Revisiting Liquidated Damages in India

Contracts often contain a stipulation or a clause that specifies the amount of money a defaulting party is required to pay to the other party in the event of a breach of contract. Under the English Law, if this stipulation is a genuine pre-estimate of the damages likely to be caused by the said breach, it is called liquidated damages. Genuine pre-estimates of loss are recoverable under law. However, if it is not a genuine pre-estimate of the loss, then it is termed as a penalty and the said clause is considered void. The question whether a particular stipulation would operate as a penalty or not is to be answered by the court taking into consideration a variety of relevant factors like the intent of the parties, the character of the transaction in question, the consequential injury to the plaintiff, etc. It is further a matter of construction that is to be decided as per the terms and circumstances existing at the time of making the contact.[1] The House of Lords in Dunlop Pneumatic Tyre Co., Ltd. v. New Garage and Motor Co., Ltd.[2] had laid down that if a stipulation is such that it operates “in terrorem” of the offending party to secure the performance of contract and if such sum is extravagant, unconscionable and disproportionately large then it shall operate as a penalty. Penalty clauses are void and irrecoverable in nature. Though the penal sum operates as a form of punishment on the defaulter irrespective of any loss, the liability of the defaulter is restricted only for those damages which can be proved against him. The English Law thus is said to impose the requirement of proving actual damage in case a stipulation is by way of a penalty.

The English position, however, is at a stark contrast to the law in India. Section 74 of the Contract Act, 1872 deals with cases that provide for a stipulation to be paid in case of a breach of contract and the difference in the Indian and the English positions was explained by the Constitutional Bench of the Supreme Court in Fateh Chand v. Balkishan Dass[3]. In that case, the Court affirmed that the said section sought to eliminate the “elaborate refinements” of the English position in distinguishing between stipulations providing for payment of liquidated damages and those in the nature of penalty. The Court also laid down the two kinds of damages that Section 74 deals with, namely:

1.Where the contract names a sum to be paid in case of breach.

2.Where the contract contains any other stipulation by way of penalty.[4]

Section 74 thus propounds a uniform principal that applies to all stipulations. Further, if a stipulation is found to be a genuine pre-estimate of the damages, the court shall award the amount decided by the parties. However, if the stipulation is found to be in the nature of a penalty then, unlike the English Law where the clause becomes void and irrecoverable, as per the Indian law, the court shall assess the extent of the loss or damage suffered by the aggrieved party and shall award reasonable compensation to it.[5] The focus of the section thus is on reasonable compensation. Compensation is said to be reasonable if it is awarded in accordance with settled principles of law. Though, the court has unqualified jurisdiction to award such compensation as it deems reasonable, it is subject to the maximum amount that has been stipulated by the parties within the contract.

This position of law was well settled but recently the Indian court seemed to have blurred the deliberate distinction between the English requirements of proving loss for liquidated damages and the Indian requirements. This note then is an attempt to elucidate and address two main issues arising with reference to Section 74:

1. Whether the section requires the plaintiff to show loss

It is well settled that a person who has not suffered any loss or damage cannot be compensated and this principle has not been abandoned by Section 74. The philosophy underlying the section is that in case of a breach, the aggrieved party must be compensated and restored to a position it would have been in, had the contract been performed. But if there is no loss caused to the party, then no question of restoration or compensation arises. Thus, the existence of a legal injury i.e. the sustenance of a loss or damage on account of breach seems absolutely essential for a party to claim compensation.

Even in Fatehchand case[6] the court had clarified that the aim of awarding compensation is to make good the loss or damage that naturally arose in the usual course of things or which was so contemplated by the parties at the time of making the contract. Thus, there can be no award of any compensation if there is no legal injury to the party. This view of the court was subsequently upheld in various other judgments by courts across the country.[7] For instance, in Haryana Telecom Ltd. v. Union of India[8], when a contractor delayed in supplying cables and the Government had to purchase the same from other sources and subsequently got it at cheaper rates, the award of the arbitrator awarding damages for breach was set aside as no loss was caused.

