Indemnity Clause in a Share Subscription Agreement: A Comprehensive Guide

Introduction

Under Section 124 of the Indian Contracts Act, 1872, indemnity is defined as a contract where one party (the “Indemnifying Party“) agrees to compensate another party (the “Indemnified Party“) for any loss incurred due to the actions of the indemnifying party or the conduct of any other person.

In the context of a Share Subscription Agreement (“SSA”), the indemnity clause serves as a critical risk allocation mechanism that protects one party, typically the investor, from financial losses or liabilities arising from various events such as contractual breaches, third-party claims, misrepresentations, fraud, regulatory non-compliance, tax liabilities, intellectual property issues, or post-closing liabilities.

Understanding Indemnity in Relation to Damages and Specific Relief

Indemnity: Designed to protect the Indemnified Party from financial losses due to specific issues like contract breaches or third-party claims. When a loss occurs, the Indemnified Party can claim compensation from the Warrantors, who must either accept or dispute the claim within a specified timeframe.

Damages: Monetary compensation awarded to a party who has suffered loss or injury due to another party’s wrongful act or breach of contract. The primary purpose is to restore the injured party to the position they would have been in had the breach not occurred.

Specific Relief: Involves remedies that compel a party to perform or refrain from performing a specific act, such as enforcing the performance of an agreement, rather than providing monetary compensation.

Key Distinction: While indemnity covers a broader scope including third-party claims and indirect losses, damages typically address direct losses caused by contract breaches. Specific relief, unlike both indemnity and damages, is non-monetary and demands performance according to contractual terms.

Framework for Drafting or Reviewing an Indemnity Clause

When drafting or reviewing an indemnity clause in an SSA, it’s essential to approach it using a structured framework comprising three key components: What, When, and How.

What is Definition of Loss

The definition of “loss” is paramount as it outlines the scope of indemnification obligations. A comprehensive definition prevents future disputes regarding covered losses.

Investor’s Perspective:

• Prefer a broad definition covering all losses or liabilities arising from breaches of representations and warranties
• Include both financial losses (e.g., reduction in share value) and non-financial losses (reputational damage, legal expenses)
• Encompass direct, indirect, and consequential damages

Company’s Perspective:

• Seek to exclude certain types of losses such as consequential or punitive damages
• Consider excluding losses arising from force majeure events or regulatory changes
• Limit indemnity to losses that directly relate to the company’s core obligations

Practical Tips:

1. Temporal Limitation: When representing the Indemnifying Party (typically the company or promoters), include the phrase “on and from the Closing Date” in the indemnity clause. This important qualifier limits the indemnification obligation to losses that occur before the transaction closes, protecting the Indemnifying Party from historical liabilities that precede their involvement.
2. Expanding Liability: When representing the Indemnified Party (typically investors), explicitly include language stating that “the Indemnifying Parties agree to jointly and severally indemnify, defend and hold harmless the Indemnified Party and its affiliates.” This joint and several liability provisions ensures that each Indemnifying Party is fully responsible for the entire indemnification obligation, giving the Indemnified Party multiple sources of recovery and strengthening their protection.

When: Triggering the Indemnity Obligation

The “when” component specifies the events that activate the indemnity obligation.

Investor’s Perspective:

• Indemnity should be triggered by any breach or inaccuracy of representations and warranties, non-compliance with applicable laws, failure to perform obligations under the transaction documents (which includes the Shareholders Agreement, SSA, or SPA), actions arising from the company or promoters’ acts/omissions, and any fraud, gross negligence, or wilful misconduct by the promoters.

Company’s Perspective:

• Materiality Threshold: Limit indemnification to material breaches only.
• Minor or technical breaches should not trigger indemnity unless they result in significant losses.

How: The Procedure for Indemnity Claims

This component addresses the procedural aspects of initiating and handling indemnity claims, ensuring clarity and minimizing disputes.

The indemnity clause is designed to protect the Indemnified Party from financial losses arising due to specific issues, such as breaches of contract or third-party claims. Under this clause, if the Indemnified Party suffers a loss, they can claim compensation from the Indemnifying Party. The Indemnifying Party must either accept or dispute the claim within a specified time frame. If the claim is accepted, the Indemnifying Party are obligated to cover the loss. In situations involving third parties, the Indemnifying Party have the option to assume control of the defense but are still responsible for covering the associated costs. Essentially, this indemnity clause ensures that the Indemnified Party is not financially burdened by losses resulting from these specified issues.

Note: If the Indemnified Party chooses to control the defence when the Indemnifying Party has elected to defend them, they should not be indemnified for those costs by the Indemnifying Party.

Key Protective Mechanisms in Indemnity Clauses

Mechanism	Investor Perspective	Company/Promoter Perspective
Limitation/Cap	No Limitation or Cap: Investors typically demand no cap on indemnity to ensure full recovery of losses.	Limitation: The company should restrict indemnity claims to the amount invested by the Indemnified Party.
Minimum Threshold	No De Minimis: Investors prefer no minimum threshold for claims.	De Minimis: Sets a minimum limit for claims to avoid dealing with small or insignificant issues.
Grossed-up Indemnity	Normal Gross Up: X = (Y × (Z/(1-Z))) where Y = Loss and Z = Shareholding in decimal Tax Gross-Up: Tax Gross-Up refers to the additional amount an indemnifying party must pay to cover any taxes that may be deducted from the indemnity payment. If the indemnified party is subject to tax on the indemnity amount, the indemnifying party must pay an extra amount to ensure that after tax, the indemnified party still receives the full amount they are entitled to. Example: If a party is entitled to ₹100 but has to pay taxes of 20%, the indemnifying party must pay ₹125 so that the indemnified party receives ₹100 after taxes. The additional ₹25 compensates for the tax deduction.	Avoid gross-up provisions that inflate indemnity amounts.
Liability Structure	Joint & Several Liability: All Indemnifying Parties are fully responsible.	Waterfall Structure: Company indemnifies first; promoters/founders only liable if company cannot fulfill obligations.
Personal Assets	Include personal assets of founders/promoters.	No Personal Asset: Founders may seek to exclude their personal assets from indemnity claims.
Basket Threshold	Low or no basket threshold.	Implement a basket threshold where indemnity only triggers once claims exceed a certain aggregate amount.

Conclusion

The indemnity clause in a Share Subscription Agreement is a crucial risk allocation mechanism that requires careful drafting to balance the interests of all parties involved. By systematically addressing the What, When, and How components, legal practitioners can create robust indemnity provisions that provide clarity and protection while minimizing the potential for disputes.