Indemnity clauses in commercial contracts

By Uday Walia and Palash Gupta, S&R Associates
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Indemnity clauses are a ubiquitous feature of corporate finance and share acquisition contracts in India. It is important to be aware of the extent of the protection offered by an indemnity clause governed by Indian law, the exclusions that apply and the potential difficulties in enforcing such a clause in an Indian court.

Indemnity clauses offer protection against damages, losses, costs and expenses suffered or incurred by the indemnified party as a result of breach by the indemnifier or the occurrence of certain events. There are significant differences between a contract of indemnity and a claim for damages for breach of contract.

Uday Walia Partner S&R Associates
Uday Walia
Partner
S&R Associates

Incidence and quantum

The liability to pay damages crystallizes when the aggrieved party establishes that there has been a contractual breach. Stipulated or liquidated damages must be a genuine pre-estimate of loss and not so excessive as to be considered to be a penalty. The function of damages in a contract is to compensate an injured party for losses for which they had specifically assumed risk. Remote losses that were not within the reasonable contemplation of parties are not recoverable.

The distinctive feature of an indemnity contract is that recovery can be sought from the indemnifier without an actual loss. The Law Commission of India in its thirteenth report has also accepted the view that “to indemnify does not mean to reimburse in respect of money paid but to save from loss in respect of the liability for which indemnity is given”. Thus, the indemnified party does not need to take legal action to recover a claim and has a right to be indemnified whenever a claim arises.

Liability of an indemnifier

Under Indian law the extent of liability under an indemnity clause is defined by the terms of the agreement, which in theory may extend to “all or any claims”. Hence the extent of obligation is directly related to the magnitude of risk assumed under the contract.

If the indemnity clause provides for legal costs and expenses, the party can be indemnified from and against such costs and expenses incurred by it. In a damages claim, these costs will need to be awarded by a court.

A clause will usually not indemnify a party against damage caused by its own negligence or misconduct, unless it clearly says so. Indian courts have not laid down a clear standard for gross negligence. However, Bombay High Court in Savatram Ramprasad Mills v Member, Industrial Court of Maharashtra and Ors, defined the term as an “utter lack of advertence to the bare requisites of precaution to be observed while discharging duty”.

Palash Gupta Associate S&R Associates
Palash Gupta
Associate
S&R Associates

Patna High Court earlier described gross negligence as a “relative term” which attaches to ordinary negligence with a “vituperative epithet” prefixed to it. However wilful misconduct has been objectively understood. It has been described by an Indian court as “conduct where a person who knows and appreciates that it is wrong conduct on his part in the existing circumstances to do or fail to do a particular thing, and yet intentionally does, or fails or omits to do it, or persists in the act, regardless of the consequences … or acts with reckless carelessness, not caring what the results of his carelessness may be”.

An indemnification obligation can also be shared. Section 44 of the Indian Contract Act, 1872, as amended, recognizes joint liability and its application departs from English common law. In India, all “joint” liability is automatically made “joint and several”, so that when two or more entities make a promise, the promisee, in the absence of an express agreement to the contrary, may compel one or more of the joint promisors to perform on the contract.

Caution while drafting

As mentioned above an indemnity obligation extends as far as the agreement provides. The indemnified party may negotiate “carve-out” clauses that seek to reduce the extent of the indemnifier’s liability. The party may also seek to include loss arising on account of the indemnified party’s negligence. The parties may negotiate whether to include all losses, damages, costs and expenses and also consequential and indirect losses. They would also have to decide whether all of this should relate to a breach or arise in connection with a breach and whether only reasonable fees and expenses should be included.

Some indemnity clauses are drafted to provide that the obligation to indemnify is only affected if a court of final appeal determines that the loss arose as a direct consequence of the indemnified party’s gross negligence, wilful misconduct or fraud. Until this determination, the indemnifier must continue to indemnify the indemnified party.

An overseas indemnified party will require approval from the Reserve Bank of India to repatriate any amount recovered in India. Any such amount may be subject to income tax in accordance with applicable laws.

Uday Walia is a partner and Palash Gupta is an associate at S&R Associates, a New Delhi-based law firm.

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