SB 496 And The Continuing Saga Of California A/E Firms’ Contractual Indemnification Risks

A significant, potentially firm-threatening, problem for every A/E firm is that governmental agencies and private owners seem compelled to use their superior bargaining power to require unlimited and uninsurable project risk allocation provisions in their professional services agreements.

Perhaps the most potent risk allocation device is express indemnification, and several aspects of an express indemnification clause can present significant risk. For example: the “trigger” verbiage can directly impose uninsurable no-fault liability (e.g., A/E must indemnify the Owner against “all claims related to its services”); or a breach of contract might be tied to uninsurable strict liability traps buried in the scope provisions (e.g., the CDs will “comply with all laws” and be “free of defects”); the parties to which indemnification is owed may be inappropriate (e.g., one the Owner’s “affiliated entities” may be a subsidiary that performs construction); or the duration provisions may waive a statute of repose defense.

A key aspect of this problem, especially in California, is the indemnification defense obligation. By both common and statutory law, the concept of indemnification includes two separate duties, a reimbursement obligation regarding covered losses, and a defense obligation regarding covered claims. Prior to the 2008 California Supreme Court decision in Crawford vs. Weather Shield, the common understanding was that the defense obligation was related to the loss reimbursement obligation. Thus, if an A/E’s indemnification was triggered by its negligence (as opposed to, for example, merely “arising out of its services”), then it had no duty to provide either reimbursement or defense unless and until it was determined to be negligent. Crawford, while professing to merely reveal the law as it has always been, profoundly changed this notion, holding that the reimburse and defense duties were separate and distinct, and that unless the contract expressly provided otherwise, the defense obligation was immediate and not fault-based. Thus, if an A/E with a negligence-triggered indemnification was not negligent and therefore has no loss reimbursement obligation, it nevertheless still has a defense obligation, and that obligation arises immediately when the client makes a demand, and applies even if the A/E was totally negligence-free — not unlike the defense of an insured driver provided by an automobile liability insurance company.

This risk of an immediate and no-fault defense obligation is greatly exacerbated by the way the liability insurance industry has evolved over the decades. General liability, or CGL, policies, which typically have “professional services” exclusions, do cover “contractual liability.” Thus, a contractor can assume project risk by contract and pass it on to its CGL insurer (for a premium that can be included in the construction contract budget so that ultimately the cost of insuring the related project risk is borne by the project owner). Professional liability, or E&O, policies, however, cover only fault-related liability, and do not cover liability solely contractual liability. Thus, if an A/E contracts (even inadvertently) to assume a no-fault indemnification obligation and is then called upon to defend its client regarding a claim related to its professional services, it is not covered by its CGL insurer because of the “professional services” policy exclusion, and it is not covered by its E&O insurer because its defense liability is solely contractual.

Effective January 1, 2018, this problem has largely been remedied by a profound change in California statutory law. Pursuant to SB 496 (which was signed by Governor Brown on April 28th), Civil Code section 2782.8 is amended to provide that any contract for architectural, engineering, landscape architectural or surveying professional services entered into on or after this date with a private or non-state governmental entity client automatically and irrevocably provides that the A/E’s cost of defending its client cannot exceed its proportionate percentage of fault. While in the legal world everything is arguable, almost certainly this limitation trumps any argument for a no-fault defense obligation, and thus largely coordinates the contractual indemnification liability with the insurance protection provided by standard E&O policies.

Note that this statutory protection does not apply to contracts with any California state agency, or to contracts with professionals other than those enumerated above such as interior designers, cost estimators, PMs and CMs.

While the new law is not retroactive, pursuant to earlier versions of Civil Code section 2782.8 there are arguable limitations on indemnification defense obligations in contracts entered into prior to January 1, 2018.

In addition, for any contract entered into before the Crawford decision by parties that did not intend to create a no-fault defense obligation but failed to understand the law as later “revealed,” arguably the contract can be reformed to conform to what was intended.

Contractual indemnification provisions remain dangerous, and will be so as long as such provisions are drafted and enforced by lawyers; but the Legislature — lead by Senator Cannella (the Legislature’s only engineer), and lobbied for by especially ACEC and the AIACC – has just taken a giant step in the right direction.