3 Contractual Defense Terms

Most companies do not anticipate the cost for reimbursing a stranger’s insurance carrier when signing a contract. However, when an unbound duty to defend is in a contract, that risk is a real and present danger. Some careful term management can help mitigate or avoid defense cost exposures.

Most are familiar with contractual indemnity clauses. These terms are intended to address the allocation of cost risks where a breach of contract results in a loss to one of the parties. The cost shifting in these terms has made them the frequent subject of legal and risk management review. But within these clauses usually lie phrases that present far more of a financial burden than indemnity. Here we examine three of them.

Defend

Where the word “defend” is included in the indemnity terms or there is a standalone defense clause, a company can become contractually bound to retain and pay for a lawyer to address a claim of breach or a third party’s damage allegations that are made against the other party to the contract. In these scenarios, the contractual obligation is not to allocate the cost of a loss but rather to try to prevent the loss in the first place. And as anyone who has gone through a legal proceeding can attest, the process costs present much more of an immediate financial burden than the potential ultimate loss.

With contractual defense terms closely tied to—or even embedded within—indemnity clauses, it is important to pay careful attention to the separate nature of the obligations. Defense commitments tend to arise immediately after a breach or claim is alleged, while indemnity obligations arise after a dispute has been determined. As such, the most important risk management points surrounding a contractual defense obligation revolve around the concepts of trigger, scope and the nature of the obligation.

Trigger

Trigger is shorthand for when the defense obligation begins. Contractual certainty, with respect to when the financial obligation to pay for the defense of another party, is essential. For example, where the defense terms are tied to “allegations” or “assertions of defect” with work or products, the obligation to defend can arise before a lawsuit or other formal legal proceeding begins. Moreover, where left unaddressed, the defense obligation can be read to include the reimbursement of defense costs incurred at any time, including those before notice or tender of the claim.

When faced with a defense obligation, address concerns regarding trigger by precisely defining when the defense commitment begins. For example, refining general terms to ensure that the defense begins only “after written notice” or is limited to “after a complaint is filed” can help provide more certainty. Consider also specifically disclaiming any responsibility for costs incurred before proper notice or not explicitly anticipated by the defense obligation.

Once triggered, there can be disputes about the defense obligation’s scope. These disagreements center on what must be defended and the costs that must be borne in connection with the defense obligation.

Where no terms define what must be defended, courts can read the bare “defend” commitment as encompassing the entire scope of a claim. This can prove especially problematic where a litigation or demand involves multiple parties and allegations well beyond a limited contractual scope of work.

Obligation

To address the prospect of unbounded financial risk presented within broad scopes of defense, the nature of the obligation must be set out with certainty. A defense obligation tied to the “proportionate extent” that a claim involves a contractual scope, or one tied only to the part of a claim “directly arising out of” a scope, can help limit the exposure the defense obligation can impose. Likewise, specifying maximum contribution thresholds in the event of multi-party claims can help contain runaway costs in huge litigations.

The nature of a contractual defense obligation is also paramount to controlling loss. These clauses can specify who can select the lawyer for defense. They can also turn the defense obligation into one for reimbursement, by which there is no ability to actively defend. Further, control over the defense, and how a claim is ultimately resolved, are terms that many times are preserved to one party over another. These controls on the nature of the defense provided within a contract can increase the financial burden on the party bearing the defense obligation and should be actively addressed in negotiation.

Many expect that their insurance company will bear a contractual defense obligation. That can prove true where the specific facts for an insured contract are within the scope of coverage.

It is also important to remember that the contractual defense obligation is separate from an additional insured obligation that the carrier might owe. The point, however, is to remember that regardless of what an insurer decides to do in response to a claim under its policy, the contractual obligation exists separately and attaches to the parties to the agreement.

It is this individual responsibility for contractual defense that insurance carriers sometimes use to seek recovery for defense fees from parties. The legal claim is one for equitable subrogation. It arises when one party to a contract has their contractual defense obligation funded by their insurance carrier. That carrier, in turn, looks to any other party in a claim that has refused or not otherwise contributed to the defense obligation. In many jurisdictions, the carrier is entitled to stand in the shoes of its insured and seek recovery of a portion of the fees the carrier paid to defend the claim.

Where allowed, this results in an insurance carrier for someone who is a stranger to a contract, to enforce a proportionate sharing of the costs incurred for a shared contractual defense obligation. Mitigating this risk—like all contractual defense exposures—requires an appreciation of the risk and active negotiation of the obligation at the time of contracting to refine the defense commitment.