If, in the course of business operations, you have signed a lease or subcontract agreement, then contractual liability is a part of your life, whether you realize it or not. Contractual liability, simply put, is the obligations or liability you assume by agreeing to the terms of a contract.
To illustrate, let’s look at very plausible example: A tenant (the “lessee”) agrees, by virtue of his written lease agreement, to “hold harmless and indemnify” his landlord (the “lessor”) for “any and all injury or damage that takes place on premises of the tenant, unless the injury or damage is caused by the sole negligence of the landlord”. A few months after signing the lease an electrical fire occurs at the lessee’s location and a customer is seriously injured by burns and smoke inhalation. The customer sues the landlord for their injuries and wins a judgment of $100,000. The lessor, by virtue of the lease agreement, turns the judgment over to the lessee for full payment to the injured customer.
Does this sound like a far-fetched scenario? It’s not, and in fact this type of contractual risk transfer happens every day in the form of a “hold harmless agreement” and “indemnity clause” commonly inserted into construction and lease agreements, service and maintenance contracts, franchise agreements and even purchase order contracts.
The Hold Harmless Agreement
The liability implications of hold harmless agreements can be enormous – such as the scenario detailed above – and yet very few business owners actually understand the purpose and intent of those agreements. The key to understanding hold harmless agreements, and contractual liability in the broader sense is the notion of answering for the liability of another. Put another way, a person or organization has agreed to assume the liability of another to an unknown third party. In the scenario above, the tenant agreed to assume the liability of the landlord to the injured customer (the third party).
Construction agreements typically have a hold harmless clause that states the subcontractor agrees to indemnify and hold harmless the prime contractor for any and all claims resulting from bodily injury and property damage while on the job site and, typically, for completed operations after the work has been completed. Construction agreements usually attempt to push as much liability to others as possible – from the owner to the prime contractor, then from the prime contractor to the subcontractors and so forth. The result of these types of agreements is often protracted and messy litigation that involves multiple parties.
The obvious question is why any person or organization would sign a contract that transfers liability to themselves? The answer is two-fold: first, that person or organization wants to do business with the party offering the contract. The party offering the contract typically holds all the bargaining power – a “take it or leave it” type of proposition. Construction contracts are generally structured in this manner. The prime contractor or developer awards the bid with the condition that the sub-contractor accepts the construction agreement as offered. The sub-contractor obviously wants the work (especially in the current economic climate) and simply signs the contract without question. The same scenario often happens in a lessor/lessee relationship: the prospective tenant accepts the lease agreement as-is or finds another location.
The second reason is often simply a lack of knowledge regarding contractual liability. A business owner may not understand the consequences of a hold harmless agreement and sign without question. We see this frequently with our construction policyholders who have been dragged into ugly and expensive construction defect litigation, often for work that was done many years ago.
Contractual Liability and Insurance Coverage
Coverage for contractual liability has been included in the commercial general liability (CGL) policy since 1986, but how this coverage applies merits further explanation. The first mention of contractual liability in the 2001 CGL policy is as the title of an exclusion and reads as follows:
“Bodily injury” or “property damage” for which the insured is obligated to pay damages by reason of the assumption of liability in a contract or agreement. This exclusion does not apply to liability for damages:
(1) That the insured would have in the absence of the contract or agreement; or
(2) Assumed in a contract or agreement that is an “insured contract”, provided the “bodily injury” or “property damage” occurs subsequent to the execution of the contract or agreement. Solely for the purposes of liability assumed in an “insured contract”, reasonable attorney fees and necessary litigation expenses incurred by or for a party other than an insured are deemed to be damages because of “bodily injury” and “property damage”, provided:
(a) Liability to such party for, or for the cost of, that party’s defense has also been assumed in the same “insured contract”; and
(b) Such attorney fees and litigation expenses are for defense of that party against a civil or alternative dispute resolution proceeding in which damages to which this insurance are alleged.
The definition of “insured contract” is also important for this discussion
“Insured contract” means:
(a) A contract for a lease of premises. However, that portion of the contract for a lease of premises that indemnifies any person or organization for damage by fire to premises while rented to you or temporarily occupied by you with permission of the owner is not an “insured contract”;
(b) A sidetrack agreement;
(c) Any easement or license agreement, except in connection with construction or demolition operations on or within 50 feet of a railroad;
(d) An obligation, as required by ordinance, to indemnify a municipality, except in connection with work for a municipality;
(e) An elevator maintenance agreement;
(f) That part of any other contract or agreement pertaining to your business (including an indemnification of a municipality in connection with work performed for a municipality) under which you assume the tort liability of another party to pay for “bodily injury” or “property damage” to a third person or organization. Tort liability means a liability that would be imposed by law in the absence of any contract or agreement.
In the tenant/landlord scenario listed above, assuming the tenant had purchased general liability coverage, the claim for $100,000 against the landlord would be handled by the insurance company. Similarly, many construction agreements meet the definition of an “insured contract”.
The verbiage in the 2001 CGL form is often referred to as being “broad” or “blanket”. It is important that you also understand other editions of the CGL form have different verbiage that may limit coverage for contractual liability. Alternately, the insurance company may attach an endorsement that severely restricts coverage in part (f) of the above definition of “insured contract”. In addition, most States have specific statutes or case law that affect the use of hold-harmless agreements. This is something you will want to discuss in detail with your insurance agent.
You should also understand that claims for “breach of contract” are completely different and not covered by the CGL policy. Breach of contract claims do not arise from liability assumed in a hold harmless or indemnity agreement and do not typically involve “bodily injury” or “property damage” losses. These types of claims also involve allegations of damages between the two parties that signed the contract, whereas contractual liability claims deal with 3rd party liability transferred from one party to another.
The bottom line is that contractual liability and hold harmless agreements are part of doing business. However, you should always read contracts before signing them and, preferably, discuss the details of the contract with your attorney and insurance agent. As always, the agents at Safeguard Insurance are here to answer your insurance related questions. Please contact us anytime and we look forward to speaking with you!