Indemnitor Beware: The Curse of Circular Indemnity
Category | Briefing Papers
Nathan is a member of the firm’s Construction Law Department. He can be reached at 612.359.7606 or nsellers@fwhtlaw.com.
You’re a general contractor hard at work on a complex, time-is-of-the-essence construction project. (These days, is there any other type?) You receive a written notice from a subcontractor of a pass-through claim for added costs due to additional work caused by incomplete plans and specifications. This is a standard design-bid-build project, under which the owner hired an engineer under a separate contract to prepare the project’s bidding documents. You review the subcontractor’s notice and confirm the extra work is necessary to complete a functioning project and was not reflected in the bidding documents. So, without giving it too much thought (you’re busy with many other pressing tasks), you prepare a cover letter and pass the subcontractor’s claim on to the owner.
The owner responds almost immediately, rejecting the claim. You scan the rejection notice and see the owner’s reference to the prime contract’s indemnification clause. The owner is arguing that you, the general contractor, are responsible to defend, indemnify, and hold harmless the owner and its engineer from the subcontractor’s extra-work claim. How can that be?
What’s the first thing you do? You could call a lawyer. But what you probably do is dig out the general contract and locate the indemnification clause. (Which is a pretty good next step.) Here’s what the indemnification clause says:
CONTRACTOR agrees to defend, indemnify, and hold harmless the OWNER and ENGINEER and their respective officers, employees, and agents from all claims, costs, damages, or losses arising directly or indirectly from the performance of the WORK under this contract.
The owner is arguing the subcontractor’s claim, either directly or indirectly, arises out of your work on the project. As a result, the owner contends you have to defend and indemnify the owner and the engineer from the claim.[1]
Circuity of Obligation: What it is and why you should be aware of it.
A “circuity of obligation” is created when, by virtue of pre-existing indemnity agreements or obligations, a claimant is in effect obligated to indemnify the respondent for claims including the claimant’s own claim.[2] In such a situation, the claimant’s right to recover damages from the respondent is offset by the claimant’s obligation to repay the same damages to the respondent.[3] When a circuity of obligation is triggered by a contractual indemnification provision, it may be referred to as “circular indemnity.”
Circular indemnity in construction contracts
Thankfully, certain state legislatures and many state courts have not taken kindly to the owner’s argument from above. For example, in Minnesota, state statutes governing building and construction contracts provide that any indemnification agreement contained in a construction contract is generally unenforceable except to the extent the underlying claim, injury, or loss is attributable to the negligence or otherwise wrongful act of the indemnitor (in our scenario, the contractor) or those for whom it is responsible.[4] Thus, an agreement in a construction contract for one party to indemnify another party from liability for the latter party’s own actions cannot generally be enforced under Minnesota law.[5]
In some jurisdictions, even though contract clauses requiring one party to indemnify another for its own misconduct are not strictly prohibited by statute, courts have interposed a rule that generally decreases the likelihood of circular indemnity. In cases that an indemnitee argues the indemnitor must indemnify the indemnitee for its own misconduct, many courts recognize a rule of “strict construction.”[6] Under that rule, an indemnity provision will not be construed to indemnify one against losses caused by its own wrongful acts unless an intention to do so is expressed in clear and unequivocal terms to that effect.[7]
As the Colorado Supreme Court has recognized, however, there is a growing trend in courts around the county to “relax the rule of strict construction in construing indemnity contracts in commercial settings.”[8] In particular, the rule of strict construction of indemnification agreements may be “somewhat liberalized” where the agreement was negotiated at arms-length between sophisticated business entities.[9] And some courts have moved away from the rule entirely.[10]
Circumventing Circular Indemnity
As should be apparent by now, circuity of obligation or circular indemnity can lead to big headaches and big legal exposure. So, what should you do?
For one, when negotiating a contract, carefully review the indemnification language. Consider whether the indemnification agreement limits your indemnification obligation to damages, losses, or claims caused by your own negligence or otherwise wrongful acts. And consider whether the agreement says you will not be responsible to indemnify another party for its own negligence or otherwise wrongful acts.
Second, if you’re in a situation in which you cannot negotiate a contract’s indemnification provision (e.g., a publicly bid project) carefully examine the clause to see if your duty to indemnify the owner, design professional, or any other party for its own negligence is expressed “clearly and unequivocally.” If not, courts will likely not enforce circular indemnity.
If all else fails (or as a first step) call a trusted construction attorney. He or she can advise whether an indemnity agreement purporting to create circular indemnity is unenforceable under statute, court rule, or for some other reason.
[1] The foregoing scenario is loosely based on a true story in which an owner made this very argument against a contractor I represented and even moved for summary judgment on the subcontractor’s pass-through claim.
[2] Nat’l Hydro Sys. v. M.A. Mortenson Co., 529 N.W.2d 690, 693 (Minn. 1995).
[3] Id.
[4] Minn. Stat. § 337.02.
[5] Katzner v. Kelleher Constr., 545 N.W.2d 378, 381 (Minn. 1996).
[6] See, e.g., Boulder Plaza Residential, LLC v. Summit Flooring, LLC, 198 P.3d 1217, 1221 (Colo. App. 2008).
[7] Public Service Co. v. United Cable Television of Jeffco, Inc., 829 P.2d 1280, 1283 (Colo.1992).
[8] Id. at 1285.
[9] Id.
[10] Chrysler Corp. v. Brencal Contractors, Inc., 381 N.W.2d 814, 817 (Mich. Ct. App. 1985).
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