Contractual Risk Management -A Potential Hot Potato

Janet Kerr, Vice President, Risk Management – Boston Properties, Boston, MA, Speaker / Moderator

David Liner, Sr. Vice President – Willis of Tennessee, Inc., Nashville, TN, Speaker

Fred Page, Partner, Holland & Knight, LLP, Jacksonville, FL, Speaker

April 29, 2008 / 2:15PM – 3:45PM

Introductions / Session Goals

• We are most honored to have you attend our session – thank you for coming!

• Today’s speakers (Janet Kerr, David Liner and Fred Page)

• Session Goals:– Discuss essential elements of contract review program and project pricing

– Focus on common areas of contract that affect risk/risk allocation

– Discuss contract negotiation strategies employed in past

– Discuss duties of agents/brokers (A/B) in the process

Introduction and Importance of Contractual Risk Management to Boston Properties

Boston Properties is a self administered and self-managed real estate investment trust.

• BP contracts with numerous parties including contractors, tenants, suppliers, vendors, consultants, architects, engineers, etc.

• Risks must be allocated to party in control of exposure and otherwise able to fund or transfer risk to third party

• On an annual basis we discuss our contractual risk management philosophy with our insurers, they appreciate our efforts which help us maintain our excellent loss ratio

• Critical issues for us include indemnity, financial security of insurer, adequate limits, scope of coverage as an add insured, waivers of subrogation, etc.

Current Contract Review Process at Boston Properties

• Model indemnity / insurance provisions for each contract type (lease, suppliers, construction, maintenance, professional services, environmental services, etc.) were developed with outside counsel, general counsel, regional counsel and our broker

• Commentary is provided within model; explaining language; providing fall back positions; detailing non-negotiable provisions and items that must be discussed with risk management prior to sign-off

• While model provisions do not address all contracts we typically review, having model insurance provisions provides consistency across our portfolio, and a basis for counsel and others at the company with authority to negotiate contracts

• We expect our brokers to take an active role in day to day contract review, assist with work load and provide technical expertise. By doing so, broker gains a greater understanding of our operations. We also actively utilize the assistance of insurance counsel on an as needed basis to round out the review team for day to day reviews

Broker’s Opening Comments

• Many agents/brokers consider in-depth contract reviews (beyond standard insurance requirements) to be outside expertise or scope of duties

• Many risk managers consider in-depth contract reviews to be outside the expertise or scope of duties of agents/brokers

• The majority of our clients and their attorneys sincerely appreciate our willingness to perform in-depth contract reviews, suggest language, etc. (even with disclaimer “we are providing suggestions, not legal advise, please have our suggestions approved by your attorney prior to incorporating in contract”)

• Contractual risk management is an important “loss control” activity – a contracts knowledgeable agent/broker working in partnership with risk manager and attorney can go a long way to eliminate or mitigate losses emanating from “bad” contracts

• Risk flows downhill – strategy different upstream vs. downstream

• In most cases, the most commercially reasonable method of allocating risk should be employed (often to transfer losses to an insurer for a premium)

Delegation & Limitation of Contract Authority Levels within Corporation (Who may assume contract risks?)

• Many based on contract size and not exposure (mistake)

• Should clearly outline corporate positions that can assume various levels of contract risks

• Contracts should be reviewed by Legal, RM, broker and others as needed – on complex project such as design/build project, engineering and construction must be involved in process

Checklist Outlining Preferred, Acceptable & Unacceptable Corporate Positions - Allocation of Contract Risks

• Include all major areas of risk (not just insurance and indemnity)

• See “Contract Terms” handout for example checklist – vary by industry

• Provides method of measuring onerous contracts

• Used in project pricing

Peer Review (legal, risk management, design and construction)

• Example design/build project must involve risk manager/legal/engineers and construction personnel

• Pre and post bid peer review – senior employees must sign off on process

• Used in project pricing

Project (product) pricing

• Measures contract and other risks based on project exposure

• Enables client to bid or price tougher projects

• Useful in negotiating with those upstream

Avoid Ambiguous/Outdated Language

• Broad from property damage, XCU, incidental medical malpractice, contractual liability, etc.

