Importance of the Indemnity Clause in a Commercial Contract

Indemnification is an undertaking by one party to compensate the other party for certain costs and expenses. Parties to a contract use a contractual indemnity provision to customize risk allocation.

Section 124 of the Indian contract Act, 1872 encompasses the concept of ‘contract of indemnity’ whereby a contracting party promises to save the other contracting party from loss (preventing or compensating) caused by the conduct of the promisor or of any other person. The claim for indemnity or indemnification arises when a party (indemnifier) promises to protect another party (indemnity holder) from any kind of loss, cost, expense, damage or any other legal consequences caused by the conduct of the indemnifier or any third party.

An indemnity clause is a commonly used element in the commercial contracts as they play an important role in managing the risks associated with commercial transactions by protecting against the effects of an act, a contractual default or another party’s negligence. The general rule is to seek an indemnity which will protect a party to the greatest possible extent against liabilities arising from the actions of another party.

An indemnity is however slightly different in commercial contract than it is in common law. The purpose of inserting the indemnity clause in a contract is to shift or allocate the risk, or cost from one party to another. More precisely it can said business transaction between the two parties by obligating one party to pay the expenses incurred by the other party under certain circumstances.

Scope of Indemnity:

Generally the indemnity clauses are drafted widely seeking to cover third parties and circumstances beyond the ordinary breach circumstances actionable under the common law. In some circumstances, the indemnity clauses also seek to apply even when there is no breach of contract by the party. The very god example of indemnity is the guarantee in which one party indemnifies another party for the act, default, or breach of a third party. Indemnities in these circumstances can therefore extend into unintended onerous obligations which the common law would not otherwise impose.

It is not uncommon for a party with the most commercial influence and bargaining strength in respect of a project, particularly where the project is large or risky, to insist on indemnities from other participants. Such indemnity clauses are often drafted in the broadest possible terms. The adoption of broad-ranging indemnities is not always, however, the best tool for achieving risk apportionment.

Ambiguity in the drafting of an indemnity clause presents a risk that the indemnity will not be held to cover losses, which they expected it to cover. Ambiguity is also a risk to the indemnifier that it will be held to cover losses that were not within their contemplation.

It is important to take care in commercial negotiations to confine and document the intended scope of the indemnity being negotiated and to identify precisely what is sought to be achieved economically.

Exceptions to indemnification:

There are a number of common exceptions to indemnification. They generally relate to circumstances where the indemnified party's own actions either cause or contribute to the harm that triggers indemnification. For example, an indemnification provision may exclude indemnification for claims or losses that result from the indemnified party's:
  • Negligence or gross negligence
  • Improper use of the products
  • Bad faith failure to comply with its obligations in the agreement 
Indemnity Claims vs. Claims for Damages:

Indemnity claims are very distinct from a claim for damages. The Bombay High Court in the case of Gajanan Moreshwar Parelkar v. Moreshwar Madan Mantri highlighted that while interpreting indemnity provisions it is necessary to note that the Contract Act is not exhaustive and common law principles should be relied upon. The common law principles governing the applicability of indemnity provisions are enforceable until and unless there is a conflict with the Contract Act or any judicial decisions rendered by the Indian Courts. Third party claims are covered under an indemnity but the damages can only be claimed against the promisor or the party who has made a promise under the contract. Another important fact to note is that indemnity claims can be made even before a party has suffered an actual loss. Consequential, indirect and remote losses can all be claimed under an indemnity clause whereas the same is not sustainable under a damage claim. There is no need to exhibit that a loss may have occurred due to breach of contract I order to claim for losses under indemnity. But for claiming damages, a clear nexus between the breach of contract and damage suffered must be established. The major benefit of an indemnity over damages is that in order to that indemnity arises due to the conduct of the indemnifier or by the conduct of any other person.

An indemnity holder is entitled to sue the indemnifier even before incurring any actual damage or loss and that an indemnity is not necessarily given by repayment after payment. Hence, an indemnified party can call upon the indemnifier to make the payment once the liability has accrued. The concept of accrual of loss or liability and the attendant obligation to indemnify can be contractually agreed upon between the parties.

The Contract Act under Section 73 only permits seeking compensation for any loss ‘which the parties knew, when they made the contract, to be likely to result from the breach of it’ at the time of entering into the contract which is commonly termed as the principle of contemplation of damages between the parties. ‘Reasonable foreseeability’ is interpreted as the serious possibility of occurrence of loss and is often the test used for damages. Further, the damages claimed must be reasonable and hence damages may not be sustainable for loss of profit or opportunity costs ordinarily. Section 73 specifically states that, ‘Compensation is not to be given for any remote and indirect loss or damage sustained by reason of the breach.” Hence, it specifically excludes any claim for remote or indirect losses.

No such restriction applies for an indemnity claim. Section 124 of the 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. A claim for damages is subject to the ordinary rules of remoteness discussed whereas a claim for indemnity is not subject to the same rules. Thus, consequential, remote, indirect, and third party losses can all be claimed by the indemnified party unless specifically excluded in the indemnity clause.

Further, while estimating the loss or damage arising from a breach of contract, the means which existed of remedying the inconvenience caused by the non-performance of the contract must be taken into account. This obligation may not arise in an indemnity unless specifically stated so in the indemnity clause. There exists no clear Indian jurisprudence on this point. Unlike a claim for damages, where a clear connection and sufficient nexus has to be demonstrated between the breach of contract event and the damage suffered, the threshold to establish is much lower in case of an indemnity and there is no onus to prove actual loss before claiming indemnity.

Duration of Liability:

Another significant issue surrounding the utility of an indemnity clause is the extended time for which it may remain available for enforcement compared to a claim for breach of contract. Statutes of Limitation exist in all states and territories of Australia that limit the time by which a claim must be brought for breach of contract. Normally, the period is 6 years for an ordinary agreement, commencing from the date of the breach.

It is critical to understand that the limitation period in relation to an indemnity clause starts from the date on which the indemnifier refuses to honour the indemnity. The indemnified party would then have a further 6 years from that date within which to bring legal proceedings to enforce the indemnity. Consequently, an action on the indemnity to seek recovery of its loss may be brought many years after the right to bring damages for breach of contract has expired. In most instances, parties granting indemnities are not adequately advised of this potential impact and the extended period of risk they are assuming as part of their indemnity obligations.

Conclusion:

Generally the indemnity clauses arise out of commercial negotiations and seek to protect specific commercial risks. Indemnity clauses are sometimes reasonable for the contract’s terms or even essential for parties to carry out an agreement. Indemnity clauses must negotiated properly before putting it into a contract. Serious consequences can arise due to a poorly negotiated indemnity clause. Ambiguity in the drafting of an indemnity clause presents a risk that the indemnity will not be held to cover losses, which they expected it to cover. It is very important to draft the indemnity clauses properly and precisely. They are reasonably important as it shifts the loss from one party to another which might have been caused due to the negligence of the former.