When the Subcontractor is Better at Dodging Indemnities than at Dodging Holes in the Ground In our review of the last quarter of 2023, we begin with a case that on first blush appears to have, more or less, a standard contractual indemnity provision. However, the subcontractor was able to dodge its duty to indemnify based on a wrinkle in the indemnity language.
In Flatiron West, Inc. v. Rma Group, Flatiron West, Inc. (“Flatiron”) served as the general contractor on a government project and Rma Group (“RMA”) was subcontracted to provide inspection services.[1] The case really begins, like so many others, with a physical injury. The employee, a welding inspector of RMA, arrived at the project site one morning. After checking in at the site office, he drove his truck towards the area where he was to perform the inspection. A truck of another subcontractor blocked his path. So, the inspector parked his vehicle, walked through an area where excavations were occurring, stepped into a hole, and sprained his ankle.[2]
Afterwards, the employee sued many parties (including Flatiron) on many negligence theories.[3] The suit did not name RMA as a defendant. The contract between Flatiron and RMA contained the following indemnity provision:
“Service Contractor [RMA] shall indemnify, defend and hold Contractor [Flatiron] harmless from and against any and all liabilities, losses, damages, expenses (including attorneys' fees, court costs, and other expenses of litigation), claims, penalties or fines (collectively referred to as 'Claims')[,] damages of property including loss of use thereof, injuries to persons, including death, on account of Service Contractor's, or any of its . . . employees . . ., negligent acts or omissions in the performance of this Agreement."[4] Flatiron tendered the complaint to RMA for indemnity. The insurer for RMA denied the indemnity because the hole the employee in question fell into was created by another subcontractor, and the insurer said the injury occurred before the employee began working. So, Flatiron filed a cross-complaint against RMA for breach of contract, express indemnity, and declaratory relief.[5] Both Flatiron and RMA filed for summary judgment on the issue of the contractual indemnity. On motion for summary judgment, RMA argued that: the injury in question occurred before the employee began his work, and thus was not in the performance of the subcontract; that the employee’s complaint against Flatiron did not allege any negligent act or omission of RMA; and that the employee was injured due to the negligent acts or omissions of Flatiron or the other subcontractor which had performed the excavation work. On its motion for summary judgment on the issue of the contractual indemnity, Flatiron argued that RMA had improperly trained its employee and that the incident did happen during the performance of the subcontract because at the time of the injury, the employee was scheduled to work, had arrived at the project site, had checked in with Flatiron personnel, was at the project site only to perform work under the subcontract, and would not have been at the site if not for the subcontract.[6] The trial court disagreed with Flatiron. The trial court concluded that the injury did not occur in the performance of the agreement because the employee was not performing a welding inspection at the time he was injured. The appellate court upheld the trial court. It interpreted the contract language of the indemnity provision to require RMA to indemnify Flatiron for claims existing "on account of [RMA’s], or any of its . . . employees . . ., negligent acts or omissions in the performance of this Agreement." It determined then that RMA was not required to indemnify Flatiron unless the claims were (1) on account of RMA’s or its employees' negligent acts or omissions, and (2) in the performance of the subcontract.[7] In short, because the acts occurred before the employee performed the welding inspection, the claims did not arise from acts in performance of the subcontract. The appellate court reasoned that the additional language of “in the performance of the Agreement” could only be construed as serving to narrow the indemnity. The appellate court reached that conclusion by comparing the indemnity provision to broader indemnities provisions containing language like "in any way connected with," "arising out of," or "resulting in any way from" the performance of the subcontract.[8] Parties seeking to avoid their alleged indemnification obligations unfortunately cannot cite Flatiron West as authority due to Cal. R. Ct. 8.1115(a). For this reason, and because matters of contract interpretation are so factually intense, I would not anticipate the case to have any broad impact. However, it’s a useful case in considering the implications of indemnities. Chiefly, if you are entering into an agreement whereby you are only party agreeing to indemnify, it’s a reminder that actual contract language matters. My view is that if the subcontract agreement in Flatiron West had contained more of the standard “arising out of or related to” language or other similar boilerplate indemnity provisions, then the outcome would likely have been different. The court no doubt had seen similar provisions in the past and the fact that this indemnity provision in question had different, negotiated language caused the trial and appellate courts to view it differently. So, the practice point is that if it is a one-sided indemnity whereby you are the indemnifying party, even a small variation in the language differentiating it from standard boilerplate might cause a court to analyze it more carefully. In practice though, I have seen many more indemnity provisions that are mutual and broad. Considering this, of course, is trickier. Technically, even a mutual indemnity ought to be considered through the prism of whether in the regular performance of the agreement such a “mutual” indemnity provision is disproportionally likely to be used against one party. Such an exercise, however, requires a bit of prognostication and as the saying goes, we plan, and the gods laugh. Here, more often, I have sought to cap the limitation of my client’s liability in a separate limitation of liability clause rather than weaken an indemnity that at least theoretically could work in our favor one day.
