In commercial supply agreements/contracts, sometimes supplier of goods prefers to take insurance in order to avoid the risk of payment by the buyer. Such commercial agreements generally put restriction on assignment of rights and/or transfer of any interest or right under the agreement by any party without the prior written consent of the other party. In this regard, it is important to understand that whether such restriction on assignment or transfer of any interest/right in the agreement would apply in case supplier of goods transfers its right in favor of insurance company by executing letter of subrogation, which is generally required by the insurance company at the time of processing the claim of insured. To find answer to this query, we have analyzed the concept of these legal terminologies and the interpretations of the courts on the same.

What is Subrogation?

Subrogation simply means substitution of one person for another; that is, one person is allowed to stand in the shoes of another and assert that person's rights against the defendant.

Subrogation is equitable assignment. The right comes into existence when the surety becomes obligated to pay the debt of the principal debtor under a contractual obligation; however, such right of subrogation does not become a cause of action until the debt is duly paid. Subrogation entitles the surety to use any remedy against the principal debtor which the creditor could have used, and in general to enjoy the benefit of any advantage that the creditor had, such as a mortgage, lien, power to confess judgment, to follow trust funds, to proceed against a third person who has promised either the principal or the creditor to pay the debt. Unless agreed otherwise, the surety has a right to sue the principal debtor in the name of the creditor.

Further, law of insurance recognizes as an equitable corollary of the principle of indemnity that the rights and remedies of the assured against the wrong-doer stand transferred to and vested in the insurer. The equitable assignment of the rights and remedies of the assured in favour of the insurer, implied in a contract of indemnity, known as `subrogation', is based on two basic principles of equity:

  1. No tort-feasor should escape liability for his wrong; and
  2. No unjust enrichment for the injured, by recovery of compensation for the same loss, from more than one source.

The doctrine of subrogation will thus enable the insurer, to step into the shoes of the assured, and enforce the rights and remedies available to the assured.

Statutory provision for subrogation under Indian Contract Act, 1872

Section 140 of the Contract Act, 1872 deals with the principle of subrogation with reference to rights of a surety/guarantor. The relevant texts of aforesaid Section 140 of the Contract Act are reproduced below:

"140. Rights of surety on payment or performance : Where a guaranteed debt has become due, or default of the principal - debtor to perform a guaranteed duty has been taken place, the surety, upon payment or performance of all that is liable for, is invested with all the rights which the creditor had against the principal - debtor."

Subrogation is an equitable right

The doctrine of subrogation is a creature of equity not founded on contract, but arising out of the relations of the parties. In cases of insurance where a third party is liable to make good the loss, the right of subrogation depends upon and is regulated by the broad underlying principle of securing full indemnity to the insured, on the one hand, and on the other of holding him accountable as trustee for any advantage he may obtain over and above the compensation for his loss.

In Re: Economic Transport Organisation Vs. Charan Spinning Mills (P) Ltd. and Anr.[2010]4SCC114, it was mentioned that:

"14. Subrogation, as an equitable assignment, is inherent, incidental and collateral to a contract of indemnity, which occurs automatically, when the insurer settles the claim under the policy, by reimbursing the entire loss suffered by the assured. It need not be evidenced by any writing. But where the insurer does not settle the claim of the assured fully, by reimbursing the entire loss, there will be no equitable assignment of the claim enabling the insurer to stand in the shoes of the assured, but only a right to recover from the assured, any amount remaining out of the compensation recovered by the assured from the wrongdoer, after the assured fully recovers his loss....."

What is an assignment?

An 'assignment' on the other hand, refers to a transfer of a right by an instrument for consideration. In case of an absolute assignment, the assignor is left with no title or interest in the property or right, which is the subject matter of the assignment.

Difference between subrogation and assignment

Both subrogation and assignment permit one party to enjoy the rights of another, but it is well established that subrogation is not of the same genus as of assignment as mentioned in the aforesaid judgment of Economic Transport Organisation. Rights of subrogation vest by operation of law rather than as the product of express agreement. Whereas rights of subrogation can be enjoyed by the insurer as soon as payment is made, as assignment requires an agreement that the rights of the assured be assigned to the insurer. The insurer cannot require the assured to assign to him his rights against third parties as a condition of payment unless there is a special clause in the policy obliging the assured to do so. This distinction is of some importance, since in certain circumstances an insurer might prefer to take an assignment of an assured's rights rather than rely upon his rights of subrogation. If, for example, there was any prospect of the insured being able to recover more than his actual loss from a third party, an insurer, who had taken an assignment of the assured's rights, would be able to recover the extra money for himself whereas an insurer who was confined to rights of subrogation would have to allow the assured to retain the excess.

Another distinction lies in the procedure of enforcing the rights acquired by virtue of the two doctrines. An insurer exercising rights of subrogation against third parties must do so in the name of the assured. An insurer who has taken a legal assignment of his assured's rights under statue should proceed in his own name.

Transfer of Interest

In order to avoid any disputes later, insurance company while settling claim of the insured generally takes a 'letter of subrogation' to protect its interest though Indian law does not mandatorily require it. Execution of such 'letter of subrogation' is considered as contractual arrangement authorizing the insurance company to recover the amount paid by it to the insured. Sometimes, such document also authorizes the insurance company to sue the debtor/third party in the name of the assured. It is pertinent to note that once assured executes a letter of subrogation, the rights of the insurer vis-à-vis assured will be governed by the terms of the letter of subrogation.

The words 'transfer of interest' have a wider meaning which includes in its ambit assignment, mortgage hypothecation etc. Hence, execution of letter of subrogation in favor of the insurance company may be construed as 'transfer of interest' and consequently, may be considered as violation of an agreement if the same restricts transfer of any interest by any party.

In view of the above, it is recommended that the commercial supply contracts, should specifically permit subrogation in favour of the surety in case of payment of debt by the surety. Alternatively, appropriate language may be inserted in the assignment clause of such agreements, creating an exception for subrogation in favour of the insurance companies. The validity of the Letter of Subrogation may, be questionable in case the assignment clause prohibits any kinds of assignments or transfer of interests in favour of third party.

However, absence of such clauses in the agreement, will not extinguish the right of the insurance company to recover the amount from the third party/debtors under the 'principle of subrogation' since insurance company is not privy to the arrangement entered into between buyer and supplier/seller provided insurance company has made full reimbursement of the loss and cost to the supplier/seller. The right to recover the claim amount is a statutory right given by the statute to the surety/insurance company and such right can't be extinguished unless the same is specifically waived off by the surety/insurance company in writing.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.