New California Statute Prohibits Residential Builders from Imposing Type-I Indemnity Agreements on Subcontractors After January 1, 2006

By Randel J. Campbell and Ralph R. Rhoades

Residential construction subcontracts entered into after January 1, 2006, may no longer contain "Type I" indemnity clauses in favor of the builder for construction defect claims. AB 758 is being hailed as a victory for California subcontractors who have been facing a crisis in availability of liability insurance. Governor Arnold Schwarzenegger signed the bill into law on September 29, 2005.

As enacted, AB 758 is not likely to be the panacea for construction defect liability that subcontractors had hoped for. The wording is dense and ambiguous. The law regarding "additional insured" obligations is left unchanged. Worse yet, developers may be able to circumvent the very protection from indemnity obligations the statute purports to provide to subcontractors.

The Goal of AB 758

Proponents of AB 758 contend that Type-I indemnity obligations unfairly shift liability from builders to their subcontractors and have caused the insurance rates for California subcontractors to skyrocket. Supporters argue that increased insurance costs have reduced the ability of responsible subcontractors to bid successfully in residential construction. Advocates of AB 758 hope that it will make general liability insurance more available to subcontractors in the residential housing industry.

Assemblyman Ron Calderon, the author of AB 758, explained his perception of the need for the bill as follows:

  • In the construction arena, developers are forcing subcontractors to contractually indemnify them for losses where the subcontractor is less than 100 percent negligent. In the case of a Type I indemnity agreement, the subcontractors must indemnify for losses arising out of the negligence of the developer. The only loss not indemnified is the sole negligence or willful misconduct of the developer. In other words, if the developer is 99 percent negligent and the subcontractor is 1 percent negligent, the subcontractor must indemnify the builder for the entire loss. If the subcontractor does not agree, the developer will look for another subcontractor, essentially shopping for a willing participant. Type I indemnity agreements and the Presley decision have helped to cause general liability insurance rates to skyrocket as insurance companies attempt to assess the risk of insuring work that a subcontractor is not responsible for. These two issues have had a twisted effect on the subcontractor industry. Subcontractors who are "here today and gone tomorrow" are the beneficiaries of these policies while the long-time union contractor suffers. It is entirely unfair for the state to condone this shift of liability onto a subcontractor. Subcontractors should not be responsible for someone else's mistake.

In an effort to address these issues, AB 758 amends Civil Code § 2782 by adding sections (c) and (d) as follows:

  • (c) For all construction contracts,... all provisions...affecting any such construction contract...that purport to indemnify, including the cost to defend, the builder, as defined in Section 911, by a subcontractor against liability for claims of construction defects are unenforceable to the extent the claims arise out of, pertain to, or relate to the negligence of the builder,...or for defects in design furnished by those persons, or to the extent the claims do not arise out of, pertain to, or relate to the scope of work in the written agreement between the parties. This section shall not be waived or modified by contractual agreement, act, or omission of the parties. Contractual provisions, clauses, covenants, or agreements not expressly prohibited herein are reserved to the agreement of the parties. (d) Subdivision (c) does not prohibit a subcontractor and builder from mutually agreeing to the timing or immediacy of the defense and provisions for reimbursement of defense fees and costs, so long as that agreement, upon final resolution of the claims, does not waive or modify the provisions of subdivision (c). Subdivision (c) shall not affect the obligations of an insurance carrier under the holding of Presley Homes, Inc. v. American States Insurance Company. [ ]

The Implications of AB 758

AB 758 attempts to ameliorate the "twisted effect" that Type-I indemnity agreements and "additional insured" obligations have had on subcontractors in the residential housing industry. Yet, in creating "protection," the Legislature may have perpetuated the ills it tried to cure.

