Contract Guide and Course for Design Professionals – module 4 of 9. An AIA Continuing Education registered course. Discussion of the following contract areas: incorporation by reference, indemnification clause, contractual liability, and insurance.  Course slides:  Contracts for Design Professionals by C-Risk – Module 4


Hello, this is Kent Holland with Construction Risk, L.L.C. And today we’re going to do another module in the contract guide for design professionals. It’s my pleasure to be with you today. Thank you for tuning in.

Incorporation by Reference

All right. Let’s get started today. This is an AIA. registered course. The first clause that we’ll talk about today is incorporation by reference. Points that we should think about are to be sure to obtain and read the prime agreement that’s being incorporated into your subcontract. It surprises me how often a design firm will send me their subcontract to review and want my comments or my firm’s comments, but they don’t send the prime agreement along that’s incorporated by reference. Certainly if you are an attorney or a risk manager, you are going to need to review both the prime agreement and the subcontract to understand what’s going on.

Because think about this: if you agree to a subcontract that has good indemnity language or good limitation of liability language, or other types of clauses that you feel are really good for you, but then you have an incorporation by reference that says, “anything from the prime contract that is different or inconsistent with the subcontract is going to prevail.” Well, then you’ve lost all the benefit of all those subcontract terms. So when we review a prime agreement, what we do is we take exception to specific clauses in the prime. And sometimes we’ll do that by, when we’re reviewing the subcontract, if we like the Limitation of Liability, we’ll say, “this clause will prevail over anything inconsistent in the prime.” But there are just different ways to do it. And you’ll need to think that through.

An example clause concerning incorporation by reference is the A.I.A. C401 from 2007. And it provides that “a copy of the architect’s agreement with the owner, known as the prime agreement, is attached as Exhibit A, and is made a part of this agreement.” A pretty typical term. There are other more elaborate ways to do that will specifically say, instead of just that simple language, it will say something more like, “Whichever of the two terms, the prime or the subcontract that is more onerous or more detailed is going to prevail.” So, be careful to really read that language.

As a subcontractor, a design professional should amend the clause that I just talked about, to add an exception for any specific identified articles of the subcontract that you want to prevail over the prime. So you can revise the prime agreement clauses, also as they would apply to the design professional in the event that they are unacceptable.

Indemnification Clause

Let’s turn next to the indemnification clause of the contract. We’re going to talk now about indemnification. This is one of the really critical clauses of the contract, particularly as regards shifting of risk, and issues concerning insurability of those risks that gets shifted. The problem with an indemnity clause is that unlike a contractor’s contract, where you can have an indemnity and you can name the project owner as an additional insured, and therefore the general liability policy is going to pick up coverage for that owner of the project, that gets sued as a result of acts or omissions of the contractor.

The professional policy cannot name a project owner as an additional insured. And therefore when you, by the indemnity agreement, agree to indemnify the project owner for anything other than liability arising out of the negligence of the design professional, that becomes a contractual liability, a liability that only exists because of the contract language of indemnity clause. It wouldn’t exist at common law. A judge could not award damages against you at common law, but for the fact that you executed that indemnity clause. Now, that’s called contractual liability. And in a professional liability policy, there is a contractual liability exclusion. That means that if you were to agree to that kind of indemnity, you have no professional liability coverage for it.

So the indemnity provisions are being written so broadly in some of the project or owner-generated contracts that I’m seeing, that the first party breach of contract claims are covered. All errors and omissions are covered by that indemnity, even if there was no negligence. All damages whatsoever, as long as the design professional was just a little bit responsible. So you’ll typically see some language that says something like, “If it caused in whole or in part by the design professional…” But that’s not acceptable, and we’ll explain why.

So again, there’s no professional coverage specifically for the terms of the indemnity clause. The typical contractual liability exclusion in a professional policy is going to say something to the effect that there’s no coverage for contractual liability, except to the extent that the contractual liability would have existed in the absence of the contract language. So it becomes very important to review the indemnity clause, and to mark it up, revise it accordingly.

I’m going to put up a few example clauses throughout our discussion today showing some bad language, and the improved language that might be recommended. And you’re going to see a big disclaimer at the end of this presentation today, where basically I say, look, this is all for educational purposes. I’m not practicing law right now by giving you this presentation, although I am a construction lawyer. I am not here as your lawyer today. Basically the disclaimer says, use all of this at your own risk. This is all for education. You should be going and talking to your lawyers, and to your risk managers, and to your insurance brokers and underwriters to get more feedback on all these issues that we’re talking about.

