Need for indemnity to facilitate commercial transaction

By | August 13, 2019
indemnity to facilitate commercial transaction

The whole point of instituting the indemnity clause in the commercial contract is to exclude the affected party form any type of loss or incurring any type of liability.

Introduction

India’s GDP rate for this quarter is 6.8% and with the introduction of new reforms in the recent budget speech of Hon’ble finance minister Nirmala Sitharaman, it can be said that India is aiming for the 5 trillion dollar economy for boosting its economic growth, and this can only be viable if more business takes place in India with Indian companies. Now to facilitate more business, the business nurturing environment has to be provided by the government which includes giving tax exemptions and also amending various business laws.

The most basic law which governs almost all the business relationship in India is the Indian Contract Act. It’s the principle act which regulates all the aspect of the contract starting from the basic question whether a contract s valid pr not to when can the contract of guarantee or indemnity can take place. The aspect we shall be focusing on is the indemnity clause in facilitating commercial transactions.

The contract of indemnity as described in section 124 of the Indian Contract Act[1], is a contract between two parties where one party promises to indemnify the other party in case the later one suffers from any loss or to incur any kind of expenses or to protect him from any legal consequences which have been caused by the conduct of the promisor himself or caused by the third party. Like if A states that he shall bear all the expenses or losses incurred by B which is caused by the act of the third-party with whom B has any type of contract, let it be Z in this case.

The whole point of instituting the indemnity clause in the commercial contract is to exclude the affected party form any type of loss or incurring any type of liability.

This type of contract is needed especially for companies dealing with high-risk business as they enable one party to be protected against the liability arising from the act of another party. This type of contract ensures that one party is protected from any unforeseen circumstances and contract like these promote the business as companies can trade without having to worry about the incurring losses from the third parties as they are secured in that front.[2]

        I. Analysis of indemnity clause

There is as such no restriction or any exclusionary clause as in for what contracts indemnities will apply and in what contracts it shall not be. The applicability of the indemnity clause mainly depends on the willingness of both the parties to enter in such contracts, the type of contract, i.e. whether the contract is high risk or low risk one? and the financial credibility of the third party with which company is having contractual relationships. There are namely two situations were having indemnity clause is advisable[3]:-

  1. Where the nature of the transaction is such that the chance of incurring a loss is high
  2. And, in cases even if a loss has been incurred, the remedies available won’t suffice to cover the loss.

Though there are certain contracts in which inscribing of indemnity clause should be avoided which are:-

  1. Consumer contracts: -indemnities paid by the consumer to a business are generally deemed unfair
  2. Confidentiality agreement: – an indemnity clause in this kind of agreement will potentially increase the liability of the party who is receiving the confidential information allowing the disclosing party to recover for all liabilities, costs, claims, and expenses incurred in connection with the breach, as opposed to the loss it actually suffers.

There are certain losses which can’t be indemnified like:-

  1. The loss occurred because of the indemnified party’s deliberate acts, like in case of insurance, if the insured burnt down his own house, then the provision of indemnity should be allowed.
  2. If the indemnified person incurred a loss due to his own fraud by way of undertaking illegal activities[4].

Now, prior to the amendment of section 124 of the Contract Act, it previously stated that only those cases of indemnity would be taken into account which has occurred due to the conduct of the promisor or any other third party. The essential principle was that loss has to have occurred only with the intervention of any human act.

But if a loss occurred due to any natural act, that type of events wasn’t specified previously in the section.  It also didn’t include the ambit of the contract of insurance. Then with the suggestion of the 13th Law Commission Report[5], it recommended amending the provision to its present state, now the present provision as it stands states that any loss incurred which may or may not have been caused by human activity can be indemnified.

