Advising Indemnification Agreements with Charles Stec, J.D.

In the second episode of a special two-part series, Executive Vice President Daniel Frazee interviews Charles Stec, J.D., accomplished attorney at Lanak & Hanna, to advise construction companies on what to include in indemnification agreements.

Daniel Frazee: Welcome back to StudioOne™ everybody. We're happy to be joined again by Charles Stec from Lanak and Hanna. We're going to change the conversation a little bit. Charles was nice enough to talk with Drew Garcia, our landscape leader about sub-contract agreements. We're going to shift into indemnification So, welcome back to the studio, Charles, and thanks again for joining us.

Charles Stec: Thanks for having me back. It's my pleasure.

DF: Okay, well, let's talk about indemnification agreements. More specifically, tell our listeners what should go through their minds when they hear that word indemnification and how it may impact them in construction?

CS: So indemnification is a big legal word that simply means a promise to pay for damages or defects that arise from your work.  The bigger concern lately because of the cost of litigation is that there is a duty to defend also included with a duty to indemnify. What that really means is that if there's a claim, you end up being responsible to pay for the legal fees and costs of the person that's making that claim against you. And those costs, especially in smaller claims, can sometimes exceed the value of the actual damages at issue.

So an indemnification provision in a contract can be used to really define who is going to be responsible and to tell a subcontractor that they're responsible for damages that arise from their work. But how we write that provision can very much impact how it will be interpreted and what your actual allocation of responsibility will be.

DF: Okay. So, furthering that part of what you're talking about, can you provide us with an example how indemnification, when worded a specific way, can negatively impact, let's say, a lower tier trade that we might represent?

CS: Sure Daniel. Let’s take a drywall subcontractor as our example. If our drywall subcontractor has an indemnification provision as contract, that ultimately says that he is responsible to defend and indemnify for claims arising from or any way related to his work, then if we had a scenario where there was a water leak from the roof, from plumbing, whatever it is, and it ultimately results in the wall that's dry walled having buckling or mold, then in the event of a claim, that drywall subcontractor could arguably be responsible to indemnify and defend because our provision says in any way relating to his work.

But if we rewrite that position to just say he's only responsible for claims that arise from the negligent performance of his work. Now, in our scenario of the water leak, his duty to indemnify and to defend won't be triggered because the claim ultimately comes from a water leak, not from something wrong with how the drywall work was installed

DF: Okay, that makes sense. And I'm going to go a little off cuff with you, but I want to better understand because I think we have a lot of clients that have concern with redlining contracts, right? They're working with a preferred contractor, a really solid relationship. They don't want to disrupt that. So in your experience, when there is pushback, when there is redlining of contracts, how do most general contractors respond to that when you insert that type of wording. Does it depend on the general or is there some reasonable compromise that you've seen?

CS: So I've actually seen mostly reasonable compromise. I think everybody knows that a contract is ultimately supposed to be negotiated at arm's length. It's supposed to be the two parties are negotiating their position. What people are afraid of as a subcontractor is, "Oh, I'm not going to get the work because I'm not just accepting the contract as it is." But in that scenario, that contractor is running the risk that you're going to argue later that this was a contract of adhesion. Take it or leave it and therefore it's not enforceable. So they're typically open-minded and I have many, many a times in my recent past found myself on the phone with the general contractor's lawyer and we negotiate the few positions that are disputed in a contract. They expect it and for the most part if your requests for revisions are reasonable, they're going to get accepted.

DF: Very helpful. That's very helpful. So let's continue looking at indemnification clauses from a subcontractor's perspective. Walk us through what they may see in a typical contract and some specific examples, again, back to redlining or changing language that can minimize their exposure.

CS: So all contracts are a little different, and every one of these indemnity provisions has been written by different lawyers, so they're all a little different, but I'll give you kind of a general idea of what one normally sounds like. So my example is, “subcontractor agrees to indemnify and hold harmless the owner, contractor, and their agents, and any entity or person for which the contractor is responsible per the contract documents, from and against any claims, damages, or losses, including attorney's fees and costs arising from or in any way related to the subcontractor's work.”

So using my example, there's a few things that you would want to consider redlining with that provision. The first is the vague description of who you're promising to either defend or to indemnify. So in our example it said any entity or person for which the contractor is responsible. Well that's not defined and that creates a very real possibility that you could find yourself either having to provide defense fees for--or indemnity--to parties you've never even met and having to pay potentially multiple defenses. So in that case, I would strike that language in its entirety and instead make sure that each of the people that you were agreeing to identify are clearly defined. Normally that's going to be the prime contractor and the owner only. There may be some scenarios on certain jobs where you would agree to someone else, but it should be defined so you know who and what responsibility you're taking on.

