Analysis of Indemnity Under a Contract

Vineet Verma

January 2, 2023

Analysis of Indemnity Under a Contract

The term indemnity derives from the Latin word “indemnis,” which denotes ‘to be unharmed or to have no losses or damages’. Since it includes loss resulting from a third party’s action in addition to the party with a direct contractual obligation, the term “indemnity” has a broader connotation. On the other hand, damages, have a limited coverage and are strictly restricted to the parties to the contract. The fundamental tenet of indemnity is to put an individual back in the position or circumstances in which they were before the accrual of the liability. Additionally, regarding monetary damages, an indemnity grant may be greater than the actual adversity and may not accurately reflect the genuine adversity. 

Typically, under the claim of indemnity, one party (the indemnifier) undertakes to safeguard another party (the indemnity holder) from any loss, expense, cost, damage, or other legal ramifications brought on the indemnity holder on account of the indemnifier’s actions or inactions or those of any third party. The overall objective of an indemnification in a contract is to transfer obligation, in full or in part, from one party to another. While negotiating business contracts, extensive discussion and attention are paid to indemnity clause. A loosely drafted indemnity clause may have serious repercussions and really put a spoke in the wheel and can adversely effect the interest of the party. However, the fundamental question is whether there is any justification for seeking indemnification rather than pursuing the legally permissible option of suing for statutory damages under the Indian Contract Act of 1872 (the “Contract Act”). 

In this article, we will focus on the obligations arising out of an indemnity clause, the distinction amongst the other legal provisions enshrined under the legal framework which are used interchangeably with indemnity. 

Legal Status

 A “contract of indemnity” is defined in Section 124 of the Contract Act 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, is called a “contract of indemnity”. 

An indemnity holder’s rights are enshrined under Section 125 of the Contract Act. The indemnity holder shall be entitled to the following damages from the indemnifier according to the foregoing provision:

(a) all damages that he could be required to pay in a lawsuit for any matter covered by the pledge to indemnify;

(b) any costs he would be required to pay in any such lawsuit if, in filing or defending it, he complied with the promisor’s instructions and acted prudently under normal circumstances absent any indemnification arrangement or if the promisor gave him permission to bring or defend the lawsuit;

(c) all amounts that he may have paid under any compromise of any such suit provided that the compromise complied with the promisor’s instructions and was one that the promisee would have made if there had been no contract of indemnity or that the promisor authorised the compromise.

Indemnity Protection 

Indemnification clause is a provision in an agreement under which one party (or both/all parties) commits to compensate the other (or each other) for any harm, liability, or loss arising out of the agreement. Generally, a party undertakes to indemnify the other in cases wherein the former is at fault. This clause could also be used to absolve a party from any responsibility for damage or other liability arising from the commercial transaction under the agreement

Typically, an indemnity clause acts as an inter-party insurance, shifting risk and liability between the parties. It does so be creating the obligation that one party (the indemnitor) will pay for losses the other party (the Indemnitee) becomes liable for, either for any losses related to the agreement, or for losses from certain types of claims. 

Contractually, a separate obligation, but also quiet commonly included in the indemnification clause is defence where the indemnitor will not only pay for the losses of the indemnitee but will defend (by hiring a lawyer to defend) the indemnitee against the claim in court. 

Guarantee and Indemnity

Quiet often, guarantees and indemnities are used synonymously. However, there exist an underlying difference amongst these two legal terminologies, and one needs to be mindful of while drafting an indemnity clause to avoid any ambiguity.

In contrast, a guarantee is a promise to be responsible for a third party’s debt or default. Thus, basis components of a guarantee are third party obligations to exist and the intention of the parties to secure the performance of that obligation through the guarantor. Obligations under guarantee are secondary in nature, i.e. a guarantee is invoked only when the original party is unable to or fails to fulfil its obligations under the agreement. However, a guarantee obtained by concealing material facts or by misrepresentation is invalid. On the other hand, obligations under an indemnity are primary and independent of any underlying obligation. Indemnities do not require there to be a third person who is vicariously liable.

Liquidated Damages and Indemnity 

Non-compliance or breach of an obligation by a party causes loss to the non-breaching party. In order to encourage parties to be compliant and disincentivise any breaches, sometimes the parties pre-determine the amount of damages required to be paid in the event of a default, non-compliance, breach and the like. 

Liquidated damages (sometimes also referred to as liquidated and ascertained damages) are damages whose amount the parties stipulate during the negotiation of an agreement for the non-breaching or injured party to collect as compensation upon a specific breach (e.g. failure to perform or delayed performance).

The underlying idea behind a liquidated damages clause is not to punish the defaulting party, but simply to have a distinctive for non-compliance. The sum agreed under this clause may not be astronomical or catastrophic for the breaching party, but high enough to make it sense in complying. The underlying intention is more towards making the parties compliant, rather than penalising them for non-compliance. 

