Drafting and Interpreting Indemnity Agreements: Living Forward, Understanding Backwards

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Black’s Law Dictionary defines indemnity as one’s obligation to make good any loss, damage or liability incurred by another to a third party. Typically, this obligation arises within a larger contract, within which the indemnitor contractually assumes responsibility for injuries later sustained by a third party and who, therefore, promises to reimburse the other contracting entities that may be secondarily liable for the given injuries. In the abstract, the concept of indemnity radiates benignity—a simple understanding between two entities that upon the occurrence of a condition, Party X will indemnify Party Y. Indeed, drafting indemnity provisions appears to require no special education or skill, their comprehension being well within the capability of anyone able to read the provision and give effect to its terms by applying their ordinary, popular and commonly-accepted meaning.

While many lawyers often pretend that indemnity agreements are encrypted in legal jargon and that we alone hold the key to their use and understanding, it remains a poorly guarded secret that nothing inherent to indemnity agreements makes their interpretation the exclusive prerogative of the legal profession. In fact, non-lawyers find these pretentions off-putting, believing that lawyers needlessly frustrate contractual negotiations. Undoubtedly many have encountered the ill-concealed contempt of prospective clients brashly rejecting the need for legal services, as a friend once exclaimed, “I am an engineer paid to negotiate construction contracts involving millions of dollars and I certainly comprehend English well enough to understand a simple indemnity clause.”

Life can only be understood backwards, but it must be lived forwards.
While acknowledging that most educated and reasonably sophisticated persons can readily understand indemnity agreements in the abstract, my friend’s contempt for legal services ignores the brilliance of Kierkegaard’s maxim and reflects his naïve belief that the mutual cordiality of two parties “living forward” to a prospective contract continues throughout its execution. He fails to temper his expectancy with the practical reality that while indemnity agreements are written, considered and initially understood living forwards, i.e., their authors are looking prospectively onto the black and white possibility of some future event, the agreement will necessarily be interpreted and understood “backwards,” i.e., after an event has occurred. Retrospective interpretation often clouds a once black-and-white agreement into varying shades of grey. Where flexible, forward-looking negotiators might once have agreed suddenly gives way to the hard reality that preferring one interpretation over another carries costly consequences. Thus, while my friend might feel comfortable negotiating a given indemnity agreement that reflects his common understanding, he should temper that comfort with the practical understanding that if disputed, his “common understanding” might evaporate within the crucible that is litigation.

We undertake this study of indemnity agreements with Kierkegaard’s maxim ringing in our ears. At its conclusion, the reader should leave armed with a general framework from which to read and interpret indemnity agreements over and above the reader’s ability to comprehend the English language.

To begin, it is necessary to differentiate three types of indemnity agreements, which may be distinguished by the breadth of the indemnitor’s obligation to make good losses, damages or liabilities incurred by a third party:

  • 1. Limited form – a limited indemnity clause obliges the indemnitor to make good those losses, damages or liabilities arising from the indemnitor’s negligence or fault. Simply stated, the indemnitor must cover only those liabilities it caused.
  • 2. Intermediate form – distinguished from the limited form clause because it obliges the indemnitor to make good those losses, damages or liabilities arising out of the indemnitee’s concurrent or partial negligence. Simply stated, the indemnitor must cover those liabilities it caused, even though the other party contributed to cause those liabilities.
  • 3. Broad form – distinguished from limited and intermediate because it obliges the indemnitor to make good all losses, damages or liabilities regardless of the indemnitee’s sole negligence or fault. Here, the indemnitor covers all liabilities, regardless of whether it contributed to cause those liabilities.

Whereas the limited indemnity provision merely requires the indemnitor make good only those losses directly attributable to it, both the intermediate form and the broad form provisions purport, to varying degrees, to shift the burden of indemnitee’s negligent behavior onto the indemnitor. That is, Party X will indemnify Party Y for Party Y’s own negligence, even if Party X was not negligent. Obviously, allowing Party Y an unfettered right to pawn its negligent behavior onto Party X raises red flags as it runs contrary to a fundamental tenet of tort law: an entity should be responsible for its own injurycausing conduct. Conversely, however, these more robust indemnity provisions might serve public interest by facilitating the freedom of the contracting entities to mutually allocate risks in accord with their own guideline, rather than a uniform dictate. As a primary example substantiating broader indemnity provisions, consider the instance in which an employee of Party X is injured primarily, but not solely, as a result of the employee or Party X’s negligence. In considering these potential liabilities, X and Y might prefer a reciprocal indemnity agreement where X and Y accept the sole responsibility for their own employees. A reciprocal agreement serves the dual purpose of giving X and Y certainty regarding each entity’s liability exposure while ensuring that employees are subject to the direction and control of only one master, their employer. In this instance, Texas acknowledges the right of contracting entities to allocate risks as they see fit.

