An Insurers' Pinch Hitter? Is a “Real Time” Defense Under an Indemnity Agreement as Real as it Sounds?

Crawford v. Weather Shield Mfg., Inc. (2006) __Cal.App.4th__.

Survey the professions of insomniacs in January 2006, and leading the list would be general contractors not named as additional insureds on their subcontractors' insurance policies. Perhaps they had indemnity agreements, but who would prefer a defense provided by a subcontractor over that provided by an insurance carrier? Subcontractors were required to defend if they were liable under an indemnity agreement. Insurers had the immediate duty to defend so long as the general contractor risked even the most remote potential of liability for covered damage.

On February 2, a California Court of Appeal tried to put those sleep-deprived general contractors at ease. In Crawford v. Weather Shield Mfg., Inc., the court ruled that a subcontractor could be required to provide a defense before there is any ruling on liability under an indemnity agreement, and that the duty to fund a defense is triggered as soon as the matter is tendered-regardless of whether the subcontractor is ultimately found liable under the indemnity agreement.

After some careful analysis, general contractors will again bolt upright in bed. There are good reasons why a subcontractor should not be required to defend until there is a duty to indemnify. An indemnity promise in no way duplicates the protection provided by additional insured certificates. There is no requirement that a subcontractor provide independent counsel to ensure the claim is not steered toward claims outside the indemnity obligation. Worse yet, defense fees under a hold harmless agreement are "contractual damages," which reduce the available policy limits for indemnity under the subcontractor's policy.

If nothing else, the Crawford decision is controversial. The court takes on six other Courts of Appeal as well as a member of its own bench in declaring this new rule. By the time this article is published, the opinion may be decertified or accepted for review by the California Supreme Court. Even if the opinion is depublished, the prospect that a trial court could issue a similar decision justifies analysis of the Crawford ruling.

First, a disclaimer: For ease of discussion, I will use the term general contractor as synonymous with indemnitee- the entity that is owed indemnity. For indemnitor, the party who owes indemnity, I will use the term subcontractor. Please don't construe this as taking sides: General contractors are just as likely to be on the receiving end of a tender from an owner as a subcontractor is from a general contractor. Likewise, subcontractors often assert indemnity clauses against sub-subcontractors or suppliers.

Won the Battle, Lost the War

Mr. Crawford was one of a group of homeowners who filed suit for construction defects, naming as defendants the developer, subcontractors, and a window manufacturer. The developer cross-complained against the window manufacturer, seeking attorney's fees incurred in defending the window claim as well as any indemnity the developer might owe. The contract between the developer and the manufacturer provided: "[Manufacturer] does agree to indemnify and save [Developer] harmless against all claims...growing out of the execution of the work, and at his own expense to defend any suit...against [Developer] founded upon the claim of such damage..."

At trial, the court dismissed the strict liability claim against the manufacturer. The jury then found in favor of the manufacturer on the negligence and breach of warranty claims. Yet despite owing no indemnity, the manufacturer was found liable for a portion of the developer's defense fees because the suit was "founded on" claims of damage growing out of the execution of the manufacturer's work.

Between the jury trial on the complaint and the bench trial on the cross-complaint, the California Supreme Court held that manufacturers of component parts could be subject to strict products liability in tort. On that basis, after the trial court issued its decision on the defense issue, it granted plaintiff's motion for new trial. The parties appealed the new trial order and the award of defense fees to the developer.

The Indemnity Issue Is Too Appealing

Appellate practice dictates that a court resolve the case before it on the narrowest grounds available, and decline to issue any advisory ruling unnecessary to its ultimate ruling. Here, the California Supreme Court's opinion constituted a change in the law, justifying the order granting a new trial. On that basis, the Court of Appeal would have been on sound footing to affirm the new trial order, remand the case for retrial, and wait for the defense issue again to ripen. If there were a verdict against the manufacturer on strict liability, it would owe a defense to the developer. If instead the manufacturer again prevailed, only then would it be appropriate for the Court of Appeal to rule on the defense issue.

Yet two of the three justices could not resist deciding an issue that did not need to be decided, and thereby created a conflict among the Courts of Appeal where there had been unanimity before. Despite the fact that the case would be retried, the court ruled that the manufacturer should owe a defense regardless of the subsequent verdict.

Which Came First: The Indemnity Chicken or the Defense Egg?

An insurer's duty to defend was always treated as broader than a contractor's duty to defend. A carrier had to defend even if ultimately no damages were owed; the mere allegation of potentially covered damage was enough. In contrast, if a contractor owed a defense, it would be required to reimburse the indemnitee for any post-tender attorney's fees only after it was held liable to pay indemnity.

The Crawford court fantasized that subcontractors were getting rich off the interest accruing while the indemnity payment issue was being litigated under this system. To prevent such ill-gotten gains, the court determined that the defense duty could not be satisfied by merely reimbursing the indemnitee after the indemnitor was found liable. "A defense obligation is of necessity a current obligation. The idea is to mount it, render it, and fund it now... Defense is the rendering of a service at the time-the emphasis is on the present tense."

Because the agreement to defend created an obligation to provide a present "service," by definition the obligation could not have been contingent on a subsequent indemnity finding. The contract required a defense of any claim growing out of the manufacturer's work. "Such language necessarily contemplated application without an adjudication of that party's negligence because the defense of a claim must necessarily take place before the claim itself is adjudicated. It just can't exist otherwise."

How then is a contractor's duty different from a carrier's duty? The Crawford court distanced itself from any suggestion that a contractor is required to provide a complete defense; rather, under the terms of its contract, the manufacturer was responsible for its part of defense costs reasonably attributable to the unfounded window claims. In other words, the contractor takes on the role of an insurer in defending claims involving that contractor's work. Yet like an insurer, that contractor's duty to defend is broader than its duty to indemnify. The result is a "defense by division": simply divide the general contractor's fees by the number of subcontractor cross-defendants.

