In Brief - Legal Analysis of Damages, Indemnity, and Limitation of Liability
Abstract
This article provides a practicaland easy-to-understand analysisof three key contractualclauses: damages, indemnity,and limitation of liability. Itexplains how each clausefunctions in the context of acontractual breach, highlightingtheir differences and legalimplications under Indian law.Using relatable examples, thearticle clarifies when damagescan be claimed, how indemnityprotects against specific third-party claims, and howlimitation of liability capsfinancial exposure.
INTRODUCTION:
If you’ve ever perused a commercial contract, chances are you’ve come across three confusing clauses – Damages,Indemnity and Limitation of Liability. At first glance these clauses may seem the same, serving the same purposeto remedy a breach of contract and this is where the confusion may arise.
So, what is the difference and what ties them together? These clauses pertain to remedies available in the eventof a contractual breach, but each provides a different form of remedy and how to limit ones exposure to potentialliability. Understanding how they differ is a curtail aspect to anyone involved in examining, drafting, negotiatingor simply reading any contract. Why? Because knowing when and how each applies can significantly impact risk allocation and legal outcomes.
Let’s break these down step by step-Before we dive into these clauses, it is important to note what constitutes a breach of contract, as these clausescomes into play only after a breach has occurred. A contract begins with a simple premise, when one party makesan offer to provide to another a product or service and the other accepts the offer, with or without consideration- this process forms an “Agreement” under the Indian Contract Act, 1872, and if the agreement is legallyenforceable it taking the form of a “Contract”. The offer initially made by the party becomes a “Promise”. Thispromise, if broken constitutes a breach. This is where the protective mechanisms of Damages and Indemnitycome into effect. The extent of protection available and the degree of liability placed on the promisor willdepend on the Limitation of Liability clause, which is tailored to each contract.
So, what is the difference and what ties them together? These clauses pertain to remedies available in the eventof a contractual breach, but each provides a different form of remedy and how to limit ones exposure to potentialliability. Understanding how they differ is a curtail aspect to anyone involved in examining, drafting, negotiatingor simply reading any contract. Why? Because knowing when and how each applies can significantly impact risk allocation and legal outcomes.
Let’s break these down step by step-Before we dive into these clauses, it is important to note what constitutes a breach of contract, as these clausescomes into play only after a breach has occurred. A contract begins with a simple premise, when one party makesan offer to provide to another a product or service and the other accepts the offer, with or without consideration- this process forms an “Agreement” under the Indian Contract Act, 1872, and if the agreement is legallyenforceable it taking the form of a “Contract”. The offer initially made by the party becomes a “Promise”. Thispromise, if broken constitutes a breach. This is where the protective mechanisms of Damages and Indemnitycome into effect. The extent of protection available and the degree of liability placed on the promisor willdepend on the Limitation of Liability clause, which is tailored to each contract.
1. DAMAGES:
Damages represent a form of compensation awarded by a court or by a tribunal for loss or injury caused to one party resulting from the breach of contractual duty from the other party. In the context of a contract, this duty is defined by the terms agreed upon by the parties.
Now that we understand the basic idea behind a clause relating to damages, there may occur confusion relating to the term “damage” and “damages”. While damage refers to the actual harm or loss suffered, damages are the compensation awarded by a court/tribunal for the harm or losses incurred.
A breach occurs when a party fails to perform one or more of the obligations imposed upon him by the contract. When a contract is breached, the party who suffers any loss or damage resulting from the breach is entitled to be compensated by the party responsible for the breach. However, Damages are awarded only to the extent of the loss that naturally arises from the breach, meaning those that are direct and foreseeable consequences of the breach; hence no damages are granted for remote or indirect losses sustained as a result of the breach. Moreover, the law places a duty on the plaintiff / the party claiming damages to act reasonably. This means A party cannot claim damages while remaining wilfully ignorant of the harm or failing to take reasonable steps to mitigate the damage. It is also pertinent to note that the extent of a breach and the entitlement to damages must be adjudicated by a court of law; they cannot be unilaterally decided by the parties.
Let’s understand this better with an example: A purchases a wholesale order of 50 mobile phones from B who is a manufacturer through a purchase agreement. Upon inspection after delivery, A notices that 5 of the mobile phone boxes are ruptured, which has allowed water to seep in and damaged the phones. As per the damages clause in the purchase agreement, A is entitled to receive compensation equivalent to the value of the 5 damaged phones. The amount A can claim from B should be equal to the amount A paid to B and not what A would’ve received from retail sale.
Now that we understand the basic idea behind a clause relating to damages, there may occur confusion relating to the term “damage” and “damages”. While damage refers to the actual harm or loss suffered, damages are the compensation awarded by a court/tribunal for the harm or losses incurred.