What’s the Damage in Offering to Clone BBQ Sauce?
Regarding limitation of liability clauses, the U.S. Court of Appeals for the Ninth Circuit has certified a question of law for the California Supreme Court at the nexus of California law and limitation of liability clauses. Before going into why, there are three points that should be understood by the non-legal reader as background:
First, when a U.S. Court of Appeals is deciding an issue of California law for which it believes there is no controlling precedent, it may request that the California Supreme Court issue a decision in accordance with Cal. R. Ct. 8.548(b). That’s what is occurring here and in this issue of the blog we will not know the outcome as it’s basically a public submission of the issue to the California Supreme Court.
Second, limitation of liability clauses will be upheld under California law as a general rule. But under section 1668 of the California Civil Code, all contracts which have for their object, directly or indirectly, to exempt anyone from responsibility for his own fraud, or willful injury to the person or property of another, or violation of law, whether willful or negligent, are against the policy of the law.
This makes complete sense. Imagine that the seller of a used car knows that the transmission is broken. He proceeds to sell the car for $10,000 through a written agreement that represents the car to be in perfect working condition and which limits the liability of the seller to one dollar in any lawsuit arising out of the agreement. If such a contract were allowed to exist, the buyer could sue the seller for fraud, win the lawsuit, and only be awarded one dollar. Without section 1668, a seller in that position could, effectively, contract around and vitiate the law on fraud.
Third, contracts often contain limitation of liability clauses that limit the type of damages. The most common clause of this sort will limit an award in a breach of contract action to direct damages and will prohibit indirect, special, or consequential damages. These are themselves somewhat fuzzy concepts in their own right. But at a high level, to consider the distinction, imagine that a painter spills a bucket of paint on a customer’s leather sofa. The costs to reupholster or replace the leather couch would be direct damages. If the customer had to rent another sofa for their annual Oscar party while their sofa was being reupholstered, then that would be considered a consequential or indirect damage.
With this backdrop, we can finally turn to New England Country Foods, LLC v. Vanlaw Food Products, Inc.[9] In 1999, New England Country Foods, LLC (“NECF”) began selling a proprietary barbeque sauce to Trader Joe's Company (“Trader Joe’s").[10] Although NECF initially manufactured its barbecue sauce, eventually it outsourced manufacturing to Vanlaw Food Products, Inc. ("Vanlaw").
Towards the end of NECF’s agreement with Trader Joe’s, Vanlaw offered to “clone” the barbecue sauce and sell to Trader Joe’s without NECF. Trader Joe’s accepted that offer and terminated its nineteen-year relationship with NECF. Ultimately, however, Vanlaw was unable to clone the barbecue sauce.
NECF contends that the written agreement with Vanlaw prohibited it from “reverse-engineering” the barbecue sauce and therefore NECF sued Vanlaw for contract and tort causes of action.[11] However, the written agreement contained this limitation of liability clause:
"[t]o the extent allowed by applicable law: (a) in no event will either party be liable for any loss of profits, loss of business, interruption of business, or for any indirect, special, incidental or consequential damages of any kind[.]"[12] Seemingly without denying its behavior, Vanlaw tried to dodge the lawsuit with a motion to dismiss. Vanlaw’s motion to dismiss claimed that the limitation of liability clause barred the complaint because NECF would be attempting to collect past and future lost profits, attorneys' fees and costs, and punitive damages. The district court agreed with Vanlaw and dismissed the complaint based on the contractual limitation of liability, but gave NECF permission to amend the complaint.[13] In its first amended complaint, NECF added allegations that its harm was only in the form of lost profits (both past and future) and that if the court applied the limitation-of-liability provisions in the agreement, then it would completely exempt Vanlaw from liability from the wrong alleged.[14] Vanlaw moved to dismiss the amended complaint on the same basis as before and the district court agreed again, finding that the limitation of liability provision in question was permissible under section 1668 because it "does not bar all liability, just liability for specific types of relief."
NECF appealed the decision.
We can see immediately why the Ninth Circuit is in a pickle here. On the one hand, it appears we have an obvious wrongdoer in Vanlaw. And on the other hand, the contract in question would seem on its face to prohibit any recovery. If Vanlaw had succeeded in selling the new barbecue sauce, NECF would have had the ability to seek injunctive relief and stop the manufacture of it. But because the limitation of liability clause here barred the recovery of lost profits and of loss of business, in this instance NECF would be left holding the bag. My prediction is that the Supreme Court of California will issue an answer that ultimately upholds the decision of the district court. There are some appellate decisions suggesting that section 1668, despite its broad language, only applies to contracts that involve the public interest. Here, we have an agreement between two businesses.[15] Thus a consumer is not involved. Next, California might have a public interest in prohibitions against reverse-engineering being upheld. But that is technically not at issue. If parties want reverse-engineering prohibitions upheld, it is within their power to do so by simply not including limitation of liability provisions which prohibit lost profits. In any case, a decision from the California Supreme Court on this issue will hopefully add clarity. The practice point here is easily apparent. Review the limitation on liability provision and game out several possible scenarios. At first blush, a limitation of liability clause wherein consequential damages or lost profits are excluded might seem appealing. Afterall, who wants to pay out speculative damages? But what if you are the party who is wronged?
You Can’t Win if You Don’t Show Up
In the first quarter of the 2023, I wrote about the possibility of arbitral findings being used against business owners who were not parties to the arbitration agreement. In this quarter there was a case where a default judgment in state court kept a debt from being discharged in the bankruptcy court.
In Blue Green Plantation Envelope Enters. v. Johnson (In re Johnson), the debtor/defendant was the managing member of a California limited liability company called Target Equity, LLC ("Target Equity") and a control person for the purposes of California securities laws.[16] Target Equity claimed it was raising money to purchase interests in Zabala Farms of Salinas, LLC ("Zabala Farms") which operated a marijuana farm and cultivation business.[17]
The plaintiff claims to have seen an ad for the offering while he was on vacation in Cabo San Lucas. He submitted his contact information and on return ultimately engaged in a sales process with the debtor and the debtor’s brother that culminated in the plaintiff touring the farm and making a $1,324,700 investment on March 7, 2018.
About fourteen months later, the plaintiff filed a complaint for damages in the Riverside Superior Court ("Riverside Court"), alleging damages related to allegations of the defendant's violation of California securities law.[18] It’s unclear in the record why, but the defendant did not answer the complaint and a default was entered against the defendant. The Riverside Court held a hearing to prove up the default. The plaintiff testified at the hearing. It does not appear from the record that the defendant was at the hearing. In October of 2019, the Riverside Court found that the defendant, among others, sold unqualified securities in violations of sections 25110 and 25503 of the California Corporations Code, and entered judgment in favor of the plaintiff, including a joint and several judgment against the defendant (later in the bankruptcy case, the debtor) in the amount of $1,465,948.96.[19]
It would appear from the record that the debtor made no payment on the judgment.
On May 8, 2022, the debtor filed a voluntary petition for bankruptcy under chapter 7.[20] The plaintiff filed an adversary proceeding to declare the above judgment to be non-dischargeable in bankruptcy. Next, the plaintiff filed a motion for summary judgment on the issue of non-dischargeability on the basis that: (i) under Section 523(a)(19)(A) of the Bankruptcy Code, a debt of an individual debtor is not discharged if the debt is stemming from the violation of any federal or state securities laws; and (ii) the findings of the Riverside Court in the default judgment should apply in the adversary proceeding.[21]
The court agreed and granted summary judgment. In a very detailed opinion, it found (among other things) that California law accords preclusive effect to default judgments, at least where the judgment contains an express finding on the allegations.[22] Therefore, it granted the preclusive effect to the findings of the Riverside Court and found that the judgment was non-dischargeable.
For the seasoned legal reader, I doubt this opinion offers much insight and it’s not terribly surprising. But for everyone else, there are nuggets here. I do not wish to sound like a curmudgeon, but we live in a society that is increasingly pliable about deadlines. Agreements often have cure periods, late fees can be argued, and people flake over social obligations. Against this backdrop, I think the rigidity of the courts can be a surprise even to business owners. While it is true that I have seen judges give incredible flexibility to parties who have been participating in the process, some of the most hopeless matters that have come across my desk were similar to this case. If you don’t answer or participate at all, an early administrative hearing or a default judgment can hang around your neck. Even if a case against you is strong, the leverage of being present in the process is far better than not responding at all.
Next, over the years I have heard more aggressive business owners flippantly suggest that if a lawsuit were brought against them or if a pending lawsuit ended unfavorably, they would just file bankruptcy–or as one colorful client of mine many years ago said, “We would just go “BK.”” To the extent this language is merely calming anxieties in the midst of a pending lawsuit, then I would agree with Steve Martin: “Through the years, I have learned there is no harm in charging oneself up with delusions between moments of valid inspiration.” But Blue Green Plantation Envelope Enters is a reminder that this can’t be taken as a serious strategy. There are so many exceptions to whether a debt can be discharged, the better path is to fight any claims against you in the first forum.
**********************************************************
Endnotes
[1] Flatiron W., Inc. v. Rma Grp., No. C096486, 2023 WL 8227919, at *1 (Cal. Ct. App. Nov. 28, 2023).
[2] Id. at *2.
[3] Id. at *2.
[4] Id. at *1.
[5] Id. at *2.
[6] Id. at *3.
[7] Id. at *6.
[8] Id. at *7.
[9] New England Country Foods, LLC v. Vanlaw Food Prods., Inc., 87 F.4th 1016 (9th Cir. 2023).
[10] Id. at 1018.
[11] Id. at 1018–19.
[12] Id. at 1019.
[13] Id. at 1019.
[14] Id. at 1019.
[15] In a somewhat similar 2023 case in Wisconsin, a wholesaler of medical supplies had entered into an agreement to purchase medical gloves which were never delivered. The wholesaler sued to recover the lost profits it would have earned had it received the gloves and been able to sell them downstream. The agreement had a provision: “Neither party will be liable to the other party for any incidental, indirect, special, or consequential damages, arising out of or in connection with this Agreement.” The court was applying Wisconsin law which more expressly provides that” Consequential damages may be limited or excluded unless the limitation or exclusion is unconscionable.” Wis. Stat. § 402.719. However, in its reasoning the court also cited that the agreement was the product of negotiation and bargaining between sophisticated businesses. Dental Health Prods., Inc. v. Sunshine Cleaning Gen. Servs., 657 F. Supp. 3d 1151, 1159 (E.D. Wis. 2023). The same reasoning would apply here.
[16] Blue Green Plantation Envelope Enters. v. Johnson (In re Johnson), No. 6:22-bk-11736-RB, 2023 Bankr. LEXIS 2951, at *2 (Bankr. C.D. Cal. Dec. 15, 2023).
[17] Id. at *2.
[18] Id. at *4.
[19] Id. at *5.
[20] Id. at *5.
[21] Motion for Summary Judgment at Ex. A, Blue Green Plantation Envelope Enters. v. Johnson (In re Johnson), No. 6:22-bk-11736-RB, 2023 Bankr. LEXIS 2951 (Bankr. C.D. Cal. Dec. 15, 2023).
[22] Blue Green Plantation Envelope Enters., 2023 Bankr. LEXIS 2951, at *14–26.