in defending and indemnifying the general contractor.

Previous Legislative Changes Impacting Construction Contracts

To ameliorate the harsh impact these indemnity and insuring obligations on general contractors and subcontractors, the California Legislature amended statutory law relating to construction contracts three times between 2005 and 2010. The amendments were:

• AB 758, passed in 2005. AB 758 amended Civil Code Section 2782, prohibiting the enforcement of “Type I” indemnity agreements in residential construction contracts entered into after January 1, 2006, in construction defect claims only. Subcontractors can no longer be required to either defend or indemnify a “builder” to the extent that the claim arises out of the conduct of parties other than that subcontractor. Importantly, the amendment was limited to residential construction defect claims. Owners and contractors were free to continue to use Type I indemnity agreements in commercial construction projects. And, Type I indemnity rights remained preserved with respect to other claims such as bodily injury, general liability, construction delays, etc. Notably, only a “builder” i.e., developer, was prohibited from enforcing Type I indemnity agreements by this amendment, leaving general contractors and straw-man builders free to continue using Type I indemnity provisions.

• SB 138, passed in 2007. SB 138, effective January 1, 2008, again amended Civil Code Section 2782 to close the major loopholes left by AB 758. Specifically, SB 138 prevented general contractors (not just builders/developers) from enforcing Type I indemnity agreements in residential construction defect claims.

• AB 2738, passed in 2008. AB 2738 revised the 2005 and 2007 amendments to California Civil Code Section 2782 to provide that, for residential construction contracts entered into after January 1, 2009, subcontractors can no longer be required to insure, defend, or indemnify a builder or general contractor to the extent that the construction defect claim arises out of the conduct of parties other than that subcontractor. AB 2738 also established a rather extensive and complex scheme for the defense obligation arising from a claim for indemnity under which the subcontractor, following receipt of a proper tender of the claim and pertinent claim information, has the option to defend the portion of the claim related to its scope of work or pay “no more than a reasonable allocated share” of defense costs. If the subcontractor fails to properly or adequately defend the claim, the general contractor or construction manager may pursue it for compensatory and consequential damages and attorney’s fees and costs. Finally, the Legislature added Sections 2782.9 and 2782.95 to the Civil Code, which apply only to wrap-up insurance on both private and public residential projects. The new Sections 2782.9 and 2782.95 implement similar limitations on Type I indemnity agreements and require various disclosure obligations in conjunction with OCIP’s (Owner Controlled Insurance Programs) or CCIP’s (Contractor Controlled Insurance Programs).

Because these amendments focused on construction defect litigation in California, existing California law as of the end of 2010 provided that owners and contractors remained free to continue to use Type I indemnity agreements and insuring obligations on commercial construction projects. And, Type I indemnity rights remained preserved with respect to other non-construction defect claims such as claims for bodily injury, general liability, construction delays, etc.

Senate Bill 474

What SB 474 Does.

SB 474 amends California Civil Code Section 2782 and adds a new Civil Code Section 2782.05. The SB 474 amendments will become effective January 1, 2013.

The new amendments are lengthy and complex. Stated simply, they provide:

• Construction Contracts: Indemnification. Provisions in commercial construction contracts entered into on or after January 1, 2013, that require a subcontractor to indemnify a contractor, construction manager, or another subcontractor to pay for the cost of defending against claims for the 1) active negligence of others, 2) willful misconduct of others, 3) design of others, or 4) to the extent that the claim does not arise out of the scope of work of the subcontractor, are against public policy and are unenforceable. In essence, this means that each party will be held liable to the respective degree to which it is found to be at fault for any kind of claim, including property damage or bodily injury. Civil Code Section 2782.05 (a).

• Construction Contracts: Defense Obligation. The parties to a commercial construction contract entered into on or after January 1, 2013, remain free to contract to require the subcontractor to pay for or provide a defense for the contractor or construction manager arising out of a claim allegedly involving the subcontractor’s work on the project until such time as a determination is made that the subcontractor is not required to indemnify the contractor or construction manager. The amendment sets forth a fairly extensive and complex scheme, similar to existing law for residential construction contracts, under which the subcontractor, following receipt of a proper tender of the claim and pertinent claim information, has the option to defend the portion of the claim related to its scope of work or pay “no more than a reasonable allocated share” of defense costs. If the subcontractor fails to properly or adequately defend the claim, the general contractor or construction manager may pursue it for compensatory and consequential damages and attorney’s fees and costs. Civil Code Section 2782.05 (e)–(f).

