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Energy Law Exchange

March 20, 2015

Zachry Construction Corp.: The End to Indemnity for Exemplary Damages?

In August 2014, the Texas Supreme Court decided Zachry Construction Corp. v. Port of Houston Authority of Harris County, 2014 WL 4472616 (Tex.). While the case involves construction issuesand specifically the enforceability of no damages for delay clauseskey portions of the decision could have significant impacts on energy disputes. In particular, the case resolved an issue present in many energy cases and that has long divided the Texas appellate system: whether a company can shield itself from liability for exemplary damages through contractual indemnity provisions. The Zachry Court ruled that contracts incentivizing reckless or intentional misconduct violate public policy (even when among sophisticated parties), and exceed acceptable limits of the freedom to contract. Its reasoning and dicta are even more broad and should spell the end of indemnity for exemplary damages.

A State Divided

The Texas Supreme Court had not previously held whether or not a pre-injury release or indemnity for gross negligence claims was against public policy, and a split had developed among the appellate courts. The issue generally arose when courts were called upon to interpret contractual clauses pursuant to the express negligence test, which requires parties to expressly and unambiguously state within the contracts four corners that a party will be granted a release or indemnity for its own negligence. There has long been ample case law in Texas instructing practitioners on how to prepare contract provisions to satisfy the express and conspicuousness tests, but the case law has been somewhat divided on whether indemnity for gross negligence should be treated differently than indemnity for ordinary negligence.

One line of cases has said that a gross negligence claim is not a separate claim from negligence, and the difference between the claims is more of degree than kind. Found primarily in the opinions of the San Antonio appellate court, these cases noted that a party should be presumed to have meant all shades of negligence when it agreed to release or indemnify another party for its negligence. Accordingly, these decisions held that a release from negligence claims also released claims for exemplary damages under a theory of gross negligence. Notably, these opinions expressly stated they either were not considering issues of public policy, or instead declared a contract between business entities should be interpreted as written and matters of public policy are best left to the Legislature or Supreme Court. See Newman v. Tropical Visions, Inc., 891 S.W.2d 713 (Tex.AppSan Antonio 1994); Webb v. Lawson-Avila Construction Inc., 911 S.W.2d 457 (Tex.App.San Antonio 1995).

On the other hand, appellate courts such as those in Dallas and Beaumont have found that releases purporting to exempt a party from liability arising from its own gross negligence are void as against public policy. These opinions examined the differences between negligence and gross negligence, noting that the latter includes conduct posing an extreme risk of harm to others and an actor proceeding with conscious indifference to the rights, safety, and welfare of others. Further observing that a finding of gross negligence could trigger an award of exemplary damages, these courts concluded that claims of gross negligence are not included in release and indemnity agreements concerning negligence, even when all aspects of the express negligence test otherwise are met. See Smith v. Golden Triangle Raceway, 708 S.W.2d 574 (Tex.App.Beaumont 1986); Van Voris v. Team Chop Shop, LLC, 402 S.W.3d 915 (Tex.App.Dallas 2013).

As a result, contracting parties who specify that Texas law will govern their agreements have faced uncertainty concerning the manner in which indemnity and release provisions might be construed. And woe to those who agreed to the Harris County courts as the exclusive venue for disputes, as the Houston First and Fourteenth appellate courts developed their own split along the lines cited above! Compare Tesoro Petroleum Corp. v. Nabors Drilling USA, Inc., 106 S.W.3d 118 (Tex.App.Houston [1st Dist.] 2002 (agreeing with Newman) with Del Carmen Canas v. Centerpoint Energy Resources Corp., 418 S.W.3d 312 (Tex.App.Houston [14th Dist.] 2013 (agreeing with Van Voris).

The Impact of Zachry

The Zachry case should be considered to have resolved this split. The dispute in Zachryconcerned a contract provision by which Zachry agreed the Port would not be required to pay delay damages even if delays were due to the Ports negligence, breach of contract, or other fault. Instead, Zachrys sole remedy would be an extension of time to complete the project. However, a jury found the Port to have engaged in arbitrary and capricious conduct, active interference, bad faith and/or fraud, and further found such conduct was responsible for the projects delays. Under these circumstances, the Texas Supreme Court held the no damages for delay provision unenforceable, and that the owner could not shield itself from liability after deliberately and wrongfully interfering with the work.

Other commentators have ably recognized the impact of this decision upon parties ability to shift risk in construction contracts, and that certain common-law exceptions are now established as applicable to limit no damages for delay clauses. But the language employed in Zachry is broader and seems clearly to apply also to general release and indemnity agreements, including those found in energy contracts. The Court declared that exempting a party from tort liability for harm caused intentionally or recklessly is unenforceable on ground of public policy, and expressly extended this principle to contract liability. Indeed, the Court recognized that to conclude otherwise would incentivize wrongful conduct and damage contractual relations. The Court rejected the argument that parties should maintain the freedom to contract for such provisions if they choose, flatly stating that freedom has limits. Nor was the Court persuaded that the rule should be applied differently to a sophisticated party like a large construction company, declaring that the laws protection against intentional injury is not limited to the helpless. 2014 WL 4472616 at *10.

Although Zachry was examining a no damage for delay clause impacted by arbitrary and capricious behavior, its reasoning is not so limited. The opinions language should neuter any further argument that a party can contractually exculpate itself from liability for damage caused by its intentional or reckless misconduct. And while the Court had not decided the issue before, its opinion in Zachry stated that the Court had previously indicated that pre-injury waivers of future liability for gross negligence were be void as against public policy. As a result, release and indemnity agreements that concern negligence claims no longer should be interpreted to include claims of gross negligence, much less allegations requiring a higher standard. And thus, such provisions cannot shift the risk of exemplary damages awards from one party to another.

This result should be hailed as proper and just. It seems hardly fair for a party to agree to indemnify another for negligent acts, only to discover after a catastrophic event that it also bears responsibility for the intentional or grossly negligent acts of the indemnitee. Parties should not be incentivized to be reckless by the belief that they have contractual protection. Nor should negotiating parties be expected to evaluate the likelihood and cost of the other party acting fraudulently or in bad faith.

Best practice remains to be specific when drafting contractual provisions, and to expressly state that claims of gross negligence, malice, fraud, and other intentional misconduct are not included in any release or indemnity obligation. But after Zachry, a party should recognize it cannot rely upon release or indemnity provisions to shield itself from liability for gross negligence or intentional misconduct.