From Risk to Resilience: Strategic Use of Indemnity and Guarantees

[Muskan Sharma is a 5^th year B. Com LL. B (Hons.) student at the Institute of Law Nirma University, Ahmedabad]

Introduction

When business corporations merge or acquire, they navigate a complex landscape of agreements and due diligence to mitigate any future risk or harm associated with the corporation. Given, the binding nature of such agreements and the imposition of hefty penalty in the event of breach every clause is important. Clauses such as Indemnity, warranty, guarantee & representations are some of the most scrutinized & negotiated between the parties to bring out the most suitable and fair deal for all the parties involved in the mergers and acquisitions transaction.

Indemnity as a Legal Shield Against Losses

The indemnity under contract law is a legal principle that simply means ‘to compensate for the loss and damage caused’. It can be expressed both in the form of contract or clauses in a contract. ‘Contract of Indemnity’ is defined under Section 124 of The Indian Contract Act,1872 (“ICA”), in such contract or clauses, there are two parties involved, where one party (indemnifier) promises to compensate the other party (indemnified party) for the loss or damage caused to such indemnified party because of an act or omission of an act by the indemnifier or any other person. This contract can be either in written form or implied from the parties conduct provided the terms of such contract must be unequivocal.   

The unique nature and interpretation of indemnity clauses in legal agreements are highlighted in the landmark case of Deepak Bhandari vs Himachal Pradesh State Industrial Development Corporation Limited wherein the apex court shed light on the nature of indemnity contracts and elucidated that the contract of indemnity is a separate and independent contract from the main contract. Furthermore, the stamp duty payable on indemnity clauses is separate and in addition to the amount payable for a general contract.

The extent of compensation under indemnity is narrow and limited, only the losses or damages that the indemnifier has explicitly agreed upon are compensated. The indemnity agreements are construed strictly and do not include all the consequential or specific obligations that may arise from an indemnity clause. This principle was underscored in the case of Gajanan Moreshwar Parelkar vs Moreshwar Madan Mantri where the court held that the indemnifier’s liability is confined to the precise terms of the indemnity and does not include liabilities beyond what is expressly stipulated. This ruling ensured that the indemnifier is not held accountable for unanticipated or broader liabilities unless explicitly stated in the contract. A precise understanding of the limitations within indemnity clauses is crucial for effective negotiation and ensuring a clear grasp of the coverage between the parties.

Indemnity in Business: Protecting More Than Just Finances

The rationale behind indemnifying a party is deeply rooted in the idea of protecting against unfair loss or damage. The parties have the autonomy to enter into the contract with clauses incorporated as per their mutual discussion and best interest of the corporation but to prevent inequitable clauses that the parties may decide to incorporate in the contract especially when the indemnifier has leverage over the indemnity holder, the clause of indemnity comes into play.

The indemnity clause delineates the events that shall be indemnified in case of damage, if any. These events have occurred because of such factors or events that were in the control of the indemnity holder. Therefore, indemnity prevents undue burden on all the parties and holds the indemnity holder liable for the damages till the extent of events covered under the indemnity clause.

In transactions, indemnity clauses are particularly important. They often address risks and issues that may have arisen during or after the transaction. In definitive agreements Indemnity clauses are generally kept as a condition precedent, if any problem arises during pre- or post-closing of the transaction the indemnifier is under obligation to indemnify the indemnity holder to the extent that is mentioned in the specific agreement.

A well-drafted & structured indemnity clause, which specifies the events & factors that trigger this clause and the extent to which such damage or loss caused shall be covered, will ensure the adequate addressal of any potential risk and liabilities that may arise.

The Multifaceted Role of Guarantee

Section 126 ICA defines a ‘Guarantee’ as a contract involving three parties: the creditor, the principal debtor, and the surety. In this tripartite contract, surety promises to fulfil the obligations of the principal debtor in the event of a default, providing an additional layer of security for the creditor and ensures that the creditor’s interests are protected.

An interesting aspect of guarantee contracts is their validity even in cases when the principal debtor lacks the legal capacity to contract, provided that the surety is aware of this incapacity. The same was clarified and further explained in the landmark case of Kashiba Bin Narsapa Nikade vs Shripat Narshiv[1]  that if the principal debtor is a minor, the surety assumes the role of the principal debtor and becomes personally liable for the debt.

Additionally, the flexibility inherent in guarantee contracts allows the surety to tailor their commitment, whether guaranteeing the entire debt or a specified portion, which provides a mechanism for controlling risk. However, this also places an onus on the surety to fully comprehend the potential liabilities they are assuming, as their obligations can be extensive and coextensive with those of the principal debtor, subject to certain legal exceptions.

Exploring the Reach of Surety Obligations

In a guarantee contract, if the principal debtor fails to meet their obligations, the surety is responsible for covering that liability. But how extensive is this responsibility is a question of discussion.

As per Section128 of the ICA, a surety’s liability is generally co-extensive with that of the principal debt, the surety’s obligation mirrors the principal debtors i.e. if the principal debtor’s liability is reduced or extinguished, the surety’s liability will also be proportionally reduced or extinguished.

A surety can choose to limit their liability in specific ways. For instance, the surety may guarantee either the full debt up to a fixed sum or only a portion of the total debt. This flexibility allows the surety to manage their exposure and define the extent of their commitment.

Exonerating Sureties from Liability

Understanding how a surety can be released from its obligations is crucial in navigating a guarantee, a breakdown of the ways a surety can discharge its liability and the exceptions to keep in mind are mentioned below:

1.   Revocation of Guarantee

Before entering into the guarantee contract, the surety assesses all the risks and liabilities associated with the transaction, for which he is providing a continuing guarantee. However, ever after calculating and assessing all the risk factors and events associated with the transaction, there might be some unforeseen risk or events that may occur. In such cases, the surety can revoke his continuing guarantee, as per Section 130 of ICA, by giving notice to the creditor regarding the same. In case of the death of surety, his continuing guarantee shall be revoked concerning future transactions. However, his liability before death shall be discharged from his estate.

2. Discharge Due to Creditor’s Actions

Surety safeguards the interest of the creditor and is liable to fulfil the obligation of the principal debtor against the creditor but what if the actions undertaken by the creditor affects negatively the rights of surety, would the surety still be held responsible for fulfilling his liability?

In such events, if the creditor varies the terms of the guarantee contract without obtaining the surety’s consent if the creditor releases the principal debtor from their liability, or if the creditor agrees to a settlement or grants the principal debtor more time to fulfil the obligations without consulting the surety or if the creditor’s actions or omissions hinder the surety’s ability to enforce their rights then, in all the abovementioned events, the surety is no longer held liable.

3. Invalidation of the Guarantee Contract

A guaranteed contract can be invalidated when the foundational integrity of the contract is compromised. When the guarantee was established based on concealed information or fraudulent representations, it can be deemed invalid and may lead to the discharge of the surety’s liability. Additionally, if the contract pre-condition the involvement of a co-surety for the guarantee to be valid and such a co-surety does not participate, the guarantee may be invalidated.

Conclusion

A comprehensive understanding of indemnity and guarantees is essential for effective partnerships and mitigating any risks associated with it. Indemnity serves to protect against specific losses by ensuring that financial compensation is provided for damages, thus safeguarding parties from unforeseen financial impacts. Conversely, guarantees offer an additional layer of security by holding a surety accountable for the obligations and actions of a principal debtor. By exploring the various types of guarantees and the specific conditions under which a surety’s liability may be discharged, businesses can craft well-structured, equitable agreements. 

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[1]  Kashiba Bin Narsapa Nikade vs Shripat Narshiv (1895-1896) ILR Bom 466