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This article has been written by Niket Khandelwal, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho. The article has been edited by Ruchika Mohapatra (Associate, LawSikho) and Dipshi Swara (Senior Associate, LawSikho).

Introduction

The term Indemnity derives its existence from the Latin word “indemnis” which means suffering no loss or damage. Whereas to indemnify means to make good a loss. Section 124 of the Contract Act, 1872 defines a contract for indemnity. An indemnity is a promise made by one party (“Indemnifier”) to hold the other party (“Indemnity Holder”) harmless against losses caused by the first party’s actions. There can be a variety of reasons as to why a party requests indemnity from another party or voluntarily provides indemnity to the other party. Common examples can be where indemnification is provided in case any of the representations made to the other party turned out to be untrue or if there is any fraud committed by any directors/employees of one party and this results in a loss to the counterparty. Hence the loss that one party may have suffered on account of another is now born by the second party itself. 

There may be remedies available under legislation similar to indemnity, even without the insertion of an indemnity clause in some cases. For example, if a director enters into a related party contract without securing the approval of the board or shareholders as required under the Companies Act, 2013, the director concerned has to indemnify the company against any loss that may be incurred by him on account of such transaction. 

However, this kind of statutory indemnification may not be available in many cases and may flow only from the terms of the contract. Therefore, it is advisable to have an indemnity clause included in a contract so that both parties can feel protected. 

Some samples of indemnity clauses are listed below

Indemnity arising from breach of representation or warranty

An indemnity clause in a shareholding agreement can require the promoter/founder/directors to indemnify an investor. An indemnity clause in a loan agreement will usually require a borrower to indemnify the lender for a breach of representation or warranty. Syndicate lending agreements can contain indemnity clauses requiring the syndicate members to indemnify each other. For example, consider the following indemnity clause from a syndicate loan agreement:

“Each member of the Syndicate shall indemnify and hold harmless other members of the Syndicate from and against any claims, actions, losses, damages, penalties, expenses, suits or proceedings of whatsoever nature made, suffered or incurred consequent upon or arising out of any breach of any representation, warranty or undertaking or in the performance of the obligations by such member or arising out of the acts or omissions of such member of the Syndicate (and not any other member of the Syndicate) under this Agreement.”

Third party Infringement claims and litigation owing to intellectual property violations

This is a common reason for the insertion of indemnity clauses. For example, consultants, freelancers, and employees may be asked to indemnify the organization in case any work done for the organization infringes the intellectual property of a third party and such third-party claims infringement, or initiates or succeeds. In legal proceedings against the organization. The third-party indemnity clause can include costs of any out of court or negotiated settlement amount for any such claims. For example, consider the following indemnity clause:

“Indemnification for Third-Party Claims. Party A shall indemnify, defend and hold harmless Party B against any and all loss arising out of, by reason of, in connection with or as a result of third-party claims in connection with intellectual property that is the subject matter of license under this agreement.”

Exclusion of indemnity

There are certain losses that cannot be indemnified, such as:

  1. Loss caused by the other party’s deliberate acts: For example, in a contract of insurance, the insured person should not be indemnified if the event which triggers such acts results from their own intentional act. 
  2. Loss caused by the other party’s own crimes/frauds: A contract of indemnity does not cover the losses caused by the receiving party’s own illegal acts. 

Limitation of liability 

This clause provides a financial cap on the amount of liability or limits the liability to certain kinds of losses only, whether with respect to an indemnity claim or with respect to a breach or otherwise. Often, contracts have limitations stating the kinds of losses that a party can claim. For example, a clause can state that a party can claim direct losses but not indirect or consequential losses. Direct or general losses are those which can be foreseen to directly result from the non-performance by a party. While indirect or consequential losses are those losses that may be an indirect consequence of the breach or non-performance. For example, loss of profits on account of delay in service to customers resulting from non-delivery of software to the company may be considered an indirect loss.

Financial caps in limitation of liability clauses are existent in the terms of a contract of the service provider with a consumer (for example, an airline company with passengers), software contracts and terms of use of cloud-based software, contracts of a business with its vendors, etc.

In most financial facilities contracts, however, the lender will insist that there be no limitation of liability clause inserted in the agreements because a failure in repayment of a loan can have a ripple effect and can result in additional costs relating to recovery, which might exceed a stated amount. Most lending agreement templates will, therefore, not include limitation of liability clauses favouring a borrower.

Furthermore, breaches such as breach of confidentiality may also be specifically excluded from the scope of limitation of liability clauses. The amount which is payable by means of damages or as an indemnity does not have any cap and can even be higher than the value received in such cases. This is because there can be an unforeseen loss caused in such cases and it might not be possible to limit or quantify it.

Indemnity vs. guarantee

Indemnity and Guarantee are very different from each other. A table explaining the difference has been compiled here:

BasisIndemnityGuarantee
MeaningA contract where one party promises to the other party that it will compensate the other party in case of any loss suffered by it by the act of the promisee or a third party.A contract wherein a party promises to another party that he will perform the contract or compensate for the loss, in case of default by the principal debtor.
Maturity of Liability Where a default or loss occursWhen the principal debtor fails to perform.
Parties involvedTwoThree
Manner of inclusion in contractsIndemnity clauses are typically included in the parent contract itself.Guarantee is usually executed as a separate contract with the reference to the principal contract.

