PRACTICAL CONSIDERATIONS II
The Risk of Paying More than Your Fair Share
Let’s start with the basic premise that the purpose of a contract is to allocate risks, rewards and responsibilities in a way that each party finds agreeable for a particular commercial transaction. Construction contracts are intended to do just that. Whether the contract is between the Owner and the Contractor; the Owner and the Architect or whether the contract involves subcontracts entered into by the Contractor and the Architect, the purpose is to lay out the risks, rewards and obligations in a clear and unambiguous way so that the parties can proceed with the confidence that unexpected or unforeseen consequences will not occur. By this, I do not mean things such as unexpected site conditions, unusual weather, etc. as these risks are almost always dealt with and covered by the contract. What I am talking about are the risks that (1) the Contractor or Architect could be held liable in a dispute for more than his/her proportionate fault in causing the Owner’s damages and (2) the potential liability of the Contractor or the Architect to the Owner is not capped at the amount of liability insurance that was required by the contract.
The following example will illustrate these points. Many Architects and Contractors have faced the following scenario: A building, or series of buildings (e.g., college campus) has serious defect issues, e.g., water intrusion. The damages are catastrophic requiring reconstruction in the tens of millions of dollars. In the investigation of the cause(s) of the defects contributing to the water intrusion, in this particular case, construction defects are readily identified as the primary cause. In another scenario, it could be that design defects were the primary cause. In this first scenario, the Owner’s experts, joined perhaps by the Contractor’s experts, also identify what they contend is a design flaw that may be contributing to the water intrusion and resultant damage. The design team vehemently disagrees. It is next to impossible to prove whether the design issue did, in fact, contribute to the water intrusion or, if it did, where this occurred. It is universally agreed that the main culprits are the construction errors and there is strong disagreement as to whether there was, in fact, a design defect and whether that purported defect contributed at all to the water intrusion and resulting damage.
Let’s assume this case moves forward and eventually ends up in mediation. The reasonable cost to repair figure is generally agreed to be around $50 million. The Owner focuses the negotiation on the Contractor but runs into issues related to insurance coverage; indemnity claims between the Contractor and subcontractors and other issues. The Owner concludes the best he can do with the Contractor and the subcontractors is a settlement of $35 million. They agree to settle at this amount contingent on the settlement being found to be a good faith settlement pursuant to California Code of Civil Procedure 877.6. The Owner and Contractor thus file a motion with the Court to determine that the $35 million settlement is a good faith settlement pursuant to Code of Civil Procedure section 877.6, The motion is granted which discharges (dismisses) the Architect’s cross-complaint against the Contractor and subcontractors for equitable indemnity. The cross-complaint for equitable indemnity was filed because under California law, both the Contractor and Architect are jointly liable to the Owner for 100% of the damages which they jointly caused even though a jury might assign 90% of the proportionate fault to the Contractor and only 10% to the Architect. This occurs because of a legal doctrine called joint and several liability.
With the good faith motion being granted, the Architect’s cross-complaint is now dismissed. If the cross-complaint was not dismissed and the case went to trial and the jury assigned 10% of the $50 million in damages to the Architect, you might think that the Architect’s liability would be $5 million but because of joint and several liability, the Architect’s liability is now $15 million ($50 million minus the $35 million paid by the Contractor). You might think that in fairness, the Architect should be able to recoup all but the 10% of proportionate fault assigned to the Architect from the Contractor. Thus, you might think that the Architect would owe the Owner $15 million but he would be entitled to equitable indemnity from the Contractor in the amount of $10 million ($15 million minus the $5 million of proportionate fault assessed to the Architect. If this is what you are thinking, you would be wrong! Because of joint and several liability and because of the good faith motion procedure prescribed in California Code of Civil Procedure 877.6, the Architect’s exposure and liability to the Owner is $15 million despite being only 10% proportionately at fault!
