Recent California Supreme Court Ruling Impacts Duty To Defend Under An Indemnity Agreement
Indemnity provisions are used by parties to a contract to define their rights and obligations toward one another in the event of a third party lawsuit arising out of their contractual relationship. The terms of the indemnity provision may require one party to indemnify the other, under specific circumstances, for money paid or expenses incurred as a result of a third party lawsuit. The indemnity provision may also assign to one party responsibility for the other’s legal defense of the third party lawsuit.
California case law going back to Regan Roofing Company, Inc. v. Superior Court, 24 Cal.App.4th 525, 29 Cal.Rptr.2d 413 (1994), has limited the defense obligation to third party lawsuits for which there was an indemnity obligation under the indemnity provision. Under this approach, an indemnitor’s defense obligation was not triggered by mere allegations that the indemnitor was negligent. An actual showing of negligence was required.
The California Supreme Court recently rejected this approach in Crawford v. Weather Shield Mfg. Inc., 44 Cal.4th 541, 79 Cal.Rptr. 721 (2008). The California Supreme Court held that when an indemnity clause provides a duty to defend, rather than a mere promise to pay defense costs as part of the indemnity obligation, the duty to defend extends to all third party lawsuits that allege facts that would give rise to an indemnity obligation.
In Crawford, the developer of a large residential project hired a subcontractor to manufacture and supply wood-framed windows for the project. The contract required the subcontractor “to indemnify and save [the developer] harmless against all claims for damages … loss, … and/or theft … growing out of the execution of [the subcontractor’s] work,” and “at [its] own expense to defend any suit or action brought against [the developer] founded upon the claim of such damage[,] … loss or theft.”
A group of homeowners sued the developer, subcontractor, and other parties involved in the construction of the project. The homeowners alleged numerous construction defects and asserted, among other things, that the windows supplied by the subcontractor leaked and caused extensive damage to their respective homes. The developer cross-complained against the subcontractor seeking indemnity for the amounts paid to the homeowners, and the attorneys fees and expenses incurred in defending the homeowners’ claims.
The window leaking issue went to trial, and the jury returned a general verdict finding that the subcontractor was not negligent. The trial court held that the jury’s finding absolved the subcontractor of indemnity liability to the developer. With respect to the developer’s claim for attorneys fees and defense expenses, the trial court held that the subcontractor was liable for the developer’s defense costs even though the jury found that it was not negligent.
The court of appeal affirmed, holding that the subcontractor was liable for the developer’s defense costs regardless of its own negligence. The court reasoned that the subcontractor’s duty to defend arose immediately when the suit was filed against the developer and, therefore, the duty to defend did not depend upon a determination of whether the subcontractor was negligent.
The California Supreme Court granted review limited to the issue of whether the subcontractor had a duty to defend the developer even though the jury found that the subcontractor was not negligent, and the parties accepted an interpretation of the indemnity clause that gave the developer no right to indemnity unless the subcontractor was negligent.
The California Supreme Court first emphasized that the rules for interpreting indemnity agreements and liability insurance policies differ significantly despite the resemblance between these two types of contracts. Ambiguities in insurance policies are construed against insurers because of their superior bargaining power. In the non-insurance context, however, the indemnitees have superior bargaining power and may use it to unfairly shift to the indemnitors a disproportionate share of financial consequences and legal fault.
The California Supreme Court held that even if the indemnity clause was strictly construed in favor of the subcontractor, the subcontractor had an obligation to defend, from the outset, any suit against the developer insofar as it alleged damages arising from the subcontractor’s negligent role in the construction of the project. The subcontractor had a contractual obligation to defend such a suit even if it was later determined that the subcontractor was not negligent. In other words, the subcontractor’s obligation to defend was not limited to those claims that the subcontractor ultimately is obligated to indemnify.
In reaching its holding, the California Supreme Court analyzed Section 2778 of California Civil Code, which sets forth the rules for interpreting indemnity contracts. The rules are deemed part of an indemnity agreement unless otherwise indicated in the contract.
Section 2778 provides that a promise to indemnify against liability “embraces the costs of defense” against such liability. The statute specifies that an indemnitor has an obligation to defend the indemnitee against claims embraced by the indemnity agreement even though the indemnitee chooses to conduct its own defense. The statute also states that if the indemnitor declines the indemnitee’s tender of defense, a good faith recovery against the indemnitee is conclusive against the indemnitor. If however, the indemnitor was not provided reasonable notice of the claim, or was not allowed to control the indemnitee’s defense, recovery against the indemnitee is only presumptive evidence against the indemnitor.
The California Supreme Court concluded that an indemnitee’s obligation under Section 2778 is not limited to payment of the indemnitee’s defense costs after the fact. According to the court, implicit in the duty to defend the indemnitee against all claims “embraced by the indemnity” is that the duty arises immediately upon the tender of defense. Because the duty to defend arises before a determination of whether indemnity is actually owed, the indemnitor’s duty to defend under the statute cannot depend on the outcome of the litigation. Thus, unless otherwise stated in the contract, Section 2778 requires the indemnitor to defend the indemnitee against all claims that allege facts that would give rise to a duty to indemnify.
Under California law, an indemnitor’s duty to defend is no longer limited to third party lawsuits for which the indemnitor has an indemnity obligation. The indemnitor’s duty to defend extends to all claims that allege facts that would give rise to an indemnity obligation. The indemnitor has a duty to defend such claims even if it is determined in the third party action that it was not negligent. To limit or eliminate the indemnitor’s defense obligation, the indemnity provision must explicitly include language to that effect.