3 Types of Indemnities (Energy Construction) [Gaille Energy Blog Issue 79]
- Posted by scottgaille
- On July 10, 2019
- 0 Comments
An indemnity is one party’s agreement to hold another harmless for certain types of claims or losses. A typical definition of Indemnify would be as follows:
“Indemnify” means release, reimburse, protect, indemnify, compensate, make whole, make good, hold harmless, and defend (including taking such steps and incurring such fees, costs, and expenses as may be necessary to defend any Claims/Losses, whether pre-litigation or in connection with any proceedings in any court or other tribunal, and shall include the obligation to pay attorneys’ fees, court costs, and expert fees).
Why do we bother with indemnities? After all, isn’t everyone in the United States already liable for the damages they cause? While it’s true that amounts owed as a matter of law might be similar to those owed under an indemnity, this is not always the case. For example, consider an accident at a construction gate between a contractor’s vehicle and a third party. The third party sues both the contractor and the project owner, causing the owner to incur legal fees. Without a contractual indemnity obligation by the contractor to pay the owner’s legal fees, it’s unlikely that the owner would be able to recover them (at law).
Contractual indemnities have been developed to provide more certainty regarding which party is responsible for various types of claims and losses. While these provisions vary, it is helpful to characterize indemnities as falling into one of three categories:
- Control-based. A control-based indemnity allocates risk for loss to the party in control of a project. If something goes wrong at the construction site, the control-based indemnity presumes that the contractor running the site is responsible. The owner does not need to prove that the contractor was negligent; the owner only needs to show that it incurred a loss related to the contractor’s work.
- Fault-based. A fault-based indemnity allocates risk for loss to the party that was at fault. Under a fault-based indemnity regime, a contractor would only be responsible for indemnifying the owner for a loss to the extent the contractor’s negligence caused it. While a fault-based regime more closely mirrors what a party would be typically liable for (at law), the indemnity can cover losses (such as legal fees) that might not otherwise be recoverable.
- Identity-based (or knock-for-knock). An identity-based indemnity—typically referred to as knock-for-knock—allocates risk based on the identity of the injured person, irrespective of which party was at fault. Under an identity-based indemnity regime, each party is entirely responsible for any losses sustained to its property or incurred by its personnel—even if they were caused by the other party’s negligence. Knock-for-knock indemnities often reverse the background law, protecting an otherwise responsible party from liability.
Which Indemnity Regime Is Appropriate for Which Project?
When the contractor responsible for building an energy facility has control over the means and methods of the work—and execution of the work occurs within a reasonably defined physical area—the control-based indemnity regime creates appropriate incentives. The party in control of the work space is deemed to be responsible for any and all losses occurring there. The owner need only prove that it has suffered a loss arising from the contractor’s work (and the amount of the loss). There is no requirement to prove that the contractor breached a duty.
This is in contrast to a fault-based indemnity regime, in which a contractor can dispute whether or not it breached a duty—or alternatively, point the finger for the loss at a third party. For example, consider an accident at the project’s gate between two vehicles, one belonging to the contractor and the other to a third party. The third party sues not only the contractor but also the owner. The owner incurs $100,000 of legal fees defending the matter. A jury finds that the contractor was 60% at fault, the third party was 40% at fault, and the owner was not at fault. In a typical fault-based regime, the contractor’s indemnity would be limited to 60% of the costs incurred by the owner—and the owner would be out-of-pocket $40,000 in legal fees for an accident it had no involvement with.
But what happens if the owner was responsible (in whole or part) for the loss? Although the presumption is that the contractor is responsible for all losses incurred by the owner, the contractor usually has the opportunity to prove that the owner was at fault—thereby overcoming the presumption of the contractor’s liability. For example, consider an accident at the project’s gate between two vehicles, one belonging to the contractor and one to the owner. If the contractor can prove that the owner was 30% responsible for the accident, the contractor’s obligation to indemnify the owner would be reduced from 100% of the owner’s loss to 70% of the owner’s loss.
Identity-based or knock-for-knock indemnities are designed for work spaces where many contractors are working in close quarters—and no single contractor has any real control over the work space. The knock-for-knock indemnity arose in the context of high-risk offshore energy projects involving multiple contractors:
“It was acknowledged by the industry that contractors’ balance sheets would be unable to cope with potential liability for the destruction of an entire oil rig facility and it also assisted with risk allocation at a practical level, because in an off-shore environment it was common for the sharing of tasks between different contractors and a blurring and overlapping of responsibilities, making it difficult to determine fault if an issue occurred…The use of knock-for-knock indemnities may not be appropriate in onshore projects in circumstances where each contractor’s site during the construction period is clearly defined, the location is not inherently hazardous and the risks are not as significant as in an off-shore environment.” (Tina Middis, Knock for Knock Indemnities—Are They Appropriate for On-Shore Infrastructure Projects?)