Thus, their apparent benignity aside, the interpretation of indemnity agreements involves more than reading the provision and giving effect to its terms in accord with their ordinary, popular and commonly-accepted meanings. Rather, their interpretation necessitates balancing competing policy interests of allowing contracting entities the liberty to freely and voluntarily enter into a given contract with the State’s interest in ensuring that negligent parties be responsible for their own injury-causing conduct. Inherent within this calculus, courts will often assess the relative “bargaining power” of the contracting entities to ensure that a given indemnity provision was the result of a mutual, bargained exchange among equals rather than a product of the large over the small.

In interpreting indemnity language within a contract, Texas applies those same rules of contractual interpretation that it would apply to other contracts. So long as the agreement is not ambiguous, the court will ascertain the intentions of those making the agreement and give effect to those intentions. If ambiguous, however, the indemnity agreement will be strictly construed in favor of the indemnitor; i.e., the court will void the indemnity agreement. But the court will not manufacture ambiguity; words and phrases are given their ordinary, popular and commonly-accepted meaning.

To balance the competing policy interests discussed above, Texas has established the two-pronged “fair notice” test requiring contracting parties intending to shift the risk of negligent conduct from one party to another to provide “fair notice” of that intention. First, “fair notice” requires the parties to specifically express their intention to transfer risk from one party to another within the four corners of the contract. Thus, if Party Y intends Party X to make good those liabilities incurred from Party Y’s own conduct, the proffered indemnity agreement must specify those conditions under which X must make good. For example, if Y intends X to make good liabilities arising from Y’s sole negligence, the agreement must specify that intent because, as we have seen, any ambiguity will nullify the indemnity agreement.

Courts interpreting these intermediate and broad form agreements in the face of the “express negligence” rule will generally approach the agreement systematically, looking for identifiable “magic language” signifying the mutual intent to shift the consequences of one party’s negligence onto another. Thus, when reading a potential indemnity agreement, the reader should ask whether it includes the “magic language,” e.g., “EVEN TO THE EXTENT SUCH CLAIM IS CAUSED... BY THE CONCURRENT OR SOLE NEGLIGENCE OR FAULT” of the indemnified party. Without these magic words that the agreement specifically protects the indemnified party from its OWN or SOLE negligence, or that the agreement applies  “regardless of fault,” the proffered agreement does not give “fair notice.” This rule applies even if an otherwise “fair reading” would indicate that the contracting parties  “inferred,” rather than explicitly stated, their intent to create a broad form agreement; an “implicit indemnity agreement requiring the [indemnitor] to deduce [its] full obligation is unenforceable.”

But “fair notice” involves more than specificity in defining those circumstances under which the indemnity agreement would apply. Under its second prong, the Texas “fair notice” doctrine requires the indemnity provisions to be conspicuous, i.e., something must appear within the contract to attract the attention of a reasonable person when [s]he looks at it. Stated more simply, an indemnity agreement should call attention to itself ensuring that the indemnitor (Party X) understands that by executing the contract, it is assuming responsibility to make good certain losses of Party Y. By its nature, conspicuousness ensures a base level of mutuality among the contracting parties. An indemnity agreement hidden within a contract evinces subterfuge rather than a mutual, bargained exchange among equals. Consider the following statements made by courts interpreting whether a given clause is conspicuous.

Conspicuous

  • More visible than other items on the page.
  • The entire contract consists of one page; the indemnity language is on the front side of the contract and is not hidden under a separate heading.
  • Provisions referred specifically to the indemnity provision on the reverse side of the purchase order and there was printed in large, red type on the front of each page of the order a notice that the agreement included the terms on the reverse side of the order.
  • Paragraph containing indemnity agreement is eight lines long and the subject matter of the entire paragraph is “waiver and release."

Not Conspicuous

  • Hidden on the reverse side of a sales order under a paragraph entitled “Warranty” and was surrounded by completely unrelated terms.
  • Appearing on the back side of a delivery order.
  • The language appeared in small, light type on the back of a rental form and was surrounded by unrelated terms.
  • The provisions are located on the back of a work order in a series of numbered paragraphs without headings or contrasting type.

