Negotiating indemnities: An investor’s perspective

By Bakhtiar Sunavala, I&S Associates

Indemnity clauses in investment agreements are generally highly negotiated, as they can have a significant financial impact on both sides long after a transaction has closed. The first draft (typically circulated by the investor’s counsel) sets the tone for the negotiation bearing in mind that an investor typically wants the widest indemnity provision ensuring full and fast recourse. In contrast, a target/promoter will try to ensure that the indemnity provision is narrow, specific and limited, so as to minimize potential loss.

Indian Contract Act, 1872: Section 124 of the act defines an “indemnity” as a contract by which one party promises to save the other from loss caused by the conduct of the promisor or of any other person. Although views diverge on whether: (a) the indemnity holder is required to suffer an actual loss before it can claim on the indemnity or (b) a claim can be made once the loss is absolute or crystallized, recent judgments of various high courts favour the latter view.

Bakhtiar Sunavala
Bakhtiar Sunavala

Foreign Exchange Management Act, 1999: Under the act, permitted transactions involving the inflow or outflow of foreign exchange require the general or specific approval of the Reserve Bank of India (RBI). There is no general policy on granting approvals for indemnities to be given by residents in favour of non-residents, and the RBI decides each application on a case-by-case basis. As a general rule, however, the RBI is reluctant to permit residents to incur foreign currency exposure. The RBI is likely to require complete details of the transaction or project in relation to which an Indian person or entity has given an indemnity to a non-resident person or entity, the relationship between the two, and other details which will help determine the circumstances and the approximate amount of any foreign exchange outflow. If however the indemnity becomes payable on the basis of an arbitration award, the RBI and authorized dealer (banker) would generally permit such a payment.

Enforceability: The right to enforce an indemnity should generally arise when a third party claim received by the indemnity holder is absolute (i.e. clear and enforceable). However as stated above as the legal position is not finally settled, indemnity provisions should clearly specify that the indemnity holder (investor) is entitled to enforce the indemnity on receipt of a clear and crystallized claim as courts while enforcing indemnities would strongly consider the intention of the parties. If the investor is a non-resident, the investor may have to wait for an arbitral award before it can realize the amount due under the indemnity.

Breaches: From the investor’s perspective, indemnities should cover not only breaches of representations and warranties but also contractual breaches of covenants and obligations, as well as specific issues arising from the due diligence exercise. If any material issues arise from the due diligence, they should be resolved by reducing the purchase price or as conditions precedent to completion, rather than through indemnities.

Caps: An investor should look to negotiate a clause without any minimum or maximum caps. Success will largely depend on the percentage and value of investment.

Limitation: Parties generally negotiate the limitation periods of indemnities and often settle on the periods prescribed by law. The limitation periods for enforcing claims based on various causes of action differ and are distinct from the period of the indemnity. Claims must be enforced within the period specified by the Limitation Act, 1963. Under section 28 of the Contract Act, one cannot contractually: (a) shorten the period of limitation prescribed by law within which a party can enforce its rights; or (b) restrict a party from enforcing its rights. This means that while an indemnity may be granted validly for any term, the period for enforcing the claim (assuming it arises within the indemnity period), cannot be reduced to a period less than what is statutorily embodied by the Limitation Act.

Disclosures: Warranties give an investor means of legal redress against targets/promoters if a relevant statement made about the business proves incorrect or inaccurate. Even though the investor may have conducted a thorough due diligence, the target/promoter needs to detail any such factual inaccuracies in a disclosure letter, which is given to the investor at the time of execution and updated at the time of completion. The disclosure letter limits the potential liability of the target/promoter to the investor for any breach of the warranties. Disclosure letters should be specific and investors must negotiate against any general disclosures sought to be made by the promoters.

From an investor’s perspective an indemnity clause should: (1) specify that the investor is entitled to enforce the indemnity once a claim or loss is absolute or crystallized, without having to suffer an actual loss; (2) cover breaches of representations and warranties, covenants, obligations and specific issues arising from the due diligence exercise; (3) not contain minimum thresholds or maximum caps; (4) be clear and unambiguous and permit easy calculation; (5) specify a long period of indemnity; and (6) ensure all disclosures are specific (i.e. in relation to identified representations and warranties).

Bakhtiar Sunavala is a founding partner of I&S Associates. The views expressed are the author’s and are not a substitute for specific advice.


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