Okay. The first example of a bad indemnity clause, I’m going to put up on the screen right now, and we’ll just talk through this. The clause reads as follows: The design professional shall indemnify and save harmless the client, and its officers, directors, employees and agents, from and against all liability, loss, damage or expense, including attorney’s fees, by reason of liability imposed upon the Client, arising out of or related to the design professional’s services, whether caused by or contributed to by the Client or any other party indemnified herein, unless caused by the sole negligence of the Client.

When reviewing that clause, I hope that you will see several different problems in that clause. One of the problems, of course, is that you are indemnifying this whole host of entities, not just your client, but also officers, directors, employees. And sometimes I see that clause go and say you’re going to indemnify the consultants, the contractors, other firms, and affiliates of the owner. And it becomes vast. So you need to manage who is going to be able to rely upon that indemnity. Pay attention to that detail.

Another issue is you’re picking up attorney’s fees. Now, one of the things about a professional liability policy is that if you agree to defend the project owner, notice this one said you’ll “indemnify and hold harmless.” It didn’t say “defend.” But the next version of it is even worse. It says you’ll “indemnify, defend and hold harmless the client.” Well, there’s no coverage for defending your client. Because under the American system of law, we defend ourselves. We don’t defend somebody else. We had no legal obligation to defend a project owner. Therefore, again that’s a contractual liability that the court would not impose on you, but for that contract language. Therefore, your insurance policy on the professional side is going to deny coverage for those defense costs.

Now, the issues is, does that also apply to defense costs that you might be picking up by way of indemnity? Indemnity, of course, is different from defense in that defense means, as soon as your project owner is sued or a claim is made against them, you then pick up an obligation to start defending them on behalf of the owner. That means you’re paying for defense costs before you’ve ever been determined to be negligent. So that obviously is a real issue, a real problem.

But there’s also a potential problem even if you don’t have to defend upfront, but instead you indemnify, meaning you pay the damages after it’s been determined that those damages were caused by you, the design professional. And as part of those damages that you’re agreeing to pay, you’re agreeing to pay defense costs. Now again, if a court would have imposed those defense costs on you as part of the damages that the owner is entitled to recover, or some third party is entitled to recover, then those would be allowable under the policy for the most part. However, if the only reason you are required to pay those attorney’s fees as part of the indemnity is, again, the indemnity language, no coverage is excluded from coverage under the policy.

The next clause that I want to talk about is still indemnity. But my point here is that we need to be aware of agreeing to defend the project owner for damages caused, “in whole or in part,” by the design professional. That language means that the design professional is going to be required to indemnify for all the damages, even if only a part of those damages were caused by the negligence of the design firm. The courts generally look at that language and say, when you agree to defend or indemnify for damages caused in whole or in part, that means if they’re partly caused by the design firm, the design firm has committed to indemnify for the whole of the damages.

And then the owner will sometimes craft the language of the clause to say, “except in the event that the damages are caused by the sole negligence of the owner.” And that’s intended to avoid the anti-indemnity statutes that a lot of states have. My advice on this is always to take the time to revise, delete the language “in whole or in part”, and revise it to say that you’re only going to be responsible for damages “to the extent caused by” the negligent performance or the negligent act, error, or omission of the design professional.

Third Party Claims

There is an interesting issue that has come up in the last several years for indemnity clauses. Historically it was understood that indemnification was supposed to deal with third party claims against the indemnified party. In other words, if a third party had a claim against the project owner for whom you were working on a project, the project owner would come to you as a design firm saying, “indemnify me for these third party losses I had to pay.”

Unfortunately, it seems courts are starting to misapply the indemnity clause, so that they’re even applying them to even first party claims by the project owner against the design firm or against the contractor, if it’s the contractor indemnity with a project owner. But it’s taking care of first party claims for breach of contract or breach of warranty. The indemnity was never intended to be used that way, but that’s the way it’s starting to be used.

What I’ve done is to take care of that problem. I just routinely now, when I see an indemnity clause that doesn’t mention third party claims, I make a point of revising it to state that the indemnity is only for damages to the extent caused by the design professional’s negligence for damages arising out of third party claims against the project owner. I’m going to put up a clause now that deals with that. Take a look at this clause.

“Indemnification. Notwithstanding any clause or provision in this Agreement or any other applicable Agreement to the contrary, Consultant’s only obligation with regard to indemnification shall be to indemnify and hold harmless (but not defend) the Client, its officers, directors, employees and agents from and against those damages and costs that the Client is legally obligated to pay as a result of third party claims, including the death or bodily injury to any person or the destruction or damage to any property, to the extent caused by the negligent act, error or omission of the Consultant or anyone for whom the Consultant is legally responsible, subject to any limitations of liability contained in this agreement.”

