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How Contractual Indemnity/Hold Harmless Agreements Work (In Theory)

Clients are often confused as to the application of the indemnity or hold harmless provision in services/commercial contracts.  Some clients believe that a party to a contract cannot sue the other party (the party to be indemnified or held harmless).  Other clients do not realize that if a third party sues the other party, the first party may be responsible not only for the other party’s damages, but also its defense costs.

As discussed in my earlier article, the indemnity or hold harmless provision is one of (if not the #1) most important provisions in a contract.  As a result, it is wise to have a basic understanding of the application of contractual indemnity.  It is also often necessary to have an attorney review indemnity provisions, which are often lengthy and very complex, as the consequences of whether or not the indemnity provision may be triggered can be substantial.

The indemnity or hold harmless provision is one of the most important provisions in a contract

Indemnity, Generally

The Merriam-Webster dictionary defines indemnity as “a promise to pay for the cost of possible damage, loss, or injury” or “a payment made to someone because of damage, loss or injury.”

California Civil Code section 2772 defines indemnity as “a contract by which one engages to save another from a legal consequence of the conduct of one of the parties, or of some other person.”

By way of example, let’s take a typical subcontract.  Typically, the subcontractor agrees to indemnify the prime contractor.  That is, the subcontractor promises to pay for the prime contractor’s damage, loss or injury caused by some defined event or events or circumstance.

Note: The scope of this article is limited to services/commercial contracts, not insurance or surety agreements – which impose different indemnity and defense obligations on both parties.  

 

Indemnification

The prime contractor’s indemnity rights generally arise from the prime contractor suffering damage, loss or injury (or a claim or lawsuit) caused by the subcontractor or a third party.  [In California, a prime contractor cannot obtain indemnify from its own active negligence or willful misconduct.]

Needless to say, if the subcontractor’s own conduct harmed the prime contractor, the subcontractor would be required to pay the prime contractor.  Such damages may be covered by liability insurance, if the harm was caused directly by the subcontractor’s negligence.

The more difficult issues arises where a third party’s conduct harms the prime contractor.  Generally, the third party’s conduct must be specifically related to the subcontractor’s conduct (scope of work) to trigger the duty to defend.  Typically, this would be a supplier, sub-subcontractor, or sub-consultant.  The specific indemnity language controls this issue.  Such damages or may not be covered by the subcontractor’s liability insurance.

Duty to Defend

The California Supreme Court has held that in every indemnity agreement, there is also a duty to defend (unless the agreement provides otherwise).  In our example, to the extent the subcontractor has a duty to indemnify the prime contractor, it also has a duty to defend the prime contractor.

Thus, if the prime contractor is sued by a third party, the subcontractor may have to defend, or pay for the defense of, the prime contractor.  This obligation is triggered immediately by a tender by the party to be indemnified (the prime contractor).  Thus, the subcontractor’s obligation to defend or pay for the defense of the prime contractor starts as soon as the prime contractor makes a demand on the subcontractor.  This can be costly, both financially and legally, if not handled promptly and properly.  Further, these damages are likely not covered by liability insurance, as it is considered a contractual obligation.

To put another wrinkle in this complicated area, the California Court of Appeals has held that a party’s duty to defend may be triggered by the allegations of a party’s wrongdoing. As such, in our example, even if the subcontractor was ultimately found to not be liable for the prime contractor’s damages, the subcontractor may still be responsible for the prime contractor’s defense because of the allegations of wrongdoing.  Again, the specific indemnity or defense language will control this issue.

Conclusion

Indemnity provisions are typically lengthy and very complex, and can have substantial consequences if triggered or not.  Often, a single word or phrase can trigger whether or not an indemnity (or defense) provision may apply.  As such, we recommend having an attorney review indemnity provisions in your contracts or any contracts proposed by another party, prior to executing the contract.