DF: Okay.

CS: In our same example, another consideration is you could add language excluding liability for the owner or the general contractor's negligence. So let's talk about what that would be. For example, if the owner knows there's an unsafe condition there, there's a hole in the ground, a bad step, whatever the case may be, he doesn't tell anybody about it and leaves it there and one of your employees gets injured. Excluding that liability would make sure that the owner becomes responsible and you're not indemnifying the owner for your employee or some other person's injury that's actually coming from a condition the owner knew about and left there and didn't tell anybody.

Similarly, if another contractor on the job has done something that is so poor that it is potentially a danger either to other work or to cause injury. Let's say framing was done with a too small of a header and nobody knows that one day comes crashing down. That would be an example that if the contractor knew that their other sub had put in that bad header and didn't tell anybody that you would want to exclude that damage. So I definitely recommend adding language, excluding the gross negligence of either the owner or the contractor.

DF: Okay, all right.

CS: And a final example, it goes back to the defense costs. So in every contract for indemnity, the law implies this duty to defend. And the duty to defend arises at the time that they tender it to you, they say we've got a claim against us. And so you're now paying the legal fees of somebody else before the claims ever resolved and it's determined whether or not you did anything wrong.

Now, in our example, it said attorney’s fees and costs and you could imply that that is that duty to defend, but simply striking that wouldn't be enough, because the law actually implies the duty in to any contract of indemnity. So you have to specifically excluded it. So what you could say is I have no duty to defend a lot of times though Your contractors and owners might reject that. So what we could also consider is limiting what that duty to defend to be.

Two possibilities you could talk about is; saying that you will only agree to pay your proportionate share of the potential defense costs based on your proportionate share of the potential damages so that it's now shared amongst other subcontractors or of the contractor whoever else might be involved in the particular accident or event. The other would be to put a limitation of liability provision in where you could say our liability is either limited to what insurance proceeds pay or even to a specific dollar amounts. I've seen people say let's put it to the total amount that I was paid on the project or a set number like $100,000. Those types of provisions can help limit that defense cost that you ultimately could see picking up from an alleged accident.

DF: Okay, all right. Thanks for kind of going into that detail. Very helpful for our subs to understand some areas to be focusing on. So, if you look at indemnification clauses from a direct contractor's perspective on commercial and service contracts, what should they be watching out for and how can they redline or a change language that can minimize their exposure?

CS: Sure. So, obviously, when you're talking about these direct contractors, those on a commercial or a service agreement, their relationship is a little bit different. So they're now no longer a subcontractor lower down in the chain, but they're in a direct contract, probably with the project owner. So a lot of our discussion before on subcontractors would still apply, but there's a few other things that you might want to look at as well.

First, I've seen in a lot of direct contracts lately that in the indemnification provision, one of the parties to indemnify that owners have been adding is the design team, either the architect or the engineer. Those should be excluded because as the contractor--unless we're talking about a wholly different subject, which is design build agreements--the contractor has no control over the design. They're not able to influence how it's done, how it's built, or most of the times the design's done long before they ever get there. So to indemnify the design team doesn't make sense because it's not someone that you ever had any ability to control the quality of that work. So I think that those should be excluded, be redlined out, and also you would consider adding a phrase that says something to the effect of the contractor is not responsible for claims that arise from design defects or design errors or emissions. You don't really want to be taking on liability for a designer that you didn't have any business with and you're not in contract with.

DF: That makes sense.

CS: Another example that I've seen is that a lot of these indemnification agreements with owners are very broad. They say all claims, damages, liabilities, or losses and the problem is it doesn't clarify for what claims. Are we talking about claims from the owner or claims made to the owner? So what I've been recommending lately is that in those broad indemnity provisions, that it be revised to say for third party claims. That way the owner can't sort of hodgepodge the indemnity provision into a requirement to you to pay their defense fees to sue you. So that's a revision that we've seen come up more often than not lately.

