What is the enforceability and practical utility of indemnity clauses in context of inward foreign investment, considering the regulatory constraints imposed by Indian foreign exchange laws.
Indemnity clauses play a critical role in cross-border investments, protecting investors against losses arising from breaches of warranties, covenants, or identified risks. These provisions create a contractual right to seek compensation — even before the loss is actually incurred — offering pre-emptive protection against liabilities beyond mere compensation. Without such clauses, investors must seek damages through courts or arbitration after suffering losses.
However, indemnity payments to foreign investors are subject to statutory thresholds under Rule 9(6) of the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules): (i) the indemnity amount cannot exceed 25% of the total consideration; and (ii) cannot exceed beyond 18 months from the date of payment of full consideration. Amounts exceeding these thresholds require prior Reserve Bank of India (RBI) approval. In this context, the RBI’s recent position on the payment of damages under arbitral awards merits attention.
RBI’s Stance on Payment of Damages
In NTT Docomo Inc. v. Tata Sons Limited, an award for damages was passed by an arbitral tribunal in London in favour of NTT Docomo Inc. (Docomo) directing Tata Sons Limited (Tata) to pay damages to Docomo as Tata had failed to perform its obligation under the shareholders’ agreement (SHA).
The SHA obligated Tata to find a buyer for the shares purchased by Docomo in Tata Teleservice Ltd. (TTSL) in the event that TTSL failed to achieve certain performance indicators at a price which was higher of: (i) the fair value of the shares as of 31 March 2014; or (ii) 50% of the price at which the shares were purchased by Docomo.
The tribunal found Tata breached its unqualified obligation, rejecting arguments of needing prior RBI approval due to alternative performance methods. Tata was thus liable for damages to Docomo. During enforcement, the RBI intervened, asserting its approval was required for any remittance. The Delhi High Court noted RBI viewed the remittance as disguised sale consideration, despite being characterized as damages.
The Delhi High Court rejected RBI’s contention, holding that RBI could not recharacterise the nature of the payment stated in the arbitral award, and that prior approval was not required for remitting damages under such an award.
Subsequently, in GPE (India) Ltd. & Ors. v. Twarit Consultancy Services Private Limited, an arbitral award granted GPE (India) Ltd. (GPE) damages after Twarit Consultancy Services Private Limited (Twarit) had failed to perform its contractual obligations under the share purchase agreements. The Madras High Court held the award to be enforceable as a decree of the court but made payment subject to the RBI’s prior approval.
The court cautioned that while evaluating the application for approval, the RBI should consider that the Indian company had represented and warranted the agreements’ validity and enforceability. It further observed that foreign exchange outflow concerns could be avoided if the awarded amount is not repatriated but instead retained or reinvested in India.
Twarit appealed to the Supreme Court, which issued notice to the RBI seeking its views on whether prior approval was required. RBI clarified that payments made pursuant to arbitral awards qualify as current account transactions and therefore do not require its prior approval. This view was upheld in the Supreme Court’s final judgement on the matter as it clarified that payments for damages are distinguished from capital account transactions involving equity instruments and therefore fall outside RBI’s regulatory ambit, establishing that there are no impediments in law to enforcement of the arbitral award.
The RBI’s revised stance suggests that indemnity-related payments made pursuant to arbitral awards could also be permitted without prior approval. However, a specific law will always prevail over general law in case of any conflict and since indemnities are subject to express thresholds under the NDI Rules, it is our view that any indemnity payments exceeding these limits would require prior RBI approval — even if enforced through arbitral awards.
Understanding the Basis for Distinction
Under Indian foreign exchange laws, current account transactions are permitted without prior approval from the RBI unless expressly restricted, whereas capital account transactions require prior RBI approval unless explicitly allowed. RBI classifies indemnity payments as capital account transactions, while treating damages awarded under arbitral proceedings as current account transactions.
India’s approach to current account transactions is consistent with its international commitments. As a International Monetary Fund (IMF) member India is bound by Article VIII of the IMF Articles of Agreement, which prohibits member countries from imposing restrictions on payments and transfers for current international transactions. Likewise, as a World Trade Organization (WTO) member and signatory to the General Agreement on Trade in Services (GATS), India is committed to avoiding restrictions on international transfers and payments for current account transactions.
The Balance of Payments Manual (BOP Manual) published by the IMF provides further support for this approach. It includes ‘payments of compensation’ as current account transactions, encompassing compulsory payments awarded by courts and out-of-court settlements including compensation for non-fulfilment of contracts.
While the RBI has not yet clarified the distinct treatment of indemnity payments and damages, considering the global positions described above, this differentiation likely stems from the distinction between the nature of indemnity and damages: (i) indemnity can be claimed even before an actual loss is suffered and without determination by court; and (ii) it encompasses payments wider than mere compensation as in the case of damages.
While the rationale behind the Indian government’s differential treatment of indemnity and damages is understandable, it is important to note that this approach diverges from the practice in developed markets such as the United States and the United Kingdom. These jurisdictions, operating with fully convertible currencies, generally do not impose exchange control restrictions on indemnity payments.
What is the Way Forward?
Considering RBI’s distinction between indemnity payments and damages, foreign investors must carefully assess whether to include indemnity clauses in transaction documents. If such clauses are excluded, the remaining covenants must be clearly articulated, and representations and warranties should be comprehensively drafted to enable recovery of losses as damages for breach.
Where this approach is adopted, the arbitration clause should expressly allow the prevailing party to recover arbitration and enforcement costs. The governing law and seat of arbitration should be chosen strategically to ensure enforceability in India.
