The interplay between a claim for damages and a contract of indemnity has been the subject of judicial scrutiny since the introduction of these concepts under the Indian Contract Act, 1872 (Contract Act). In this article, we analyse the distinction between the scope of losses covered under these two concepts in light of judicial precedent, and highlight the continuing divergence between the jurisprudence developed by courts and prevailing market practice in India.
We also examine the commercial rationale underlying the market practice for coverage, or rather exclusion, of indirect and consequential losses from indemnity protection, and identify factors that may influence how indemnity clauses are negotiated in transaction documents going forward.
At the outset, it is important to distinguish between the purpose of a claim for damages and that of a contract of indemnity. The primary purpose of damages is to compensate an aggrieved party for loss caused by a breach of contract. Where one party fails to perform its contractual obligations, the other party may claim monetary compensation for the loss or injury suffered as a result of that breach. In the case of damages, compensation ordinarily arises after loss has been suffered. The objective is to place the injured party, so far as money can do so, in the position it would have occupied had the contract been duly performed.
In contrast, a contract of indemnity is protective in nature. It is intended to protect one party against specified losses, whether arising from the acts of the promisor or, where so agreed, a third party. In certain circumstances, an indemnified party may seek relief once liability has accrued and become absolute, even if actual payment has not yet been made. The essential purpose of an indemnity, therefore, is to allocate risk and insulate the indemnified party against the financial consequences of defined events or claims.
Scope of losses – Contract for Damages vis-à-vis Contract of Indemnity
Under the Contract Act, damages are generally available in respect of losses that arise naturally in the usual course from the breach, or which the parties knew, at the time of contracting, were likely to result from such breach. Compensation is therefore typically confined to:
- actual losses or injuries suffered by the aggrieved party due to the breach;
- losses that are a natural and probable consequence of the breach, that the parties could reasonably foresee at the time of entering into the contract; and
- in some cases, consequential losses may be covered if they were within the contemplation of both parties when the contract was made.
Accordingly, damages must be reasonable and not remote. Losses that are too remote or indirect are generally not recoverable. Further, a claim for damages is ordinarily accompanied by the duty to mitigate loss, which requires the claimant to take reasonable steps to reduce or contain the loss suffered.
A contract of indemnity, on the other hand, is broader in scope. It covers losses that may arise from:
- any specified event or act, including those caused by the conduct of the promisor or a third party;
- losses that may not necessarily result from a breach of contract, but from other circumstances as defined in the indemnity agreement; and
- both direct and indirect losses, provided they fall within the terms of the indemnity.
The indemnified party is protected against all losses specified in the contract, regardless of whether they are immediate or consequential, as long as they are within the scope of the indemnity. Further, Section 124 of the Contract Act does not specifically provide for a duty of the claimant to mitigate the loss, unless such obligation is specifically imposed under the contract.
Judicial Position
The judicial precedents have time and again confirmed the distinction between the concepts of “damages” and “indemnity” and have opined the inclusion of indirect and consequential losses within the ambit of a contract of indemnity.
The Bombay High Court in “Gajanan Moreshwar Parelkar v. Moreshwar Madan Mantri” while interpreting indemnity provisions clearly held that the Contract Act is not exhaustive and common law principles are to be relied upon.
For instance, in the case of “A. Krishnaswami Aiyar v. Tatha Raghaviah Chetty And Another“, the Hon’ble Madras High Court differentiated between ‘damages’ under Section 73 and ‘indemnity’ under Section 124 of the Contract Act, and observed that a contract of indemnity is a code by itself; consequently, parties are free to choose the extent and nature of losses, which would be the subject matter of the contract.
Further, the Delhi High Court in the case of “IFFCO Tokio General Insurance Co. Ltd. Vs. Indo Rama Synthetics Ltd.” upheld payment of consequential losses which has a reasonable nexus to the business interruption causing the loss.
The common law courts adopting a similar approach have further propounded the concept of indemnity. In the case of “Total Transport Corporation v. Arcadia Petroleum Limited“, the courts held that ‘indemnity’ may refer to all loss suffered which is attributable to a specified cause, whether or not it was in the reasonable contemplation of the parties.
Market practice in India
Although the legal distinction between damages and indemnity is reasonably clear, market practice in India has generally favoured the exclusion of consequential and indirect losses from indemnity clauses.
Some of the commercial rationale for such exclusions can be:
Unpredictability and uncertainty:
Indirect or consequential losses are, by their nature, less predictable and more difficult to quantify than direct losses. These losses may include lost profits, loss of business opportunities, reputational harm, or other damages that do not flow directly and immediately from the event giving rise to the indemnity.
Avoidance of disproportionate liability:
Including indirect losses in an indemnity clause can result in liability that is disproportionate to the value of the contract, or the consideration received. For example, a relatively minor breach or event could, in theory, trigger claims for substantial consequential losses, such as lost profits over several years. This potential for disproportionate liability can deter parties from entering into contracts or lead to increased costs as parties seek to hedge against such risks.
Clarity and reduction of disputes:
The concepts of “indirect” or “consequential” losses are often subject to interpretation and can lead to disputes over the scope of indemnity. By expressly excluding such losses, parties can reduce ambiguity and the likelihood of protracted legal battles over whether a particular loss is covered by the indemnity. This clarity benefits both parties by setting clear expectations and reducing the risk of litigation.
Conclusion
While practical and commercial considerations continue to drive the exclusion of consequential and indirect losses from indemnity clauses in Indian transaction documents, such exclusion is not mandated as a matter of law.
Indeed, in recent years, parties have shown greater flexibility in negotiating indemnity clauses that extend to certain indirect or consequential losses, often by prescribing contractual mechanisms for identifying, measuring, or capping such losses. These drafting solutions can reduce uncertainty and limit disputes while preserving the risk-allocation function of an indemnity.
Hence, there may be a case for re-visiting the way indemnity clauses have to be negotiated for transaction documents and not to paint the clauses related to indemnity and damages with the same brush, since the principles for the same are at a different footing.
(Views are personal)
