The Viewpoint Indemnification Provisions – Is the fight on the indemnity clause worth the effort

The Viewpoint Indemnification Provisions – Is the fight on the indemnity clause worth the effort

Bar & Bench

By Nandish Vyas and Pranati Ishwar 

A typical Indian acquisition transaction is incomplete unless the parties have gone through the customary debate on indemnification obligations. Indemnification related issues are one of the last few items which form part of the “open issues list” in a negotiation process of an acquisition agreement. Given the labor and effort surrounding this sometimes unending debate, this article seeks to examine the context in which indemnification rights are relevant for acquisition transactions, and also seeks to explore if there are areas where they are potentially not worth the traditional lawyerly argument.

As a precursor to this discussion, and in view of observations of Indian courts in relation to indemnification, it is necessary to first examine the statutory provisions relating to indemnification, and the key differences between the right to indemnification and the right to damages. Section 124 of the Indian Contract Act, 1872 defines a contract of indemnity as a contract by which one party promises to save the other from loss caused to the other by the conduct of the promisor himself, or by the conduct of any other person. It has been acknowledged by Indian courts that this statutory provision does not comprehensively encompass the entire law on indemnification, and the scope of indemnification is broader than what the statute contemplates. For damages, section 73 of the Contract Act gives a right to the parties to a contract to claim for damages in case of a breach of contract, i.e. compensation for the loss or damage caused by breach of contract.

Indian courts have observed that these two rights are often confused, because when a contract is broken, indemnity is often found to coincide with the measure of damages; and, in such cases, whether the right is called the right to indemnity or right to damages, the end result is the same. The two concepts are nevertheless quite distinct, the key substantive and process related points of difference being the following:

Breach of contract: Unlike in the case of damages, a breach of the contract in question is not an essential ingredient for a right to indemnification. This is the reason why ‘specific indemnity’ rights are commonly negotiated for certain events, de hors a breach of contract.

Indemnification for acts of third parties: As contemplated in section 124, indemnity can be claimed for loss arising out of the conduct or action of not just the contract-counterparty, but also any third party. In fact, in view of the broader scope of indemnification (discussed above), courts have also recognized that indemnification may be claimed for events which do not depend on the conduct of the indemnifying party or any third person.

Timing of enforcement of rights: Whilst this issue is a debatable one in the context of indemnification rights, certain courts (including the Bombay High Court) have held that an indemnity holder may enforce the indemnity without the occurrence of an actual loss, in cases wherein the promisor incurs an absolute obligation/liability, and the contract of indemnity covers that obligation/liability. Therefore, in an appropriate case, one could obtain an order compelling the indemnifying party to set aside a fund out of which the liability of the indemnified party may be met, or to pay the amount due directly to the third party, without the indemnified party going out of pocket.

Quantum of recovery: Damages may be awarded for an amount which is more than the actual loss incurred (in case of special damages, or pre-estimated liquidated damages), and in some occasions even less than the actual loss incurred, whereas an indemnification generally puts a person in the same position as prior to the loss. An arguable point on this aspect is whether indemnification can potentially be claimed for amounts which are in excess of the ‘direct’ and ‘reasonably foreseeable’ losses. A comparison of the language of section 73 and section 124 suggests that the right to recover a loss based on an indemnification clause may not necessarily be subject to all the statutory constraints placed on the right to claim damages (i.e. that the loss should be direct and immediately foreseeable, that the loss should not be a consequential loss, that the party claiming breach should have taken measures to limit losses, etc).

Whilst all of the above key differences have more or less been traditionally recognized by Indian courts, in the case of State Bank of Saurashtra vs Ashit Shipping (2002), the Supreme Court of India has held, whilst considering an indemnity bond, that “the question of making good the loss arises only when there is proof that loss is suffered”. In cases of insurance (which is again an indemnity contract, in a broader sense), the Supreme Court of India has held that it is only upon proof of the actual loss, that the assured can claim reimbursement of the loss to the extent it is established (this becomes important given the recently increasing phenomenon of ‘indemnity insurance’ relating to acquisition contracts –insurance policies indemnifying the indemnifier). The observations in these cases raise a concern as to whether the practical effect of an indemnification right, in an enforcement scenario, would be much different – either substantively or procedurally – from the contractual right to damages.

Given the above, it needs to be clarified that the benefits of a right to indemnification cannot be ignored, particularly where a party wishes to seek recourse from the indemnifying party, absent of a breach of contract. Also, even in cases of a breach of representations and warranties, or other breaches of contract, the right to indemnification can potentially be more advantageous, given the prospective scope of claiming an amount which is higher than what would be claimed as damages. However, as stated above, it is quite possible that in cases of breach of contract, a court would view the right to indemnity as coinciding exactly with the right to claim damages. More specifically, where the indemnification obligation are subject to indemnification caps, “de minimus” provisions or “baskets” or otherwise restrained (as is sometimes the case), indemnification provisions should be carefully crafted for specific matters.

In the ‘indemnity analysis’, careful thought should to be given to the type of acquisition transaction. The language of an indemnification clause becomes more important where the acquisition is not a 100% acquisition, particularly since it becomes even more difficult to establish a loss to the acquirer in such cases (and therefore more difficult to claim damages).

While acquisition contracts in India have traditionally followed certain settled patterns and formulae, in fit cases, it is worth considering modifications to the typical indemnification clause. It goes without saying that the importance of tailor-made detailing of each indemnity clause (as opposed to mere use of precedent) is even more relevant in the current scenario, where disputes on acquisition contracts and shareholder contracts appear to be representing an increasingly larger slice of the transaction lawyer’s time pie-chart.

It is also not out of place to mention that there are various unanswered questions of law relating to concepts surrounding the scope of an acquirer’s right to seek recourse, such as (i) does the limitation on liability in an indemnity clause preclude a party from claiming damages in excess of the indemnity limits, outside of the indemnification clause?; (ii) does a loss to the investee company always amount to a loss to the investor for the purposes of seeking indemnification?; (iii) will a monetary crystallization of the indemnification obligation in specific scenarios (akin to the concept of liquidated damages) save the indemnified party of proving the quantum of loss?; (iv) most importantly, where damages and indemnity coincide, to what extent are the limitations relating to damages claims relevant to indemnification claims?

Given the number of issues that are unclear around this subject (like in a majority of areas of Indian transaction laws), one looks forward to the day when these issues are the subject matter of a full-fledged debate on an acquisition agreement in an Indian court.

Nandish Vyas (pictured left) is a Senior Associate and Pranati Ishwar is an Associate at AZB & Partners. The views expressed in this article are the personal views of the authors and do not represent the views of the Firm.

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