Playing Hot Potato: Indemnity Strikes Again

Baked potato

Indemnity can be like playing hot potato (for those of you closer to the Minecraft generation, in the game of hot potato, a metaphoric “hot potato” is tossed between (ahem amongst) players while music is playing, and when the music stops, the player holding the hot potato is out. It’s a barrel of monkeys, trust me.).

Anyway, like hot potato, with indemnity an owner typically requires its general contractor to indemnify the owner (sometimes the property owner in TI projects and occasionally design professionals) from and against any and all claims arising out of, related to . . . blah, blah, blah . . . the general contractor’s scope of work . A general contractor in turn will usually require indemnity from its subcontractors. And subcontractors will require indemnity from their sub-subcontractors. And down the line it goes with each party pointing their finger at the next party down the proverbial “food chain.”

But it doesn’t always happen that way as the next case, American Title Insurance Company v. Spanish Inn, Case No D067137, California Court of Appeals for the Fourth District (August 14, 2015), illustrates.

Background

In Spanish Inn, Spanish Inn, Inc. (“Spanish Inn”) entered into a $6 million construction loan agreement with Nara Bank for the construction of a hotel in Palm Springs, California.  As is typical in such transactions, to secure its loan, Nara Bank recorded a construction deed of trust against the property. Unusually, however, Nara Bank also required that Spanish Inn obtain a title insurance policy to protect against losses arising from mechanics liens.

Spanish Inn obtained a title insurance policy from First American Title Insurance Company (“First American”). However, as a condition of issuing the title insurance policy, First American required that Spanish Inn and the other owners of the property (“Spanish Inn Defendants”) enter into an indemnity agreement whereby they agreed to indemnify First American if any mechanics liens were recorded on the property. See where this is going.

Delays and cost increases later caused Spanish Inn to miss the completion deadline under the construction loan agreement and Nara Bank foreclosed on its deed of trust. Pacifica L 39, LLC (“Pacifica”) purchased the property in a nonjudicial foreclosure, and when two contractors filed suit to foreclose on mechanics liens they had recorded on the property, Pacifica tendered the claims to First American who accepted the tenders.

First American then demanded that the Spanish Inn Defendants defend and indemnify First American under the terms of their indemnity agreement with First American, which they refused. First American then sued the Spanish Inn Defendants seeking $250,876.53 in damages, comprised of $207,119.58 in attorneys fees incurred by First American in defending against the mechanics liens, $20,950 paid by First American to settle one of the mechanics lien claims, and 10% interest on the total.

Note: the decision does not say what happened with the second mechanics lien claim, which was quite substantial, at $800,000.

While the case was pending in the trial court, First American filed a motion for summary judgment on its claims against the Spanish Inn Defendants. The Spanish Inn Defendants opposed the motion arguing that the mechanics liens fell within a coverage exclusion in the title insurance policy for “liens . . . created, suffered, assumed or agreed to by the insured claimant.” According to the Spanish Inn Defendants, Nara Bank “created” the mechanics liens by failing to provide sufficient funding, and by failing to provide sufficient funding, it caused the two contractors to record mechanics liens on the property. Thus, they argued, First American was not required to defend against the mechanics liens under the title insurance policy and the Spanish Inn Defendants in turn weren’t required to indemnify First American.

The trial court didn’t buy it and ruled against the Spanish Inn Defendants, who appealed.

The Court of Appeals Decision

On appeal, the Court of Appeals explained that contractual indemnity has three elements. The indemnitee (i.e., the person being indemnified) must show that: (1) the liability is covered by the contract; (2) that liability existed; and (3) the extent thereof.

Addressing each of these elements in turn, the Court of Appeals stated that the Spanish Inn Defendants did not appear to contest that First American’s claim “is covered by the contract” and so the first element was satisfied.

As to the second element, “that liability existed,” the Court of Appeals held that liability did in fact exist, though on different grounds that the trial court. Rather than falling outside the coverage exclusion as the trial court had found, the Court held that a provision in the indemnity agreement granting First American the right to “conclusive[ly]” determine coverage under the title policy was binding on the Spanish Inn Defendants. Specifically, the provision provided:

5.6 Determination of Coverage. Any determination of coverage by First American shall be conclusive evidence that the matter is within the Title Policy coverage as to the Mechanics Liens for purposes of this Agreement.

Because First American had determined that the mechanics liens were covered under the title insurance policy, and because its determination was conclusive, Spanish Inn was bound by First American’s determination and thus obligated to indemnify First American. Wow, talk about giving away your rights.

And finally, as to the third element, “the extent [of liability],” the Court of Appeals held that First American had satisfied this element through declarations of its in-house claims counsel together with the outside counsel’s billing statements which established the extent of legal expenses incurred by First American to defend against the mechanics lien claims.

Note: The court did not address the settlement payment made by First American or First American’s claim of interest at 10%. Presumably, the settlement payment was clearly a liability incurred by First American, and as to the 10% interest, there might have been an interest provision in the title insurance policy.

Finally, the Court of Appeals rejected the Spanish Inn Defendants’ argument that First American’s “conclusive” right to determine coverage was subject to the implied covenant of good faith and fair dealing. “‘[A]lthough it has been said the implied covenant finds ‘particular application in situations where one party is invested with a discretionary power affecting the rights of another,'” explained the Court, “if the express purpose of the contract is to grant unfettered discretion, and the contract is otherwise supported by adequate consideration, then the conduct is, by definition, within the reasonable election of the parties and ‘can never violate an implied covenant of good faith and fair dealing.'” Ouch.

Conclusion

This past week we wrote about a case where a general contractor’s insurer had successfully subrogated a claim it had paid by arguing that a subcontractor should have paid the claim under the terms of an indemnity agreement the subcontractor had entered into with the general contractor. In Spanish Inn, a title insurer was similarly able to utilize an indemnity agreement to seek reimbursement, but this time, against the owners of the insured property.

If you’re involved in the construction business the writing appears to be on the wall: if you agree to indemnify someone, the courts are going to hold you to it.

Be careful out there.

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