The proof of some loss thus seems indispensable[9] though it does not seem necessary to prove the extent of it. Loss therefore is a prerequisite for an award for damages.

2.Whether the section requires the plaintiff to prove loss

In Fateh Chand case[10], the Constitutional Bench had expressly held that Section 74 undoubtedly allowed an aggrieved party to receive compensation from the party who had broken the contract, whether or not actual damage was proved to have been caused by such breach. Even in Maula Bux v. Union of India[11], the Court was of a similar opinion and held that a reasonable compensation for the breach of a contract could be awarded by the court even if the aggrieved party did not prove the actual loss it had suffered on account of such breach. Further, in certain cases, it may also not be possible for the court to assess the compensation that is likely to arise on account of a breach. This essentially meant that the section thereby dispensed with such a requirement and the emphasis of Section 74, is not on proving the actual loss or the extent of the loss suffered by the party.

Following this line of reasoning, the Supreme Court in ONGC v. Saw Pipes Ltd.[12], further propounded that Section 74 must be read with Section 73 which in essence reiterated that a party is not required to prove the actual loss or the extent of loss suffered by it before it could claim a decree for the award of reasonable compensation from the court. The Court further opined that a party was not required to lead evidence to prove loss in a case where, at the time of making the contract, the parties were aware of a particular loss that was likely to arise on account of a breach of the contract. But the same would not be true if the Court finds that no such loss could have occurred at all by the said breach.

The law thus seems to be clear, that while Section 74 of the Contract Act requires the aggrieved party to show legal injury to be able to claim compensation, the section does not intend for the injured party to prove each penny worth of loss that it has suffered. It is sufficient for the aggrieved party to merely show that hurt or damage was caused. It is for the court to determine the extent of loss that was suffered by the aggrieved party and then applying the reasonable man standard to further determine and award such compensation as is sufficient in that particular case, subject of course to the maximum stipulation provided for within the contract itself.

The problem arises with the interpretation of the words “whether or not actual loss is proved to have been caused thereby” as has been adopted by the Indian courts in the recent past.

In early 2015, the Supreme Court interpreted the phrase in a contrasting light as opposed to the interpretation adopted in the aforementioned cases. This was the case of Kailash Nath Associates v. DDA[13] where the dispute was whether a delay in payment would attract Section 74 of the Contract Act even if the respondents subsequently sold the property at a significantly higher amount. While analysing the scope of compensation to be awarded under Section 74 the Court held the expression “whether or not actual loss is proved to have been caused thereby” to mean that wherever it was possible for the party claiming compensation to prove the actual damage, such proof was not dispensed with. Thus, in every case a party must prove the extent of the loss suffered by it. The exception, however, was for cases where the damage was difficult or impossible to prove and in such cases the requirement to prove the extent of loss was dispensed with.

Similarly, in Union of India v. Motor & General Sales Ltd.[14], the Bombay High Court refused to give reasonable compensation to the aggrieved party since they were unable to “prove” the loss suffered by them. Similar to the Saw Pipes Ltd. case[15], in this case there was a delay in providing delivery of certain goods and the question for consideration was whether such a delay would attract the provisions of Section 74. The High Court of Bombay, failed to acknowledge that the loss caused by delay may not always result in a monetary loss that is easy to prove and that such delay could cause a loss that is otherwise difficult to account for.

What is even more important to note is that, irrespective of the kind of loss caused, the Constitutional Bench in Fateh Chand case[16] and the subsequent cases thereafter had made it amply clear that to prove the extent of loss is not required and that the aggrieved party is only to show the hurt or loss caused to them.