Another that really is beneficial and it sort of goes back into the design question from a minute ago is putting in a reverse indemnity provision. So in a lot of projects, the owner provides to the contractor a set of plans, maybe some reports, some geotechnical reports, whatever the case may be, and the contractor does their work based on those reports. In a reverse indemnity provision, the owner agrees to indemnify the contractor for errors and emissions in those reports. So let's take for example, you are doing, you know, subterranean grading and there is a retaining wall to hold in that subterranean dig if the design plans didn't build a big enough set of supports and you build what's in the design plans and it fails, you shouldn't be the one responsible for that failure because it's the design, not the construction. So the reverse indemnity provision would then make the owner responsible to go to that designer for that claim rather than come to you as the contractor.

DF: Okay, all right.

CS: Finally, there are a lot of other ancillary provisions in a contract that read together with the indemnity provision can help minimize your liability. We talked about two of them with the subcontractors. That's a consequential damages waiver, those indirect costs that may come up. And the other being excluding damages for latent defects. We talked about it in the underground, an unknown type, things you wouldn't know there, like utility or box. Those types of provisions you could consider having in there and they would define when your indemnity would kick in.

Others that you could talk about adding would be a clearly defined delay provision. If your project is running late, who's responsible for that or defining what the damages would be and maybe setting a liquidated damages amount on a daily rate or a monthly rate. So at least you could control your risk because you know what that potential damage would be if it runs late.

And finally, it would be a provision limiting what recoverable damages could be, either to insurance proceeds or the maximum amount of liability, like we discussed earlier.

So the main point is that every construction business is a little different. And it makes sense to tailor your contracts to the type of trade that you're in, the type of jobs that you're doing, they could be public, they could be private, and there's different risks and allocations that come with those different types of projects. So in my belief, a little bit of foresight in working with your contracts in advance can really help control your risks in the event that something does go wrong in the future.

DF: Well, and I think Drew alluded to it too, that your process of being out in front of this and proactive really aligns with how we interact with our clients trying to mitigate risk on the front end. But so often we get feedback that sometimes crosses that line of insurance to legal, where we can comment and provide some feedback, but we don't have the expertise that you do in the background that can really help them truly negotiate these contracts or just tighten up everything that they have with respects to sub-agreements and/or indemnification.

So these bullet points are so helpful for us and our team, and I can't thank you enough for sharing this. I know this is just the tip of the iceberg too. I know what you do for many of our clients is so effective. Tell us again, if people need to connect with you, what's a good way to start the dialogue?

CS: Well, again, thank you for having me here today. It's been a pleasure. You're absolutely right. It is the tip of the iceberg. There are so many different things we could talk about. We could have gone on for hours. I really do like to tailor to a specific contractor's needs. So the best thing to do is literally to reach out. We're available by phone, consultation is free, I can be reached at my office, it's 714-451-7919, send me an email, that's ckstec@lanak-hanna.com or you can go to our website, which is Lanak-Hanna.com.

I say it all the time and I'll say it again here, I think that a little bit of upfront attention, a small amount of money you spend consulting with a lawyer. If it saves you from one lawsuit, it's worth every penny.

DF: Agreed and I think that's been consistent with the clients that have partnered with you and I think they would say the same thing. So thank you again and thanks to our listeners for joining us again in this series and we'll see you next time.

Catch Up on Part 1

Navigating Subcontract Agreements with Charles Stec, J.D.

In the first of a special two-part series, Executive Vice President Daniel Frazee and Landscape Group Vice President Drew Garcia, interview Charles Stec, J.D., accomplished attorney at Lanak & Hanna, to discuss how construction companies can best navigate subcontract agreements. 

Daniel Frazee: Welcome everyone and thanks for joining us. I am Daniel Frazee, the construction group leader and we're back in StudioOne™ with Drew Garcia, our landscape group leader. Welcome Drew.

Drew Garcia: Dan, good morning. How you doing?

DF: Doing fantastic. We're really excited to be joined by Charles Stec, an accomplished attorney supporting the construction industry with Lanak and Hanna. Charles is here to share his experience in representing California trade and general contractors, which includes several of our clients. And more specifically, I think we're going to get inside two important but very distinct topics, subcontract agreements and indemnification. Welcome, Charles, to StudioOne™.

Charles Stec: Thanks for having me, it's my pleasure.

DF: So before we get started, Charles, tell us more about yourself and how you became so focused in the construction industry?

CS: Well, I actually got my start in the trades. I worked as a roofer back in the 90s and 2000s and worked on a lot of different projects: residential, commercial, public projects. Ultimately I still have and maintain a general contractor's license and when I got into the law I ended up gravitating back to construction both because of my experience but also because I believed as a lawyer that I could help contractor clients navigate the pitfalls of the construction industry by getting involved earlier.

