[Editor's note: A version of this story appears in the November 2020 issue of Oil and Gas Investor magazine. Subscribe to the magazine here.]

With very rare exceptions, oilfield contracts address allocations of the financial consequences of risks arising out of the performance of the work. This is usually done in some version of a “knock-for-knock” indemnity scheme where each party agrees to be financially responsible for claims related to its own people and property and to indemnify, defend and hold harmless the other party and its “group” of related/interested parties from and against such claims.

This includes protecting a party from a claim even where the loss at issue results from the negligence, strict liability or other legal fault of that party. Third-party claims, environmental responsibilities and claims arising out of catastrophic events such as a blowout are often addressed separately.

This allocation of financial responsibility is based in part on a desire to avoid protracted litigation driven by efforts to apportion fault for a loss among the many parties that are typically at a well site. Without a clear contractual allocation of risk, each party will engage counsel that will seek to downplay its own liability while seeking to find fault with the actions of others at the site. In doing so, defense counsel will engage in extended discovery (to the delight of the plaintiff’s counsel) funded by multiple insurers.

While by no means a perfect solution, a knock-for-knock scheme allows a single party to focus on settling or defending a claim rather than attempting to establish the negligence and fault of others involved with the work.

A knock-for-knock indemnity scheme also allows each party to more efficiently insure the risks presented by their operations and incentivizes employers to invest in safety and loss control to mitigate the likelihood of injury to their own employees (or those of their subcontractors) or damage to their property.

Certain exceptions to a knock-for-knock scheme are typically made where the party with the most to gain financially from the work at issue assumes more liability than the other party. For example, in drilling contracts, the oil and gas company stands to gain far more financially from the results of the drilling than does the contractor, who is merely earning a fixed day rate. As a result, the oil and gas company typically assumes the financial consequences of catastrophic loss—such as a blowout or pollution flowing from the well—even if such loss is caused by the drilling contractor.

The Role of Insurance

In addition to contractual indemnity undertakings, and as a separate legal obligation, oilfield contracts require the parties to obtain insurance coverages and name and waive the indemnified parties to them, ideally “to the extent” of the relevant risk allocations and indemnity undertakings.

Insurance is required so that the indemnified party does not need to rely on the willingness or financial ability of the indemnitor to pay following a loss. Access to the indemnifying party’s insurance is particularly important if the indemnified party caused the loss, as the indemnifying party may have very little motivation to reimburse a party where the loss materially impacted business, personal relationships and reputation. Even if the indemnitor wants to pay, it may not have the financial wherewithal to do so for a major loss.

An indemnified party that was named as an additional insured on the indemnitor’s liability insurance has status and rights under the insurance policy that it can assert directly to protect its interest should the indemnitor fail to act. If they are not named, the party owed indemnity needs to rely on the indemnitor to pursue a claim under its own “contractual liability” coverage.

Naming and waiving are very important on property policies also as it should legally preclude the insurer from subrogating against the indemnified party following payment of a claim. As the insurer “steps into the shoes” of its insured to assert subrogation rights, subrogation should not be possible where those “shoes” come with an obligation to indemnify a party. But insurers do occasionally try and a party which is an additional assured on a policy will be very well positioned to rebuff such a claim.

Applicable State ‘Anti-Indemnity’ Laws

Oilfield service contracts may be subject to maritime or state law interpretation and enforcement. Certain states have prohibitions against oilfield indemnities for one’s own negligence that must be considered, while maritime law permits parties to contractually allocate risks.

The Texas Oilfield Anti-Indemnity Act (Texas Practice and Remedies Code § 127.001 et seq.) invalidates or limits indemnity provisions that purport to indemnify a person for property damage or personal injury caused by the negligence or fault of that person unless the indemnities are (i) mutual and (ii) covered by insurance. If the parties carry differing amounts of insurance, the indemnity is limited to the lower amount of insurance obtained by the parties. This means that a reciprocal knockfor-knock indemnity undertaking that is not supported by mutual insurance undertakings will be void or capped by the lower amount of insurance coverage carried by the parties.

Like the Texas statute, Louisiana’s Oilfield Anti-Indemnity Act (La. Rev. Stat. Ann. § 9:2780) invalidates contractual indemnity for personal injury claims caused by the person claiming indemnity. (Louisiana does not nullify indemnities for property damage.) Unlike the Texas statute, the Louisiana statute does not contain an exception for insurance coverage. As a result, contracting parties cannot avoid the Louisiana statute merely by requiring mutual insurance coverages in support of the indemnity obligations.

However, Louisiana has developed a court- created workaround known as the Marcel exception. Under Marcel, a court will not void an additional insured undertaking where no material part of the cost of adding the additional insured to the policy was borne by the party owing indemnity. The thought is that where a party to be indemnified paid the full cost to be made an additional insured, it should get the benefit of the bargain with the insurer.

In light of the Louisiana and Texas anti-indemnity statutes, the role of insurance is of paramount importance, and the failure to include proper insurance undertakings will result in the indemnity being voided or capped if Texas law applies or will preclude access to a Marcel solution if Louisiana law applies.