• Construction Contracts: Public Entities. Existing law provides that any contractual provisions that attempt to impose on a contractor or relieve the public agency from liability for the public agencies’ own active negligence are void and unenforceable. SB 474 extends to subcontractors and suppliers the protection against indemnification for the public agencies’ own active negligence. Civil Code Section 2782 (b).

• Construction Contracts: Private Owners. As with public entities, the SB 474 amendments provide that, for any contracts entered into on or after January 13, 2013, any contractual provisions that purport to impose on a contractor, subcontractor, or material supplier, or relieve an owner (who is not acting as a general contractor, supplier, or construction manager) from liability for the owner’s own active negligence are void and unenforceable. Civil Code Section 2782 (c). A homeowner performing home improvement work on his own home is excluded from this amendment. Civil Code Section 2782 (c) (3).

What SB 474 Does Not Do.

Either intentionally or inadvertently, the SB 474 amendments do not address the following:

• The new Civil Code Section 2782.05 (a) does not apply to residential construction contracts involving original construction intended to be sold as an individual dwelling unit. Civil Code Section 2782.05 (b) (1). Residential construction is instead governed by the amendments that were part of AB 2738, passed in 2008.

• The new Civil Code Section 2782.05 (a) does not appear to extend the same protections afforded to subcontractors to suppliers. The definition of “subcontractor” in the amendment may arguably be broad enough to be inclusive of a pure supplier. Yet, suppliers are specifically referenced and protected in other portions of the SB 474 amendments suggesting that the omission of suppliers from the new protections against general contractors requiring suppliers to enter into Type I indemnification agreements with the general contractor may be intentional on the part of the Legislature. In our mind, the different treatment of suppliers would make little sense. There is no doubt this will be an issue to be resolved in the courts or through further clarifying legislation.

• While the new Civil Code Section 2782.05 (a) prohibits construction managers from requiring subcontractors to indemnify or defend them pursuant to Type I obligations, the SB 474 amendments are silent as to design professionals, and whether contract documents for a project may contain language that requires general contractors, subcontractors, or material suppliers under certain circumstances to insure, defend, or indemnify a design professional where that design professional is not functioning in the capacity of construction manager.

• AB 2738, passed in 2008, implemented protections for subcontractors on residential projects where wrap insurance programs were purchased for the project. The SB 474 amendments contain no such protections for subcontractors on commercial projects.

• The SB 474 amendments do not prohibit homeowners on single family home remodel projects to require Type I indemnity or insuring obligations in their favor. Civil Code Section 2782 (c) (3).

Where Do We Go From Here?

The net result of the SB 474 amendments is a labyrinth of permitted and prohibited contractual relationships between the various parties on a construction project, depending upon the nature of the project, the capacity of the owner, and the degree of involvement of the contractor. The gaps, the questions, and the issues that remain for the future scheme for indemnity under Civil Code Section 2782, et.seq., include:

-Will suppliers, like subcontractors, benefit from the new protections against Type I indemnity obligations on commercial projects? Or, was the omission of suppliers from the language of the amendment intentional by the Legislature?

-The new Civil Code Section 2782.05 (a) prohibits public entities, private owners, general contractors and construction managers from requiring indemnification for their own active fault on commercial construction projects. Subcontractors, under the new SB 474 amendments, have the added protection that they cannot be forced to indemnify general contractors and construction managers to the extent that the claim does not arise from the work of the subcontractor. Therefore, in the future general contractors will find it substantially more difficult to leverage a subcontractor to pay for damages caused by a different subcontractor’s work. This should incentivize general contractors to select reputable and viable subcontractors for their projects.

– Under the SB 474 amendments, subcontractors can no longer be required to insure a general contractor, construction manager, or another subcontractor to the extent that the claim arises out of the conduct of parties other than that subcontractor. The question arises, what does “insure” mean in this portion of SB 474? The Legislative history behind SB 474 is replete with discussion by the author and supporters concerning one of the intended purposes of the amendments, to wit, the prohibition of obligations by subcontractors to procure additional insured coverage, insuring the active fault of the general contractor, construction manager or other subcontractors.

“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.”

Bill Analysis, page 6, Senate Floor, May 31, 2011.

