The Subcontractor Revolution
Examining the Trend Away from Type I Indemnity and Additional Insured Coverage
By Joe Duncan , Phyllis Modlin , Kevin Moore
Historically, parties to the construction process have long sought to shift or pass-through the risks associated with construction through a variety of contract provisions. Such provisions have included exculpatory clauses, limitations of liability clauses, liquidated damages clauses, and, most importantly, insuring provisions or express indemnity agreements. Where possible, these indemnity provisions sought to place the burden of litigation costs and damages upon subcontractors and material men.
More recently, new statutes and case law in many states have shifted the pendulum of risk allocation from favoring general contractors and developers to favoring subcontractors and material men. Included in this trend, several states have attempted to extinguish coverage avenues created when Additional Insured coverage is broader than what is allowed through contractual indemnity. These changes have been so prevalent that, in April 2013, the Insurance Services Office (ISO) released new Additional Insured endorsements to reflect the trend. As this trend continues, it will have significant implications with respect to future construction defect litigation.
In many aspects, the subcontractor revolution began with state limitations on indemnity provisions. A number of states have restricted the right to contract to defend another for its own negligence, limiting the type of indemnity agreement that can be included in a contract. Generally, indemnity agreements have been classified into three types.
Type I – requires indemnification even for the indemnitee’s own negligence, including active and passive negligence. The indemnity provision is unenforceable only in the event that the damages result from the sole negligence or willful misconduct of the indemnitee.
Type II – requires indemnification for the indemnitee’s own acts of negligence that contribute to liability so long as the negligence is passive and not active.
Type III – a limited agreement whereby the indemnitor expressly agrees to be responsible for the indemnitee’s liabilities caused by the indemnitor’s acts, but does not agree to be responsible for the indemnitee’s liability caused by the indemnitee or anyone else.
Where permitted, developers and general contractors sought to use the broadest indemnity provisions allowed by law to place the risk of loss and liability on their subcontractors and material men. Indeed, certain courts interpreted Type I indemnity provisions in a manner whereby the indemnitee was not required to prove the indemnitor’s negligence to trigger the indemnity obligation.
Subcontractors and material men, and their respective insurers, rebelled against the use of Type I indemnity provisions in construction contracts, contending that such provisions resulted in developers and general contractors avoiding liability for their own negligent acts and omissions. As a result, certain states have passed litigation to prohibit the use of Type I indemnity provisions. Other states have gone further by prohibiting the use of additional insured endorsements that provide defense and indemnity obligations for a developer or general contractor’s active negligence.
As with any changes in the law, a number of states have realized unintended consequences from restricting indemnity obligations. Specifically, the restrictions are applied to the indemnity provisions but not to the insurance policies under which general contractors often seek coverage. The result is that there is often broader coverage for an additional insured endorsement for an indemnitee than is required by contract, thus creating the AI loophole.
Closing the Gap
Several states have attempted to close the gap by enacting statues or through case law that provides that AI coverage cannot be broader than what is allowed by law or required by contract. These states include: Arizona, California, Colorado, Georgia, Kansas, Louisiana, Minnesota, Montana, New Mexico, Oklahoma, Oregon and Texas (excluding residential and public works). In some states, such as Delaware, Ohio and Tennessee, appellate courts have begun to speak on the issue with differing amounts of direction.
The ISO has taken notice of these legislative and appellate trends. In early 2013, it revised Additional Insured Endorsements to restrict AI coverage to be limited by the terms provided in the contract or the indemnity obligations that are allowed by law. These changes can be seen in ISO’s CG 2010, CG 2037 and CG 2033, which were available for carriers to include in policies as of April 2013.
With the growing trend toward the elimination of Type I indemnity provisions and accompanying AI coverage,construction defect litigation will be affected in significant ways. First, the elimination of Type I indemnity provisions will likely result in increased liability payments for developers and general contractors. As an example, when using Type I indemnity provisions, developers and general contractors may have paid approximately 15 to 25 percent of a settlement. In large part, such payments covered the liability of subcontractors and material men who had gone out of business or had no viable insurance.
Now, developers and general contractors can anticipate paying as much as 50 percent of a settlement prior to any consideration of subcontractor and material men insurance problems. Such liability will result from subcontractors and material men attempting to limit their own liability by arguing that the developer or general contractor’s own negligence contributed significantly to plaintiff’s claimed damages on the basis that the design contained defects or that the general contractor mismanaged the project.
Such contention amongst the defense will likely create the next problem resulting from the elimination of Type I indemnity provisions – an increase in trials. In litigation in which developers and general contractors were enforcing Type I indemnity provisions, settlements were more attainable because developers and general contractors could leverage subcontractors and material men’s participation in the settlement process through the enforcement of the indemnity provisions through indemnity cross-complaints. Without the coercive effect of a Type I indemnity provision, the defense must agree to an apportionment of liability in a situation where all of the parties attempting to deflect greater shares of liability to each other. If agreement cannot be reached, then the matter will proceed to trial.
An increase in the number of trials will, in turn, result in an increase in defense costs. As noted above, certain states have prevented the use of additional insured endorsements that would transfer complete responsibility for the defense costs to insurers of subcontractors and material men. Other states, for example California, have provided a statutory mechanism to apportion responsibility for the developer’s or general contractor’s defense costs, but the California system is non-binding and can result in more litigation as the subcontractors and material men argue over their apportioned percentages of the defense costs.
Finally, all of the turmoil and finger pointing on the defense side may result in increased verdicts and recoveries for savvy plaintiffs. A knowledgeable plaintiff’s counsel will foster discord amongst the defense to allow the defense to prove and to drive up the value of the case through finger pointing amongst the defendants and cross-defendants. To foster this climate, counsel for plaintiff would name the developer or general contractor and all known subcontractors and material men as defendants to plaintiff’s complaint to create the most contentious environment amongst these parties as possible. Such efforts can also be accomplished with the use of contention interrogatories, which seek to establish that parties other than the responding party were responsible for plaintiff’s claimed damages.
Minimize the Negative With the possibility for increased litigation and liability costs, the question begging to be answered is how can a prudent defense counsel and insurance carrier avoid such results. Several actions can be undertaken to minimize the negative effects of the loss of a Type I indemnity provision. They include:
- Obtain all available information concerning plaintiff’s claims from counsel for plaintiff prior to filing a responsive pleading and use that information to tender to all appropriate subcontractors and material men and their insurers.
- Seek to limit the use of written discovery by using a case management order that requires all parties to deposit documents in a document depository and to provide general information concerning scope of work and insurance in response to one set of written interrogatories.
- Utilize any available contractual language to compel an early mediation involving all parties.
- Consider the use of a joint defense agreement that would have the developer/general contractor, subcontractors, and material men collectively participate in one unified defense and then litigate the apportionment of the settlement or judgment in a subsequent mediation or arbitration.
- Retain construction contracting experts early to investigate plaintiff’s claims, bid plaintiff’s cost of repair, formulate a defense scope of repair, and bid the defense scope.
- Review all of the project documents to determine responsibility amongst the subcontractors and material men for plaintiff’s claims and to track the progress of construction to determine if the developer/general contractor has significant liability for the running of the project.
- Retain design professional experts to evaluate whether design problems contributed to plaintiff’s claimed damages, particularly if the design was developer-provided.
- Have plaintiff and defense experts meet and attempt to create a consensus scope of repair, which is then bid by the defense experts.