Articles

An Overview on Indemnity Clause in Contracts

By April 21, 2020 May 1st, 2020 No Comments
AN OVERVIEW ON INDEMNITY CLAUSE IN CONTRACTS

AN OVERVIEW ON INDEMNITY CLAUSE IN CONTRACTS

A. INTRODUCTION:

The term indemnity comes from the Latin term “indemnis” which means uninjured or suffering no damage or loss. The same can also be defined as a security or protection against a financial burden. An indemnity clause is one of the important clauses that is usually incorporated in all kinds of contracts. The reason behind the inclusion of this clause in the contracts is that one of the parties to the contract gives assurance to protect and indemnify the other party, in certain circumstances as agreed between the parties to the contract, form any damage or loss.

Section 124 of the Indian Contract Act, 1872 (“Contract Act”) defines a contract of indemnity as “a contract by which one party promises to save the other from loss caused to him by the conduct of the promisor himself, or by the conduct of any other person

Thus, it can be understood from reading Section 124 of the Contract Act that indemnity can be claimed when one party gives assurance to the other party to provide protection from any kind of loss or damage that has accrued or incurred by that other party due to the action of the person who is giving such assurance. Further, it is also clear from the aforesaid section that a prior promise should be made to protect the indemnity and the question of indemnification arises only when the loss or damage which has occurred is with regard to the prior promise which was made by the indemnifier to the indemnity holder to protect from such loss or damage.

B. DRAFTING OF AN INDEMNITY CLAUSE:

The drafting of the indemnity clause has to be done in such a manner that it covers all the important aspects. The type of agreement in which the parties enter determine as to which party shall indemnify the other on the occurrence of an event as mentioned under the agreement. Further, the coverage of the indemnity clause with regards to loss has to be looked into i.e. whether only direct losses are covered or indirect loss or consequential loss are also covered. It must also be ensured that the indemnity cap is mentioned in the clause which shall determine the amount beyond which indemnity cannot be claimed. Similarly, the de minimis amount should be mentioned which lays down the minimum amount for invocation of the claim of indemnity. Further, another important area that has to be looked into is tax gross-up, which essentially means that when the indemnifier indemnifies the indemnity holder, then that amount becomes an income on which the indemnity holder has to pay tax. Therefore, while drafting the indemnity clause it may be mentioned that the indemnifier, along with the indemnity amount has to pay the tax amount that shall be payable by the indemnity holder on the indemnity amount.

C. INDEMNITY VERSUS DAMAGES:

The Contract Act already has a provision to claim damages which is laid down under section 73 of the Contract Act. Even after having a provision to claim damages, it is seen that indemnity is preferred over damages. Some of the advantages of indemnity over damages are discussed below:

  • In case of damages, the party who has suffered loss can claim for damages only after the loss or damage has occurred and the claim shall be to the extent of damage which is due to the outcome of the breach.[1] On the other hand, the indemnity holder can claim for loss or damage even when there is an accrual of liability, which means claims can be made before the loss has actually occurred.[2]
  • In the case of indemnity, it is not necessary to show a connection between the loss incurred and breach of contract. Whereas, in case of damages, it is vital to show that there is a nexus between the breach of contract and damage caused.
  • In case of damages, it can only be claimed against the party who has made the promise in the contract and the contract with reference to which claim is to be made must be a concluded contract.[3] Whereas, the indemnity holder has the liberty to claim for losses suffered due to actions of the indemnifier as well as for the actions of any third party.
  • In the case of indemnity, it covers, if mentioned in the contract, direct losses, indirect losses, consequential losses and third party losses. Whereas, during a claim of damages, it is only permissible to the extent to which the parties have knowledge of while entering into the contract and it must have occurred due to the breach of the contract.

D. CONCEPT ON FRAUD IN INDEMNITY:

While drafting and negotiating an indemnity clause, a carve-out should be provided in the indemnity clause to cover that if the indemnifier commits any fraud and it has a direct implication causing loss or damage to the indemnity holder, then in such situation the cap of indemnity should not apply and if the indemnifier is unable to indemnify for the loss or damage caused to the indemnity holder then it might also happen that personal assets of the indemnifier shall also be attached for successfully indemnifying the indemnity holder.  Therefore, it is advisable to always exclude fraud, wilful negligence etc. from the indemnity cap agreed in the agreement.

E. INDEMNITY INSURANCE:

It is referred to as a contractual agreement by which one party promises to pay compensation to another party who has sustained a loss or damages. It can also be an insurance policy which is usually taken by professionals and businesses to protect themselves from an event like negligence or failure to perform which has caused the other party to face legal and financial issues. Professionals like financial advisors, insurance agents, attorneys, accountants etc. can take indemnity insurance for safeguarding themselves from any kind of liability that they might face. Further, warranty & indemnity insurance has become very common these days in Asia with respect to transactions. The sellers such as various private equity firms are willingly seeking exit option with regard to the investments being made. The exits are forsaken either on a no-recourse or a limited recourse basis.

F. IMPLICATIONS OF INDEMNITY:

a. On legal heirs:

The concept of indemnity also extends to the legal heirs of the parties to a contract. This solely depends on the drafting of the indemnity clause wherein, the indemnifier and its legal heirs (only upon the death of the indemnifier) shall be liable to protect and pay compensation in case of loss or damage is suffered by the indemnity holder and in case of the indemnity holder along with its legal heirs (only upon the death of the indemnity holder) shall be protected from any loss or damage. If the clause does not say that clearly then the liability shall not be extended to legal heirs.

b. On successors:

If a company who is an indemnifier has promised to indemnify another company for the loss of damages and during the term of the agreement if the indemnifier company merges with another company, then the liability to indemnify the indemnity holder is also extended to the merged company. Similarly in the case of indemnity holder company if the company merges with another company, then that newly merged company shall also be protected during loss or damage. This also solely depends on the drafting and language of the clause in the agreement to bring such an aspect into the ambit of the indemnifier.

G. CONCLUSION:

The indemnity clause while being drafted goes through a lot of negotiations because it is one of the essential clauses in the contract. This clause is regarded as very important as this is the clause which will not only determine the risk on the part of the indemnifier but also the rights of the indemnity holder. Therefore, consequences may be faced by both the parties in case of ambiguities being present in the clause with regards to the coverage of the losses.  Therefore, keeping in mind all these factors, the drafting of the indemnity clause must be done precisely while finalising the contracts.

Authors: Anita Dugar, Senior Associate; Jaisis Srikrishna Das, Associate.

Disclaimer: The content of this article is intended to provide a general guide to the subject matter. For any queries, the authors can be reached at (i) anitadugar@samistilegal.in (ii) jaisisdas@samistilegal.in.

References:

[1] Maharashtra State Electricity Board v. Sterlite Industries (India) Ltd., 2000 SCC OnLine Bom 89.

[2] Jet Airways (India) Limited v. Sahara Airlines Limited, 2011 SCC OnLine Bom 576.

[3] Vedanta Limited v. Emirates Trading Agency LLC, 2017 SCC OnLine SC 454.

Updated as on April 21, 2020

Image generation credits: https://www.canva.com/templates/

Leave a Reply