Ms. Middis offers two rationales for knock-for-knock indemnities: (a) sharing of tasks/blurring of responsibilities; and (b) contractors being unable to cope with a catastrophic loss. But why should a knock-for-knock indemnity be used to limit the quantum of liability? There are many instances when a contractor with absolute control over a work site could cause catastrophic liability—such as during the construction of pipeline crossing installations. A better approach in such cases is to require a control-based indemnity regime but provide a maximum liability limitation. In such cases, (i) maximum liability limitations should never be applicable to third party losses and (ii) owner recoveries from any insurance coverage required by the contract should not apply toward the cap.
Nonetheless, some contractors continue to seek a knock-for-knock regime for projects where there is no blurring of responsibility. Their lawyers tout the reciprocity of each party being responsible for its own losses. The reality is often different—since it is more likely that the contractor will cause damage to the owner’s personnel and equipment than the other way around. The contractor may have thousands of people and hundreds of vehicles moving on the site while the owner may only have a few inspectors. It’s improbable that the owner’s inspectors are going to cause damage or injury to the contractor. It’s much more likely that the contractor is going to cause losses to the owner. This exposes a fundamental flaw of knock-for-knock indemnities. On paper, the language may look reciprocal and fair, but in practice, one party may be much more likely to avoid liability.
As such, owners of new onshore facilities (and offshore facilities where one contractor is responsible for construction) are adopting control-based indemnities that are proportionately reduced only if the owner’s negligence contributed to the claim or loss. A typical clause reads as follows:
Contractor shall Indemnify the Company Group from any and all Claims/Losses directly or indirectly based on, in connection with, relating to, or arising out of the Work or any of Contractor Group’s actions or inactions under this Agreement, including any one or more of the following [list of examples]. The preceding Indemnity obligation shall apply regardless of whether any of the Company Group was concurrently negligent (whether actively or passively), grossly negligent, strictly liable, or otherwise in breach of any duty whatsoever (whether contractual, statutory, or otherwise); provided, however, that the Contractor’s liability and Indemnification responsibility in such a case shall be determined in accordance with principles of comparative responsibility such that Indemnification by Contractor shall be reduced by such member of Company Group’s percentage of negligence, gross negligence, or willful misconduct for such Claims/Losses.
The “list of examples” (bracketed above) can be used to enumerate typical circumstances for which the indemnity applies:
- personal injury to or death of any Person and damage to or destruction of property in connection with the Work;
- damage caused by any of Contractor Group or the Work to third party facilities;
- costs arising from damage caused by any of Contractor Group to the Work, Facility, or Company Group’s existing facilities and property;
- any violation of any Applicable Law or Codes and Standards by any of Contractor Group;
- failure to comply with Good Industry Practices by any of Contractor Group; or
- injury to the Environment during the course of the Work.
The use of examples helps to focus the parties on the allocation of risks—and also improves the ease with which the indemnity can be enforced (if the loss falls within one of the examples).
Thinking about indemnities as falling within one of three classes helps practitioners to better design indemnity regimes that suit the risks of a specific project:
- Control-based indemnities generally should be used when one contractor is in control of a defined work place (even if the one contractor has many subcontractors working for it);
- Identity-based indemnities (knock-for-knock) generally should be used when there are many contractors working alongside of each other and no contractor can be fairly described as being in control of the work or the work location; and
- Fault-based indemnities generally should be used when neither of the preceding applies.
Note: The Gaille Energy Blog is now back after a hiatus due to publishing deadlines for my new book, Strange Tales of World Travel.
About the Gaille Energy Blog. The Gaille Energy Blog (view counter = 107,957)) discusses issues in the field of energy law, with periodic posts at www.gaillelaw.com. Scott Gaille is a Lecturer in Law at the University of Chicago Law School, an Adjunct Professor in Management at Rice University’s Graduate School of Business, the author of three books on energy law (Construction Energy Development, Shale Energy Development, and International Energy Development), and the co-author of just-released Strange Tales of World Travel.
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