July 1, 2009

Allocating Risk in Construction


Summer 2009

In most construction contracts, one party will agree to protect the other party from liability if something goes wrong or if something unexpected happens. Such agreements take different forms. One party may agree to "indemnify," "defend," or hold the other party "harmless." Such clauses appear similar but in fact are very different. To evaluate the risks of construction contracts, contractors and subcontractors need to understand these clauses and know what they are agreeing to and what duties and risks they are taking on.

An agreement to "indemnify" refers to the obligation to reimburse the other party for a loss or damage it has suffered. Properly drafted, indemnity agreements allocate the risk of harm to the party that is performing the work and that is therefore most able to control the work and reduce the risk of harm. A subcontractor might agree to indemnify the prime contractor from loss or damage caused by the subcontractor's work.

An indemnity obligation may be broad or limited. Properly drafted indemnity clauses limit the indemnity obligation to the extent that the loss is caused by the party providing the reimbursement. An overly broad indemnity agreement may be invalid. In construction contracts in Oregon, an agreement to indemnify someone for harm caused by that person's own negligence is void by statute.

"Defend" creates an obligation to pay the cost of defending another party against a claim brought by a third party. For example, if a subcontractor agrees to defend the prime contractor, the subcontractor will have to pay the attorney fees if the prime contractor is sued by the project owner because of defects in the subcontractors' work.

The duty to defend is separate from and broader than the duty to indemnify. In order for the duty to indemnify to arise, there must be actual proven loss. The duty to defend, on the other hand, merely requires that a claim be filed. In other words, all that is required is potential liability. The party agreeing to defend is obligated to do so, regardless of whether either party is ultimately liable to the party that asserted the claim, and the duty to defend continues until the claim is resolved. Unlike an agreement to indemnify, an agreement to defend is not limited by statute.

A hold-harmless clause creates both a duty to defend and a duty to cover any loss or harm, regardless of each party's negligence. Hold-harmless clauses often provide one party protection against any future claims but may also allocate risk between parties related to specific construction issues, such as site conditions. For example, if there are geological concerns on a project, a contractor may propose a contract clause requiring that the developer hold the contractor harmless from any liability arising out of geological issues. Under such a hold-harmless agreement, the developer would bear all the risk for that issue, including increased costs, delays, or claims brought by third parties.

If a party is required to indemnify, defend, or hold another party harmless according to a contract, failure to do so constitutes a breach of the contract. A breach of contract may lead to a lawsuit and may expose the breaching party to a judgment for damages resulting from the breach. But a breach of the duty to defend does not necessarily mean that the duty to indemnify has been breached.

Properly drafted indemnity, defense, and hold-harmless agreements allocate the risk to the party responsible. Improperly used, they can allocate all the risk to the party with the least amount of negotiating leverage, usually a subcontractor. Each clause should be carefully reviewed to ensure that no party is assuming more risk than it can bear and that it is being compensated for the risk it is assuming. If a party doesn't understand its risks and doesn't have the resources to meet its obligations if something goes wrong, the result won't be good for anyone involved. It is far better to have an attorney review, draft, and negotiate appropriate indemnity, defense, and hold-harmless clauses in advance of construction than to find out later that the contract allocates all the risk of harm or loss to you.

For more information on this topic, please contact marketing@jordanramis.com or call (888) 598-7070.


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