In a previous Clarity post, Making Contracts Work for You – Part 1: Top 5 Boilerplate Items You Don’t Read, I wrote about how you can make your contracts useful (to your side of the case) if you are in a dispute. I also wanted to provide you some pointers on the use of warranties, indemnity and insurance provisions.
A warranty is an agreement that the item sold, or some other subject matter related to your contract, conforms to a certain description. The effect of a warranty is a contractual allocation of financial risk if the item sold (or other subject matter of your agreement) does not conform to the specified warranty. A warranty is violated when the thing sold doesn’t satisfy the warranted condition. When this happens, the party who made the warranty is liable to the other party for the cost to repair or correct the issue — without regard to fault. Thus, warranties produce liability without fault, sometimes called “strict liability.” When a warranty is breached, it may also provide a basis for rescission and restitution — this means unwinding the contract.
Including warranties in contracts is an effective way to make sure your assumptions about what you are buying are included in the paperwork. Requesting warranties during negotiation and drafting of documents is a good way to find out whether each party has the same understanding of what is being bought and sold. Signing an agreement that contains warranties that you did not agree to make can produce bad results; likewise, failing to include warranties in an agreement to reflect what has been promised to you is also a bad idea.
Often, a seller will attempt to disclaim liability for any breach of warranties by requesting an “AS-IS” provision. The words “AS IS” and similar terms generally trigger a legally enforceable disclaimer of all express and implied warranties, except for warranties set forth elsewhere in the agreement.
Parties relying on warranties will often want a “survival clause” in the agreement to be sure that any important warranties continue in effect after close of escrow, for example.
Indemnity or “hold harmless” clauses are another way of allocating financial risk to a particular party in a transaction. Indemnity clauses require one party to bear the cost of certain risks defined in the contract, which can range from particular losses, lawsuits, or even non-conformance with prescribed warranties. Most commercial agreements should have some form of indemnity clause, in which one party agrees to defend (i.e., hire a lawyer) and indemnify (reimburse) the other party for the risks described.
We find that indemnity clauses are often one-sided, and sometimes taken from unrelated contracts, so that the risks which ought to be negotiated and indemnified are overlooked, while the indemnity clause as written produces results which the parties never contemplated. For example, Party A would not expect to find a clause that lays the costs of Party B’s fault back upon Party A. Yet that kind of result can happen when indemnity clauses are not carefully negotiated and drafted.
Indemnity clauses can be quite complex, including provisions regarding the selection and control of the attorneys who will defend the claim. A well-drafted indemnity clause will include a provision that the benefited party will be entitled to their reasonable expenses incurred to pay the indemnified loss, and any settlement, judgment and defense costs.
Losses are not always caused by one person or one discrete act or omission. Events like construction site accidents and other industrial accidents are often the result of a combination of factors. Environmental contamination can have multiple causes spread over decades. In such cases, the wording of an indemnity clause can make a big difference.
The legal effect of an indemnity clause is usually a question of state law. Different states have varying rules for interpreting and enforcing indemnity clauses. Therefore, the state law selected in the agreement can have a major effect on the results produced by the indemnity clause. Some states require particular wording in an indemnity clause before a court will shift the risk of a loss from one party to another. If the contracting parties intend to shift the risk of one party’s “active” negligence to the other, such an intent will often need to be specifically spelled out or the indemnity clause will not be given that effect.
Most or all states have limitations on the kinds of liabilities that may be indemnified, and some even have special statutes that change the rules in particular settings, such as construction contracts, for example. Indeed, California courts have at times distinguished between “Type I,” “Type II” and Type III” indemnity clauses. (I will spare you those details.)
Ultimately, the effect of an indemnity clause will turn on the state law chosen in the contract, the subject matter of the contract, the words used in the indemnification provision, the circumstances of the loss to be indemnified, and the different parties’ roles in producing the loss.
I can already hear it — you know what insurance is. However, did you know that a promise to procure insurance for another party can sometimes equal an obligation to cover the loss the insurance would have provided if you don’t procure it? In other words, if you promise to insure another party in conjunction with a commercial agreement, you become the insurer if the agreed-to coverage is not purchased. For this reason, insurance provisions in commercial agreements can have enormous financial consequences, particularly when a loss occurs which would have been covered by insurance required by the agreement. As is often the case with indemnity provisions, insurance clauses are sometimes drawn from old, unrelated agreements, and your contract might wind up with unfair or insufficient insurance provisions. Make sure the insurance clause fits the deal.
Next time you negotiate an agreement, make sure that you are best protecting yourself and avoiding unintended financial risks by including appropriate warranty, indemnity and insurance provisions that reflect your intentions and are enforceable under the state law selected in the agreement.