Imagine a day at the local country club—it’s 42 degrees, and all you want to do is jump into the pool. Your only oversight before diving into that pool is missing the warning sign urging you not to dive beyond a certain depth. If you happen to dive and, in the process, hurt yourself, the management of the club would not be responsible for any medical damages you may incur. However, if there was no warning sign by the pool—not even one as obscure as “Swim at your own risk”—then you can try recovering damages from the club. Simplistically, this is the concept of “indemnity” in a nutshell.
An indemnity is different from a guarantee. While indemnity is a reimbursement for a loss, a guarantee is a security to a creditor. The liability of the indemnifier is primary, and arises only when the contingent event occurs. In case of a guarantee, the liability of the surety is secondary, and arises when the principal debtor defaults. An important difference is that the indemnifier, after performing her part of the promise, has no rights against any third party, and can only sue the third party if there is an assignment of the contract in her favour. But in a guarantee, once the surety steps into the shoes of the creditor to dispel her liability, she will be able to subrogate and sue the principal debtor.
So, what does all this mean in today’s world of mergers and acquisitions (M&As) and private equity transactions?
From a transactional perspective, indemnity is probably another sub-species of compensation. A contract of indemnity is one where a person promises to save the other from any loss caused by the conduct of the promiser or a third party. Almost all contracts, including agreements used in private equity and M&A transactions, today have detailed provisions on indemnification. In such transactions, the indemnity clause has two interests embedded in it—one of the buyer/acquirer and the other of the seller/issuer/promoter. The buyer will typically insist on detailed warranties from the seller. Such warranties are usually made as of the signing date and repeated as of the closing date. They are typically backed by indemnities.
Warranties are often drafted based on general and almost standardized set of representations and warranties used frequently in similar transactions. A seller would normally try to protect herself by providing all disclosures necessary to ensure such general warranties are adequately qualified in a disclosure schedule/letter to make them contextual to the seller. Typically, a buyer will be prevented from making an indemnity claim if the seller had disclosed to the buyer the matter that resulted in the indemnity claim. So, while the seller will want to disclose almost everything to the buyer, the buyer will typically require the seller to be more specific since each disclosure is potentially a loss of an indemnity claim, as far as the buyer is concerned.
It is also usual for a seller to seek protection in the form of a de minimus (small claims that should be ignored) and an aggregate liability cap (the maximum that the seller is liable to pay in a worst-case scenario). The agreed thresholds are usually driven by the size and nature of the transaction.
It is also not uncommon for a seller to ask for a right to defend a third party claim that has given rise to an indemnity claim by the buyer. As an example, if the seller provided a warranty that there are no third party rights over its assets, but a third party indeed makes a claim over a certain asset which results in a breach of the warranty, then the seller may request the buyer to allow it to take up the matter with such third party, rather than indemnify the buyer directly. This process is usually detailed in the transaction agreement and effectively provides the seller with a mechanism of settling a claim without having to indemnify the buyer, unless the seller is unsuccessful in defending such a third party claim.
The other protection that a seller usually claims is a defined “survival period” for the warranties and indemnity claims. This means that after an agreed period of time, the buyer will not be allowed to make a claim against the seller for any breach of warranties. The objective is to let the seller know when she is completely off the hook.
Needless to say, these clauses and protections are painfully negotiated. In private equity and joint venture transactions, it is also usual to allow an indemnification of the target company, if the claim is likely to result in a liability of the target company. In other words, one shareholder (for instance, the promoters) will be required to indemnify the company rather than the other shareholder.
The next question is, when can one make an indemnity claim?
The original English maxim of “you must be damnified before you can claim to be indemnified” has been undergoing changes through judicial trends. Indian courts also now seem to be taking the view that the indemnifier is liable to the indemnified as soon as a clear enforceable claim comes into existence.
If the indemnified party is a foreign entity, then it must know that the remittance of money from India towards an indemnification claim will require consideration from an exchange control perspective and could require Reserve Bank of India approval.
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This column is contributed by AZB & Partners, Advocates & Solicitors.