Anytime a prime design firm has a contract with an owner reviewed for insurability, it will likely see a recommendation from its legal or risk advisor that a third-party beneficiary clause be stricken from the agreement.
There’s a sound reason for this: Depending on the jurisdiction and its acceptance or interpretation of the Economic Loss Doctrine, a claim arising from such a clause can result in a serious coverage issue – or possibly no coverage, whatsoever.
To get their arms around this issue, design firms should become familiar with the concept of a third-party beneficiary. Basically, a third-party beneficiary is an individual or business that benefits from a contract between two other parties.
How do third-party beneficiary clauses impact the design contract? The most obvious scenario for design professionals involves the prime designer’s contracts with their consultants. While the consultants’ work ultimately is for the project owner’s benefit, the owner typically does not contract with them directly. Thus, the consultants are not subject to a direct claim by the owner.
Yet, owners increasingly have been requesting that third-party beneficiary clauses be inserted into the prime designer’s contract. Unfortunately, they are not beneficial – either for the prime design professional or the owners – given the significant coverage issues they can create.
Certainly, from the prime’s perspective, it might appear more convenient to let the owner make a claim directly against a consultant whose work is at issue. However, by including a contractual provision that allows such a direct action, which may be the case under a third-party beneficiary clause, the prime designer might find itself in a position where its consultant has no insurance coverage.
Under its contractual relationship with the owner, the prime is responsible for the work of its consultants. Thus, as the prime, you require your consultants to carry professional liability coverage, so you absolutely want the protection in place to respond should their work be at issue.
Ultimately, the prime is legally responsible for the work of its consultants, whether they have coverage or not. Although it may seem more complicated to have claims follow the contracts, it is better for the prime once a consultant’s work is at issue or the subject of a claim to make an indemnity demand or claim against its consultant for the work at issue.
As the prime, if your relationship with your consultants is strong and their carrier is reasonable, they will generally step up and defend their work.
In most jurisdictions, for a third party to recover, the parties to the contract must have intended that a specific beneficiary would directly benefit from the performance of the contract. It is generally not enough that the party is incidentally benefitted.
Where the contract does not mention a third party, it is presumed that the parties did not intend to benefit a third party.
Navigating jurisdictional issues. Generally, the only time a third party can make a claim against a design professional is if there is bodily injury or property damage involved. However, there are jurisdictions where the courts allow third-party beneficiary claims for economic loss. These jurisdictions do not recognize the Economic Loss Doctrine, which essentially stipulates that if all you have lost is money, you must have a contractual relationship to recover.
In some jurisdictions, not only can owners make direct claims, but contractors who rely on the plans and their subcontractors can also make claims. In these jurisdictions, where the claims stipulate that the design professional has breached the standard of care, coverage will likely not be an issue.
However, this can be complicated by the presence of third-party beneficiary language in the contract. In this case, you could find yourself with unnecessary coverage issues that may only have existed because the clause was included.
Keep in mind, your professional liability insurance policy has an exclusion that states there is no coverage for a claim arising out of liability assumed under a contract or agreement, except to the extent that there would have been liability in the absence of such contract or agreement.
Accordingly, it’s important for design firms to have a basic understanding of the law that will apply to the contract they are working on and an understanding of the potential peril to all parties involved should there be a third-party beneficiary clause in the contract.
Furthermore, given the added complexity of jurisdictional issues, it’s especially helpful to have a knowledgeable risk advisor or legal counsel thoroughly review contracts for third-party beneficiary clauses or similar language, as well as other onerous wording.
Otherwise, in the absence of a careful contractual review, the prime may find itself in a situation where it is on the hook for its consultant’s work due to a declination of coverage by their carrier. The consultant may find itself with uninsurable risk, and the owner may in fact have less coverage in place than it had intended.
Lauren Martin is a risk manager and claims specialist at Ames & Gough. She can be reached at firstname.lastname@example.org.