Indemnity Laws for Drafting Indemnity Clause in Commercial Contracts

The term “Indemnity” can be defined as a security or protection against a financial burden. In an indemnity claim, a party (“Indemnifier”) promises to protect another party (“Indemnity Holder”) to the contract from any loss, expense, cost, damage or any other legal consequences caused due to an act or omission by the conduct of the Indemnifier or any third party or an event. Essentially, the underlying principle of an indemnity clause in a contract is to shift the liability, in whole or part, from one party to another.

In a commercial contract, an indemnity clause is deeply debated and negotiated. It is one of the imperative clauses as it gives assurance to indemnify the losses suffered by Indemnity Holder. The principle of indemnity is embodied under section 124 of the Indian Contract Act, 1872 (“Act”) which defines it as:

“a contract by which one party promises to save the other from loss caused to him by the conduct of the promisor himself, or by the conduct of any other person”.

A perusal of Section 124 reflects that a prior promise should be made to protect the Indemnity Holder and the question of indemnification arises only when the loss or damage which has occurred is with regard to the prior promise which was made by the Indemnifier to the Indemnity Holder to protect from such loss or damage. Furthermore, Section 125 of the Act encompasses the rights of an Indemnity Holder. According to the said provision, the Indemnity Holder will be entitled to recover from the Indemnifier:

  1. all damages which he may be compelled to pay in any suit in respect of any matter to which the promise to indemnify applies;
  2. all costs which he may be compelled to pay in any such suit if, in bringing or defending it, he did not contravene the orders of the promisor, and acted as it would have been prudent for him to act in the absence of any contract of indemnity, or if the promisor authorised him to bring or defend the suit;
  3. all sums which he may have paid under the terms of any compromise of any such suit, if the compromise was not contrary to the orders of the promisor, and was one which it would have been prudent for the promisee to make in the absence of any contract of indemnity, or if the promisor authorised him to compromise the suit.[1]

However, the definition of indemnity under the Act is narrower since the loss must have been caused either by the conduct of Indemnifier or any other third person. It is not exhaustive enough to cover consequential or specific obligations that may arise pursuant to indemnity clause. Furthermore, the judicial precedents have upheld that indemnity provisions in the Act are not self-sufficient and common law principles are to be relied upon. [2]

Significance of Specific Indemnity Clause

This post will be focusing on negotiated commercial contracts and not one-sided indemnity contracts such indemnity bonds etc.

The claim of indemnity may arise due to the conduct of Indemnifier or due to the conduct of any other person. The risk of future losses shifts towards the Indemnifier once he agrees to an indemnification obligation as spelled out in his contract. Moreover, the Indian courts have time and again observed that an indemnity holder is entitled to sue the indemnifier even before incurring any actual damage or loss and that an indemnity is not necessarily given by repayment after payment, provided however the Parties do not agree otherwise.[3]

An indemnity clause takes precedence over claim for damages as under section 73 of the Act. As per the latter, only compensation for any loss ‘which the parties knew, when they made the contract, to be likely to result from the breach of it’ at the time of entering into the contract can be claimed. However, no such restriction applies for an indemnity clause. It is a separate contract and not something arising as a consequence of breach necessarily to perform the contract. Therefore, any consequential, remote, indirect, or third party losses can all be claimed by the indemnified party unless specifically excluded in the indemnity clause. Whether the party is an indemnifier or the indemnified, it is imperative to have a well drafted indemnity clause which provides full-proof protection and balances the interests of the parties to the contract.

Indemnity Clause in Commercial Contracts

Indemnity clauses provide for management of risk of losses associated with a contract. It must be drafted in a manner that it covers all important aspects. Essentially, the nature of agreement determines the extent of indemnity obligations that one party may have towards another. Furthermore, the extent of losses has to be incorporated after carefully taking into consideration whether direct losses are to be covered or any indirect or consequential losses are to be built in.

Key Considerations from perspective of Indemnified Party

  • Define “Losses” Cautiously: Since indirect, consequential and remote losses can be claimed under indemnity clause, it is vital to be cautious in defining losses or liability. The definition must not be exhaustive, rather should use terms like Losses includes instead of Losses means. Regard must be had by the draftsman to the Party which is likely to be in breach – for instance in a Shareholders’ Agreement – the breaching party is likely to be the Promoter. Regard should also be had to the type of breaches or the nature of breaches and whether such breach would have any immediately quantifiable loss or not.
  • Proper use of phrases: It is advisable to use the phrase “Hold Harmless” instead of using terms like “made good” or “compensate” as the courts may construe it as covering claims only due to actual loss suffered by the indemnified party and not cover instances where the liability has accrued but no payment has been made. Further, usage of phrase “protect from liability” ensures that the indemnifier has an added obligation of ‘defence’ cast upon him which requires the indemnifying party to defend the indemnified against covered third-party claims depending on the language used in the clause. This is critical to ensure, as very often recovery of losses or mere reimbursement of the amount of fine, loss or penalty may be meaningless given the time and effort take by the indemnified party in actually defending any claim.
  • Obligation to defend Indemnifying Party against third party claims: Indemnity clause is an equitable remedy and therefore may provide that the obligation to defend the Indemnified Party by the Indemnifier will kick in the moment any claim is made by any third party (whether the liability has accrued or not accrued).
  • Claim Notice: It is imperative to draft an indemnity clause in a manner that the indemnity payment obligation triggers on issue of a claim notice. The clause should clearly state that upon the Indemnified party giving a notice to the Indemnifier of any claim that may arise out of an indemnity clause, the obligation of the Indemnifier to make the payment shall become due and payable upon receipt of the notice or within a period of stipulated days of receipt of such notice. Regard should be had to treatment of (a) outstanding statutory dues and (b) any statutory penalties or fines or requirement by any authority to make a deposit.
  • Tax Implications: A payment for indemnity is made due to breach of representations and warranties or breach of covenants in a contract. An indemnity clause may capture that the indemnifying party absorbs the tax consequences of any indemnifiable loss. Therefore, the indemnity payments are to be made in such a manner that the actual payment is equal to the payment due under the indemnity claim plus the amount of taxes payable with respect to its receipt.