It is relevant to note that these terms Liquidated Damages and Indemnity cannot be used interchangeably. In contrast and from the statutory perspective these two legal terminologies operate on different footing altogether. To begin with, third-party claims are covered by an indemnity, whereas the damages can only be brought against the promisor, or the person who made a promise under the contract. Additionally, indemnity claims may be raised even before a party has actually sustained a loss. Furthermore, an indemnification clause allows for the recovery of consequential, indirect, and remote damages, whereas a damage claim does not cover within its purview the element of indirect losses and is strictly restricted to direct losses. Although damages need proof of a direct link and adequate nexus between the breach of contract event and the loss incurred, indemnification can be sought for losses without proving that the loss resulted from the incident. 

It is evident that a claim for indemnity offers better and wider protection to the party. Therefore, it is highly important to draft indemnity clauses carefully in the contract. Due consideration must be laid down to the types of losses, settlement mechanism, proceeding control. 

Indemnification in M&A Arena

As this concept of indemnification holds a significant value in private M&A transactions and is highly negotiated amongst the parties. These provisions set out the terms and conditions under which one party will be required to indemnify the other party for any losses the other party may suffer post-closing of the transaction. 

To elaborate on the scope of indemnity, it is important to identify the indemnifying party and indemnified party. Typically, in a share sale transaction the sellers or the exiting shareholders provide the indemnity coverage. On the other hand, in a share subscription agreement it is the company, promoters and majority shareholders provide the indemnity coverage. Given this, in the event if there is more than one indemnifying party, the element of joint and several liability becomes important. It is relevant to note that in joint and several liability concept, the indemnified party is able to pick and choose the party to whom they would like to make a claim against. In the event, if one of the indemnifying party to the agreement dies, then the element of joint and several liability becomes crucial thereby giving much needed relief to the indemnified party to approach the other indemnifying party. 

As set out above that the indemnity is typically provided for the loss. In general, the definition of the loss is embedded in the definitive agreements which mean inter alia any damages, fines, penalties, cost, and expenses, including attorney cost. However, at the same time, a seller restricts to provide indemnity coverage against the indirect and consequential losses. It is often noted that is very difficult to ascertain the qualification of loss, therefore, indemnities act as comfort  for the buyer against known and unknown losses on account of limited visibility of the target’s business. 

Ordinarily, indemnity events in M&A transactions are typically triggered in the event of loss arising on account of breach of representation and warranties, breach of covenants, fraud, wilful misconduct etc. In this regard, a carefully crafted indemnification clause will provide much needed respite to the indemnified party ensuring that all eventualities are adequately covered in the definitive agreement to safeguard the indemnified party’s interest.     

Specific Indemnity

Invariably, every M&A transaction calls for a detailed legal due diligence to assess the benefits and liabilities of the proposed investments and to evaluate all the past and present events of the business. Very often, there are certain non-compliance or regulatory slant by the target entity which are generally discovered at the time of the due diligence and which the buyer knows as a possible risk. Therefore, any specific non-compliance affecting the core values of the transaction dynamics calls for the special attention should ordinarily be parked into the specific indemnity and is not limited by the qualifiers or adjustments. 

Limitation of Liability

From the buyer’s perspective risk allocation may seem conceptually simple, structuring indemnification provisions may become quite complicated from the sell side. As the size, complexity and economics of a transaction increase, it can sometimes be very difficult to specify the scope of a party's indemnification obligations in a manner appropriate to the value (actual or perceived) inherent in the deal. However, and to add certainty to their bargain, seller usually arrange their affairs to limit the amounts for which an indemnifying party may be responsible and prevent a party from bringing frivolous claims.

The following carve-outs are typical negotiated in indemnification arrangements especially while representing a seller:

De Minimis Amount- The de minimis amount specifies the minimum threshold a single claim must exceed a significant value to become eligible for indemnification. A party can only claim indemnification if a claim's value exceeds a minimum amount, expressed either as a percentage of the purchase price or a specified amount.

Tipping Basket- A tipping basket specifies the threshold which the aggregate amount of all claims must exceed before a party can bring any claim for indemnification. Once the threshold is exceeded, the indemnifying party will be liable for the entire amount of losses.

Indemnity Cap- An indemnity cap limits the amount an indemnifying party may be required to pay. The cap amount is generally calculated as a percentage of the purchase price but may also be a specified amount.

Survival Period- Generally, the seller to ensure that they not under the burden of providing the indemnity coverage till eternity, a survival or time period is negotiated during which the indemnity claim can be raised which is often negotiated depending upon the representation and warranties incorporated in the definitive agreement.  

Conclusion

Indemnity clause is a subject of intense negotiation in business and transactional world, as the primary objective of this clause is risk allocation, the indemnified party would invariably prefer a wider coverage and the indemnifying party would insist on certain checks and balances to be carved out while extending the indemnity coverage as this provision operates on the principles of minimise own risk and maximise its own benefits from different viewpoints. As a result, this constant push and pull amongst the parties lead to intense negotiation, hence the benefits of the indemnification coverages shift in favour of that party who is well versed with a better negotiating power. 

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