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Indemnity: safeguard against future financial exposure

Indemnity: safeguard against future financial exposure

Indemnity provisions have evolved to become an integral part of commercial contracts. An indemnity means a promise by one party (the indemnifier) to protect the other (the indemnified party) from loss caused to the indemnified party as a result of a specified act or event.

By way of an example, an insurer agreeing to pay for the loss caused to the insured as a result of a road accident is an indemnity. In a sense, indemnity is a form of insurance to the indemnified party against certain risks, i.e. the risk and responsibility to bear a specified loss shifts from the indemnified party to the indemnifier.

Legal observers have pointed to the increased risk of loss from environmental liabilities, tax claims, labour disputes and other such third-party claims in commercial transactions as the reason for the current widespread use of indemnity clauses, particularly as these may not be foreseeable at the time of entering into the contract.

A headline-making example of this is the tax claim of an unprecedented $2 billion (around Rs9,300 crore) against Vodafone Group Plc by the Indian tax authorities. Vodafone had purchased Hutch’s controlling stake in Hutchison Essar through a series of complex offshore transactions. In an unexpected move, the tax authorities sought to recover the capital gains liability of the seller (Hutch) from Vodafone on the ground that the latter as the payer should have deducted tax at source before making the payments. The risk of such claims against a purchaser or investor in typical mergers and acquisitions can be provided for under a deftly drafted indemnity clause.

The indemnity clause in the relevant contract can be the most reliable way for purchasers or investors to avoid such unforeseen financial liabilities, which are usually not factored into the negotiated deal price or covered under a separate insurance policy. Further, such losses may not be attributable to the fault of any party, and hence, may not be recoverable as damages for breach of contract. Thus, an indemnity clause acts as an important safeguard against future financial outgoings that may not otherwise be recoverable under the damages clause.

Having said so, one cannot lose sight of the meaning prescribed to indemnity under the Indian Contract Act of 1872. The Act defines indemnity in a narrow sense to mean a contract where the indemnifier agrees to protect the indemnified party from any loss caused to it either by the conduct of the indemnifier himself or by the conduct of any other person.

Surprisingly, this definition does not cover indemnity for losses that may result from events that do not necessarily depend upon the conduct of the indemnifier or any other person, such as loss caused due to a fire or an unexpected accident.

Similarly, liability may arise against the indemnified party as a result of something done by him at the request or instruction of the indemnifier. This is applicable for most principal-agent relationships.

While there is a lacuna in the law, the courts have come to the rescue and taken a view that the Indian Contract Act is not exhaustive in respect of the law of indemnity. There are precedents in which courts have extended the indemnity to cover these scenarios as well.

Even the Law Commission had taken note of this anomaly in its 13th report and recommended expanding the definition of indemnity. An amendment in the Indian Contract Act is thus desirable to bring more clarity and certainty on this aspect.

A related query that is often raised by parties proposing to enter into a commercial arrangement is: At what point of time can you invoke the indemnity provisions in a contract? Is it necessary to first prove actual loss or damage? The Indian Contract Act provides that an indemnified party can recover damages, which he may be compelled to pay in a suit filed against him or under the terms of a compromise of any such suit. Further, he can recover the costs of defending the suit or compromise, which would include attorney’s costs as well.

Based on this, previously the courts had taken a position that the indemnified party can make a claim of indemnity only after he has been sued and has incurred damages. However, in subsequent judgments, courts have held that if this view is adopted, it would throw an intolerable burden on the indemnified party as one may not be in a position to pay the damages and yet cannot avail of the indemnity till he or she has done so.

A contract to indemnify does not mean a contract merely to reimburse in respect of monies paid, but it also means, in a derivative sense, the liability of the indemnifier to save the indemnified party from a claim by a third party. It is now a settled position that if the indemnified party’s liability has become absolute, then he or she is entitled either to get the indemnifier to pay off the claim or to pay into court sufficient money which would constitute a fund for paying off the claim whenever it is made.

In other words, an indemnified party can sue the indemnifier even before suffering any actual loss, provided the indemnified party is able to satisfy the court about the existence of a clear enforceable claim against him or her and that the contract of indemnity covers the claim.

Another typical question on indemnities is the type and extent of loss that can be claimed under it. Can one claim indirect or consequential losses or losses which result from the negligence or fraud of the indemnified party itself?

Also, what about loss of revenue or business? While in respect of breach of contract, the law clearly provides that the non-breaching party cannot claim compensation for remote or indirect losses, there is no such exception provided for an indemnity contract. Much is left to the contractual freedom and ingenuity of the parties.

A typical indemnity clause thus provides for protection against all kinds of losses, claims and liabilities, howsoever arising, in relation to the specified transaction.

From an indemnifying party’s perspective, it is, therefore, important to include carve-outs for such types of losses and preferably have a cap on the maximum liability that the party is willing to take, having regard to the commercials of the transaction.

Those who draft indemnity provisions in contracts would usually bear in mind that any unreasonable, arbitrary or unconscionable clause in a contract is amenable to judicial review and courts can limit the scope of such a clause.

In conclusion, an indemnity is a very useful contractual device, which can be employed to afford the indemnified party a sort of guaranteed payment against claims against such party that rightfully pertain to the indemnifier.

There is no onus to first prove actual loss or breach before invoking the indemnity. So, unless a loss is protected by any other means such as under an insurance policy or by an indemnity created by statute, an indemnity clause is surely worth fighting for.

This column is contributed by Garima Bharati of AZB & Partners, advocates & solicitors.

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