• Terms have been obsolete since 1985, creates immediate breach of contract

Avoid Requiring Obsolete Coverage or Policy Forms

• 11/85 version of add insured endorsement is common request

• Occurrence form environmental or professional liability

• In most states current policy forms must be used

When to Require Professional, Environmental or Employment Practices Liability Coverage

• As respects professional consultants, architects, engineers, etc., client must determine failure to perform exposure to determine whether on not to require

• If primary exposure economic damages, require professional

• Environmental exposures (work/operations involve hazardous materials)

• EPLI needed whenever chance of becoming dual or special employer

When to Require Fidelity or Crime Coverage

• Any party handling funds, money, securities or property

• Any party handling insured’s employee pension plans

Special Considerations for Property/Builders Risk Insurance

• Whenever possible control placement – where not possible dictate perils – flood/EQ/B&M

• Builders Risk – often overlooked – faulty workmanship exclusion and delayed opening coverage to protect lost profits

• Mutual waivers of subrogation – some policies may prohibit against architect although most architect agreements require waivers

• Other important get right coverage includes off premises power failure, contingent business interruption and premises pollution clean-up and removal

Status as Additional Insured - When to Require

• Anyone upstream (owners, developers, GC’s, landlords, purchasers, etc.)

• On property coverage as a named insured and liability coverage as an additional insured (CGL / Auto Liability /Contractors Pollution Liability)

• Do not require status as AI under WC, EPLI or professional liability coverage

• Consider requiring status as alternate employer under other party’s work comp to extent you may be held to be dual employer

Additional Insured - Scope of Coverage

• ISO Add Insured forms changed 2004 so AI’s liability must arise “in whole or in part” from work or operations, or use or occupancy of premises by NI

• Upstream – consider expanding to include “AI’s negligent supervision, including safety and security operations, with respect to NI’s work or operations”

• Downstream – insist on using ISO AI endorsements which limit scope of AI’s coverage to liability caused in whole or in part by NI

• Owners protective liability policies offer stand-alone limits and cover NI’s negligent supervision of AI’s work or operations, hence may be appropriate in some situations

Additional Insured - Ongoing Work/Completed Operations or Both

• On residential projects or significant design/build projects, owners, developers and GC’s should require status as AI for operations under CG 2010 and for completed operations under CG 2037 through statute of limitations/repose

• If less exposure, owners, developers and GC’s should require contractor, consultant, etc. to continuously maintain P/CO for reasonable time

• Smaller contractors with no leverage with insurers may be unable to obtain CG 2037, hence popularity of wrap-ups for larger projects – complicates purchasing

Notice of Cancellation or Non-Renewal

• Insurers rarely endorse policies to send notice of cancellation or non-renewal to third parties, good faith duty falls on agents and brokers

• Certificates of insurance contain numerous disclaimers including statement policy must be endorsed for insurer to send notice of cancellation or non-renewal

• Many requirements include notice for subjective items such as “material change” or “reduction in coverage” – most insurers will not send notice for subjective items, again this good faith duty falls on agents and brokers

• When in doubt – request copy of policy and read it!

Waivers of Subrogation - When Appropriate

• Normally always appropriate – beneficial business relationship – part and parcel to basic philosophy of transferring losses in most commercially feasible manner, often to an insurer paid a premium to cover parties, certainly every avenue of subrogation must be “shut down” to extent either party is insured

• Tenant must have written waiver of subrogation from landlord or find somewhere else!

• Many contract limit waivers to property losses – why stop there?

• Do not require on professional liability

• Most states allow waivers on workers compensation but not all (KY, MO & NH prohibit – check with attorney)

Scope of Waiver of Subrogation

• When upstream, waiver should apply to all claims, loss or damage howsoever caused

• Typically the waiver should apply to extent loss or damage is insured or self insured, or is otherwise required to be insured

• Correct terminology – policies shall permit waiver of subrogation, not insurer shall waive it’s rights of subrogation

Mutual or Standalone

• Upstream or downstream?

