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  • Writer's pictureRoyzz & Co

Demystifying Indemnity in Commercial Contracts

I. INTRODUCTION


1. Indemnity: A Shield Against Loss


The term "indemnity" derives its origin from the Latin word "indemni(s)," signifying the promise of protection against loss or damage. In the realm of commercial contracts, indemnity clauses hold a pivotal place, sparking intense debates and negotiations. In an indemnity clause, one party commits to safeguarding the other party's interests. The party offering protection is known as the "Indemnifier," while the one being shielded is termed the "Indemnity Holder." This clause plays a vital role as it assures indemnification for losses suffered by the Indemnity Holder. The foundational principle of indemnity is enshrined in Section 124 of the Indian Contract Act, 1872 (the “Act”).


II. LEGISLATION


1. Navigating the Legal Landscape of Indemnity:


Upon a close examination of Section 124 of the Act, we understand that indemnification is contingent upon a prior commitment/promise to protect the Indemnity Holder. It becomes pertinent when the loss or damage incurred is linked to the earlier promise or conduct by the indemnifier or any other party toward the Indemnity Holder.


Key Points to Note:


  1. This provision encompasses indemnity claims arising from third parties, effectively shifting the entire risk of future losses to the Indemnifier.

  2. The Indemnity Holder can seek recourse from the Indemnifier even before incurring actual damage or loss. Indemnity is not necessarily provided as reimbursement after payment but can be invoked once a liability is established.

  3. It is crucial to adopt a holistic approach to interpreting indemnity clauses. The Bombay High Court has underscored that the Act is not exhaustive, leaving room for the application of common law principles.

III. USAGE


1. The Versatility of Indemnity Clauses


Indemnity clauses are widely employed in commercial agreements due to their broad scope. They cover a wide array of claims, including consequential, remote, indirect, and third-party losses. These clauses remain flexible unless explicitly restricted within the contract.


Lord Denning's perspective on the extent of the Indemnifier's liability underscores the importance of the nature and terms of the contract. Each case should be considered on its individual merits.


Furthermore, Justice M.C. Chagla, in one of its landmark judgements while deciding on when can an indemnity be claimed, took the view that if the Indemnity Holder has incurred a liability and that liability is absolute, then the Indemnity Holder is entitled to call upon the indemnifier to save him from that liability and to pay it off. The Law Commission of India had accepted the view of Justice M.C. Chagla, that to indemnify, does not mean to reimburse in respect of the money paid/losses incurred, but, as per the legislation from where it is derived, it means to save from loss in respect of the liability against which the indemnity has been given, and recommended adding a section to the Act specifying the rights of the indemnity-holder, and the remedies available to the holder.


IV. DRAFTING


It is important to carefully draft indemnity clauses to ensure clarity and comprehensive protection. Here are some key considerations:


A. For Indemnity Holders:


1. Choosing correct terminology


  1. Instead of using phrases like 'making good' or 'compensate,' it is advisable to use the term 'hold harmless'. This choice of terminology prevents the misconception that indemnification solely covers compensation for actual losses suffered. Moreover, it encompasses situations where a loss is incurred or a liability arises, even if the payment has not been made yet. The 'hold harmless' clause obliges the indemnifier to assume all liability and releases the Indemnity Holder from any liability stemming from specific acts or circumstances.

  2. Include the term 'protect from liability' verbatim. This phrase emphasizes an additional duty on the indemnifier to shield the Indemnity Holder from first-party and/or third-party claims, depending on the drafting of the clause.

  3. Use terms that give a broad interpretation such as ‘arising out of’, or, ‘including but not limited to’ and not ‘as a result of’ or ‘in connect with/to’ as the latter have a narrower interpretation and require close connections with the occurrence of an event in order to capture them within the purview of indemnity. Additionally, it would be necessary to prove a direct connection between the loss and the breach which puts the Indemnity Holder under the pressure to establish such connection.

  4. Although the Act covers third party claims, it is advisable to utilise that to the advantage and construct clause(s) which states out that the indemnifier is required to defend the indemnity holder from any third-party claims that may arise.


2. Define Term – Loss

  1. Define Losses carefully, as indirect, consequential and remote losses can be claimed under indemnity clause. It is vital to be cautious in defining losses or liability. The definition must not be exhaustive, rather should use terms like ‘Losses includes’ instead of ‘Losses mean’ to construct a more inclusive definition.

3. Claim Notices

  1. Parties can specify and agree that the obligation for indemnity payment is triggered upon issuing a claim notice. The clause, if included, should outline that the Indemnifier's obligation to make the payment becomes due and payable upon receipt of the claim notice, or within a specified period upon receipt. Further, any delay in making any claims or giving a notice does not relieve the indemnifying party of such obligation.


