Importance Of Indemnity Clauses In Commercial Contracts


According to the dictionary meaning, indemnity is protection against possible damage or loss, especially a promise of payment, or the money paid if there is such damage or loss.[1] It is a security against, or compensation for loss, etc.[2] This is where a claim for indemnity arises, in such a case there are two persons one who agrees or promises for the reimbursement or incurring the loss such a person can be called as “indemnifier”, and the other person to whom such a loss has been caused is the “indemnity holder” or “indemnified”. This is how in such cases the loss gradually shifts from one person to another person.

What is indemnity?

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. Initially the basic importance of indemnity clause is to shift the liability, in whole or in part, from one party to another party.Section 124of the Indian Contract Act,1872,lays down that the claim of indemnity ariseswhena person agrees or gives assurance to another person to save him from any kind of loss that has been caused to him by any action of the person who is promising or action of any other person who may not be a party to the contract. Here it is very clear from the above definition that the provision of indemnification arises only when a prior promise is made to save a party from the loss. The question of reimbursement arises only when there was an anticipation of loss and in that context a promise was made to incur the loss.

Under the following section the main criterion which usually gives rise to indemnity is “any action or conduct of the indemnifier or any other person or let’s say the third party who may not be a party to the contract due to which the loss or any damage that has been caused to the indemnity holder”. Section 124 of the Act it only covers those cases where the loss or damage that has been caused by the action or conduct of the promisor himself or any third party. It is very clear that it does not include any such cases where human conduct is absent.

Under Indian Law

Previously under Indian law, the definition of Section 124 of the Indian Contract Act, 1872, it included only those cases of indemnification where the loss or damage has been caused by the action or very conduct of the promisor himself or any other third party from which the claim of indemnity arises. Any promise to compensate for a loss that has not been caused by the human conduct was not covered under the purview of the section of indemnity. The section did not cover the contract of insurance. But later on The Law Commission of India in its13thReportin the year 1958, recommended to amend Section 124 of the Act and accordingly Section 124 was amended to include all the cases of loss or damage that may or may not have been caused by the action of any person. Promise to indemnify must be implied as well.

Under English Law

Basically under English common Law the word “indemnity” includes all such cases to rescue or to save the indemnified from a loss or damage that may or may not depend upon the conduct of human or the event may be fire or any kind of accident. So contract of insurance is included under the indemnity law though excluding the contract of life insurance.

A contract of life insurance cannot be termed as contract of indemnity as, for instance, a contract of insurance at the event of death a certain person or on the event of expiry of a specified time period may provide a certain amount of money may provide a certain amount of money even if the assured is still alive. In such a case the question of loss or damage suffered by the person does not arise. Again the life of a person cannot be valued unlike any property even if certain amount of money is payable at the event of the death of a person. These reasons exclude the contract of life insurance from the purview of “indemnity”.

Rights of the indemnity holder when an indemnity clause is inserted in a commercial contract

When a suit is instituted against the indemnity holder or the indemnified, he may be compelled to pay damages, and incurred costs, etc. While in a similar way he can bring an action against the indemnifier to compensate for the damages and costs, etc. paid by the indemnity holder himself, if the indemnifier has agreed in such a case for reimbursement or indemnification.Section 125of the Indian Contract Act lays down the provisionregarding the rights of the indemnity holder-

If a promise has been made in a contract of indemnity to save an indemnified from a loss or any damage by the indemnifier and the promise made by the indemnifier is within the scope of his own authority then the indemnity holder is entitled to recover from the indemnifier the following-

  • All such damages which the indemnity holder may be compelled to pay in a suit in respect of any matter provided that the promise applies to the following matter;
  • All costs which the indemnity holder may be compelled to pay in any such suit which he has brought without contravening any orders of the indemnifier and acted as a prudent man in the absence of any such contract of indemnity, or he was authorized by the indemnifier to bring or defend such a suit;
  • All sums which the indemnity holder may have paid in a case of any compromise of any such suit, if the compromise was not contrary to the orders of the indemnifier and is one in which the promise would be prudent to be made in the absence of any such contract of indemnity, or if the indemnity holder was authorized by the indemnifier to compromise the suit.

Importance of indemnity clause in a commercial contract

An indemnity is slightly different in commercial contract than in common law. Indemnity clause is the commonly used elements in the commercial contracts. 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.

As from the above definition and explanation of indemnity it is very clear that one party agrees to indemnify (often hold harmless defend) the other party. To indemnify someone is to absorb the losses caused to that party. The real significance of an indemnity clause is to protect the indemnified party against the third party lawsuits.

Indemnity clause often sets out a list of what actions a party is insured against, for example:

  • All lawsuits, actions or proceedings, demands, damages and liabilities.
  • All claims, liabilities, losses, expenses and damages arising from a contract.
  • Loss, damage, injury or accidental death from any cause to property or person occasioned or contributed to any of your acts, omissions, neglect or breach or default.

Scope of Indemnity

In commercial Contracts the indemnity clauses are drafted in a wide manner in order to include the third parties by whose conduct, action or negligence any loss or anticipated circumstances might occur, which are beyond the ordinary circumstances of breach actionable under common law. In certain special cases or circumstances the indemnity clauses might apply even when no breach of contract has occurred. Indemnities in such cases extend into unintended obligations which the common law might not impose otherwise.
Can an indemnity holder seek indemnity before he has suffered any actual loss?
It has always been a controversial point, regarding whether the indemnity holder can seek indemnity before he has suffered any actual loss in this context.

Under English common law, no action can be brought against the indemnifier for reimbursement until the indemnity holder has actually suffered any loss. This provision creates a great hardship for the indemnity holder as in some situations he might not be in a position to meet the claim or the damages from his own pocket. In those cases relief was provided by the Court of Equity. The Court of Equity evolved the rules as a result now the indemnity holder can seek indemnity from the indemnifier in respect of the obligation against which the indemnity has been promised.

In India, there have been different views among various High Courts regarding whether or not the indemnifier can be compelled to indemnify before the indemnity holder has suffered any loss. According to Nagpur High Court [3], a person cannot be indemnified before he has actually suffered any loss. The High Courts of Bombay [4], Calcutta [5], Madras [6], Patna [7], and Allahabad [8]have expressed a different view, and they are of the opinion that the indemnity holder can seek indemnity before he has suffered any actual loss.
Drafting of the indemnity clause
While drafting an indemnity provision in a contract the following points must be considered-

  • Who is the indemnity-holder and who is the indemnifier?
  • Whether or not there is any need for indemnity at all or the indemnity provides greater protection for the breach of contract than would normally be available for the breach of contract under the common law? If not, indemnity is not needed.
  • An indemnifiermust limit the amount of indemnities that is given while entering into a contract. An express obligation must be imposed so as to minimize the loss, and the duration of time in which the claim can be brought must be limited.
  • An indemnity-holder should make sure that the indemnity clause must never be drafted in a wide manner as it risks the effect of achieving the desired claims and might even exclude some anticipated liabilities,
  • Indemnity for breach of contract and breach of negligence must be considered in addition to the common law rights.
  • In the event of breach of contract, the effect of indemnity should be-
  1. The breach will also give rise to other remedies under the contract (termination, liquidated damages or rights to payment)
  2. The breach will allow the indemnified party to be entitled to a payment, compensation or reimbursement.

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.