• In most cases mutual waivers make sense, an insurer has accepted premium to accept risk, let it stop there

• Construction projects – owner / developer normally provides mutual waiver for BR, standalone for CGL/AL/WC (same with landlord as respects waivers on the leased premises)

Deductible/Retentions

• Make sure waiver applies to amounts within deductibles, SIR or self-insurance

• If not, include risk charge for increased risk (Gap & Rite Aid)

Financial Stability of Insurers

• Recognize there are not many S&P AAA rated insurers

• Typically we see minimum required A.M. Best’s rating of A- VII

• Don’t forget “licensed in state where operations are conducted, or premises or located

ACORD Certificates of Insurance

• Acord certificates of insurance do not provide binding evidence of insurance – see Hospitality Alert handout on this subject for more information

• If you accept certificates make sure copies of endorsements are attached (AI/WOS)

• Without endorsement on policy, insurer owes no duty to notify CH of cancellation

• If 80% of your certificates are acceptable (translated - no major mistakes and with proper endorsements) – pat yourself on the back!

Should You Reserve Option to Require Copies of Policies?

• Yes, especially for larger projects where there is a lot at risk

• You may have to agree to provide a non-disclosure/confidentiality agreement

Solvency of Entity

• Especially to extent indemnity uninsured or under insured

• Typical indemnity exceeds scope of insurance coverage “any and all losses of whatsoever nature”

• Beware of bait and switch situations with undercapitalized subsidiaries created to execute contracts

Control of Defense

• Defense issues are closely tied to whether insurance exists and additional insured issues

• Indemnitors and/or their insurers typically control defense if tender accepted

• Indemnities in major deal should try to keep control of counsel

• If no insurance, larger entity may forego indemnity to deep control of defense

Indemnity and Customer Relationships

• When parties dealing from equal strength indemnity terms tend to be mutual and limited (limited risk transfer)

• Party upstream should require broadest possible indemnity allowed by statute

• ISO CGL policies cover legal indemnity (subject to policy terms and conditions)

• Often, even the best negotiated provision is meaningless if the relationship is more valuable than the risk assumed

Indemnity Should Track With Scope of Insurance Coverage

• Downstream party should attempt to limit indemnity to claims for BI & PD including loss of use (track with CGL coverage grant)

• If client is downstream and normally the party indemnifying the upstream party, we suggest they attempt to negotiate the inclusion of contractual liability for personal and advertising injury liability (not just bodily injury and property damage)

Indemnity - Limit to Claims from Third Parties

• Significant number of indemnity agreements do not specify they only apply to 3rd

party liability claims

• Disputes arise when one party seeks to enforce indemnity to aid it in a contractual dispute not related to any third party claims

• Disputes between the parties more appropriately dealt with under other contract provisions (limitation of liability)

Scope of Indemnity

• Upstream – indemnity should apply to “any and all losses of whatsoever nature” – don’t dare limit it to track with CGL – who cares if the indemnity exceeds scope of their coverage?

• Downstream – only to the extent caused in whole or in part, or even better in whole, by work or operations performed by on or behalf, or use or occupancy of leased premises, etc.

• Goal for upstream party is to have broadest coverage, whether as AI or via indemnity supported by contractual liability insurance within standard CGL

• Completed operations coverage also important

Impact of Anti-Indemnity Statutes

• 32 states (if not more) have anti-indemnity statutes for construction operations (prohibit indemnification for negligence of indemnities – partial, sole or both)

• Some states have anti-indemnity statutes applicable to commercial property leases (attorney should be responsible for confirming statutes)

• Recent trend to limit indemnity and close additional insured loophole – your attorney will know what statutes are applicable in a given state

Additional Insured Loophole

• Recent trend by many states is to use anti-indemnity statute to limit scope of coverage afforded AI – See, for example, OR and WY

• Many states tend to allow broad scope of coverage for AI even if scope of indemnity limited by statute, however since July 2004 insurers have been attempting to limit the scope of coverage afforded AI to liability caused in whole or in part by NI

• Additional insured I must carefully review endorsement to confirm needs met

Limitation of Liability

• Include all forms of damages

• Include/exclude required insurance

• Need to mirror liability risk to insurance coverage, especially with E&O/Professional liability coverage

Liquidated Damages

• Reasonable given economics of deal

• Often overlooked mechanism

Consequential Damages

• Downstream party prefers to mutually exclude

• Upstream party should not excuse if possible, and should be able to negotiate for consequential damages to be recoverable at least to extent covered by required insurance

• Many examples exist where vendors negotiate terms favorable to their insurers while paying for the coverage.

