Indemnity clause in a Share Purchase Agreement

By Anurag Pareek

Introduction

Indemnity is the promise by one to compensate for any loss, liability or damage incurred by another due to an act or omission on the part of one or of some third person or an event. Section 124 of the Indian Contract Act, 1872 (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. This, however, is not an exhaustive definition of indemnity and therefore, the indemnity clauses in share purchase agreements (SPAs) on principles of common law may have a wider scope than that provided under the Contract Act.[See Endnote 1]

Are indemnity clauses significant?

Usually, SPAs provide for an indemnity clause for management of risk of losses associated with the contract. Often heavily debated and negotiated upon in SPAs, these are relevant to the sellers seeking to limit future liabilities as well as the buyers aiming to cover themselves against any losses or liabilities that arise, primarily, out of inaccuracies of representations made by the seller during sale, or due to any event which might have occurred under the ownership of the seller, or due to an event which might occur post completion of sale, not necessarily dependent on the conduct of the seller. Given the antithetical interests of both parties and the profound effect indemnification provisions have on economics of the deal, indemnity clauses are crucial to M&A transactions.

Are indemnity clauses needed when statutory remedy for damages is available?

Critical to discussion is whether there lies a benefit in seeking indemnity instead of resorting to claiming damages [See Endnote 2] under the Contract Act. This can be understood by drawing a distinction between a claim of damages and that of indemnity with respect to:

1. Parties to the claim

A claim for damages under Section 73 of the Contract Act can be made only against the party that has made the promise under the contract. The existence of a concluded contract is a sine qua non in a claim for compensation for loss and damages under this section.[See Endnote 3]
However, the promisor’s liability under indemnity provisions extends to losses or liabilities due to not just acts of the promisor but also the acts of a third party or upon the occurrence of any event. This extension is a major advantage that an indemnity clause has over a claim for damages.
 

2. When losses can be claimed

Damages for breach of a contract cannot be awarded until an actual loss is suffered since these are to compensate for the damage, loss or injury resulting from that breach.[See Endnote 4]

Whereas, the courts in India have taken the position that an indemnity holder is entitled to claim indemnification on mere accrual of liability, that is, before incurring any actual damage or loss and that an indemnity is not necessarily invoked after payment.[See Endnote 5] The discharge of the same, however, can be contractually agreed upon between the parties.
 

3. Duty to mitigate damages

Section 73 imposes upon the plaintiffs, an obligation to take reasonable steps to minimise loss and to refrain from taking unreasonable steps that would increase the loss.[See Endnote 6] No such obligation arises in case of an indemnity clause unless the contract expressly provides for it.
 

4. Reasonability, foreseeability and remoteness of damages

A claim for damages is subject to the rules of reasonability, foreseeability and remoteness. The rationale behind allowing damages for breach of a contract is to enable restoration of the economic position in which the injured would have been had the breach not taken place.[See Endnote 7] Therefore, the damages must be commensurate with the injury sustained. Similarly, it must be established that the damages are a direct consequence of the breach[See Endnote 8] and were reasonably foreseeable at the time of contracting.[See Endnote 9]
 
However, these principles of reasonability, foreseeability and remoteness are not applicable to an indemnity clause, enabling the indemnified party to demand through a broader range of claims, consequential and remote losses, provided they are not expressly excluded in the contract.
 
Limitation of liability and its advantage to the seller

Indemnification clauses under SPAs also regulate the limitations and the exceptions to the seller’s liability in respect of the claims made by the purchaser. A limitation of liability clause is the exculpatory clause that sets forth certain limitations of time and money in case an indemnity claim arises.

The ability of the purchaser to bring a claim against the seller for indemnification is generally bound by a period defined in the SPA. Similarly, the monetary liability of the seller can be restricted to the purchase price or a percentage of the purchase price under the SPA.

In addition to an upper threshold, it is also possible to set differential thresholds depending on the nature of the breach. A seller’s liability can also be limited by stipulation of minimum losses that must be incurred before the seller can be made liable. A provision for aggregation of claims can also be made under the SPA, wherein the purchaser assumes the risk until it exceeds a certain predetermined amount and it is then that the claim is made against the seller.

Conclusion

Indemnity clauses are the inherent tools to protect a purchaser’s interests in event of breach of the representations and warranties given by the seller under the SPA. In addition to contractual breaches by the seller, an indemnity clause also protects a buyer from any action of a third party or the occurrence of any event which may or may not happen prior to the closing date under the SPA.

Simultaneously, the seller’s interests are protected as his liability is limited by time and monetary constraints. Indemnity clauses also regulate, among other things, purchaser’s obligations regarding treatment of breaches before they are notified to the seller, purchaser obligations in case of third party claims, the procedure for claiming indemnification, exceptions to seller’s liability etc.

Damages, on the other hand, are the alternate remedy available under the Contract Act. Damages so awarded, as discussed above, put the purchaser at a significant disadvantage as several conditions restricting the scope of damages, that can be claimed, are imposed on the claimant statutorily. Additionally, absence of a cap on damages that can be claimed exposes the seller to uncertain liability. It is therefore, that this allocation of risks and liabilities by an indemnity clause in an SPA, provides certainty to the transaction as exposure of either party to the transaction is defined.

[The author is a Joint Partner in Corporate practice, Lakshmikumaran & Sridharan, New Delhi]