Rights of indemnity holder

The whole point of including an indemnity clause in the contract gets vitiated if the holder didn’t have any right over the indemnifier to claim the protection as sought in the contract. It would mean that the clause would become a dead letter of the contract which though exists, didn’t have any value. So the Indian Contract Act has provided for certain rights to the indemnity holder in section 125 which include:-

  1. Indemnity holder shall have the right to recover all the damages which he may be ordered to pay in any suit
  2. He also has the right to recover all costs which he may be compelled in any suit
  3. All sums which the indemnity holder may have paid in a case of any compromise of any such suit..

Types of indemnity clauses

There are namely 6 types of indemnity contracts which govern the contractual relationship between different corporate[6]:-

  1. Bare indemnities: In this type of contract, Party A promises to indemnify Part B against the loss incurred in relation to any particular event or happening, but without setting out any limitations. These types of contracts are silent regarding the fact that whether this contract will apply if the event occurred due to the act of Party B?

Reverse Indemnities: in this case, Party A promises to Indemnify Party B in case of loss incurred due to the negligence of Party B.

  1. Third-Party Indemnities: This type of contract is against the third party. In this case, Part A promises to indemnify Party B, in case any loss occurs because of the act of third Party C.
  2. Proportionate or Limited Indemnities: These are a contract is just the opposite of reverse indemnity. In this case, Part A promises to indemnify B for all losses except for the loss incurred because of the act of Party B.
  3. Financing Indemnities: These are somewhat related to the third party indemnity, where Party A promises to indemnify Party B for the failure of the Party C to honour the financial obligations concerning Party C.
  4. Party Indemnities: These contracts are mutual benefit contracts, where each of the party in contract promises to indemnify each other in case loss is incurred by the indemnifier’s breach of the contract.

      II. Need for indemnity in commercial contracts

The indemnity clause is one of the most common clauses used in contractual agreements. The basic idea of importing the concept of indemnity in the contractual relationships is to limit the loss incurred by one of the party and shift it to another party with the consent of both the parties.

The main aim is to protect the indemnity holder form the lawsuit filed against him by the third party and thus resolving him from any legal claims that can be raised against him. One of the important aspects of interpreting the indemnity clause is that the scope of the indemnity agreement has to be considered within the context of the agreement as a whole. The interpretation of the meaning and language of the clause should be done taken into account contextualism of the agreement in its entirety.

Usually, the indemnity contracts are drafted in a wide manner so that it could include the third party liabilities because if whose conduct, negligence loss has been incurred by the indemnity holder there are a multitude of the reason for incorporating indemnity clause in the contracts which include the following[7]:-

  1. Risk management

The whole point of inscribing indemnity clause in the contract is to ensure that one party doesn’t have to incur the loss in case the contract doesn’t turn out as it is expected to be. Any contract aims to ensure a profitable outcome after the transaction is complete, but to ensure profitability, one has to reduce the loss or chance of incurring the loss, and that’s what contract of indemnity provides for. It ensures that loss is borne by another party subject to certain limitations as written in the contract.

It may also happen that contract drafted in a certain way to ensure that the indemnity clause applies to both the parties, in a sense if one party incurs a loss, another party shall indemnify and vice-versa. It also provides for some qualifications which include:-

  1. Mentioning against which party the contract of indemnity shall be applied, as it cannot be possible that one party has agreed to bear the loss against every party that the company has contractual relationships with.
  2. Sometimes even the amount is mentioned, that to certain limit one shall be liable to pay to the other party to recover only a certain amount of loss, so to protect one’s self-interest as well.

    2. Unforeseeable loss

When a company enters into a contract, it usually makes provision in case the contract is breached by the other party and the company incurs foreseeable losses. The problem arises in case the company starts to incur unforeseeable losses.

The aim of the indemnity contract is to ensure that the company can recover all losses, particularly the unforeseeable ones. And it depends on the bargaining power of either party to ensure what terms shall be included in the clause. The idea is to have a safeguard mechanism from the unforeseeable loss so that it doesn’t affect the financial position of the company.