Indemnity vs. Damages

The Indian Contract Act, 1872 lays down the provision to claim damages under Section 73. Even after having the provision to claim damages, generally it is observed in the contracts that indemnity is preferred over damages. Indemnity has certain advantages over damages which are as follows:

  1. In case of damages, the party can claim for damages only after the loss arising out of such damage has occurred and the claim shall be to the extent of damage which is due to the outcome of the breach. This was held in the case of Maharashtra State Electricity Board v. Sterlite Industries.

Whereas in the case of Jet Airways (India) Limited v. Sahara Airlines Limited, it was held that the indemnity holder can claim for damages before the loss has actually occurred or when there is an accrual of liability.   

  1. In the case of indemnity, there is no necessity of showing a connection between the breach of contract and the loss incurred. Whereas in the case of damages, there is a necessity to show a nexus between the damage caused and the breach of contract.
  2. In case of damages, they can be claimed only against the party who has made the promise in the contract. Whereas in the case of indemnity, the indemnity holder has the liberty to claim the losses suffered from the actions of the indemnifier as well as the third party.
  3. In the case of damages, the claims can only be permissible to the extent to which the parties have knowledge while being a part of that contract. Whereas in case of indemnity, it can cover direct/indirect losses, third party losses and consequential losses, if mentioned and agreed to in the contract. 

Pointers for drafting an effective indemnity clause

Before drafting an indemnity clause, certain points may be referred to which will render the indemnity clause effective without any ambiguities while deciding the rights of both parties. They are as follows:

  1. Before delving into the drafting of an indemnity clause, prepare a list of all the probable actions or situations from which you can incur a loss. This is based on identification of the risk areas. Identify whether the indemnity should cover all losses or specifically mention that it will cover losses arising only from specific situations or trigger events.

For example, you could suffer:   

  1. Additional costs or loss from third party litigation on the intellectual property which is licensed to you under the contract;
  2. Additional costs or losses. Representations and warranties provided by the other party are untrue; or
  3. Actions of the other party or its officials which cause loss or damage to you.

On this basis, you can specify trigger events or keep the indemnity clause even broader.

  1. See if there is any qualification on the loss or the type of claim. For e.g., is it limited to “all claims” or “reasonable claims”? Does it restrict itself to specific losses, such as the amount arising out of tax liabilities, interest and penalties? You can also exclude certain losses, for instance, all losses will be indemnified except for the ones arising from the absolute negligence of the party which incurred the loss.
  2. Specifically, define words like “Loss” and “Liability”. A clear definition will restrict the scope of misinterpretations. 
  3. Should there be a numerical cap on liabilities? For e.g., INR 20 lakhs or the amount of service fee paid over the past three months? This needs to be determined after assessing the scope of indemnity and the possible exposure of the party you represent. 
  4. Specify the claim process, if possible. Should a notice specifying the indemnity claim be issued along with documentary evidence of the loss?
  5. State what will be the consequences if there is a default or breach of indemnity, i.e. the loss is not made good when it is supposed to be made good. Will you revoke the contract? 

Indemnified party – key considerations 

  1. “Losses” to be defined cautiously: It is important to define the losses/liability as direct/indirect, consequential and remote losses that can be claimed under the indemnity clause. Immediate attention should be on the types of breaches and whether such breaches would have any immediately quantifiable loss or not.
  2. Phrases to be used properly: Phrases such as “Hold Harmless” should be used instead of terms like “compensate” or “made good”. The recovery will be based solely on the use of language in the clause. 
  3. Obligation to defend against third party claims: The obligation to defend the Indemnified Party will start at the moment any claim is made by any third party. 
  4. Tax Implications: A breach of representations and warranties triggers the payment for indemnity. Therefore, such payments are to be made to the other party in such a manner that involves the indemnity claim plus the amount of taxes. 

Indemnifier – key considerations 

  1. Duty to Mitigate Losses: There should be negotiation and specifically a duty to mitigate losses on the part of the Indemnifier. 
  2. Limitation of Remedy Clause: The Indemnifier must take into account the “exclusive remedy” clause and “limitation of remedy” clause so that there is no ambiguity in the interpretation of a contract. 
  3. Third-Party Claims: There should be a clear process of third party claims settlement including such statutory claims. Two clauses should exist in a contract, one stating the indemnity arising out of breach of a party and one for claims relating to a third party. 

Conclusion

The indemnity clause is one of the most essential clauses in any type of contract and it goes through many rounds of negotiation. This clause determines the risks and rights of both the parties i.e., the indemnifier and the indemnity holder. There can be serious consequences to a poorly negotiated/drafted indemnity clause and ambiguities should be removed. The sole reason is that the indemnity clause shifts the loss from one party to the other party. The above-discussed points should be kept in mind while drafting an indemnity clause to measure the coverage of losses.


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