Changes In California Law Complicate Contractual Indemnity Among Contractors

Residential contractors should begin to evaluate their contractual risk-transfer tools, their litigation strategies and their analysis utilized for wrap-up coverages in light of a new bill signed into law in California.

In September 2008, California Governor Arnold Schwarzenegger signed Assembly Bill 2738, which creates significant changes to the contractual risk-transfer of owners/builders and their subcontractors who are involved in residential construction projects. The bill contains the following main factors:

o It applies to residential construction contracts for projects within California entered into on or after Jan. 1, 2009.

o Contractual indemnity between the general contractor and subcontractors is enforceable only to the extent caused by the negligence of the subcontractor.

o Regarding tender of claims under these contracts, the subcontractors have the right to provide choice of counsel and maintain control of the case.

o Under wrap-up style insurance projects, the bill eliminates the use of any contractual indemnity agreements between the general contractor and subcontractors.

o The bill also specifically outlines that the pricing of the wrap-up insurance and the specific coverage needs be contained within the bid or contract documents.

As outlined, the enforceability of contractual risk transfer is greatly impacted by the changes contained within AB 2738. Essentially, subcontractors will be responsible for their own percentage of fault of losses.

As in other jurisdictions, this will most likely lead to a longer process for the subcontractors and their carriers to agree on accepting tenders under these contracts.

AB 2738 eliminates the ability of homebuilders to obtain an immediate and complete defense against construction defect claims of the subcontractors who constructed the allegedly defective homes.

A longstanding California decision--American States v. Presley--holds that once it is determined that an insurer for a subcontractor owes a duty to defend any portion of a claim, they are obligated to defend the builder for the entire loss.

Contractors should also be mindful that broad-styled additional insured endorsements might conflict with these limited contractual agreements and could be deemed unenforceable.

In acceptance of contractual indemnity tenders, AB 2738 allows subcontractors to now choose counsel and control their defense of the claim. The bill also limits the recovery of defense costs to the particular subcontractor's share of the work.

With this change, situations may potentially arise where several different subcontractors are defending the same general contractor with various attorneys.

Sound litigation strategies will be needed to properly coordinate the defense of parties by potentially various participating subcontractors and their carriers. It will also need to be determined what rights the general contractors may have in being provided a quality defense.

The bill also contains specific changes to projects that involve any wrap-up insurance.

Under Section 2 of AB 2738, the builder will not be able to enforce any contractual indemnity on residential projects insured under a wrap policy.

Under a previous bill (AB 758), the builder was allowed to seek full indemnity from the subcontractors for claims not covered by the wrap and claims that exceeded the limits of the wrap.

However, the law's changes will essentially eliminate all indemnity rights a general contractor has against a subcontractor, including cases where the subcontractor is negligent.

Parties will need to remain mindful that there are cases where the subcontractor is negligent (such as damage caused to its work or the work of other trades during construction) which would not potentially be covered by the wrap policy, and by any course of construction insurance procured by the owner/general contractor.

Section 3 of AB 2738 imposes disclosure requirements on builders insuring projects under wraps. Under these changes, the bid documents must contain the policy terms as well as the fact that the builder will seek insurance credit/deduct from the subcontractors. It also does not allow the builder to pass through to the subcontractors more than the cost of insurance paid for by the builder.

This provision could eliminate the ability to negotiate over insurance credits and contributions during the contracting phase.

Moreover, if there are policy changes and/or the insurance carrier is replaced during the policy period, it will need to be determined if the bid documents are required to be redrafted.

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