  1. Causation

One of the needs to have a definite indemnity clause as to whether the clause comes into play in case of a specified event or even in the non-specified event as well. It’s usually the former case that indemnity clause  is given effect to like the whole idea of indemnity clause is to give safeguard against certain event caused by certain  person only, like if part A gives indemnity to B that in case C doesn’t deliver the product, then he shall pay the amount equivalent to it. Now the specified event is that C doesn’t deliver the product.

If now C delivers, but delivers the wrong product or malfunctioned product, them A shall not be liable as that was not the specified event. But if the clause mentions that A shall be liable for all non-specified events, then A shall be liable. It usually the specified event that security is given, but it again depends on the bargaining power of the parties.

  1. Extent of loss

Another underlying aspect of having an indemnity clause is to determine the exact amount of loss. Today’s economy is currently suffering from a high inflation rate, because of which there is a constant increase in price. So in times like this, it’s pertinent to specify the amount the party shall be liable to pay to the company in case it incurs a loss, or else the party may have to pay a high inflated penalty, even if the value of the contract may be much less than that.

Another aspect of this component is to determine, what shall all be included in calculating the exact amount of loss. Will, it includes all the direct loss, or shall also include indirect loss and all the consequential loss as well and also will it have the provision of interest charge in case the amount is not paid in certain time-period. It all has to be explicitly clear in the indemnity clause.

    III. Conclusion

After thoroughly analyzing in detail the ambit of the indemnity clause in any type of contract, it can be concluded that contract of indemnity is one of the principal factors in deciding whether a business is willing to enter into a contract with another party. The enforcement of contracts like this would increase the chances of more participation of the company in the economy and thus increasing the GDP of the country. An indemnity clause is very important especially of new companies who are investing for the first time in an unknown economy.

They are in constant fear of incurring unforeseeable losses and this hindrance makes the economy stagnant. But if the indemnity clause is inscribed in the contract, the new companies are assured that if anything goes west, then they are guaranteed to recover at least a certain amount of money and tough their financial position will be hampered, it won’t be hampered to that extent. It further encourages new startups and entrepreneurial ventures in the economy and motivates them to venture into the new arena of business as they would have the safeguard of recovering some amount of money, even if not all.

Though the indemnity clause is decided based on the bargaining power of either party, it has seldom restrained any company in incorporating that clause in their agreement and thus securing their self-interest.


[1] Indian Contract Act 1872, section 124.

[2] Avtar Singh, Contract & Specific Relief (12th edn, Eastern Book Company, 2017).

[3] Id.

[4] Indemnity (Rocket Lawyer) < https://www.rocketlawyer.co.uk/article/indemnity.rl> accessed 11 July 2019.

[5] 13th Law Commission Report, ‘Contract Act, 1872’ <http://lawcommissionofindia.nic.in/1-50/Report13.pdf> accessed 11 July 2019.

[6] Piper Alderman, ‘Indemnity Clauses in Commercial Contracts: How To Achieve Desired Contractual Risk Allocation’ Lexology <https://www.lexology.com/library/detail.aspx?g=db38e8d6-7451-49e1-9e74-531bf32e0d10> accessed 11 July 2019.

[7] Ciaran Noonan, ‘The Importance of Getting an Indemnity Right in a Commercial Agreement’ (Monday, 15 July 2018)<http://www.mondaq.com/uk/x/715936/Contract+Law/The+importance+of+getting+an+indemnity+right+in+a+commercial+agreement> accessed 11 July 2019.

Suggested Readings

  1. Capacity to contract(Opens in a new browser tab)
  2. Contingent contract: Concept and Scope(Opens in a new browser tab)
  3. Contract Act: Important Definitions and Decisions(Opens in a new browser tab)
Avatar
Author: Sagnik Sarkar

Sagnik Sarkar is currently studying BBA LLB in National law University, Odisha and is in his 3rd year. He is interested in mooting, writing a research paper and has publications in his name. Writing a research paper and mooting has helped him in his editing and formatting ability.

What did I miss? Don't forget to leave your valuable feedback