Most design professionals are unaware that this scenario can happen until it does. I suspect the same is true for Contractors. Many design professionals think that when they negotiate their contracts and they negotiate the amount of liability insurance that needs to be provided under the contract, any liability they may have to the Owner for damages is capped at the amount of that insurance. After all, the specific purpose of professional liability insurance is to protect the Owner from negligent performance by the design professional. If the Owner wants protection at various levels ($1 million; $5 million; etc.), this can be negotiated as part of the contract negotiation. The benefit is to protect the Owner. If the Owner wants a very high amount of coverage, some increase in fee can be negotiated so that the Architect can obtain this coverage and still make a reasonable profit on the project.
So let’s go back to the example of the project with $50 million in damages. Let’s assume the Architect has $2 million in coverage as negotiated as part of the contract. The Owner settles with the Contractor for $35 million and obtains a good faith finding from the Court dismissing the Architect’s cross-complaint for equitable indemnity. The Architect thinks he has a good case but he knows that he is now at risk for potentially $15 million if he is found at fault at all (even just 1%). If the Architect rolls the dice and goes to trial to prove that either the design was not defective and/or that any damages caused by the defect were well under $15 million (the Architect’s worst case outcome), the Architect runs the risk that if he loses, he is now exposed to millions of dollars in damages for which he has no insurance because his insurance was $2 million and by the end of a trial, it has probably been depleted to something well under $2 million. It takes a courageous Architect to go this route.
Most Architects decide that they cannot afford to take this risk as it would potentially bankrupt their firm. Instead, therefore, negotiations commence in earnest with the Owner. The Architect has tried for months to get the Owner to negotiate but the Owner’s counsel decided that the best way to tactically negotiate was to first make the best deal they could with the Contractor and subcontractors and to only then negotiate with the Architect. Where there is insufficient insurance to cover the amount at risk to the Architect (in this example, the risk is $15 million), and the amount of remaining insurance is something less than $2 million, the Owner has 2 options: (1) the Owner can make a policy limits demand and agree to settle with the Architect for the amount of insurance in the Architect’s liability policy or (2) the Owner can make a demand that exceeds the insurance in the Architect’s liability policy and requires that the Architect come out of pocket and pay monies in addition to its insurance to secure a settlement. Obviously, each of these scenarios creates tension.
Suppose the insurance in this example was $10 million as opposed to $2 million. Perhaps in this situation, the insurer would rather take the case to trial since the amount being demanded seems to be high in light of the facts that there are real questions about whether the design was even flawed and also about the amount of damage that this might have caused. The Architect, however, does not want to gamble and go to trial because if things go wrong, he has a potential exposure of $15 million which means he has $5 million of potential exposure for which he does not have insurance (assuming $10 million in coverage). Thus, the interests and strategic considerations of the insurer and the Architect may differ as to how to best proceed.
In the situation where the Owner demands not only the amount of available insurance but also demands that the Architect come out of pocket to secure a settlement, you can imagine the reaction of the Architect! First, the Architect was only asked to get $2 million in coverage which he did but now the Owner is saying the $2 million is not enough and he wants to Architect to come out of pocket! This completely changes the economic basis of the entire transaction. If the Owner felt more insurance was needed, this should have been part of the negotiated transaction and not become a problem after the contract was negotiated. More importantly, because of tactical decisions the Owner made, the Architect now has a potential exposure that far exceeds the damages due to the Architect’s proportionate fault. The Architect rightfully claims that because of joint and several liability, he is being asked to now pay monies for damages caused more by the Contractor. Instead of just being potentially liable for the 10% of proportionate fault that belongs to the Architect, he is being expected (under either a settlement or a verdict) to pay for more than his proportionate share of fault.
The question you are probably asking is “How can this happen? How can the law sanction and even facilitate such an unfair result?” The answer is that this occurs because of “joint and several liability”; because of the tendency of judges to grant good faith settlement motions (CCP 877.6) when many of these motions should be denied and because many parties fail to foresee these dangers when entering into contracts and, therefore, fail to include provisions in their contracts to protect them against these risks.
