Spring 2006

CONSTRUCTION CONTRACT INDEMNIFICATION LAW

During the last legislative session, AB 758 was passed.  That bill makes substantial amendments to California Civil Code section 2782 to rectify the perceived unfairness of contract provisions which shifted the risk for residential construction, regardless of fault of builder/developers, to subcontractors.  While the primary aim of this legislation was to outlaw the enforcement of “Type I Indemnity” clauses, (e.g., those that required subcontractors to indemnify builder/developers for their own negligence, except sole negligence or willful misconduct), the full impact of the statute is uncertain and open to debate.

Civil Code section 2782, subparagraph (c), provides that, effective January 1, 2006:

. . . all provisions, clauses, covenants, and agreements contained in, collateral to, or affecting any such construction contract [contracts for residential construction], and amendments thereto, that purport to indemnify, including the cost to defend, the builder, as defined in Section 911, by a subcontractor against liability for claims of construction defects are unenforceable to the extent the claims arise out of, pertain to, or relate to the negligence of the builder or the builder’s other agents, other servants, or other independent contractors who are directly responsible to the builder, or for defect in design furnished by those persons, or to the extent the claims do not arise out of, pertain to, or relate to the scope of work in the written agreement between the parties.  

(Emphasis added.)

 Expressly exempted from the prohibition of this statute are agreements between the subcontractor and builder regarding the “timing or immediacy of the defense,” provisions for “reimbursement of defense fees and costs,” and the “obligations of an insurance carrier under the holding of Presley Homes, Inc. v. American States Insurance Company (2001) 90 Cal.App.4th 571.”  (Section 2782(d).)

 While section 2782 has historically dealt with the enforceability of only indemnity agreements, there is a substantial possibility it could be interpreted by a court to prohibit a builder/developer from successfully suing a subcontractor because it failed to indemnify it or obtain broad insurance coverage that would protect it against damages caused by its own negligence (or that of its agents, employees, or contractors acting on its behalf). The broad language of this statute, against the backdrop of the Senate and Assembly analyses to this bill, suggests, with limited exceptions, this statute could prohibit the enforcement of any type of contractual provision in residential construction agreements which, in effect, require the subcontractor to protect the builder/developer for its own negligence.

Several of the legislative bill analyses point out that builder/developers in the past have been able to require subcontractors to assume liability for the builder’s negligence through the use of two devices:  Type I indemnity clauses and additional insured endorsements. The authors of these bill analyses point out that the use of these two methods have led to increased cost of insurance for subcontractors and complex litigation requiring that subcontractors and their insurers indemnify builder/developers for liability beyond the subcontractor’s degree of fault.  (See Senate Judiciary Committee Analyses dated July 12, 2005, and Assembly Committee on Judiciary dated April 12, 2005.)  Arguments made against AB 758 seem also to recognize the broad impact of the bill.  American International Group (AIG), in opposing the bill, stated:  “AB 758 would change the scope of indemnification and additional insured agreements that a developer or general contractor may obtain from a subcontractor.”  (Emphasis added.)  (Assembly Committee on Judiciary dated April 12, 2005.)

One obligation which is expressly exempted from the prohibition of section 2782 is the subcontractor’s insurer’s duty to defend a builder/developer under an additional insured endorsement.  The Presley Homes case specifically cited in the statute recognized that if there was a potential of coverage for the builder/developer under the additional insured endorsement of the subcontractor’s policy, the subcontractor’s insurer must defend the builder/developer against the entire action, but could seek equitable contribution from the other subcontractor’s insurers to the extent it paid more than its share of the defense. The rationale of this case was that public policy required that the duty to defend be broader than the duty to indemnify, so that if the suit potentially sought damages which fell within in the scope of the additional insured endorsement, the insurer must defend both potentially covered and uncovered claims. 

 There is a line of case authority which recognizes that when an insurer is required to defend a mixed action, that is one which seeks damages for both covered and uncovered claims, the insurer may reserve its rights to seek reimbursement from the insured for the defense costs incurred solely in defending the uncovered claims.  (Buss v. Superior Court (1997) 16 Cal.4th 35.)  Language in this new statute seems to recognize that insurers, as well as subcontractors, would be free to seek reimbursement from a builder/developer for defense costs that relate to the defense of uncovered claims.

Because subcontractors under this statute arguably do not have to indemnify or insure builder/developers for their own negligence, subcontractor’s insurers may be tempted to significantly limit the scope of the additional insured endorsements they sell.  Instead of selling the very broad CG 20 10 endorsement, subcontractor’s insurers may sell only endorsements that agree to indemnify the builder/developer for damages it is legally liable to pay because of the subcontractor’s negligence.  Under such a narrower A.I. endorsement, it may be more difficult for a builder/developer to trigger a duty to defend under the subcontractor’s policy.  In other words, there would have to be a potential that the builder/developer was sought to be held vicariously liable for a specific subcontractor’s negligence; the fact that the injury or damage potentially arose out the subcontractor’s work may not be enough.

Because the statute is not a model of artful drafting and apparently a compromise statute, we expect that its meaning will be the subject of further litigation.  Builder/developers, on the one hand, will take a narrow view that the statute only precludes claims for express indemnity for that part of the claim due to the builder/developer’s own negligence, and they are still free to insist their subcontractors name them as additional insureds on their policies with the broadest scope of coverage.  On the other hand, subcontractors and their insurers will likely advocate a broader interpretation to prohibit builder/developers shifting their obligations, whether it be done by indemnity agreements, additional insured clauses, or a combination. While AB 738 was intended to limit litigation, its effect may arguably have the effect of creating new and complex issues for litigation.  Only time will tell how the courts and the building and insurance industries will deal with the challenges raised by this new legislation. 

                                                                        ROBERT D. BRUGGE

Mr. Brugge is a Director in the firm’s Insurance Coverage Department.  Email:  rdb@kpclegal.com.

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