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Managing Risk Through Contracts

The following article is reproduced with the permission of The Hartford. No further reproductions are permitted.

Contracts are an essential part of doing business. A well-written contract can help you manage risk, protect your business and create good working relationships between you, your customers and suppliers.

But beware. When negotiating contracts with customers, you may be tempted to use their contract language in order to win jobs. If you do, you may be assuming responsibility for all losses, regardless of who is at fault. This could result in significant financial hardship for your business.

At The Hartford, we understand the risks you face and are committed to providing you with information and services to help you protect your business. The information in this newsletter may help you avoid some common pitfalls (like the example to the right) related to contracts.

Understanding the Contract
A contract is a legally enforceable promise between two or more parties. This promise (or agreement) often requires one of the parties to pay-or indemnify-the other party for a loss it suffers in fulfilling the terms and conditions of the contract.

For a contract to be legal, it must have:

  • An offer.
  • An acceptance.
  • A payment.

A contract is the framework of an agreement between parties and establishes which party is responsible for a particular risk. You should enter into a contract only with the advice of an attorney familiar with contract law. Contracts have important legal and insurance consequences that will affect your business. When used properly, contracts are an effective way to manage some of your business risk.

Contracts may be written or oral. When properly drafted, written agreements provide a clear understanding to what each party has agreed. Oral agreements, while enforceable under certain circumstances, often create problems. Agreements and understandings negotiated in good faith are sometimes misinterpreted later on, particularly after a loss has occurred.

The following example shows what could happen if you agree to hold a customer harmless - and why you should not assume responsibility for all losses - regardless of who is at fault:

You have a contract to provide machine-tooled parts to a refrigerator manufacturer. You provide the parts, but the specifications provided by the manufacturer are incorrect, and the refrigerators break down, resulting in claims for spoiled food. Because the contract contains a clause to hold the manufacturer harmless from liability, you are responsible to the end user, even though the fault lies with the manufacturer.
Contracts have important legal and insurance consequences that will affect your business. Enter into a contract only with the advice of an attorney familiar with contract law. Identify Your Goals
There is no substitute for planning. Agreements that are negotiated hastily or with incomplete information often work to the detriment of both parties. Make sure you are comfortable with the contract and that it is fair to both parties. Sometimes, when you're unable to negotiate a fair and equitable deal, it makes sense to walk away. Establishing a walk-away position is critical.

When entering into a contract, consider the following:

  • The scope of the agreement. Contracts that do not address all of the terms and conditions of the agreement may cause outcomes you neither intend nor desire.
  • The legal enforceability of the contract. Contracts that violate public policy or statute are unenforceable.
  • The ability of the parties to manage risk. Transferring the responsibility for payment to another party is an effective technique only if the other party has the capability to honor its financial commitment.

Key Elements of a Contract
If you decide to use a contract to require another party to pay if there is a loss, you should address:

  • Who the parties are. Include names and addresses.
  • The work being done. The description of the job should be specific, particularly if some of the work is being done off-site. You'll also need to address change orders, completed operations and defective work claims.
  • All the terms and conditions of the agreement. Agreements that are incomplete or not executed in a timely manner often lead to problems. Be sure to include every aspect of the job, even if it seems inconsequential.
  • Which state law applies. Generally, parties should specify which state's law applies to their contract. In the event of a claim, this will help a court interpret the agreement consistent with the intent of the parties. You should also understand that even with this agreement, courts may use their judgment in attempting to arrive at an equitable resolution.
  • Inclusion of all agreements. The contract should include all of the agreements as part of the document. Don't incorporate or refer to other documents in your contract.
  • The actual indemnification agreement.
  • Insurance requirements, if appropriate.

Hold Harmless Agreements
A common type of contract is a hold harmless agreement (also called an "indemnity agreement"). In this agreement, the indemnitor (the metalworker for the purposes of this publication) agrees to pay the indemnitee (the customer) if the customer suffers a loss. These agreements are used to control distribution of losses and to clearly identify who must pay.

The three types of indemnity clauses (or forms) that can be part of hold harmless agreements are:

Broad Form - Transfers the entire risk of loss from the customer to the metalworker regardless of fault.

Intermediate Form - Liability is shifted to the metalworker for damages caused "in whole or in part" by the customer. Under this form, the metalworker could be liable for up to 100% of the claim, even if it is only 10% at fault. The only time the metalworker would not be liable would be if the customer was solely at fault.

Limited Form - The metalworker assumes liability only for its own negligence. The limited form is a restatement of the common-law principle that one is liable for the consequences of his or her actions that lead to injury or damage.

How Courts View Hold Harmless Agreements
Typically, courts apply the general principles of contract law in interpreting agreements presented to them. They will try to enforce hold harmless agreements as negotiated by the parties in good faith. Before you agree to hold harmless agreements, you should be aware that courts generally use the following standards to interpret them:

  • Courts will analyze the plain language to determine the true intent of the parties.

  • Courts will assess the agreement as a whole, considering provisions such as indemnity clauses to assess the meaning of the contract terms.
  • Courts will consider relevant prior evidence as a way to understand the intent of the agreement. They will not, however, consider this information to contradict or modify the terms of a written agreement.
  • Courts may enforce the indemnity clause against the drafter of the agreement when ambiguity creates two or more interpretations.

Certain states have statutes that prohibit or limit broad form and intermediate form indemnification. Because the nature of these agreements is to hold a party harmless for its liability, they are sometimes considered unfair to at least one of the parties or inconsistent with good public policy. However, some states will allow these agreements if they are expressed in clear and unequivocal terms. Consult your attorney and consider state statutes when negotiating your contracts. If you don't, you may have no indemnity protection in the event of a loss.

It is also important to be cautious regarding differences in state law. Businesses involved in multi-state operations should be aware of state statute differences. For example, states may have different statutes of limitation and "duty to provide a safe place to work" laws. What is enforceable in one state may be unenforceable in another.

The Role of Insurance
The metalworker needs to make sure that its insurance provides adequate coverage for the risk it has assumed. If insurance is unavailable, the metalworker must pay the obligation from its own pocket.

Liability Insurance - Typical Coverages
A standard general liability policy provides broad coverage for bodily injury or property damage arising out of insured contracts.1

A standard general liability policy defines insured contracts 1 as:

  • Lease agreements.
  • Sidetrack agreements.
  • Easement agreements.
  • Permits issued by municipalities, except for work for those municipalities.
  • Elevator maintenance agreements.
  • Other business contracts in which the insured assumes the liability of others for their tort liability to third parties.
Coverage Gaps
Coverage gaps may be created by exclusions within the policy or within the definition of insured contracts.1 For example:

What's not covered by standard policies How to close the coverage gap
Contractual obligations to be responsible for damage to the rented or temporarily occupied premises. Obtain specific property insurance.
Professional exposures such as those of architects, doctors and engineers. Purchase professional liability or errors and omissions coverage.
Work within 50 feet of railroad exposures. Endorse the policy to remove such exclusions and/or purchase a Railroad Protective Policy.
Failure to perform services contracted for or failure of products or completed operations to perform as intended. Buy performance bonds.

1 Terms in bold are defined in the policy. Check your policy or contact your insurance agent or broker for details.

© 2004 The Human Equation. All rights reserved. No reproduction, display or sale is permitted without the express written consent of the copyright owner.

The Human Equation's newsletters and publications are intended as an information source for the clients and friends of the firm. Their content should not be construed as legal advice, and readers should not act upon the information in these publications without professional guidance. Please note that newsletters and publications that are archived by The Human Equation or are not updated after initial publication and may not contain the most current information available.