Risk management and contract negotiations – are you in breach of the contract as soon as you sign it?

March 2020 | SPECIAL REPORT: MANAGING RISK

Financier Worldwide Magazine

March 2020 Issue

Picture any large-scale transaction, whether it be a commercial lease, construction project contract or licensing agreement. The parties have negotiated the deal for months and spent thousands of dollars in legal fees. Finally, the day has come to sign on the dotted line. The deal is done, and champagne is popping. Congratulations – unbeknownst to you, you have already breached the contract.

How could this happen? Poor risk management.

Nearly every commercial agreement contains insurance provisions that require one or both parties to obtain certain specific insurance. Despite the importance of these insurance clauses, the parties are typically focused on the more exciting deal points and the insurance provisions are an afterthought.

It is often late in the negotiation process when parties realise that they will need to obtain the insurance required by the contract. Parties contact their insurance broker and relay the highlights of the coverage requirements but fail to communicate the specifics. The insurance broker tasked with procuring the coverage is rarely provided with the contract containing the insurance requirements. Even if the contract is provided to the broker, the broker is usually not an attorney and may not appreciate the legal significance of the insurance provisions.

The broker usually secures quotes only, which are far less substantive than the actual policies that will provide the coverage. The quotes generally hit the highlights of the contractual requirements in terms of type of coverage and limits, so the parties accept the quotes and move on. The contract is signed, and no one thinks about insurance again until there is a problem.

When problems inevitably arise, parties finally pay attention to the available insurance coverage, usually for the first time. More often than not, insurance that was purchased fails to satisfy the specific contractual requirements and the party responsible for procuring the coverage is in breach. This unfortunate reality leaves all parties underinsured and potentially exposed to personal liability.

What can be done to prevent the situation? Proper risk management.

For illustrative purposes, Exhibit A to the 2017 version of the A101 standard form construction agreement from the American Institute of Architects (AIA) lays out recommended insurance requirements for the parties to a construction agreement. Section A.2.3 is entitled “Required Property Insurance” and deals with only one of the many recommended coverages. The first quarter of the first paragraph reads as follows: “Unless this obligation is placed on the Contractor pursuant to Section A.3.3.2.1, the Owner shall purchase and maintain, from an insurance company or insurance companies lawfully authorized to issue insurance in the jurisdiction where the Project is located, property insurance written on a builder’s risk ‘all-risks’ completed value or equivalent policy form and sufficient to cover the total value of the entire Project on a replacement cost basis…”

In the typical scenario outlined above, the owner would see this provision and advise its broker that it needed property insurance. The broker would likely provide the owner with a basic application and procure a builder’s risk/property policy to satisfy the owner’s obligations under the contract.

At first glance, this process may seem acceptable but when the contractual language is broken down, each word or phrase has potential legal significance that may or may not have been incorporated into the coverage. If the broker has never seen the contract or has not been advised as to exactly what is needed, the coverage is almost certain to fall short of the highly specific contractual requirements.

In order to limit these potential issues, the entire risk management team (client, lawyer, risk manager and broker) should be involved from the start. Once the contractual terms are negotiated, the insurance broker should be provided with the contract and clear instructions as to what coverages should be procured. Once the quotes and corresponding endorsements are obtained, the legal team and client should work together to analyse the proposed coverage terms to ensure that the coverage lines up with the contractual requirements. Any necessary coverage revisions should be communicated back to the broker, who can seek accommodations from the carrier. The coverage should then be revised to meet the contractual requirements. If the markets are unable or unwilling to accommodate the contractual requirements, then alternative coverage should be obtained, or the contract should be revised to reflect the coverage that is available.

Due to the complexity of this process it is helpful to create a chart that tracks: (i) the contractual requirements; (ii) the issues that need to be addressed with the broker or insurance carrier; (iii) the broker or carrier’s response; and (iv) the action items necessary to resolve any issues.

To assure that all contractual requirements are met, all insurance quotes and proposed policy forms should be carefully reviewed. Further, the risk management team should review the insurance policies after issuance to assure the contractually required coverage and agreed upon revisions are in fact provided by the insurance carriers.

Ideally this process will result in policies being procured that all parties agree comply with the contractual requirements. In that case, the policies can be attached to the agreement as an exhibit, with a corresponding contractual provision confirming that the parties have reviewed the attached policy and agree that it satisfies the procuring party’s obligations pursuant to the contract.

In order to be most effective, this type of in-depth analysis must be performed by experienced coverage attorneys, risk managers and insurance brokers who genuinely understand the subject matter of the agreement, as well as the available coverages. The parties need to know which coverage requests are achievable, versus which requests the market cannot reasonably be expected to accommodate.

Contractual negotiations are fluid and it may not be realistic to perform an exhaustive analysis as it pertains to every line of coverage required by the contract. That said, any iteration of the above-referenced review is better than nothing. Every coverage enhancement that can be achieved helps to ensure contractual compliance and serves to improve coverage, which benefits all parties.

No coverage is perfect, but every improvement chisels away at potential coverage defences and denials further down the road. Insurance will be called into question once a dispute arises; an already challenging time. Implementing proper risk management protocols at the outset of a contractual negotiation can help to ensure that trying times are not further complicated by breaches of the underlying agreement.

Jason M. Adams is a partner at Gibbs Giden. He can be contacted on +1 (310) 552 3400 or by email: jadams@gibbsgiden.com.

Jason M. Adams

Gibbs Giden