Key Considerations from perspective of Indemnifier

  • Duty to Mitigate:Unless expressly provided in the indemnity clausethere may not be any specific obligation cast upon the Indemnifier to mitigate losses. Hence, the Indemnifier must negotiate and specifically provide for duty to mitigate in the indemnity clause.
  • Going for Limitation of Remedy clause:As mentioned earlier, contracts have limitation of liability clauses which simply limit the liability of the Indemnifier but does not rule out other contractual remedies to be pursued against the Indemnifier. However, an Indemnifier must always go for a ‘limitation of remedy’ clause which takes into its ambit both the limitation of liability and exclusive remedy clause and leaves no room for any ambiguity in interpretation.
  • Survival of Indemnity clause:While, parties may state that the indemnity clause will survive the termination of the agreement. However, from an Indemnifier’s perspective, it is important that the survival clause is tailor made. For instance, it may be stated any indemnity claim arising out of breach of representations may be valid for a limited period of two years post the closing of the agreement.
  • Treatment of Third Party Claims: Spell out clearly the process of settlement of third party claims and statutory claims. It would be advisable to have two separate provisions with respect of indemnity arising out of breach (of a party) and separately for third party claims. Questions of what are the rights of the indemnified party in the defence of a third party claim could be clearly carved out. As an Indemnifier seek protection against permission to settle or defend cases at the whim of the Indemnified.

Indemnity Clauses in M&A Transactions

In our previous post, we had discussed the importance of representations and warranties as deal protection devices in M&A transactions. Further to the same, this part seeks to elaborate significance of indemnity clause in M&A transactions.

Indemnity clauses provide for management of risk of losses associated with a contract. For instance, in a Share Purchase Agreement (“SPA”), the indemnity clause is heavily negotiated and is of utmost importance to limit future liabilities of buyers and sellers in order to cover themselves against losses or liabilities that may arise due to inaccurate representations or due to any event which might have occurred under the ownership of seller. Hence, drafting a sound indemnity clause is crucial for any M&A transaction, more so in an outright acquisition.

Broadly, the indemnity clause covers four considerations-namely, (i) misrepresentations in the contract, (ii) breach of warranties and covenants, (iii) acts or omissions incurred prior to closing date, and (iv) acts or omissions after the closing date.

Typically, in an M&A transaction, a buyer has higher negotiating power as compared to sellers. Therefore, it is imperative to have a tailor made indemnity clause which protects the interests of seller. Hence, from the seller’s perspective, the indemnity clause in SPA must carve out limitations and exceptions in respect of claims made by the buyer. The limitation of liability puts a cap on limitation of time and money in case an indemnity claim arises. Hence, the ability of a buyer to raise an indemnity claim is limited to pre-determined period defined in the SPA. Similarly, the consideration towards indemnity claim can also be pre-determined as a certain percentage of purchase price under SPA.

On the other hand, from the perspective of the Indemnified, one could explore creation of an escrow automatically on a claim arising or as a claw back to ensure that any liabilities if arising can be secured without the requirement of litigating or taking the matter to arbitration.

In sum

Indemnity clause is one of the most essential clauses in a contract and goes through a lot of negotiations during the drafting process. It is regarded to be crucial as it not only determines the risk on the part of the Indemnifier but also the rights of the Indemnity Holder. Hence, consequences may be faced by both the parties in case of ambiguities being present in the clause with regards to the coverage of the losses. The reason why indemnity provisions are taken with a pinch of salt is given the laborious enforcement in civil / commercial court cases in India. However with the advent of time bound arbitration, enforcing indemnification clauses would become a reality and hence both parties should visualise their requirements and ensure due importance is given to this provision.

Archana Balasubramanian, Partner; Vaishnavi Vyas (Associate Trainee)

[1] Section 125 of  Indian Contract Act, 1872

[2] Gajanan Moreshwar Parelkar v. Moreshwar Madan Mantri (1942) 44 BomLR 704.

[3] Jet Airways (India) Limited v. Sahara Airlines Limited and Ors, 2011 (113) Bom LR 1725; Khetarpal v. Madhukur Pictures, AIR 1956 Bom 106.

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