Indemnity is used as a shield from liability, but how useful is it?
Venkatesh Vijayaraghavan details key issues that affect its efficacy
While indemnity provisions are routinely included in all kinds of contracts, including those for mergers and acquisitions and the supply of services or products, they are often misunderstood and may be of little help unless drafted carefully.
An indemnity is typically sought to compensate for breaches of representations (or assurances on certain matters) and covenants (or agreements to do or not do certain things) and also for specific and anticipated or unknown sources of risk, such as litigation or tax liabilities.
It is helpful for parties on both sides of an indemnity to be aware of its legal effect, and also understand drafting mechanisms that can be used. Otherwise, a party may include an indemnity to protect claims arising from contract breaches, only to find that it instead serves mostly to limit liability for such claims. In addition, the law may prohibit or restrict certain types of recovery.
An indemnity provision may occasionally not be necessary to protect against the risks that are most likely. Above all, parties should understand the purpose for which they seek to use the indemnity in their transaction.
This article introduces some customary indemnity provisions and briefly explains the benefits and restrictions arising from Indian law.
A party can claim compensation under section 73 of the Indian Contract Act, 1872, “for any loss or damage” arising from a breach of contract, “which naturally arose in the usual course of things from such breach, or which the parties knew, when they made the contract, to be likely to result from the breach of it”.
Therefore, the first step when seeking to protect claims is to check if sufficient protection is already available under the law and, if not, to determine what kinds of claims must be enabled by contract, specifically under an indemnity provision.
One of the key benefits of including indemnity provisions in contracts is that while claims arising from breaches of contracts must be adjudicated before damages are required to be paid, claims being made under an indemnity provision may be restricted.
Therefore, an indemnitee (or party benefiting from an indemnity provision) can claim amounts payable under the indemnity prior to final adjudication. The claim could include legal and other costs associated with the prosecution or defence of a claim under the contract.
While indemnity provisions are addressed by sections 124 and 125 of the Contract Act, the courts have indicated that these sections do not exhaustively define all possible indemnity provisions. As a result, parties to a contract are free to allocate risks, such as losses arising from events other than the conduct of any party.
While an indemnity provision usually first mentions losses arising from breaches of representations and covenants, in reality it is the items that follow – indemnities for costs and expenses and certain known liabilities – that make the indemnity necessary. Indeed, as the concepts of indemnity and damages for breach of contract are separate under Indian law, combining them may obscure the effect that each has on the rights of the claimant.
From the perspective of an indemnitor (or party providing the indemnity), an indemnity provision is an opportunity to contractually limit amounts that can be claimed. Much like the indemnitee, the indemnitor would also find that, in certain respects, the law has already done the work.
For example, one possible limitation in an indemnity is that a claimant cannot claim compensation for losses to the extent they have or should have been mitigated.
While it is possible to draft a more explicit duty to mitigate, section 73 of the Contract Act, which covers compensation for losses caused by breach of contract, provides a good start. Section 73 requires that in estimating the loss “the means which existed of remedying the inconvenience caused … be taken into account.”
In addition, an indemnitee seeking to avoid mentioning a specific duty to mitigate (which would presumably be actionable) could point to section 125 of the Contract Act, which requires that an indemnitee act prudently in recovering damages and costs arising from indemnified proceedings.
Insurance recoveries are another limitation occasionally seen in contracts. Under this provision, the indemnitee must deduct amounts recovered (or that could have been recovered) through an insurance claim from claims for indemnity. This is usually resisted by indemnitors as indemnity claims may pre-date insurance recoveries, which are subject to various deductibles.
An obligation to pay back amounts in the nature of double recovery (i.e. once under the indemnity and later again under the insurance) may, however, be more acceptable.
Other limitations include carve-outs, or exceptions to the indemnity, for the negligence, gross negligence, fraud and/or wilful misconduct of the indemnitee. Anything lower than a standard of intentional or fraudulent actions is likely to be resisted by the indemnitee as other standards may not be as specific and may leave the door open for the indemnitor to whittle down the claimable amount.
However, the common law position is that an indemnity will not usually compensate for the indemnitee’s own negligence.