“This bill, sponsored by a number of subcontractor associations, would, except in certain instances, place restrictions on commercial construction agreements, and insurance provisions associated therewith, that require a promisor to indemnify, release, hold harmless, insure, or defend another person against the actual or claimed liability, damage, or expense arising, in whole or in part, from the negligence, willful misconduct, defective design, violation of law, or other fault of that person or that person’s agents, employees, independent contractors, subcontractors, or representatives. This bill would thus provide that contract and insurance requirements that shift indemnity away from at-fault parties to non-fault parties would be void and unenforceable.”

Bill Analysis, page 3, Assembly Floor, September 1, 2011

Viewed in this prism, the term “insure” in the new statute is arguably ambiguous. Was it the intent of the Legislature, as the language of the statute would suggest, to simply prohibit future construction agreements themselves from functioning as a form of self-insurance by the subcontractor? Or, did the Legislature instead intend to prohibit contractual obligations by subcontractors to procure additional insured coverage insuring the active fault of the general contractor, construction manager, or other subcontractors on future commercial projects? The language in SB 474 appears to have originated from AB 2738, pertaining to residential defect construction. And, there is very little evidence in the legislative record for AB 2738 concerning the purpose or intent behind this same language. We think that the ambiguity of this portion of the SB 474 amendments will undoubtedly encourage legal attacks on the new Civil Code Section 2782.05. Counsel for insurers, in particular, may argue that any contractual requirements for additional insured coverage by subcontractors that requires indemnity or a defense for the active negligence of the general contractor or construction manager are per se unenforceable.

-And what of design professionals? Will they allowed to continue their insistence on being indemnified and insured on commercial projects as long as they are not assuming management functions, or have the SB 474 amendments effectively closed that door?

Answers to these questions and others may need to be resolved by the courts. This process will likely take three to five years to work its way through the court system following execution of the construction contract.

Sadly the contractual and indemnity scheme created by Civil Code Sections 2782 and 2782.05 for both commercial and residential construction projects is an open invitation for finger pointing and litigation between the parties on a project. Owners and general contractors can be expected to continue the current practice of seeking indemnity against any subcontractor and supplier conceivably involved in the claim, and tender to their insurers under AI endorsements. In turn, subcontractors will point the finger back at the owners, asserting active or sole fault, and against general contractors claiming that the general contractor bears all or most of the fault for failing to properly sequence or coordinate the project. The one “advantage” to the present scheme is that the exposure for a loss usually filters down to one or more large insurance carriers for one or more of the subcontractors. Those insurance carriers then resolve the claim short of trial to avoid the exposure to substantial indemnity and attorneys’ fees. As for the future, there is little doubt that subcontractors and their insurers, armed with the SB 474 amendments, can be expected to fight back at substantial expense to all parties involved in the claim.

Meanwhile, we have one year before the SB 474 amendments take effect. This offers owners and contractors the opportunity to evaluate the likely effects of the SB 474 amendments on their construction contract forms and insurance programs, and make appropriate changes in advance of January 1, 2013. As one example, in light of the 1) uncertainties posed by the SB 474 amendments, and 2) the inability of owners and general contractors to be able to pass their active negligence on to subcontractors on future projects, it may be advisable for the parties, and general contractors in particular, to seriously explore alternative insuring arrangements such as CCIPs on future commercial projects.

Also, the question arises for owners, general contractors and trade contractors alike, of whether to redraft their standard construction forms and general conditions to account for the SB 474 amendments. One view— the more conservative approach—would be that a party should revise its contract forms to strictly comply with the changes in the law, thus avoiding the possibility that a court might strike any portion of the indemnity provision or insuring requirements in a construction agreement, as well as the costs and fees of litigating issues raised by the indemnity provision. However, given the uncertainties with the SB 47 amendments and their implications, the alternative view is that owners and general contractors should continue to insist on the most comprehensive indemnity and insuring requirements possible, while also inserting qualifying language in the indemnification provision limiting indemnity “to the fullest extent allowed by law”. In our view, both approaches have merit.

Ralph R Rhoades
Parton | Sell | Rhoades

For questions or more information about this topic, please contact Ralph Rhoades at rrhoades@partonsell.com

Introduction California Senate Bill 474 (SB 474) was signed into law by Governor Brown on October 9, 2011. SB 474 provides that provisions in commercial construction contracts entered into on or after January 1, 2013 that require the parties to indemnify or defend an owner for its active fault, or require a subcontractor to defend, […]