AB 758 Leaves Presley Homes Intact

Typically, residential construction subcontracts require additional insured endorsements (AIEs) that name the builder as an "additional insured" party on the subcontractor's liability policy. After providing an AIE to a builder, the insurer has an obligation to defend the builder from all claims arising out of the subcontractor's work, regardless of the subcontractor's involvement or degree of fault. Likewise, the builder is covered for its sole negligence. Moreover, an AIE issued by a subcontractor's liability carrier to a builder requires the subcontractor's carrier to provide the builder with a defense to all claims in a lawsuit, not just claims arising from the subcontractor's work. (Presley Homes, Inc. v. American States Insurance Co.)

Interestingly, AB 758 expressly does not affect the obligations of an insurance carrier under the holding of Presley Homes, and it does not prevent the builder from demanding that the subcontractor provide insurance coverage for the same items the builder is prohibited from demanding in an indemnity agreement. So, even without a Type-I indemnity obligation, the subcontractor's insurers may end up paying to defend builders against construction defect claims. With the insurance industry reporting that nearly $7 in defense costs are paid for every dollar paid in liability costs for claims made in these lawsuits, we question whether subcontractors will truly see a reduction in insurance premiums after AB 758.

Notwithstanding AB 758, Will "Builders" Continue to Obtain Type-I Indemnity Protection?

Despite the intent of AB 758, ambiguities in the statutory language may allow builders to continue demands for Type-I indemnity from subcontractors for construction defect claims. AB 758 eliminates Type-I indemnity clauses in favor of the builder "as defined in [Civil Code] Section 911." This begs two questions: (1) What is a "builder," and (2) Can a "builder" require a Type-I indemnity obligation from its general contractor, which in turn can require Type-I indemnity obligations from subcontractors?

Civil Code § 911(a) defines "builder" as "any entity or individual, including, but not limited to a builder, developer, general contractor, contractor, or original seller who at the time of sale was also in the business of selling residential units to the public..." (emphasis added). Civil Code § 911(b) goes on to state: "'builder' does not include any entity or individual whose involvement...is limited to his or her capacity as general contractor or contractor and who is not a partner, member of, subsidiary of, or otherwise similarly affiliated with the builder." Under the language of the statute as written, we expect "builders" can (and probably will) utilize an independent general contractor entity between the builder and the subcontractors to impose Type-I indemnity obligations.

Although Civil Code § 911 provides that "for purposes of this title, these nonaffiliated general contractors... shall be treated the same as subcontractors," general contractors may still be required to provide Type-I indemnity agreements in their contracts with builders. We take "for purposes of this title" to refer to Title 7 of Part 2 of Division 2 of the Civil Code, yet Civil Code § 2782 occurs in Title 12 of Part 4 of Division 3. There is no language in Section 2782 that nonaffiliated general contractors are the same as subcontractors, and the statute specifically refers to "subcontractors."

This means that AB 758 does not affect the ability of general contractors and builders to enter into contracts containing Type-I agreements. The independent general contractor can then enter into subcontracts that require Type-I indemnity. This is the typical contractual relationship on commercial construction projects, where it is well settled that Type-I indemnity obligations are part of the cost of doing business. The net effect is that AB 758 does not preclude Type-I indemnity obligation from flowing from a builder through a general contractor and then to subcontractors.

Conclusion

Despite its intentions, it does not appear that AB 758 will have any impact on the number and cost of construction defect lawsuits in California. It may or may not change how the defense of construction defect claims is funded, depending on how the AIE issue is resolved. AB 758 will certainly change the language of residential construction contracts and subcontracts, but it may not make general liability insurance more available for subcontractors. If developers of mass-produced housing successfully utilize independent general contractor entities to procure Type-I indemnity protection, the purpose of the statute will be thwarted. Allocating the risk for (seemingly inevitable) construction defect claims is an important aspect of any development strategy. But risk allocation is only one aspect, and developers will have to analyze and balance other considerations before deciding how to proceed. We suspect that, as courts apply AB 758 in the coming years, the litigation of construction defect lawsuits may not change much at all.