Pay No Attention to Those Decisions Behind the Curtain

No fewer than six prior Courts of Appeal, in the Crawford court's eyes, were confused by the term "indemnity." Those misguided courts "merely assumed the defense obligation was part of a classic indemnity obligation." Thus, even where a prior Court of Appeal dealt with the same indemnity clause as the Crawfordcourt and ruled no defense was owed until the subcontractor's indemnity obligation was determined, the Crawford court found that the defense discussion was unnecessary to that court's ruling on the issue before it. Oblivious to the speck in its own eye, the Crawford court believed that none of the six courts contradicting its ruling needed to address the issue.

Pay No Attention to the Insurance Policy Behind the Curtain

The Crawford court did not view this as a situation where a "small-time carpentry shop [was] suddenly being asked to defend all the claims brought against a big developer in major construction defect litigation." Rather, the court assumed the liability would all be covered by insurance. "[I]ndemnity contracts also typically require that the sub put the general or developer on that insurance contract. (After all, we may assume that developers would rather look to a sub's insurer for 'defense and indemnity' than they would to subs themselves.)" "Those defense costs, at least so far as this present appeal is concerned, will all be borne by the subcontractors, or more likely, the subcontractors' insurers... If the next phase were indeed a successful contribution action between insurers, then things would have come full circle back to the equitable allocation model...with the developer's insurer still on the hook for its portion of defense costs."

Between a Rock and a Hard Place

Let's face it, if you're worried about this issue, it's because you forgot to make sure you were named as an additional insured on the subcontractor's policy. The trouble is, now what are you going to do about it?

Your first concern should be policy limits. In a circumstance of a serious, multi-plaintiff construction action, there may be the prospect of a high six-figure defense and a seven-figure settlement or judgment. Unlike attorney's fees under most general liability insurance policies, which do not erode the policy limits, defense expenses under an indemnity clause are treated as contractual damages which will reduce the policy limits available for indemnity. If the subcontractor has a $1 million liability policy, there is the prospect that at least a substantial chunk of the limits will be consumed by the defense. If the subcontractor has diminished insurance limits or assets remaining with which to satisfy the indemnity payment, a substantial portion of the indemnity must come from you. You got a free or subsidized defense, but now the indemnity payment shows up on your loss run and will adversely affect your ability to get reasonably priced insurance later. If instead the subcontractor's policy limits were preserved for indemnity, you wouldn't have that mark on your record.

Another concern is that a subcontractor is not bound by the requirement of Civil Code § 2860, which requires an insurer to appoint independent counsel if counsel could steer the defense to uncovered claims. By its terms, that statute applies only to insurers. If the general contractor fears counsel retained by the subcontractor may not protect its interests, the general contractor may have to hire independent counsel at its own expense.

So where does this leave the party seeking indemnity? Given the choice, the general contractor should favor indemnity over defense, and its own counsel over counsel provided by the subcontractor. Because clauses routinely involve the obligation to provide defense and indemnity, the general contractor should demand from the subcontractor proof that it has the economic wherewithal through a combination of primary and excess policies or assets to fund the potential indemnity and defense obligations under the contract. If the subcontractor has its $1 million policy and a backhoe, then the general contractor might be able to convince a court that the subcontractor had insufficient assets to fulfill its contractual obligations, so as to justify a rejection of the defense offered by the subcontractor.

Another strategy to be used in conjunction with the above suggestion would be for the general contractor immediately to serve a Code of Civil Procedure § 998 settlement demand for the subcontractor's policy limits. If the demand is rejected, the general contractor might be able to argue that the subcontractor's carrier is liable for all contractual damages (including attorney's fees) regardless of the policy limits.

From the subcontractor's perspective, it should offer an immediate defense, and then take refuge in statutes holding that if the general contractor decides to defend itself, the subcontractor has discharged its defense obligation. It would then leave the general contractor to convince a court that the promised defense was illusory, because it merely cannibalized the indemnity protection by providing the pretense of a full defense.

A Conflict and a Challenge

The court assumes that if a carrier provides a defense to the general contractor under the additional insured endorsement, this problem disappears. In fact, the problems may multiply. In the prior case law, courts routinely recognized that a defense provided under an additional insured endorsement satisfied the requirement of a defense under the indemnity agreement. Under the logic of this new ruling, the general contractor can claim a separate defense from the subcontractor even if the carrier is providing the defense. In a sense, the Crawford court is correct that it does not treat the subcontractor as an insurer as a result of its ruling-it treats the subcontractor worse than an insurer. Now indemnity clauses can be considered as "super insurance policies," covering risks routinely excluded in general liability policies. In the end, the effect is to destroy the concept of a reservation of rights as we know it, because whatever is excluded under the insurance policy will now be argued as encompassed by the indemnity agreement.

In an attempt to explain why it needed in excess of 22,000 words to describe what the Crawford court believed to be a statement of existing law, it made the following comment:

"Indemnity is an inherently dull subject anyway... The comedy troupe Monty Python once made the subject of insurance-insurance of all things- the butt of a comedy skit. But we doubt that even comedians of their caliber would try to make 'indemnity' the topic of comedy. It is a topic so deadly dull that it makes insurance look interesting." Regardless of one's opinion about the court's holding, anyone writing or speaking on the topic of indemnity should take heed of this point. Hopefully, this article and my May 24 seminar in Oakland, California will help to change the public's perception of indemnity.

By William A. Bogdan