The concept of joint and several liability derives from the concept of joint tortfeasors. Joint tortfeasors are two or more individuals who either (1) act in concert to commit a tort, (2) act independently but cause a single, indivisible tortious injury, or (3) share responsibility for a tort because of vicarious liability. If two or more parties have JOINT LIABILITY, they are each liable up to the full amount of the obligation. If two or more parties have SEVERAL LIABILITY, each tortfeasor is liable only for their respective obligations based on their percentage of fault. If, however, two or more parties have JOINT AND SEVERAL LIABILITY, any of the defendants can be pursued as if they were jointly liable and it becomes the responsibility of the defendants to figure out their respective proportions of liability and payment. This is typically done by the filing of equitable indemnity cross-complaints by the Architect against the Contractor and vice versa. The Owner may not recover for the same injury twice but has the option of proceeding against just one jointly and severally liable defendant to recover 100 percent of his damages. The concept of joint and several liability was intended to ensure that the plaintiff is made whole where one or more defendants cannot make good on the damages. If the plaintiff (e.g., Owner) recovers 100 percent of the joint and several damages from the Contractor, for example, the Contractor can recover an amount from the Architect that is equal to the percentage of fault assessed to the Architect. Thus, if the Architect is assessed 10 percent of the fault for causing the joint and several damages, the Owner can recover 100 percent from the Contractor and the Contractor can recover 10 percent from the Architect.
In our example, the damage caused by the water intrusion would arguably be joint and several because although water getting in from the alleged design deficiency was independent from the water getting in from the construction defects, the results arguably caused an indivisible injury (damage). This means that if the case goes to trial, each defendant is liable for 100% of the joint and severally caused damage assuming they are found to be at fault. In sticking with our hypothetical, let’s assume there had been no settlement and the case went to trial with the Contractor and Architect as defendants and the jury finds the Architect’s proportionate share of responsibility to be 10%. This 10% of $50 million translates to $5 million. With no settlements and all parties as defendants, the Architect can be liable to the Owner for 100% of the damages or he can be liable to other defendants for no more than 10% of the damages. If the Owner seeks to collect the full verdict amount from the Architect, the Architect will be entitled to recoup 90% of this payment from the Contractor. If there is a settlement, however, that is found to be a good faith settlement under Civil procedure Code section 877.6, the entire picture changes. Assuming a $35 million settlement by the Contractor, because of joint and several liability, the Architect’s liability would now be $15 million (the difference between the $50 million in damages and the $35 million received in settlement from the Contractor). This is true even if the jury thought the Architect’s proportionate share of responsibility to be 10 percent. Thus, despite the fact that the Architect’s liability, as found by the jury, is really $5 million on a proportionate fault basis, the Architect’s real liability is now $15 million!
This gives rise to the obvious question of whether the Architect can succeed on his equitable indemnity claim against the Contractor to recoup the amount that exceeds the Architect’s proportionate share of fault. If the Architect is required to pay $15 million when his proportionate share of fault would result in him paying only $5 million, can the Architect seek to recoup the $10 million from the Contractor? After all, by finding the Architect to be 10% at fault, the jury found the Contractor to be 90% at fault. While the Contractor settled for $35 million, should the Contractor not be required to pay 90% of the $50 million which translates to $45 million? If not, should the Owner not be required to absorb the $10 million since the Owner settled with the Contractor for too little? The answer to both questions is “NO.”