Because the “fair notice” test remains an imperfect scale from which to weigh competing public policy interests and to ensure that indemnity agreements are a product of mutual bargaining rather than unfair dictates, intermediate and broad form indemnity provisions have come under increasing legislative scrutiny. In 1985, in enacting the Texas Oilfield Anti-Indemnification Act, the Texas Legislature found oil and gas contracts were often the result of an inequality among contractors rather than a mutual obligation and, consequently, against public policy. Thereafter, the Legislature mandated that indemnity agreements pertaining to these interests be mutual and supported by insurance. Similarly, the Legislature enacted Chapter 130 of the Texas Civil Practices & Remedies Code to protect registered architects and licensed engineers from abusive property owners in certain construction projects by forbidding property owners from requiring architects and engineers to indemnify that property owner from the owner’s negligence. Likewise in 2011, the Texas Legislature enacted Texas Insurance Code Section 151.102, prohibiting all intermediate and broad form indemnity provisions in construction contracts after January 1, 2012.27 The Legislature defined “construction contract” broadly, essentially including any agreement affecting the design, construction, or alteration of any building, structure or other improvement.

Additional Insured Endorsements
Recalling the earlier acknowledgment that there is nothing inherent to indemnity agreements making their interpretation the exclusive prerogative of the legal profession, one presumes the reader has readily digested both the different types of indemnity agreements and the essential legal framework under which Texas courts will give effect to these risk-shifting agreements. Indeed, the reader should be motivated to do so because these disputes often involve significant amounts of money and their apparent lack of complexity often operates to increase, rather than decrease, the number of potential interpretations. But no study, however brief, of indemnity agreements would be complete without a discussion of insurance issues, which add further complexity.

Sophisticated risk-shifting agreements usually require a prospective indemnitor to guarantee its ability to comply with its indemnity obligations by purchasing liability insurance, thus protecting the presumed indemnitee against potential insolvency. While this insurance mandate can be a simple directive within the indemnity agreement that the putative indemnitor maintain the requisite liability coverage, most risk-shifting agreements involve a separate and distinct “additional insured” provision requiring the prospective indemnitor to take the additional precaution by adding the indemnitee as an “additional insured” onto its commercial general liability (CGL) insurance policy.

Under Texas law, placing the insurance requirement within the indemnity language, rather than as a separate and distinct obligation, makes the directive contingent upon (or supplemental to) the larger indemnity language. Thus, if the indemnity language fails, the insurance obligation fails also; the insurance provision has no effect beyond the applicability of the indemnity agreement. But by merely separating the insurance obligation from the indemnity obligation, the insurance obligation stands or falls on its own, independent of the indemnity provision. A properly written, separate “additional insured” provision can effectively relieve the presumed indemnitee of any financial burden associated with its own negligent behavior, even if the indemnity agreement is invalid.

While a detailed legal discussion of these “additional insurance” provisions is beyond the scope of this paper, a general overview is necessary. Disputes over “additional insured” provisions ultimately boil down to a disagreement between two or more insurance companies over which of them is financially responsible for a given claim. In the abstract, insurance companies loathe providing coverage to “additional insured” for the additional insured’s own negligence and systematically object.

Thus, the nature of the CGL policy and the language within “additional insured” endorsement is of paramount importance.

By and large, additional insured provisions generally come in two types. First, the given policy may specifically name the “additional insured,” providing that additional insured with a “certificate of insurance.”

More commonly, however, a CGL policy will simply define “insured” to include, for example, “any person or organization that is an owner of real property or personal property on which you are performing ongoing operations or a contractor on whose behalf you are performing ongoing operations...” Obviously, for the “additional insured,” the certificate of insurance is preferable as it constitutes unmistakable evidence of coverage under the policy and that this coverage applies independently of any indemnity language.
Conversely, however, the second type of language is often preferable to insured contractors, especially when that insurance needs to be spread among numerous participants in a risk-creating activity. Ultimately, when negotiating a services agreement, the parties should consider the extent they desire the additional legal protection afforded by carrying a “certificate of insurance.”

In conclusion, one trusts the reader finishes this brief overview of indemnity agreements armed not only with the necessary framework from which to read and interpret indemnity agreements but also with the ability to consider and compose indemnity language that serves their clients’ interests. And while poking fun at omnipresent disconnect between pretentious lawyers and contemptuous clients, applying Kierkegaard’s maxim to enlighten the divergent perspectives between clients’ “living forwards” and lawyers’ “understanding backwards” should embolden us to compose indemnity agreements within the common understanding of lawyers and non-lawyers alike. Indeed, one should not set this article aside determined to encrypt future indemnity agreements in rote legal jargon unintelligible to all. Ultimately, one should draft indemnity agreements with the expectation that they will be read and applied.

Source: Originally published in The Houston Lawyer, the magazine of the Houston Bar Association, Vol. 52 No. 1, July-Aug. 2014 at p. 18. Reprinted by permission.

Topics:  Contract Drafting, Contract Interpretation, Indemnity Agreements

Published In: General Business Updates, Insurance Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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