What I've noticed in my practice is that many contractors don't consult with an attorney until something goes wrong and they get sued. And at that point, they've already got the contract, says what it says, the facts are the facts. What I like to do is get involved earlier. And at that point, we can look at contracts, we can look at what's going on in a project, and try to assess risks and minimize risks. So the firm I work for, Lanak and Hanna, were really a one-stop construction shop. We handle everything that's related to a construction business. So from the outset, we handle, for example, the contracts, but also bids during the project, labor issues that might come up. And at the end, collections such as stop notices and mechanics liens, or in the event something goes wrong, defending against a defect or a damages claim.

DG: Very good. Yeah, I think we can relate with your guys’ proactive approach to business and how you're trying to kind of consult with your customers in advance of an issue and obviously when there is an issue reacting to it and making sure that you're there for them. We take a similar approach to the way that we do our business. And when we jump into subcontract agreements you know Rancho Mesa we've got a number of different businesses that we help support. We could have general contractors; we could have trade contractors that are a part of a project. We've also got service contractors that might be subbing out small portions of their work where it might not be as glaring or they might think there's not a need to have a subcontract agreement.

Obviously, it's important. Can you talk to us about why the sub contract agreement is an important step in the relationship between two service partners and how it provides clarity?

CS: Sure, Drew. Let's start with the basic, what is the purpose of a contract? Really the purpose of a contract is to allocate risk by defining the rights and responsibilities between your two service providers to avoid disputes that are caused by misunderstandings or to set forth what's going to happen if something actually does go wrong. So generally what we see a lot of in the most common disputes between contractors and subs or a service provider and their subcontractor is simple things like payments, or what happens when there's extra work. So a subcontract agreement can be used to put those things into writing and set forth those basic terms; what that subcontractor is going to get paid, what the specific items that are included in their scope are, so if there is extra, we can define what is and what isn't extra, and then how that subcontractor is going to get paid. Are they getting paid on a progress payment, or are they getting paid on a lump sum when it's done?

If something does go wrong, the subcontractor agreement also has the benefit of setting forth how it's going to be resolved. For example, if that subcontractor doesn't finish their work or they get terminated, who's responsible for the cost to complete that work? Another example would be if there's an injury or damages that come from their work, how do we apportion that responsibility? And another example after that would be If something does go wrong and we can't resolve it, what's the procedure going to be? Are we going to go to litigation and spend years in court? Are we going to consider arbitration, which might cost us a little more upfront, but could get to a resolution faster?

The main point is a subcontract agreement is giving you an opportunity to allocate your risks, which allows you to better bid a project. If you are taking on a lot more risk, you're probably going to want to charge a premium for that risk. On the opposite side if you are passing that risk on to your subcontractor perhaps then you might be able to bid at a tighter rate. So a subcontract agreement's big main purpose is to really define things so that we know what's going to happen rather than leaving it up in the air.

DG: Well, so that makes sense. And when somebody's putting together a subcontract agreement, maybe it's the first one that somebody like you is putting together for a business. Is it kind of a, “hey, this one agreement fits all types of work that you might subcontract” or should the business look at more of a focused approach in terms of the type of work that they're subbing out or the type of project that they're on? Would that bring any nuance to the subcontract agreement?

CS: It would. So there's really two answers to your question Drew. First, yes, there are many general provisions that you're going to use through all your different types of subcontractors. Those are going to be those basic provisions like price, payment methods, what's the scope of work, how do we handle change orders, what's that procedure and the notice, maybe schedule and your insurance requirements.

But second, there's going to be some provisions that really are specific to the type of work you're subbing out. So take for example, if you're subbing out work where people are working in the ground, they're doing digging, they're doing trenching, they're planting materials. There's a large possibility that you could have unknown obstructions, whether there's big rocks or boulders in the ground or there's an unidentified utility. You might want to have a provision then that's going to assign who's responsible for those unknown encounters? Is it going to be the subcontractor who's then going to price it higher to deal with their risk of the unknowns? Or is it going to be the general contractor? Or is it going to be the owner? And that's going to affect both your pricing and bidding on the project, but it's also going to affect when that comes up, how do you deal with that dispute? Having that provision in place allows you to have the answer so you don't actually have to have a dispute and go to litigation.

