Are Indemnification and Guarantee Clauses Just Empty Promises?

Parties to a construction project—owner, contractor and design professionals—face significant potential risk. For this reason, during contract formation and negotiation, there should be candid discussion on the fair allocation and management of project risks—with risk generally allocated to those in the best position to control it.

07/01/2005


Parties to a construction project—owner, contractor and design professionals—face significant potential risk. For this reason, during contract formation and negotiation, there should be candid discussion on the fair allocation and management of project risks—with risk generally allocated to those in the best position to control it.

Risk management begins with finding ways to minimize or transfer risk. Then, should potential risk become reality, it becomes a matter of absorbing or funding the resulting liability. But the capacity to absorb liability is unbalanced among principal parties. They don't profit equally, and there isn't equality in the nature of their risks. Contracts and negotiations should attempt to balance the ability to control and absorb risk among the parties.

One strategy for spreading risk among all parties is insurance. As a form of indemnification, insurance shifts risk from one party to another. Insurers assume liability in the event of a loss, but they must be able to measure and quantify their assumption of risk.

This is the background to a discussion of indemnification and guarantee clauses, contract provisions often tendered by an owner to the design professional. The concept of indemnification—hold harmless—is simply an agreement to assume a specific liability in the event of a loss. Guarantee is synonymous with warrant or certify and means to assure the total accuracy, truth or perfection of something.

However, these clauses might endanger one of a design professional's best risk management tools: professional liability insurance. These provisions come from two paradigms, neither of which is applicable to services provided by design professionals.

One paradigm is the assumption that certain protections for the owner that are common in a construction contract are likewise appropriate and applicable to a professional services contract—which can lead to problems. An owner might believe both contractor and design professional are bound by similar laws of contract and practice. But there are important differences recognized by law that distinguish both the risk and limit of consequence for each.

Contractors vs. design professionals

A contractor's control over the outcome of a construction project is primary to its standing under the law. The contractor physically takes control of the owner's property during the construction and builds an improvement, exercising command over the materials, means, methods and sequences used to accomplish the task. Generally, the contractor is held responsible for damages caused by faulty workmanship and safety concerns while both property and improvement are in its hands. If successful, the contractor stands to profit commensurate with the risk.

Contractors usually provide broad indemnification to the owner through provisions in their contract. The historic rationale for this indemnification is based on the principle that when one party takes possession and control of the property of another, the associated risks will follow.

The economic rationale is equally straightforward: Because the contractor is better positioned than the owner to control the risks of construction, the contractor can more efficiently manage those risks or transfer them to subcontractors or insurers.

Design professionals, on the other hand, render professional services: studying, planning, designing, administration, etc. They do not assume control of the owner's property. By law, they have a duty to perform services in a non-negligent manner, and are only responsible for damages from the consequences of their negligence in the performance of services.

They are generally not required to pay for damages resulting from the fault of others. Damages customarily do not include value added to the project from post-design changes. The historic and economic rationales that support indemnification by the contractor do not apply to the design professional.

Design is not a commodity

A second problematic paradigm equates a design professional's services with an article of trade or commerce. An article of trade or product provided by a vendor, commonly procured by purchase order, would customarily include provisions requiring the "promises" of certifications, guarantees and warranties. Vendors or contractors provide guarantees because they are obligated under the law to stand behind their work.

Services of the design professional, however, are not subject to such "promises"—that a certain result has been reached, standard has been met or statement or condition is true, correct or perfect. The design professional is not obligated under the law to guarantee performance, or even its result. Under the standard of care to which design professionals are judged, it is not expected that they be perfect. If design professionals agree to certify or warrant their services, they are promising perfection and are assuming a level of responsibility far beyond the normal standard of care.

Applying the concepts of indemnification and guarantee derived from the above paradigms to design professionals puts them in the position of assuming risk far in excess of what is required by law. The costs associated with those risks are not readily measurable, and they have no ability to insure against it. If, by contract, design professionals accept a broad indemnification or guarantee provision, they may be voiding the protection of professional liability insurance.

What's covered

Design professionals' professional liability insurance policy provides payment for all sums, in excess of the deductible, for which they become legally obligated to pay as damages and claims expenses as a result of an act, error or omission (negligence) in the performance of their professional services. The policy is unique, specialized and carefully tailored to remain within the limits of the design professional's obligations under the law—nothing more, nothing less.

All professional liability insurance policies on the market today contain similar exclusion provisions with wording to the effect that "the insurance does not apply to liability assumed by the professional under any contract unless the professional would have been liable in the absence of such contract, due to his own error, omission or negligent act." In other words, if the design professional, by contract, assumes the risk of another, and liability is incurred, the insurer is excused from the requirement for coverage. This provision specifically makes all but the narrowest of indemnification clauses uninsurable.

More specifically, in regard to guarantees, a second provision similarly found contains wording that excludes "express warranties or guarantees." The intent is clear and unmistakable, and is again derived by exposure that the professional assumes by contract, which is in excess of what is required by law.

Why ask for an empty promise? Construction projects almost never go by the book. Weather, field conditions, product imperfections, human error and countless other problems are virtually inevitable. Generally, for a project to be successful, the interests of all parties are best served when the possibility of risk to the project is honestly acknowledged and discussed at the front end of contract negotiations.

Indemnification and guarantee provisions in a professional services agreement between an owner and design professional, unless formed with a sense of balance and purpose for insurability, are in essence empty promises. The design professional can neither collect a premium for assuming—nor insure against—someone else's risk. Contract provisions that potentially deprive a design professional of the financial capacity to respond in the event of a loss are neither fair nor justified. From all parties' points of view, it makes far more sense to reach a fair, equitable and enforceable agreement where promises made are promises kept.





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