To Due Diligence or Not To: The Effect of Due Diligence on Indemnity Clauses
[Anisha is a student at Christ (Deemed to be University).]
The principle of 'caveat emptor' puts the duty on the buyer to assure themselves of the legality or favorability of a transaction before entering into it. A prudent buyer, in light of the same, would conduct its own due diligence on the business it is trying to acquire or invest into to check the business' financial status, the risks and liabilities associated with the business and whether the investment is worth the risk being taken by it. The law generally dictates that a buyer or investor must be made liable for any losses suffered henceforth in the business. The investor must conduct due diligence on the business before acquiring or investing in it. However, the law has seen a preeminent reversal in the case of indemnity clauses to the ongoing principle being completely disregarded. A contract of indemnity is defined under Section 124 of the Indian Contract Act 1872 as ‘a contract by which one party promises to save the other from loss caused to him by the contract of the promisor himself, or by the conduct of any other person’.
Caveat Emptor Regarded
The principle of due diligence was recently discussed in the case of Anuj Jain v. Axis Bank, wherein the court noted that due diligence is a necessary exercise to ascertain the viability of a proposal and that the onus falls on the financial institutions to examine whether the security provided by an enterprise is adequate and genuine.
Furthermore, the Supreme Court of India in the cases of Nirma Industries Limited v. SEBI and Pramod Jain v. SEBI, in line with the principle of caveat emptor, denied the applicant’s requests to withdraw the public offers made by them for acquiring shares in their respective target companies in light of new information which considerably reduced the value of the transaction. The court blamed the parties’ lack of due diligence and the omission on their part to take due precautions before entering into a business transaction for the economic losses suffered by them. It was opined to be a fair assumption that the applicants had been given a fair opportunity to conduct their due diligence, only pursuant to which had they agreed to invest into their respective target companies, and so they could not be allowed to back out of their decisions when the transaction did not culminate as expected.
Caveat Emptor Disregarded
Courts in India have been known to defend the sanctity of indemnity clauses in contracts to the extent of completely disregarding the principle of caveat emptor by abstaining from acknowledging the due diligence conducted by the buyers as material evidence against the enforceability of the indemnity clause. Courts have based their decisions at the behest of Section 14(b) of the Sale of Goods Act 1930, which guarantees an implied warranty of quiet possession not disturbed by claims of alleged knowledge and the sanctity of the agreement entered into voluntarily by the parties, as can be observed in the judgments discussed hereinafter.
The Bombay High Court, in the judgment of Adai Mehra Productions v. Sumeet Mehra, witnessed the counsel for the appellants arguing, relying upon Section 14 of the Sale of Goods Act, 1930, that as per clause (b) of the provision, the implied warranty by a seller to a buyer with regards to the buyer having the right to enjoy quiet possession of the goods is absolute in nature and the seller cannot abstain from its obligations on the grounds of alleged knowledge of the buyer. The court upheld the absolute nature of the implied warranty, which falls contrary to the principle of caveat emptor, as even if the buyer had knowledge of any defect, the same does not absolve the seller from making good on its representation, failure of which would make it liable to compensate for the breach.
Industry experts have not refuted the significance of due diligence; rather, they believe that an indemnity clause acts as an additional safety mechanism for a buyer after irregularities crop up in a due diligence examination. The clause assures the buyers a straight-jacket, hassle-free claim mechanism in the occurrence of a specified event which directly results in the seller’s liability regardless of the other factors involved.
As per Indian law, there lies a statutory guarantee for a good title that exists unless the same is expressly excluded by way of a contract. The knowledge of the purchaser in no way affects the right to be indemnified. The exception to this lies when a buyer is known to deliberately purchase a property whose defective title it was aware of before entering into the contract and had only entered with the intention to claim the resultant damages, as was held in the case of Bhagyathammal v. Dhanabagyathammal. The ambit of 'knowledge' when it relates to indemnity clauses is a highly negotiated term keeping in mind the transaction documents, independent investigation clauses and other provisions that have the ability to affect the indemnity clause and the resultant liability on the seller.
Another judgment that tilts heavily in favour of the supremacy of the indemnity clause is the judgment of the Bombay High Court in the case of GWL Properties Limited v. James Mackintosh & Co. Private Limited. The case dealt with an agreement entered into between two parties which consisted of the following indemnity clause produced verbatim:
“Any Representations and Warranties herein or Representations and/or Warranties contained in any certificate or writing of either Party shall be deemed to be material and to have been relied upon by the other Party, notwithstanding any investigation, due diligence or inspection made by or on behalf of such Party with respect to the other Party’s or his/its/their business, and shall not be affected in any respect by any such investigation, due diligence or inspection.” (Emphasis Supplied)
The respondents alleged that the petitioners had suppressed documents and claimed indemnity for the same. The petitioners argued that the respondents had conducted due diligence before entering into the transaction, and the documents had in no way been actively suppressed by them and would have indisputably been discovered in the course of due diligence.
The arbitral tribunal, finding in favour of the respondents, reasoned that a clause to the effect of indemnity not being affected by any due diligence conducted by the respondents had already been assented to by both parties. Hence, the agreement would prevail over any previous documents, correspondence or information. If a representation had been made, irrespective of the party’s due diligence, the onus falls on the seller to ensure its accuracy.
The court opined that, based on the contract, there was a fair understanding that the respondents had entered into the transaction based on the warranties and representations made by the petitioners. Therefore, the due diligence conducted by the respondents could in no way nullify their claim to indemnity.
The aforementioned judgments confirm that any prior disclosures or due diligence conducted by parties do in no way take away the binding effect of the indemnity, guarantee, surety or warranty clauses, and a party is under no obligation to conduct any due diligence, as is prudently preferred, in the existence of such clauses.
The principle of 'caveat emptor' places a duty on the investor to ensure the soundness and evaluate benefits accruing from the transaction they wish to enter into, but with the surge in the inclusion of indemnity clauses in contracts with the onus falling on the seller to ensure the soundness of the offer made by them, the principle of 'caveat venditor' has gradually assumed a more dominant role. Buyers are attempting to iron-clad themselves against any form of irregularity in the transaction that has the potential to harm their stakes. Recent trends indicate a surge in buyers relying on representations and warranties insurance to shield their interests even though the insurance is not capable of providing a blanket protection. This is in furtherance of indemnity clauses already incorporated in the contract that put an investor/buyer in a position of advantage against the seller. The only check on this advantage currently available as per the Indian law is to inspect whether the contract had been entered into for the sole advantage of abusing the indemnity clause.
In ruling in favour of the indemnity clause diluting the effect of due diligence, courts have acknowledged the sanctity of the agreement entered into between the parties. However, at the same time, there is an essence of inequality in the negotiating power of the parties in such clauses, which warrants a transition in the treatment of such dilemmas by courts in the near future.