California Code of Civil Procedure 877.6 provides that any settlement that is determined by the Court to be “in good faith” “shall bar any other joint tortfeasor… from any other claims against the settling tortfeasor for equitable comparative contribution, or partial or comparative indemnity, based on comparative negligence or comparative fault.” For a settlement to be deemed to be a “good faith settlement” means that it is supposed to be “in the ballpark” of the settling tortfeasor’s potential liability for the claim. It has been the experience of this writer that CCP 877.6 motions are almost always granted as being in good faith especially when large sums are paid in the settlement. Judges want cases to settle. During the life of the case, judges often recommend to the parties that they schedule a mediation and attempt to get the case settled. Also, when certain joint tortfeasors settle and the settlement is confirmed as a good faith settlement, it puts pressure on the remaining joint tortfeasors which creates leverage to get them to settle. For all these reasons, the vast majority of settlements are confirmed by the Courts as good faith settlements.
So where does this leave design professionals? How can you avoid getting “set up” such that your joint/several exposure far exceeds your proportionate share of fault? Here are a few very important recommendations:
First, add a provision in your contract with the Owner that states that in any claim or lawsuit brought by the Owner, the Architect’s liability shall be several only, and not joint and several, and that the Architect’s several liability shall be limited to the Architect’s proportionate percentage of fault.
Second, be sure to negotiate a limitation of liability provision in your contract with the Owner that limits your liability to the Owner to the amount of insurance you have available to cover the claim at the time of settlement or at the time of judgment. Even if you are successful in getting a provision in your contract that limits your liability to your several liability, i.e., the liability based on your proportionate share of fault, the amount of lability could still conceivably exceed the amount of insurance that you have to cover these damages. Also, if your insurance is like most, the coverage under your policy will be reduced as defense expenses are incurred by the insurer. The amount of coverage may also be depleted by other claims made against the same policy. As a result, while you may start off with a policy with limits of $2 million, for example, the amount of insurance left at the time of settlement or at the time of a judgment may be substantially less that $2 million. If you have a limitation of liability clause that limits your liability to $2 million because this is the insurance required to be provided as part of the contract, you may find yourself woefully short at the time of settlement or judgment. In such a case, your firm’s assets would be at risk to cover the delta between the amount of available insurance and the $2 million stated in the limitation of liability clause. Thus, the imitation of liability clause should limit your liability to the amount of insurance available at the time of judgement or settlement.
Third, if possible, get the Owner to agree to indemnify you against any liability that exceeds your limitation of liability amount. In the example used in this article, if you went to trial and suffered a $5 million judgment and only had $1.75 million in available insurance, the Owner would be limited to recovering $1.75 million from you. However, let’s assume the Contractor did not settle and the Contractor seeks to recover $5 million from you on an equitable indemnity claim as the amount of your proportionate fault. Since you are not in contract with the Contractor, you do not have a limitation of liability agreement with the Contractor. The only way to protect yourself against this risk is to have an agreement with the Owner whereby the Owner would indemnify you for the difference between the $5 million and the $1.75 million of available insurance.
Fourth, always try to engage the Owner in settlement discussions as early as possible and stay engaged in those discussions. No matter how good you think your case may be, do NOT sit back as other settlement discussions are on-going and find yourself caught as the “last man standing” without a settlement. Remember, if you settle early and get a good faith settlement, this allows the Owner to exert more pressure on the remaining defendants as now they will be confronted with an exposure that potentially exceeds their proportionate fault. Also, design professionals can often assist the Owner in making the case against the Contractor and subcontractors particularly when many who worked for the Contractor are no longer around or available and when the Architectural team is still together and has project knowledge that may be difficult for the Contractor to develop.
Fifth, if you do get “set up” and find yourself in the position of being the last man standing with joint/several liability; you are unable to get some of the provisions recommended into your contract and you feel the Owner’s settlement with the Contractor, for example, is not fair and exposes you to the Owner for far more than your proportionate share of fault, your only option is to fight the motion for good faith settlement (CCP 877.6) with everything you’ve got. Many people make only a token effort at opposition because they know that the motion is likely to be granted. This may be your only shot at avoiding a disproportionate exposure, however, so your opposition should be considered highly important and any/all resources necessary should be dedicated to preparing the opposition.
If your office needs assistance in drafting these contractual provisions or in negotiating your contracts, please contact: