Risk Shifting Through Contracts

Abstract: In an increasingly global economy, medical device manufacturers are finding that they must rely more and more on supply chains in order to control costs and successfully compete in the marketplace. It is no longer sufficient for a manufacturer to be agile and lean. Its entire supply chain must also be agile and lean. However, the efficiencies that facilitate the flow of a product to the marketplace also cause risk to spread through the supply chain, as every link in the supply chain exposes its participants to products liability risk. Companies that proactively develop and apply risk management practices in the production of a product can help to limit their products liability exposures. This article discusses how contractual agreements that allocate risk between supply chain participants can be an effective risk management tool in a company’s risk management strategy and discusses three risk-shifting provisions that are often used to transfer risk through contracts. 

Much has been written about the importance of cooperation and collaboration across supply chain participants. The competitive nature of the market requires all supply chain members to work together to quickly get products out to the marketplace. These tight-knit business relationships can be strained when supply chain participants are named as defendants in a products liability lawsuit. Moods can shift quickly from collaboration and cooperation to protectionism, as each company is primarily concerned with optimizing its own position and minimizing its own liability. The resulting finger-pointing across supply chain participants can damage business relationships and affect the bottom line of the entire network.

Companies that prepare in advance are better equipped to preserve important business relationships as well as protect themselves from unintended liability. One of the most effective ways companies can prepare for such events is to have written contracts in place with their supply chain partners. Written contracts that transfer or limit a company’s liability in the event of a products liability lawsuit can help preserve important business relationships as well as guard against unwanted or unintended liability.  

Contracts may include a variety of risk transfer provisions that allocate risk among various parties or projects. When employing such provisions, it is important to remember that the risk has not disappeared, it has merely been transferred to the party that can best mitigate its potential effect.

The purpose of this article is to raise awareness of three types of risk transfer provisions that are often used in an effort to transfer risk via contracts. This article is not intended to be a comprehensive or exhaustive discussion of these provisions. It is important to note that these are basic descriptions and while these tools in theory are conceptually simple to understand, the actual transfer of risk in a contract is a highly complex and technical endeavor. It is therefore important to consult with your legal counsel and insurance professionals regarding how these provisions might be employed in your company’s contracts.

Indemnity Provisions

Indemnity provisions, often referred to as hold harmless agreements, are the primary vehicle by which companies across the supply chain typically shift or apportion risk in a contract. Indemnity provisions may include any, or all, of three obligations to (1) indemnify, (2) defend, and (3) hold harmless the other party. “Indemnify” means to reimburse the other party following a loss. “Defend” means to pay the other party’s legal expenses as it defends itself against a third party claim. “Hold harmless” may have different meanings, but most generally it is understood to be an agreement to absolve another party from any responsibility for damage or other liability arising from a transaction. 

A simplified, broad indemnity provision in a contract may look something like the following:

Indemnity provisions can be extremely effective risk transfer tools for companies. For example, a manufacturer that contractually agrees to indemnify a vendor becomes liable for damages that occur as a result of the transaction that are within the scope of the indemnification. In other words, much of the risk incurred as a result of the transaction lies with the manufacturer. Vendors who fail to include indemnifying provisions in their contracts with the manufacturer (and vice versa) could be held liable through tort law for an injury that occurs due to the acts, or in some instances the failure to act, of a manufacturer.

Indemnity provisions can be mutual, granting both parties a right of indemnity if held liable for the acts or omissions of the other. In other words, each party respectively carries the potential liability associated with their own products or work. A simplified mutual indemnity provision may look something like the following:

Indemnity provisions do not have to provide for absolute and unlimited indemnity but can be specifically tailored to fit the needs of the contracting parties. For example, indemnification provisions can include restrictions such as the following:

• Monetary limits on the amount of indemnity to be paid;
• Time restrictions on the duration of the indemnity obligations; or
• Categories of claims to which the indemnity obligation does or does not apply.

It is important to note that the laws governing indemnity provisions vary from state to state. Provisions that may be upheld in one jurisdiction may not be upheld in another. Therefore, companies should review state laws regarding indemnification provisions prior to including one into a contract. Otherwise, a court may invalidate the indemnity provision—or in extreme cases the entire agreement—and a company could find itself financially responsible for a liability it believed had been successfully transferred.

An additional word of caution regarding indemnity provisions: Before granting indemnity to a contracting party, a company should carefully check the wording of its insurance policy to make sure that the indemnification clause does not exceed the scope of its insurance coverage. In other words, a company may want to compare its insurance coverage to the indemnification clause to be sure that all of the actions (or inactions) that it is agreeing to indemnify are covered by the policy. If the indemnification clause exceeds the scope of coverage, the company will be contractually responsible for the uninsured liability. Risk managers should have a close working knowledge of their organizations’ insurance policies. 

Additional Insured Provisions 

Additional Insured provisions are also useful tools for companies when shifting or apportioning risk. These provisions require one party to list the other party as an “additional insured” on its insurance policy. This reinforces the risk transfer achieved with the indemnity agreements by providing the additional insured with direct rights under the policy.

A simplified additional insured requirement provision may look like the following:

The insurer is obligated to indemnify and defend the additional insured in accordance with the policy terms and conditions. The fact that the additional insured pays no premium does not diminish the insurer’s obligation to the additional insured. Thus, companies who are listed as additional insureds on their fellow supply chain participants’ insurance policies may receive additional insurance coverage in the event of a lawsuit.

As with indemnity provisions, additional insured provisions may be customized according to the specific needs of the contracting parties. The provision may require that the insurance meet certain needs with respect to:

• Duration of coverage;
• Policy limits;
• Policy form (“claims made” vs. “occurrence”); or
• Hazards to be covered.

A company who adds an additional insured provision to a contract should require the contracting party to provide proof of compliance. In other words, companies should contractually require their supply chain participants to provide evidence that they are in fact listed as additional insureds on vendors’ insurance policies. This evidence may generally be supplied in the form of a Certificate of Insurance or an Additional Insured Endorsement.

Note that a Certificate of Insurance is not itself a valid endorsement to a policy and usually does not provide the specifics of what is covered. As insurance companies sometimes revise their Additional Insured Endorsements to limit their coverage obligations, companies who are listed as additional insureds on their supply chain participants’ policies should request copies of the actual endorsements in order to understand the extent of coverage.  

Exculpatory Provisions

An exculpatory provision is one that relieves a party from liability resulting from its own wrongful acts. In other words, it is a party’s attempt to escape tort liability for claims resulting from its own negligence. Companies should take care to watch out for these provisions when receiving a contract drafted by another party.

A simplified exculpatory provision may look something like the following disclaimer:

Exculpatory provisions may initially seem like an effective risk transfer tool; however, companies should be wary of including—and extremely wary of accepting—such provisions in contracts with their supply chain participants. While exculpatory clauses can be convenient tools to shift risk and avoid litigation, they garner mixed reviews from the courts. As a general rule, courts will not enforce an exculpatory clause against an act that was caused by willful neglect or gross negligence, and some states bar these provisions as against public policy. 

Narrowly tailored exculpatory provisions may be used to shift risk in limited circumstances; however, companies that use or accept such provisions in contracts with their supply chain network should do so with caution and should consider consulting with a local attorney prior to entering into the contract. 

When exculpatory provisions are appropriate, they need not limit all liability. For example, some of the limitations of liability may include: 

• Monetary limits on the amount of liability to be paid;
• Restrictions on the duration of the exculpatory provision;
• Specific remedies (e.g., lost or destroyed equipment must be reimbursed according to its replacement, rather than its intrinsic value); or
• The types of claims to which the exculpatory provision applies (e.g., remedies are limited to those arising from express warranty claims).

Conclusion

While these provisions may seem simple and straightforward, the old adage that “things are rarely as simple as they seem” certainly applies here. It is important to consult with your legal counsel and insurance professionals during any contract negotiations. Companies that take the time and effort to incorporate risk transfer provisions into their contracts, as appropriate, and have them reviewed by the proper personnel can do much towards limiting their products liability exposure and preserving important business relationships.