The beauty of the freedom of contract is that it affords parties the opportunity to allocate risks to the entities in the best position to guard against those risks. Proper risk allocation is especially important in the construction industry where projects are completed through the performance of a network of agreements. Be cautious, however, because the bargained-for risk transfer recorded in your written agreement may be a mirage.
There are several means to contractually allocate risk, some more effective than others. One of the most commonly used risk transfer provisions incorporated into contracts is the indemnity clause. Nevertheless, indemnity clauses are often misunderstood, inartfully drafted, and may not apply as intended by the parties, especially in the construction setting.
While indemnity provisions are perhaps the most powerful forms of risk transfer in commercial contracts, about 85 percent of the states have enacted some form of anti-indemnity legislation applicable to construction contracts. These statutes require courts to construe indemnity agreements much differently than intended by the parties to the contract. For example, Illinois has enacted the Construction Contract Indemnification for Negligence Act, 740 ILCS 35/0.01, et seq., commonly referred to by practitioners as the “anti-indemnity statute.” This statute invalidates any agreement within a construction contract whereby one person agrees to indemnify another person for the second person’s own negligence. Sounds simple enough, right? It’s not.
After states began enacting anti-indemnity statutes, many construction professionals attempted to circumvent the legislation by incorporating language explicitly stating that the indemnity provision does not apply to the extent the indemnitee is negligent. Problem solved, right? Nope.
Even where the indemnity obligation is expressly inapplicable for the indemnitee’s own negligence, courts in several states still refuse to enforce the bargained-for risk transfer provision in construction contracts. Again using Illinois as an example, Illinois courts construe “partial indemnity” provisions as attempts to bestow rights of contractual contribution, which contravene the public policy behind the Illinois Joint Tortfeasors Act, 740 ILCS 100/0.01, et seq. The Illinois Joint Tortfeasors Act provides pro rata contribution rights among joint tortfeasors, but permits a party to extinguish the contribution rights of joint tortfeasors by entering into good faith settlements with the injured party. As such, the Illinois Joint Tortfeasors Act encourages settlements in allowing individual parties “buy their peace” even though all parties in the claim do not agree to settle. By contrast, contractual contribution rights created by “partial indemnity” agreements could obstruct settlements as the contribution rights would not be extinguished as to the non-settling parties. In other words, parties would refuse to settle since their exposure to joint tortfeasors would remain. Given that public policy favors settlement in the litigation setting, Illinois courts refuse to recognize contractual contribution. Accordingly, a party to a construction contract in Illinois cannot effectively transfer risk via full or partial indemnity provisions.
Illinois is far from the exception. Over half of the states apply their own form of anti-indemnity statute in prohibiting full or partial risk transfer by indemnity agreements in construction contracts.
Given the application of anti-indemnity statutes in a majority of U.S. jurisdiction, indemnity provisions can be ignored in those states, right? Wrong! Courts generally presume contracting parties know the law (i.e. the existence of the anti-indemnity statute). Additionally, many courts presume that contracting parties do not insert useless terms into their contracts. So, in interpreting indemnity agreements in construction contracts, courts may construe the terms, which are unambiguously indemnity provisions, as something other than a standard agreement for indemnity. Confused yet?
Despite the fact that a cardinal rule of contract interpretation is to give effect to the intent of the parties to the agreement, several states with anti-indemnity statutes apply indemnity provisions as waivers of the liability limitations provided by worker’s compensation statutes.
State worker’s compensation systems have been established, in part, as a compromise in recognizing that: (1) employees needed to be compensated for workplace injuries; and (2) employers needed protection from indefinite risk. Accordingly, worker’s compensation systems define the benefits an injured worker can receive and includes limits on employers’ exposure. Generally, an employer’s liability will be limited to the amount the employer paid in worker’s compensation benefits. However, many courts in jurisdictions with anti-indemnity statutes apply indemnity agreements in construction contracts as waivers of the limitations afforded under the worker’s compensation system despite the fact that such application is not necessarily consistent with the intent of the parties to the agreement.
The fact of the matter is that most states have enacted some form of anti-indemnity legislation applicable to construction agreements. Among the states with anti-indemnity legislation, the actual statutes and judicial treatment of indemnity provisions varies widely. Some states only prohibit indemnification for the indemnitee’s sole negligence. Other states only prohibit indemnity agreements for public projects. Some jurisdictions permit partial indemnification. Also, there are several factors written into anti-indemnity statutes, which limit their application. The key is to understand how each jurisdiction will construe and apply the terms of the contract.
Accordingly, drafting a contract to allocate risk as intended by the parties is not enough. Rather, a proper legal review of the application of those terms in the appropriate jurisdiction is required to ensure the agreement will be enforced as intended. Otherwise, you may not enjoy the benefit of your bargain.
Doug Allen is a partner in the Chicago office of Foran Glennon Palandech Ponzi & Rudloff and a member of the Firm’s Construction Law and Professional Liability litigation team and concentrates his practice in representing architects, engineers, design-build firms and contractors. Allen is authorized to practice law in the state courts of Illinois, the United States Supreme Court and U.S. District Courts for the Northern and Central Districts of Illinois.