Comparatively let's imagine that your subcontracting out work like roofing or windows or plumbing. Those come with the possibility of a water intrusion claim, there could be a leak there could be a burst pipe. So first and foremost we think well damages from that would probably be covered by insurance but there are other things that aren't and that's going to be those incidentals. For example, if you have a plumbing leak and it's in a residence or in a business, there's a possibility that owner is going to make a claim for loss of use or for a loss of profits because they haven't been able to operate their business. What we would want to then consider is whether or not you should have a consequential damages waiver that essentially says if there's these other indirect costs like the loss of use or like the loss of profits, who's going to be responsible for that? Is that going to be the owner or is that going to be the contractor or the subcontractor that caused the damage? And again, that's going to allocate to you how do you want to price this project? Because your bid is probably going to be affected by how much risk you're taking on. So those are two possible provisions that you might want to make more specific to your individual subcontractors and the type of work that they're doing.

DG: Got it. So obviously having open dialogue with a professional like yourselves in terms of what the project might look like for the business helps to kind of cater to the subcontract agreement or the specific needs of that agreement.

So in general, how often should somebody relook at their, the general provisions of their subcontract agreement that might be unanimous across all of their agreements? Is it an annual thing, bi-annual? Is there a recommendation in terms of how and those things should be re-looked at and revisited?

CS: Well, we generally recommend having your contracts re-looked at yearly. Now, some years there might be nothing to change, but other years there could be. The issue is the law is constantly evolving. So what the regulations are out there, whether it's from the CSLB or it's going to be from decisions from the court, are going to change over the years.

Let's take example, most common thing, pay. In the last several years, we've seen many revisions. Going back, not long ago, if paid provisions were allowed, which essentially said that the contractor and the subcontractor would share the risk that the owner doesn't pay. California has since prohibited those and said, no, that's not reasonable., it's against public policy, we want subcontractors to get paid. So now those are prohibited. Yet I still see them in contracts all the time that haven't been updated.

Similarly, California does allow pay when paid, which says that the subcontractor’s payment can be delayed until the contractor is paid by the owner. We saw just in the last couple of years, the court come back though and find one scenario where it decided to limit those provisions. And specifically, it was a lot of these provisions were being written to say that if the owner and the prime contractor got into a dispute, that the subcontractor had to wait to get paid until that dispute, whether it was litigation or arbitration, was resolved. Courts came out and said, that's not reasonable because it potentially makes that subcontractor who may have nothing to do with the dispute have to wait for payment for even years until that litigation is resolved. So the court said now that “pay when paid” provisions have to be reasonable. So I've been recommending in the last couple of years’ revisions to contracts to define what that reasonable period is.

So the answer to your question is ultimately contracts should probably be reviewed yearly. Some years it's going to be more, some years it's going to be less, but you want to stay up to date with the current codes, the current decisions, and the CSLB rules that are ever changing.

DG: Very nice. Now that makes sense. Last question, last subcontract question for you. So obviously having them is important, making sure that they are catered towards the work that you guys are, that you're putting into place. You know, I think the answer is probably obvious on this, when should that subcontract agreement be signed? But I'd like you to comment on that, but also what are some pitfalls if they're not signed before the project takes off? What are some concerns or what could that create in terms of, you know, future issues or maybe more immediate issues if that agreement isn't in place before the project takes off?

CS: Well, I think starting off, I would say what we've been talking about assigning risk and responsibility is really going to impact your pricing. So I would recommend having those agreements signed early.

What a lot of my contractor clients have been doing is they're doing master subcontractor agreements where with the regular vendors that they're using, they have an overall agreement that sets forth the terms and conditions and their assignment of risk and how they're going to deal with problems that they typically would foresee in an agreement that gets signed long before there's ever a job in place. Then when there's a particular job, they'll issue a purchase order and that purchase order will just incorporate the terms and conditions of that master subcontractor agreement. That's a really good place to be because then when you are bidding on a project, you already know how you are allocating risk amongst yourself, your subcontractor, and the owner, and you can price accordingly.

DG: Yeah. Again, it makes total sense.

DF: Okay. Well, tell us if people need to connect with you, what's a good way to start the dialogue?

CS: Again, thank you for having me here today. I can be reached at my office, it's (714) 451 -7919. Send me an email, that's cksetc@lanak-hanna.com or you can go to our website, which is Lanak-Hanna.com.

DG: Thank you again and thanks to our listeners for joining us and we'll see you next time.

Continue to Part II