As you read through that clause with me, you should note a number of important things. First, I’ve put in parenthetical, “but not defend,” close parenthetical. The reason for that is, in a state like California, if you say that you are going to indemnify a public owner, then the state law and statute automatically reads into that, that you’re also going to have to defend the owner. So to get around that, I think that simple little phrase, “but not defend,” or “shall not defend,” will suffice to make it clear that there’s no obligation to defend the project owner.

Notice the clause that says, about half way down, that what you are doing is indemnifying against damages that the client is “legally obligated to pay as a result of third party claims.” That gets to my point about the third party claims. So it’s only after it’s been determined that the project owner is legally obligated to pay damages because of these third party claims that the indemnification obligation of the design firm kicks in.

Again, the insurance policy can handle that, because if it’s determined that that damage resulted from the negligence of the design firm, causing that third party claim, that’s what the professional liability coverage is there to cover. You’ll have to obviously look at other terms and conditions of the policy to make sure that that actually works in your specific policy. But that’s pretty much a norm.

Notice again in this clause, I’ve put in the language that it’s only for damages “to the extent caused by the negligent act, error, or omission of the consultant”. Again, it’s the “to extent” language that’s so key here. Because even if you have all this other convoluted language in an indemnity clause, it talks about the owner’s percentage of responsibility and this responsibility, or in whole or in part, this language cures that by saying, we’re only going to indemnify to the extent caused by our negligence.

And the other key here is using the word “negligent” or “negligence.” Do not agree to simply indemnify for damages from all acts, errors and omissions. Because as we talk about in the standard of care section of this series of modules, not every act, error or omission is a negligent one. Design firms are not expected to be perfect, and by an indemnity clause, you might circumvent a very good standard of care clause elsewhere in your contract by agreeing to basically be perfect here and to indemnify your client for your failure to be perfect, even though in the standard care clause, you said you’re going to be exercising the generally accepted standard of care. So that becomes an issue.

I’m going to put up a slide now that shows the indemnification clause that comes out of the E.J.C.D.C. contract language, the Engineers Joint Contract Documents Committee language. And this is from E.J.C.D.C. E-500 2008 version, article 6.10 A. Now, I’m not going to read this whole clause because it’s very long. So I’m just going to put it up here in the presentation for just a couple of minutes. Not a couple of minutes. I should say maybe 10-15 seconds. So you can take a look at it, and you can go back and look at it later, or go into the E.J.C.D.C. documents to get it. So it is indemnification by the engineer, and it uses a lot of the language that we just talked about. So take a look at this.

There’s much more that we could say about indemnification, but for the purposes of this short workshop today, that’s really all we have time for. Insurance is another area that we need to touch on. But it’s a very big subject. And we really don’t have sufficient time in this short module to cover it in any detail. There are a couple of issues, however, that I would like to touch on.

Professional Liability Policies

One is, if you are dealing with a consensus docs 240 contract, beware that it requires the design professional to give the project owner copies of the actual insurance policies, the professional liability policies as well. In my view, that is not appropriate. The design firm should not give the entire policy. Most of these policies, or many of them, are very proprietary. They have endorsements. They’re manuscripted for large design firms. And you wouldn’t want the project owners to have those, or even your competitors. They’re yours. They were negotiated by you. So the most that would be given would be a certificate of insurance to show the owner that you have the insurance that was required.

Another problem that we’ve already discussed is that the professional policy does not have insurance that’s going to specifically cover indemnity. So whenever I see a contract that says that you’re going to be required, as a design firm, to have insurance specifically covering the indemnity clause, I strike it out. Because there’s no such thing. The most you’re going to get would be language in your standard policy that says, there’s an exclusion for contractual liability, including indemnity, except to the extent that the liability would have been imposed in the absence of the contract language.

So to that extent, as long as the indemnity is consistent with the common law responsibilities, it’s no big deal. But you can’t go out and commit to defend your project owner, or to indemnify your project owner for first party claims, or to indemnify your project owner for non-negligent acts, errors, and omissions, and then think you can go out and buy insurance coverage for that. For that reason, the provision in the contract that says you’re going to have insurance for the indemnity should be stricken.

Again, we’ve touched on this. But in the insurance policy, most owners understand they can be named as an additional insured under the general liability policy of the design firm, but they cannot be named as an additional insured under the professional liability policy. So if you see an additional insured requirement for professional coverage, it must be stricken.

Thank you for joining me today. I hope you enjoyed this session that we did on risk management. And if you would like to contact me, I am putting a slide up her at the end that has my name, phone number, email address and website information. Don’t hesitate to call me or contact me, particularly if you’d like continuing education credits. We’ll explain how that can be accomplished. Thanks. Look forward to seeing you again.