Agencies Are Liable To Compensate Their Principals If Their Services Are Deficient. Contract Drafting Tips For Agencies To Protect Themselves, And Enable Rapid Enforcement

This article deals with disputes concerning the skill and duty of care owed by an agent to his principal while conducting its business.

The article discusses drafting solutions to help principals rapidly recover compensation from agents for their negligence or misconduct while at the same time protecting agents from unfounded allegations by principals.

Keywords: Agency Agreements, Compensation, Negligence, Misconduct

Reference: Indian Contract Act, 1872, Section 212, Illustration b 

Indian Contract Act, Section 212

Section 212 of the Indian Contract Act sets out that an agent is bound to maintain such a standard of care while conducting his principal’s business, as is expected of any person conducting similar business. In effect, the section provides that an agent is bound to conduct his principal’s business with the same standard of care and skill as if he was conducting the business for himself.

The section further provides that an agent is liable to compensate his principal for losses caused by his misconduct, negligence, or lack of skill unless he has made the principal aware of his lack of skill. However, the section limits the agency’s liability only to losses directly resulting from negligence, misconduct, or lack of skill. 

An agent is not liable to compensate the principal for any remote or indirect losses.

Section 212, Illustration b

A, an agent for the sale of goods, having authority to sell on credit, sells to B on credit, without making the proper and usual enquiries as to the solvency of B. B, at the time of such sale, is insolvent. A must make compensation to his principal in respect of any loss thereby sustained.

In the above illustration, it is clear that the agent has been negligent and, therefore, liable to compensate his principal for the loss sustained, i.e., the price of the goods. However, in most cases where a principal sues an agent for compensation, the agent would argue that he did exercise the standard of care expected of him.

Modern-day illustration:

X appointed Y as its agent to perform due diligence on Z’s medical instruments manufacturing business, in which X was considering investing. Y’s brief was to report on ‘factors affecting the health of the business.’ Y performed the due diligence and reported that the financials of the business were strong. Consequently, X invested a significant sum of money in acquiring a stake in Z’s company. 

However, a few months after investing, the company’s factory building collapsed, and the business incurred significant losses as a result. A subsequent investigation revealed that Z had failed to maintain the building properly, a fact that was not part of Y’s report to X.

Consequently, X sued Y for compensation for the losses caused by Y’s failure to perform its due diligence properly.

Interpretation and Analysis:

In the above example, the agreement was not clear on the scope of the due diligence that Y was required to do. Therefore, Y would argue that it had exercised the standard of care required for prevailing industry practices. 

On the other hand, X would argue that the condition of the factory building was a factor that would affect the health of the business. Therefore, by not including assessing the building as part of its due diligence, Y had failed to discharge its obligations as X’s agent.

Both parties would be required to lead oral and documentary evidence to support their arguments, and the dispute would not be capable of being resolved using a rapid resolution tool like Online Dispute Resolution (ODR).

However, there are solutions to make disputes arising from such agreements rapid resolution friendly. These solutions are discussed below.

Solution 1 – Ensure Clarity On Agent’s Obligations

An agency agreement must be unambiguous about the agent’s obligations. It is not sufficient to merely state that the agent must adhere to ‘standard industry practices.’ The reason is that, in the event of a dispute, both parties will have to prove to a judge or arbitrator precisely what the prevailing industry practices are, which will require parties to lead oral and documentary evidence, rendering the dispute unsuitable for ODR. However, if the agreement clearly defines the agent’s obligations, a judge or arbitrator can arrive at a finding on the agent’s negligence or misconduct based on the facts of the case and a reading of the agreement. The case will not require the parties to lead much additional evidence.

In our example, the agreement should have defined the due diligence’s scope based on the nature of Z’s business and Y’s specialization. Doing so would protect both parties as it would ensure that Y can be held accountable for any lapses, while at the same time preventing Y from being obligated to do anything beyond it’s skill set.

Solution 2 – Ensure Easy Computation Of Compensation

Just as agreements must be drafted to enable a Judge or Arbitrator to quickly determine which party has breached a contract, they must also be drafted to enable quick computation of compensation and damages.

Contracts can be drafted to enable easy computation of compensation by incorporating clauses that either pre-decide the compensation one party would be liable to pay the other if it breaches the contract, or provides an easy-to-apply formula to compute the compensation.

In our example, the compensation Y would be liable to pay X in the event it was found to have been negligent or committed misconduct could be the amount invested by X, minus any return X had earned on the investment. 

Solution 3 – Accelerates the Dispute Resolution Process

The agreement should have a dispute resolution clause giving the claimant the right to ask for the arbitrator’s appointment by a named institution or ODR platform, and for such appointment to be made within 35 days of receipt of the defendant receiving notice.

In these cases, it will better serve the parties if either the dispute resolution clause itself or the institution or ODR platform promises a process that binds the arbitrator to rapid resolution. ODR Platforms often do this by minimizing oral hearings, not accepting documentation delays, and not allowing adjournments unless in emergencies.

Simple Explainer for the Layman:

Sunflower Holdings, a Venture Capital Fund, appointed Finance First as it’s agent to perform due diligence on Good Health Technology, a medical instruments manufacturing business, in which Sunflower Holdings was considering investing. Finance First’s brief was to report on ‘factors affecting the health of the business.’ Finance First performed the due diligence and reported that the financials of the business were strong. Consequently, Sunflower Holdings invested a significant sum of money in acquiring a stake in Good Health Technology. 

However, a few months after investing, the company’s factory building collapsed, and the business incurred significant losses as a result. A subsequent investigation revealed that Good Health Technology had failed to maintain the building properly, a fact that was not part of Finance First’s report to Sunflower Holdings.

Consequently, Sunflower Holdings sued Finance First for compensation for the losses caused by its failure to perform it’s due diligence properly.

Finance First argued that it had exercised the standard of care required as per prevailing industry practices and that an assessment of the factory building was not part of the brief.

Sunflower Holdings, in turn, argued that the condition of the factory building was a factor that would affect the health of the business and therefore, by not including an assessment of the building health as part of it’s due diligence, Finance First had failed to discharge it’s obligations as Sunflower Holding’s agent.

The dispute could have been rapidly resolved had the agreement been explicit on Finance First’s brief and had a clause specifying that disputes would be resolved using a designated ODR Platform.

About the Article

Rapid Contract Enforcement is an essential requirement for the growth and prosperity of India. It will enable more investment, entrepreneurship, and trust for all stakeholders in business and commerce. The community of lawyers in India does not have access to a practical and scholarly manual that gives them a path to deliver rapid contract enforcement to their clients. Such a manual will also help lawyers to draft contracts that enable timely enforcement. Quick enforcement requires the effective use of the Arbitration Act, the institutional framework, and technology-enabled dispute resolution infrastructure. This article belongs to a series where the author analyses each of the Illustrations available in the Contract Act and recommends practical approaches to rapid enforcement.

About the Author:

Dushyant Krishnan is a Mumbai based lawyer and the co-founder of House Court, an online dispute resolution platform.

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