Vandeventer Black LLP: Important Changes for Indemnity and Duty to Defend in California

Vandeventer Black LLP: Important Changes for Indemnity and Duty to Defend in California

Authored by attorney David V. Rose

Recent changes in California law carry important consequences for insurers of construction managers, general contractors, and subcontractors. These changes, codified in section 2782.05 of the Civil Code [version available to lexis.com subscribers], provide additional protections to subcontractors and their insurers in two primary ways: first, they make it harder for construction managers, general contractors, and subcontractors (collectively, "upstream contractors") to get indemnity or insurance protection from subcontractors, and second, they make it harder for upstream contractors to obtain a legal defense from their subcontractors.

The recent changes only apply to private commercial construction contracts and contract amendments entered into on or after January 1, 2013. The new laws do not apply to direct contracts with public agencies, contracts for residential construction, or contracts with the owner of real property to be improved. Therefore, these laws do not, for example, affect contracts with cities or school districts, contracts for original construction intended to be sold as an individual dwelling unit, or contracts for remodels and improvements. (It is unclear whether residential contracts includes contracts to build multiple homes or a subdivision). Finally, these laws do not apply to contracts with design professionals, including architects, landscape architects, engineers, and land surveyors.

Shifting Grounds for Indemnity: Active vs. Passive Negligence

California state law prohibits contract provisions that require a subcontractor to indemnify an upstream contractor against liability arising out of the upstream contractor’s "sole negligence or willful misconduct" (§ 2782(a)). The new law also prohibits a subcontractor from indemnifying or insuring against liability arising out of an upstream contractor’s active negligence or willful misconduct. This prohibition cannot be waived. The new statute does, however, allow subcontractors to indemnify and insure against liability arising out of an upstream contractor’s passive negligence, as long as the upstream contractor was not solely responsible. It should be noted that while limiting express contractual indemnity, this statute does not in any way restrict claims for equitable indemnity.

Whereas previously the consequential distinction was between the upstream contractor’s sole and partial responsibility for the liability, the most important distinction under the new statute is that between active and passive negligence. Passive negligence is generally found in cases of nonfeasance, including the failure to discover a dangerous condition, the failure to exercise a right to inspect work or specify changes, and the failure to exercise a supervisory right to order removal of defective material. Active negligence is generally found when the party participates in an affirmative act of negligence, including digging a hole that later caused an injury, knowingly supplying a scaffold that did not meet safety requirements, creating a perilous condition that resulted in an explosion, or failing to install safety nets in violation of a contract. The line remains blurry, however, and is likely to result in increased litigation until the distinction is clarified.

Duty to Defend

The new statute additionally prohibits contract provisions that would require a subcontractor to defend a suit arising out of an upstream contractor’s active negligence or willful misconduct. Subcontractors and their insurers can now only be required to defend upstream contractors in cases where the upstream contractor was both partially and passively negligent. California law requires upstream contractors to tender a claim to any subcontractor or insurer from whom they want a defense. Under the new law, the upstream contractor still has to tender a claim, but this tender now has some specific requirements: (1) it must include the information provided by the claimant relating to claims caused by the subcontractor’s scope of work, and (2) it must include a written statement proposing a reasonable allocation of fees and costs for defense and explaining how this allocation was determined. The new law requires that the upstream contractor must allocate a share to itself to the extent that the claim arises out of its own work, and a share to each subcontractor to the extent that the claim arises out of the subcontractor’s work. Upon receiving written tender, the subcontractor or insurer may choose either (a) to defend the claim with the counsel of its choice or (b) to pay no more than a reasonable allocated share of the defense fees and costs on an ongoing basis during the pendency of the claim. Questions about the meaning of and what constitutes a "reasonable allocation" are likely to be litigated until courts give more guidance. Until then, a "reasonable allocation" of fees and costs might look like this:

Suppose a contractor gets sued for plumbing and roofing defects in a new office building. The claim alleges that the plumbing and the roofing both leak, and that the contractor should have done a better job inspecting the work (passive negligence). The contractor then tenders a claim for a defense to its roofing and plumbing subcontractors, on the basis of the duty to defend clause in their contracts, and they pass this tender along to their insurers. This tender must include information from the plaintiff’s claim that describes alleged problems relating to the subcontractors’ work. If the contractor tendered a claim to the subcontractor who did the electrical work, for example, that subcontractor would not owe the contractor a defense, because the claims were not related to electrical work.

Furthermore, the tender would have to include a reasonable allocation of fees and costs. For example, it would not be reasonable for the contractor to ask the roofing subcontractor to pay for the whole defense, since the roofing subcontractor had nothing to do with the plumbing. It would also be unreasonable for the contractor to ask the subcontractors together to pay for the whole defense, without allocating any of the cost to itself, since the claim partially arises out of the contractor’s failure to inspect the work. Instead, it would be reasonable in this case to conceptualize the lawsuit as including two claims, one for the plumbing and one for the roofing, and to have the contractor split the cost for defending each claim with the relevant subcontractor. So the contractor would pay for 50% of the roofing claim defense and 50% of the plumbing claim defense, the roofing contractor would pay for the other 50% of the roofing claim defense, and the plumbing subcontractor would pay for the other 50% of the plumbing claim defense. These costs might be assessed on a monthly basis, or every three months, or on some other basis. Finally, if the roofing subcontractor had gone out of business or was bankrupt and was unable to pay its share, the contractor would have to cover the entire cost of the roofing claim defense itself, and would not be allowed to charge that amount to the plumbing subcontractor.

Insurance

Under the new law, as with indemnity and the duty to defend, a subcontractor cannot be required to purchase insurance covering the liability for claims arising out the active negligence or willful misconduct of an upstream contractor. The statute makes an explicit exception, however, for any wrap-up insurance policy. This may impact the kinds of policies that subcontractors will seek going forward, as many may desire to modify indemnity endorsements or move toward more frequent use of wrap-up policies.

Conclusion

Overall, section 2782.05 enacts important changes in the law of indemnity, the duty to defend, and insurance, all of which redound to the benefit of subcontractors and their insurers, and to the detriment of upstream contractors and their insurers. The most immediate impact of this statute for insurers is the creation of new grounds upon which to challenge unreasonable defense allocations, and the resulting shift in exposure from subcontractors to upstream contractors.

While this update addresses the most important aspects of the new law, there are several nuances of the statute that should be considered carefully. For further assistance in complying with these recent changes in the law, or for additional information, contact Vandeventer Black, LLP.

These articles are meant to bring awareness to these topics and are not intended to be used as legal advice.

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