A breach occurs when a party fails to perform one or more of the obligations imposed upon him by the contract. When a contract is breached, the party who suffers any loss or damage resulting from the breach is entitled to be compensated by the party responsible for the breach. However, Damages are awarded only to the extent of the loss that naturally arises from the breach, meaning those that are direct and foreseeable consequences of the breach; hence no damages are granted for remote or indirect losses sustained as a result of the breach. Moreover, the law places a duty on the plaintiff / the party claiming damages to act reasonably. This means A party cannot claim damages while remaining wilfully ignorant of the harm or failing to take reasonable steps to mitigate the damage. It is also pertinent to note that the extent of a breach and the entitlement to damages must be adjudicated by a court of law; they cannot be unilaterally decided by the parties.
Let’s understand this better with an example: A purchases a wholesale order of 50 mobile phones from B who is a manufacturer through a purchase agreement. Upon inspection after delivery, A notices that 5 of the mobile phone boxes are ruptured, which has allowed water to seep in and damaged the phones. As per the damages clause in the purchase agreement, A is entitled to receive compensation equivalent to the value of the 5 damaged phones. The amount A can claim from B should be equal to the amount A paid to B and not what A would’ve received from retail sale.
2. INDEMNITY:
At the outset, it’s essential to distinguish between damages and indemnity, as they are fundamentally different concepts. While damages compensate for a breach after it occurs, indemnity acts as a protective assurance-ensuring that a party will be covered from any losses they may incur, due to the actions of the promisor that give rising to a third arty claim.
But how does this clause operate in practice? In practical terms, an indemnity clause shifts the financial risk from one party to another. Where the indemnifier (the person giving the indemnity) promises to cover specific losses or liability an indemnified party may incur due to the actions of the indemnifier. Must the indemnified party wait until a loss is actually incurred before seeking relief? Indian courts have clarified this question by stating that a party may invoke a right to indemnity even before suffering an actual loss, as long as the loss is certain or imminent. This reinforces the preventive and risk shielding nature of indemnity clauses in contracts.
Damages are claimed by a party to a contract who suffers a loss due to the default/breach of contract by the other party. In contrast, indemnity is itself a contract or a clause that
provides protection against potential losses, which may arise due to the actions of parties to a contract affecting a third party. These losses may not necessarily result from a breach of contract and may occur under a contract of indemnity between the promisor and the indemnity holder. A right to indemnity is given by the original contract where as a right
to damages arises in consequence of a breach.
Let’s understand the concept of indemnity better through an example:
After receiving the delivery of mobile phones from B, A sells them in his retail store. One of the phones is purchased by C, who begins using it. However, one day, the phone’s battery explodes in C’s pocket, causing serious burns and requiring medical treatment. As a result, C files a lawsuit against A, alleging that he sold a defective product and claiming compensation for his injuries. In response, A invokes the indemnity clause in his purchase agreement with B and seeks to recover the amount from B, holding B responsible for the defect and the resulting damages thereby
protecting A from any loss that is attributable to B.
3. LIMITATION OF LIABILITY:
The Limitation of Liability clause is a standard provision of most commercial contracts. This clause functions as a
prospective measure by placing a cap on the amount one
party may be held liable for, whether this liability is due to damages or due to indemnity.
Although The Indian Contract, Act, 1872 does not
explicitly refer to “Limitation of Liability”, its principles are reflected in section 74 of the act, where it addresses situations where a contract specifies a sum payable upon breach or includes terms resembling a penalty. When such a clause exists, the
aggrieved party is entitled to a reasonable ompensation, not exceeding the amount stipulated under this clause as agreed between the parties to a contract.
For this cap to be enforced, the specified amount of
liability must be fixed estimating a genuine, preestimated or reasonable amount. It is ultimately for
the courts to ascertain whether the sum is fair and
proportional during claim settlement. In essence, both
damages and indemnity claims are subject to the financial ceiling established by the limitation of liability clause.
Let’s understand the concept of limitation of liability
with reference to the previous examples on damages
and indemnity:
In both cases-whether A claims damages for the 5 water-damaged mobile phones or seeks indemnity from B after being sued by C for the defective mobile phone; B’s responsibility to compensate A is restricted by the imitation of liability clause in the purchase agreement. The clause sets a cap on the
maximum amount B is required to pay, regardless of
the extent of the loss or damages suffered by A.
Therefore, even if A’s actual losses exceed this
amount, B is only obligated to pay up to the specified
limit. This provision protects B from unlimited
financial exposure and ensures that liability remains within a pre-agreed, manageable range.
CONCLUSION
A clause for Damages offers a remedy in the form of a compensation for loss arising out of breach of contract, while the Indemnity clause acts as a shield against liability, requiring the indemnifier to cover specific losses incurred by the indemnified party. Both these provisions
are intrinsically linked by the Limitation of Liability clause, which sets the
maximum extent of financial liability that a party may bear under the contract.
Together, these clauses define the risk
landscape of a contract, hence should be
carefully analysed.