This may not seem like a significant issue, as the overwhelming majority of oilfield agreements do contain reciprocal insurance obligations. However, from time to time we see contracts where the larger, more economically powerful party requires the smaller party to place coverage and name and waive the larger party but include no reciprocal undertaking by the larger party to place insurance and name and waive the smaller party or its group thereon.

The thought of the larger party is, presumably, that it does not want the other contracting party to have rights under its insurance or be able to directly pursue a claim under its policies. Instead, the smaller party will be forced to rely exclusively on the indemnity undertaking of the larger party, which can use economic clout to alter the financial impact of the loss.

But as discussed above, not having reciprocal insurance undertakings can void or cap the indemnity undertakings under applicable state laws, like those of Texas that require mutual indemnities supported by insurance.

We will also sometimes see contracts that contain reciprocal knock-for-knock indemnity undertakings that obligate each party to place insurance and name and waive the other party’s group but limit the naming to some dollar amount below the actual limits of the naming party’s liability program. We assume the thought is to protect the indemnitor’s insurance from a “limits loss.”

It is a worthy goal to protect your insurance program from excessive claims, but this approach may be short-sighted as the indemnity at issue likely is not capped or limited. Absent the application of the Texas Oilfield Anti- Indemnity Act (which should limit an indemnity obligation to the extent of available insurance), it is possible that insurers may try to avail themselves of a limit on liability and leave the indemnitor to bear the loss above that amount.

Drafting Issues

In addition to the impact of anti-indemnity laws, there are a number of other potential problems that need to be addressed in drafting indemnity provisions.

Poorly drafted clauses. Clauses are occasionally poorly drafted and may include errors resulting from “cutting and pasting” provisions from other agreements, which can result in incorrect descriptions of the parties owed indemnity, undefined or incorrectly used terms, and the like. Agreements also can unintentionally fail to comprehensively describe the activities that are covered by the indemnity (e.g., ingress and egress to work sites, loading and unloading of vessels).

The best way to avoid this issue is to have clearly defined terms that can be used throughout the agreement, including a definition for “Claims” that is appropriately broad (e.g., includes attorney’s fees; costs of litigation, such as experts; interest charges), as well as a clear definition of the “Groups” to be indemnified and named and waived on insurance coverages.

Failure to meet applicable legal requirements. A knock-for-knock indemnity can obtain the desired benefit only where parties are indemnified for losses that result from their own negligence. Most jurisdictions require that such an indemnity be “expressly” stated and be conspicuous to the parties, which usually means the relevant wording is capitalized, in bold, and/or underlined. Otherwise, the parties are back to hiring counsel to determine percentages of fault for all involved.

One consideration here is whether the indemnity will extend to claims resulting from the indemnitor’s sole or gross negligence. Some parties find this idea offensive and exclude such claims from the scope of the indemnity. Others want to include it for fear of having counsel engage in protracted—and expensive—efforts to show that a given claim fits within the exception such that no indemnity is owed.

An indemnity scheme also needs to be drafted in consideration of applicable state law prohibitions against protecting a party from the consequences of its own gross negligence or willful misconduct.

Sometimes indemnity undertakings will include provisions that seek to require courts to “reform” them if they are contrary to applicable law and in lieu of a court’s just holding that they are unenforceable.

Failure to require the correct insurance. Contracts must clearly specify the insurance needed to support the risk allocations and indemnity undertakings in the agreement. This will be driven by the scope of work and include, as examples, operator’s extra expense coverage for a contract calling for the drilling of a well or hull, and protection and indemnity and vessel pollution insurance in a contract requiring work using a vessel.

Ideally, form agreements will anticipate operations that may require additional, specialized insurance and will state that such coverages will be placed “as needed” (e.g., a provision requiring aircraft liability coverage if any aircraft are used in performance of the work).

In addition to specifying the required coverages, the agreement needs to clearly state the endorsements and modifications such coverages need so that they will properly support the risk allocations in the agreement. Examples include making the indemnitor’s coverage primary to the extent of the indemnity, requiring that parties be made an “alternate employer” with a waiver of subrogation on workers’ compensation policies where “naming” them as additional insureds is not appropriate, and obligating insurers to pay for “voluntary” removal of wreck or debris.

As insurance is being relied on to finance the contractual indemnity, the agreement should require insurer notice to additional insureds 30 days prior to the cancellation of coverage. Parties may also want to seek prior notice of any “material changes” to coverage, but insurers and brokers don’t usually agree to this for fear of litigation over what was material.

The agreement should also specify who will bear any deductible (usually the party owing indemnity).

Conclusion

Contractual risk allocations are of paramount importance to E&P companies when engaging vendors and suppliers. To this end, steps must be taken to ensure the indemnities and associated insurance undertakings are appropriate in scope and enforceable.

Jim Noe is a partner at Jones Walker LLP who represents energy industry clients in transactions, disputes and government relations matters. He also managed multibillion-dollar LLOYDS of London insurance programs and administered risk management and claims management programs.

Tim Woodard is Head of Office – Louisiana for Lockton Companies, where he focuses on delivering risk management advice and insurance solutions to companies in the Marine and Energy industries.