Indemnity provisions also usually seek to exclude consequential damages from the definition of the term “losses” and to clarify that the parties do not anticipate lost profits and consequential damages being payable. Section 73 of the Contract Act, which relates to damages for breach of contract, states that parties cannot recover indirect or remote loss.
Lastly, an indemnitor could seek to avoid liability under an indemnity by carefully drafting representations, covenants and other obligations or agreements to bear certain liabilities. For example, they could limit liability by qualifying certain assurances as being “to the knowledge of” the indemnitor or by referring to a detailed disclosure schedule made available to the indemnitee prior to the completion of the transaction.
An indemnitee should also review the ability of the indemnitor to pay for claims under the indemnity. For example, a “shell” entity created for a transaction may not be well-capitalized and may not be able to pay out under an indemnity – a parent guarantee may be required.
Limitations commonly seen in indemnities in M&A transactions are baskets, thresholds and caps. A basket is a level of losses that must be incurred for the indemnity to be triggered. In addition, the indemnitor is only liable for losses above this level when the indemnity is triggered.
A threshold is similar to a basket, except that the indemnitor becomes liable for the full amount of losses incurred if the indemnity is triggered. A cap is a level beyond which the indemnitor will not be liable for payment even if the indemnitee suffers losses beyond it. It is relatively common in Indian contracts to see this third category of limitation.
Researching market trends in contractual indemnity provisions in India is a challenge as existing Indian regulations and stock exchange rules do not require listed companies to publicly disclose material contracts. In addition, industry bodies in India do not appear to track indemnity provisions in private or public company M&A transactions.
More importantly, cases dealing with indemnity provisions in M&A transactions that have proceeded all the way to final judgment are rare. This may change eventually given the recent rapid increase in Indian M&A activity.
M&A transactions are sometimes used to obtain assets owned by a corporate entity that is under pressure for various reasons. The transaction would seek to introduce new management and practices to protect and nurture a valuable but underpriced business or asset.
In such a situation, the acquirer would not want to inherit a serious problem, such as a known legal proceeding that entails substantial liability, a part of the asset that carries with it environmental claims or possible claims from minority shareholders.
If an acquirer offers a higher price in an active auction scenario based on assumptions about a critical aspect of the business, such as the continuation of a tax holiday, the acquirer would seek to protect against liabilities that may deprive it of such benefits.
Other challenges faced by acquirers include having to negotiate and deal with several, or several groups of, unrelated shareholders, each of whom will undoubtedly want to limit their own liability, particularly if they do not control the entity that is being sold.
A diligent acquirer may also wish to use a strong indemnity as a due diligence device, compelling the sellers to review the accuracy of their assurances. The sellers’ willingness or unwillingness to provide such an indemnity could be a sign of the degree of risk involved.
While negotiating agreements, a frequent request from parties, often axiomatically and without background, is reciprocity. Particularly in M&A transactions, this may not be appropriate without an understanding of the risks involved in the transaction. Demanding a mirror indemnity or other provisions in this manner may only serve to create obligations for no good reason.
For example, acquirers will seek protection from liabilities arising from an unknown asset they are acquiring, principally because the sellers – having been prior owners of the asset – understand these risks much better. Sellers in a cash acquisition chiefly seeking deal closure may seek protection against the risk of a clawback – through means such as indemnities – of the amounts paid by the acquirer. An indemnity provided by the acquirer for its limited assurances made to the seller on organization, authority and the like, will do little to fulfil this purpose.
However, if the acquisition is to be for consideration other than cash, such as shares in the acquirer, the sellers could rightfully require an indemnity for representations of the acquirer, as the seller will be exposed to risk from the acquirer’s shares.
Multiple approaches could be adopted to use an indemnity to protect against known liabilities.
The protection could be a “blanket” indemnity provision. Such an indemnity would not be subject to the various limitations applicable to other parts of the indemnity provisions, such as those that cover breaches of representations, and, importantly, would not require an adjudication of breach of contract.
For example, a blanket indemnity on pre-closing tax liabilities would not be subject to limitations. However, an indemnity for losses incurred because of a breach of a representation that all taxes were validly paid in periods prior to closing or that there is no known risk to a tax holiday would normally be subject to limitations.
