Associate, GameChanger Law Advisors
An indemnity clause is a standard provision in a contract. By definition, Section 124 of the Indian Contract Act, 1872 (“ICA”), defines a ‘contract of indemnity’ whereby one party (“Indemnifying Party”) of the contract promises to save the other party (“Indemnified Party”) from any loss or damage caused to the Indemnified Party, owing to any conduct of the Indemnifying Party.
Essentially, an indemnity clause protects the Indemnified Party from any harm, loss or damage that may be caused by the Indemnifying Party to the contract, which may occur due to instances such as fraud, misrepresentation or breach of the provisions of the contract. In such instances, the Indemnifying Party is liable to indemnify or compensate the Indemnified Party to limit the impact of the breach on such party. The idea is to put the Indemnified Party in a position that they would have been in, had the breach not occured.
However, in most instances, especially in commercial contracts, an indemnity clause is structured in such a way wherein the Indemnifying Party not only agrees to indemnify the Indemnified Party, but also other third-parties who are not privy to the contract. Such parties often include officers, employees, and directors if it is the case of a company, and also affiliates, agents, representatives, sub-contractors and so on, depending on the nature of the contract.
You may be wondering – if such third-parties are not privy to the contract, then are they entitled to claim indemnity from the Indemnifying Party? Let’s look at an example. Two companies enter into a software development agreement, where Company A is appointed to develop a specific software that is customized to the business of Company B. Company B relied on the representations provided by Company A, and subsequently entered into the agreement. However, Company A made false representations about their business, and never ended up developing the software in accordance with the agreement; and owing to this, Company B faces a huge loss, and its directors and employees are adversely impacted by this. Now, in this case, is it possible for the directors and employees, who are not privy to the contract, to claim indemnity for all the loss that they faced, as a result of misrepresentation by Company A?
This explainer note seeks to analyse this exact question. This note first explains the common law doctrine of privity, and then answers the question on whether third-parties can claim indemnity from a contract that they are not privy to.
(1) The Doctrine of Privity of Contract– No Third-Parties Allowed
To understand the issue in more detail, we need to first understand the core of the problem at hand, which stems from the doctrine of privity of contract. Back in 1861, the Court in the case of Tweddle v. Atkinson, held that a third-party cannot sue upon a contract made between others, even though it was made for their benefit.
In India, the Courts have adopted a similar view. The Supreme Court in M.C Chacko v. State Bank of Travancore, stated that no right can be enforced by a person who is not a party to a contract. The Punjab and Haryana High Court in L. Shiv Dayal Kapoor and Others v. Union of India, New Delhi and Another, held that the term ‘privity’ implies a mutuality of will and is considered to be an interaction between the parties. No one but the parties to a contract can be bound by it.
The role of ‘consideration’: As provided for in Section 10 of the ICA, one essential element for a contract to be considered lawful, is consideration. With this prerequisite, it can be argued that since third-parties are not providing consideration (of any kind) with respect to the contract, they cannot be considered as a party to the contract – irrespective of whether the contract is for their benefit.
Thus, as a general rule, the following are the different aspects of doctrine of privity of contracts:
- People cannot enforce rights under a contract to which they are not a party to;
- People who are not party to a contract, cannot have contractual liabilities imposed on them; and
- Contractual remedies are designed to compensate only parties to the contract, and not third parties.
(2) The Exception: When can Third-Parties claim Indemnity?
The Stance in United Kingdom:
In United Kingdom, the stance is straightforward. The Contracts (Rights of Third Parties) Act, 1999 (“CRTPA”), allows a third-party to enforce the provisions of a contract, under the following circumstances:
- The third-party has to be expressly identified in the contract by name, as a member of a class, or description; and
- That provisions must confer a benefit to the third-party.
In light of this, the Court in Chudley v. Clydesdale Bank, held that for the purposes of the CRTPA, it is not necessary that the third-party should have had knowledge of the contract at the time that it was executed, as knowledge of the contract is not a prerequisite under the CRTPA.
Conduct, Acknowledgement or Admission – The Exception in India:
Unlike in United Kingdom, there is no law that explicitly provides for this in India. While the doctrine of privity of contract is well established, the Indian judiciary has carved out certain exceptions to the same. Some of these exceptions include:
1. Trust: Pursuant to Section 56 of the Indian Trusts Act, 1882, and as highlighted in the case of Babu Ram Budhu Mal and Ors. v. Dhan Singh Bishan Singh and Ors., if a contract creates a trust in favour of a third-party beneficiary, then the beneficiary is entitled to enforce it.
2. Family arrangement: The Andhra High Court in Gomi Bai and Ors. v. Uma Rastogi and Anr., reiterated that in the case of a contract for a family settlement or maintenance, and where the intent of the contract is to benefit a third-party, then similarly, the third-party can enforce the contract.
Another such exception was laid down by the Calcutta High Court in Smt. Narayani Devi v. Tagore Commercial Corporation Ltd. and in Jnan Chandra Mukherjee v. Manoranjan Mitra and Ors. The Court held that the parties to the contract can create privity with a third-party, by way of their conduct, acknowledgement and admission, or otherwise if the party constitutes itself as an agent of the third-party. With this approach, if an indemnity provision makes reference to third parties, as mentioned above, then such third-parties may claim indemnity in the event that they face a loss or damage as a result of a breach by the Indemnifying Party.
In the case of N. Devrajr and Ors. v. M. Ramakrishniah, the Court laid down that when a party to a contract is made aware about the relationship of the other party with a third-party, and is aware of the participation of and corresponds with the third-party, then there can be said to be a privity to the contract by virtue of conduct, acknowledgement and admissions. Further to this, as the Delhi High Court in Utair Aviation v. Jagson Airlines Limited and Ors. rightly observed, determining what would constitute as ‘conduct, acknowledgement and admission’ would depend on the circumstances of each case and the relationship between the parties.
While the ICA limits claiming indemnity and compensation in the event of a breach to the parties of the contract, these are not exhaustive provisions.
For example, an indemnity clause in a share purchase agreement is generally structured in a broader way, in order to protect the interests of the investor. Often, not only do sellers agree to indemnify the investors, but also their successors, affiliates, partners, directors, officers, employees, agents and representatives and so on. This provides another layer of assurance and safety to the investors and their team. When such language regarding third-party claim to indemnity is incorporated in the share purchase agreement, it can be reasonably inferred that by the seller’s acknowledgement and conduct, such third-parties will be entitled to claim indemnity from the seller, in the event of a breach which has resulted in loss or damage.
The Indian judiciary has taken a flexible stance on this matter, as opposed to strictly adopting the doctrine of privity of contract, by allowing third-parties to claim indemnity from a contract that they are not privy to. This would include instances where third-parties are directly and adversely impacted by a breach of the contract by the Indemnifying Party, and would ensure that their rights and interests are also protected.
The Author would like to thank Amrut Joshi (Founder Partner, GameChanger Law Advisors), Mahit Anand (Senior Associate, GameChanger Law Advisors), Saket Rachakonda (Senior Associate, GameChanger Law Advisors) and Wilfred Synrem (Associate, GameChanger Law Advisors) for their inputs.
Disclaimer: This post has been prepared for informational purposes only. The information / or observations contained in this post does not constitute legal advice and should not be acted upon in any specific situation without seeking proper legal advice from a practicing attorney.
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