In the realm of commercial contracting, the allocation of financial risk between parties is a defining feature of the contractual relationship. Clauses addressing compensation, such as indemnities, general damages for breach, and liquidated damages are often discussed together, yet they differ fundamentally in both nature and legal effect. Given these distinctions, clarity and precision in drafting are essential to ensure that the parties’ intentions are accurately reflected and legally enforceable.
In the context of a share purchase agreement (“SPA”), it is common for the purchaser to seek extensive warranties from the seller in relation to the business and affairs of the target company. These warranties serve as assurances that the target company’s financial records, assets, liabilities, contracts, regulatory compliance, and other material matters are accurate and in proper order, unless otherwise disclosed. Such provisions enable the purchaser to rely on the seller’s representations and provide a basis for recourse in the event of a breach.
By contrast, in a service agreement, the service provider undertakes a series of contractual obligations, the proper performance of which is critical to the fulfilment of the agreement. Here, the focus shifts from representations about the past or present state of affairs to undertakings concerning future performance and delivery of services.
Despite their differing contexts, both warranties in an SPA and covenants in a service agreement serve a common commercial and legal function, i.e., they enable the relying party to place trust and reliance on what has been represented or promised, thereby forming the foundation of contractual fairness and commercial predictability.
Nevertheless, even where extensive warranties or covenants are in place, a purchaser or paymaster will often raise a key question: what remedies are available if the seller or service provider breaches its obligations, and why is an indemnity clause necessary when the purchaser is already entitled to damages at common law for such a breach? While both damages and indemnities aim to make the purchaser or paymaster whole in the event of a breach or default, they operate on fundamentally different legal principles and afford distinct forms of protections.
Remedies for Breach: Damages and Obligation to Compensate
When a representation or warranty clause under an SPA, or a general obligation or liability clause under a service agreement is breached, Section 74 of the Contracts Act 1950[1] clearly provides that the purchaser or paymaster is entitled to claim losses or damages from the defaulting party. The right to damages arises as a legal consequence of the breach and does not stem from any specific contractual provision.[2]
In essence, damages serve as compensation to the aggrieved party for the loss, harm or injury suffered as a result of the breach and are distinct from the obligations originally stipulated in the contract. In assessing the damages arising from a breach, the court will consider external factors and apply the principles established in Hadley v Baxendale, which focus on both foreseeability and reasonableness.
Only those damages that could reasonably have been contemplated by the parties at the time the contract was formed as likely to result from a breach are recoverable. In other words, the aggrieved party may recover only losses as naturally arise from the breach or were within the reasonable contemplation of the parties at the time of contracting as a probable consequence of the breach.[3] The precise measure of damages depends on the context of the contract, the nature of the breach and the evidence presented, with the court exercising its judgement to ensure that the award is fair and proportionate to the actual loss suffered.
Indemnities as a Risk Allocation Tool
In contrast to damages, an indemnity is generally more direct and comprehensive, providing the indemnified party with greater certainty and protection against specified risks. It represents a contractual promise by one party (for example, the seller or service provider) to compensate the other (the purchaser or client) for losses arising from defined events, such as a breach of warranty, misrepresentation, or failure to perform. Unlike damages, which arise as a legal consequence of a breach, an indemnity operates as a proactive contractual commitment that enables the indemnified party to recover losses without having to prove foreseeability in the same manner as required for damages.
The right to indemnity is contractual in nature and arises from the terms of the indemnity clause.[1] The indemnifier’s obligation is triggered by the occurrence of a specified event or loss falling within the scope of the indemnity, rather than by a breach of contract. For instance, in a share sale transaction, if the seller undertakes to indemnify the purchaser against undisclosed tax liabilities and the tax authorities subsequently issue a demand against the target company, the purchaser may recover the amount directly from the seller. This principle is recognised under Section 77 of the Contracts Act 1950, which permits recovery once the indemnified loss has arisen.[2]
Indemnities are therefore a powerful risk allocation tool, as they shift the financial consequences of specific risks entirely to the indemnifying party. However, they must be drafted with precision, as courts generally interpret indemnity provisions strictly in accordance with their wording. In practice, indemnity clauses are often employed to address clearly identifiable and high-risk exposures, or to cover losses that are difficult to quantify, such as tax liabilities, intellectual property infringements, or regulatory compliance breaches. By doing so, they provide the indemnified party with greater certainty and protection against potentially significant financial consequences.
Having considered how indemnities and damages for breach of contract function to allocate risk and protect parties in commercial agreements, it is equally important to understand how indemnities and liquidated damages operate within the broader framework of contractual remedies. While both mechanisms share the common objective of securing financial recovery, they achieve this through different means and under distinct legal principles.
Liquidated Damages and Contractual Certainty
In commercial contracts, liquidated damages clauses are commonly incorporated as a means of providing pre-agreed compensation in the event of a breach. Such clauses stipulate a sum payable upon the occurrence of a breach and must represent a genuine pre-estimate of the loss likely to be suffered by the innocent party.[3] Malaysian courts will assess whether the stipulated amount is reasonable, having regard to the innocent party’s legitimate interest in enforcing contractual performance and the proportionality of the clause. Proof of actual loss is not the sole determinant of reasonableness, though it serves as a useful reference point.
In determining reasonable compensation, the courts typically compare the agreed liquidated damages sum with the probable loss likely to result from the breach, ensuring that no significant disparity exists between the two.[4] Importantly, a liquidated damages clause operates as a ceiling, whereby the stipulated sum represents the maximum recoverable amount.[5] Where the sum stipulated in a liquidated damages clause is extravagant or unconscionable in comparison to the anticipated loss, the clause may be considered as a penalty and rendered unenforceable.
An indemnity, by contrast, constitutes a contractual undertaking to hold the other party harmless from losses caused by the indemnifier or by any other specified person.[6] The indemnitee is entitled to recover all losses falling within the scope of the indemnity, provided that the indemnitee has acted prudently or with the authority of the indemnifier.[7]
Although both indemnity and liquidated damages clauses serve to safeguard parties against loss, their legal nature and mode of operation differ fundamentally. An indemnity is a primary obligation to make good a specified loss, whereas liquidated damages provide a contractual mechanism for pre-agreed compensation arising upon a breach.
Ultimately, the focus should not rest on rigid legal classifications, but on identifying the mechanism that best aligns with the parties’ commercial objectives and risk appetite. Each clause must be construed in its proper context to ensure that the parties assume only the risks they have expressly undertaken, thereby achieving an outcome that is both legally defensible and commercially coherent.
[1] Section 74 of the Contracts Act 1950
[2] Malayan Banking Bhd v Basarudin bin Ahmad Khan [2006] MLJU 528-Paragraph 10
[3] Hamdan bin Johan & Ors v FELCRA Bhd & Ors [2010] 8 MLJ 628-Paragraph 19
[4] Malayan Banking Bhd v Basarudin bin Ahmad Khan [2006] MLJU 528-Paragraph 12
[5] Section 77 of the Contracts Act 1950
[6] Cubic Electronics Sdn Bhd (in liquidation) v Mars Telecommunications Sdn Bhd [2019] 6 MLJ 15 – Paragraph 37
[7] Cubic Electronics Sdn Bhd (in liquidation) v Mars Telecommunications Sdn Bhd [2019] 6 MLJ 15 – Paragraph 68
[8] Section 75 of the Contracts Act 1950
[9] Section 77 of the Contracts Act 1950
[10] Section 78 of the Contracts Act 1950