A second approach could be to ask the seller to deposit in escrow the amount that is likely to become due as a result of a known liability (e.g. the claimed amount of damages under an existing legal proceeding). The escrow could be under the control of a financial intermediary who could agree under a separate agreement to pay out the amount decreed by a court or an arbitrator.
The acquirer could also withhold an amount equal to the known exposure and agree to pay the amount following resolution of the legal proceeding or any other known source of risk.
Another approach could be for the indemnitor to arrange a bank guarantee in the amount of the known exposure for the benefit of the indemnitee, which may be called on at any time during a specific period.
However, foreign investors should note that any indemnity payments, holdback or earn-out payments for shares, or escrow or bank guarantee arrangements involving payments to a non-resident are subject to foreign exchange regulations. In addition, some of these payments may need the prior approval of the Reserve Bank of India, which may be difficult to obtain.
Moreover, an entity in demand (or its shareholders) may be reluctant to agree to any such restrictions on the full amount payable in the transaction, and may prefer to deal only with acquirers that do not require such provisions. If so, the blanket indemnity may be a fallback option for the acquirer.
The appetite for sellers to take such indemnity risks depends on market trends and also on the price being paid. A seller taking a loss on an investment is less likely to agree to postponed payments or escrowed amounts than one that is profiting significantly.
While negotiating indemnity provisions that address breaches of representations in an M&A transaction, sellers will work to limit the time period for survival of claims. Acquirers, on the other hand, will try to extend this period. It is important to carefully review the language used to describe the survival period.
An indemnitor can limit the period within which notice of a claim must be served on the indemnitor as a condition precedent to a suit. However, section 28 of the Contract Act prohibits agreements that restrict the period within which a suit may be brought or those that extinguish the right to make a claim after a specified period.
In addition, while the periods specified under the Limitation Act, 1963, cannot be extended by contract, parties should review the starting point from which the period of limitation begins to run with respect to a particular breach. For example, under section 17 of the Limitation Act, a claim triggered by fraud will not be restricted by any period of limitation until it was or could reasonably have been discovered.
The last piece in a discussion on indemnity is the mechanism to address third-party claims. Section 125 of the Contract Act requires that an indemnitee either be authorized by the indemnitor to participate in or settle a legal proceeding or that the indemnitee act prudently in doing so, unless the indemnitor has ordered otherwise.
The exact process to be followed, including notice requirements, appointment of counsel and other advisers and allocation of related costs, the right to co-defend or assume claims and the right to information, can vary and depends on the requirements of the contracting parties. However, the party drafting the indemnity or with better leverage in the transaction is frequently at a greater advantage.
Service providers usually require the protection of indemnities as the liability associated with or benefit gained from the performance of a service often exceeds the fee paid for the service.
For example, in the financial sector, merchant bankers are subject to liabilities for providing services in relation to offers and sales of securities under applicable laws, including the Indian Companies Act,1956, and the Securities and Exchange Board of India’s regulations. These liabilities could easily exceed the fee for such services, which is usually a small percentage of the amounts raised in such sales.
Merchant bankers, who may be better known than their clients, such as newly listed companies, may be the target of investor lawsuits or regulatory actions arising from the services that they provide.
Therefore, to guard against these risks, merchant bankers will, as a first step, require their clients to assure them that all information communicated to investors meets the standard of accuracy required by the law. In addition, to ensure that liability for lawsuits is allocated to the client, merchant bankers will also require indemnities for losses due to claims made arising from disclosure in an offer document and breaches of representations and covenants.
Indemnity provisions will be a helpful defence against liabilities only if considered carefully at the outset of a transaction or an engagement. M&A transactions, in particular, vary greatly from deal to deal and the risks that arise during due diligence and negotiations should be used as the basis for drafting the indemnity. Lastly, it is helpful to review where the law may act as a backstop for the indemnitee or as a limit on liability for the indemnitor, as well as recent dealmaking trends.
Venkatesh Vijayaraghavan is a lawyer at S&R Associates. The views expressed in this article are personal to the author and not a substitute for legal advice.