Standard of Care – Professional Services

• Downstream – usual and customary standard preferred (or “commercially reasonable” standard)

• Firm performance based standards should be resisted – if assumed, it is critical to clearly establish what constitutes performance and build in ability to be flexible as upstream party adjusts specifications

• Upstream – greater specificity, performance standards, minimums and milestones, especially with IT contracts

Warranty

• Downstream – limit to 3 R’s (repair, replace, refund) and combine with limitation of liability provisions

• Upstream – tie into performance standards, regardless of whether product or service at issue

Force Majeure

• Parties should always be excused for uncontrollable circumstances

• Beware of exceptions based on negligence and for provisions that give one party ability to control contingencies

• Assess risks involved with labor and material issues and whether provision reaches far enough to protect your interests (port strikes)

Pre-Existing Conditions

• Typically allocated to property owner in construction setting

• Especially important to allocate responsibility for pre-existing environmental conditions

Unforeseen or Unanticipated Conditions

• Typically allocated to property owner in construction setting

Intellectual Property/Trade Secrets

• Many contracts today impact intellectual property/trade secrets of company

• Analyze potential IP exposure given scope of work and factor into indemnity analysis (often only way to win is to get someone else to pay)

• Protect databases, grant limited access to vendors as needed, and insert non- disclosure provisions into agreements

• Non-disclosure provisions and passwords help protect trade secrets maintain their secret nature and may reduce privacy headaches for company

Restrictive Covenants

• Risk management to the company includes assessing risks of losing key employees and trying to mitigate consequences

• Consider loss of business / revenue streams / key suppliers, fabricators or importers

• Loss of groups of employees

• Restrictive covenants to consider include non-compete, non-solicitation and anti- piracy provisions

• Consult counsel on enforceability of non-compete provisions for employees in various states

• Strategic maximization of rights under restrictive covenants can be a life saver

Arbitration

• Some prefer arbitration to law suits

• Becoming more expensive and similar to lawsuits

• Can be costly with panel of private arbitrators

Attorneys’ Fees Provisions

• Shifting costs and fees of suit to losing party is always a way to consider limiting exposure

• Some states interpret the provisions as reciprocal regardless of language

• Tends to cause more lawsuits than it prevents and attract lawyers into dispute

• Empowers smaller companies to go after larger ones, especially where smaller company has nothing to lose

Termination

• Beware of perpetual agreements and recurring fees

• Flexibility/trap door to bail out of relationship often key

• Times change

Change Ownership or Control

• Try to carefully link change of ownership control provisions to termination rights

• The company across the table may not be the one doing your work

Software Licensing

• The horror stories of companies facing liability for exceeding software licenses are plenty

• Beware of relying on junior IT employees because they “get it”

Damage & Destruction (Premises Lease)

• If you are tenant make sure your obligation to repair damage and destruction does not apply to extent loss or damage covered by landlord’s insurance

• “All risk” aka “special form” legal liability insurance if obligation to repair is unlimited, or you cannot get waiver of subrogation from landlord procuring property insurance – but you have to have this location

Maintenance & Repair (Premises Lease)

• Similar to damage and destruction, the obligation to repair should not apply to extent losses covered by required insurance

• Lease should be clear on responsibility to repair boilers, machinery or equipment servicing premises and glass

Improvements & Betterments (Premises Lease)

• Either party may be able insure – both landlord and tenant have use/equity interest

• Unless lender requires landlord to insure all improvements, typically the party funding improvements insures on behalf of both parties

• Need to be clear with insurers as to the existence of insurable interests