4. Depositing the Claim Amount (optional and subjective)

  1. In cases of securing monetary surety, if the amount is disputed by the Indemnifier, one could consider including a provision that requires depositing the claim amount with an arbitrator or court or escrow, as per prescribed limits and regulations of law. However, one needs to be careful in situations of mutual indemnifications, as your own client could be held by the same arrangements.


5. Exclusion from Indemnity Capping

  1. To bear in mind, that unless otherwise given in the agreement, one can always insert a provision in the indemnity clause which states that in case of any wilful negligence, breach or fraud committed by the indemnifier may/shall be considered to be excluded from the indemnity cap, if any, agreed upon.


B. For Indemnifiers:


1. Duty to Mitigate

  1. In an indemnity provision, it is advisable to include a duty to mitigate losses clause. This clause obliges the Indemnity Holder to take reasonable actions to minimize losses and refrain from actions that unreasonably exacerbate the loss. The underlying reason is that the Indemnity Holder cannot recover damages for any loss (whether caused by a breach of contract or breach of duty) which could have been avoided by taking reasonable steps.

2. Basket or Deductible Threshold

  1. Consider the use of a threshold limit to determine the materiality of a claim, either as a deductible or a basket. In the case of a deductible, the Indemnifier is liable only for the amount exceeding the agreed threshold. In the case of a basket, the Indemnifier is liable for the entire amount once the basket threshold is met. This type of arrangement is largely used in large transactions and overseas markets.

(Illustration 1 Deductible: if the Deductible threshold is agreed to be INR 50,000/-, then, in order for the indemnity holder to claim any indemnity from the indemnifier, the claim amount needs to be in excess of the threshold of INR 50,000, which is either INR 60,000 or even INR 50,001, or anything above it. Thus, in such a case, the indemnifier shall be liable to indemnify the indemnity holder of such excess claim amount, as in this case for an amount of INR 10,000 or INR 1 respectively.)


(Illustration 2 Basket: considering the same illustration 1 hereinabove, in case there is a Basket threshold of INR 50,000, and in the event the indemnity claim amount being INR 60,000 or INR 50,001 then, then the indemnifier shall indemnify the holder for a total value of INR 60,000 or INR 50,001 respectively. However, following the same principle as above, the threshold of INR 50,000 needs to be hit in order for an indemnity claim to arise.)


3. Exclusion and Limitation of Liability

  1. The Indemnifier shall ensure that the liability clause is not too wide to capture the liability for specific losses, including loss of production, loss of use, loss of profit, loss of information and/or data and any indirect or consequential damage, however, such exclusion and inclusion negotiations depend upon the terms and nature of the agreement. Further, it is advisable to limit the indemnifier's liability for all losses, claims, or damages stemming from the agreement, subject to a predefined caping amount.

4. Limitation on Remedies

  1. The Indemnifier may also consider inserting a limitation of remedy clause, wherein, it can limit the other party’s remedies that it can pursue against the indemnifier. Thus, the Indemnifier can limit or provide certain exclusive remedies that the Indemnity Holder may have to pursue its claim. This clause is largely used in the overseas jurisdiction.


C. For Both Parties (or Either Party):


2. Survival Clause


  • Commercially, both the parties generally agree for the survival of indemnity clauses, post-termination. Customized clauses may include limitation periods for specific claims, aligning with the nature of the business arrangement or transactions.


V. KEY TAKEAWAYS


  • Indemnity clauses are pivotal in commercial agreements. Under Indian law it is derived from the section 124 of the Act and there are certain rights given to the Indemnity Holder which are enlisted under section 125 of the Act.

  • Indemnity extends to third-party claims, allowing actions to be taken before actual damage or loss occurs. Holistically, the interpretation of the indemnity clause is not exhaustive, and reliance could be laid out on common law while interpreting the same.

  • The scope of indemnity is vast, covering a wide range of losses and claims. The Indemnifier's obligation is invoked when liabilities become absolute.

  • Drafting indemnity clauses requires careful consideration of language and a foresight for future issues, for which one can lay a reference to the drafting pointers given hereinabove.

  • It is advisable to include ‘exclusion and limitation of liabilities’ and ‘indemnity capping’ provisions to manage/limit commercial risks effectively.


In conclusion, understanding and crafting effective indemnity clauses is crucial in modern commercial contracts. The legal landscape surrounding indemnity is complex and multifaceted, making it imperative for businesses and legal professionals to navigate this terrain with a keen eye for detail and a strong grasp of both legal principles and practical implications.

 

Disclaimer: This note is based on the author's expertise and publicly available data, offering a perspective for the sole purpose of concept understanding. It is not intended as advice to individuals or corporate entities. The author disclaims all responsibility and liability for anyone who has read or intends to act, or not act, based on the contents of this note. No reader or individual should act on the information herein without first seeking professional legal advice.

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