The judgment of Kailash Nath[17] and Motor & General Sales[18] essentially thus restricts the scope of Section 74 to say that the requirement to prove the actual loss by the party is dispensed with but only in cases where such proof is not possible. Such a construction of Section 74 is bad in law and is against the very essence of the section itself. To dispense with the proof of actual loss or damage was a deliberate departure made by the Indian legislature from the complicated principles of English common law. A further problem also arises with the standard to identify genuine pre-estimate of loss in India. For instance, A (landlord) and B (tenant) enter into a rent agreement which contains a clause that specifies that if B were to vacate the tenanted premise before the expiry of the agreement then A would be entitled to receive a 3 months worth rent from B as compensation. Ordinarily such a stipulation is regarded as a genuine pre-estimate of the loss A is likely to suffer on account of finding a new tenant. But consider a scenario where A finds a new tenant within a month of B vacating the premises. The question for consideration then is whether a reasonable man standard ought to be adopted since A has not actually suffered a loss of 3 months as provided for in the stipulation or would the standard of the plaintiff be adopted. Borrowing from the English system, the former standard must be adopted but in practice, the Indian courts require the loss to be proved even in cases of genuine pre-estimates.[19]

That this was not the intent of the legislature is evident from the illustrations[20] within Section 74 itself and in particular, Illustrations (a) and (b). A bare reading of these illustrations evidently shows that in either case the plaintiff did not suffer any loss. In such a scenario it may even be argued that imposing the requirement of proving a legal injury itself is contrary to the intent of the section, let alone proving the extent of the legal injury suffered.

The emphasis of the section is on awarding reasonable compensation. But the current interpretation as accepted by the courts displaces the reasonable man standard that was adopted for awarding compensation under Section 74. The courts seem to be mistaking the requirements of proving loss under the common law system and the requirement of showing loss under the Indian system. If an aggrieved party were to prove the loss it suffered in every case of breach of contract, then the very purpose of having a stipulated sum in the first place would fail.

 

IVth year student, BA LLB, Jindal Global Law School, O.P. Jindal Global University, Sonipat.

[1]  Commr. of Public Works v. Hills, 1906 AC 368 (PC).

[2]  1915 AC 79 : 1914 UKHL 1 (HL).

[3]  AIR 1963 SC 1405.

[4]  Fateh Chand case, AIR 1963 SC 1405.

[5]  Fateh Chand case, AIR 1963 SC 1405.

[6]  AIR 1963 SC 1405.

[7]  State of Kerala v. United Shippers and Dredgers Ltd., 1982 SCC OnLine Ker 112 : AIR 1982 Ker 281. See also: Maula Bux v. Union of India, (1969) 2 SCC 554 : AIR 1970 SC 1955; ONGC v. Saw Pipes Ltd., (2003) 5 SCC 705; Kailash Nath Associates v. DDA, (2015) 4 SCC 136.

[8]  2006 SCC OnLine Del 575 : AIR 2006 Del 339.

[9]  Pure Pharma Ltd. v. Union of India, 2008 SCC OnLine Del 739 : ILR (2009) 1 Del 272.

[10]  AIR 1963 SC 1405.

[11]  (1969) 2 SCC 554 : AIR 1970 SC 1955.

[12]  (2003) 5 SCC 705.

[13]  (2015) 4 SCC 136.

[14]  2016 SCC OnLine Bom 6787.

[15]  (2003) 5 SCC 705.

[16]  AIR 1963 SC 1405.

[17]  (2015) 4 SCC 136.

[18]  2016 SCC OnLine Bom 6787.

[19]  Union of India v. Raman Iron Foundry, (1974) 2 SCC 231 : AIR 1974 SC 1265.

[20]  It was held in Jumma Masjid v. Kodimaniandra Deviah, AIR 1962 SC 847 that: “It is the duty of a court of law to accept, if that can be done, the illustrations given as being both of relevance and value in the construction of the text. The illustrations should in no case be rejected because they do not square with ideas possibly derived from another system of jurisprudence as to the law with which they or the sections deal. And it would require a very special case to warrant their rejection on the ground of their assumed repugnancy to the sections themselves. It would be the very last resort of construction to make any such assumption. The great usefulness of the illustrations, which have, although not part of the sections, been expressly furnished by the legislature as helpful in the working and application of the statute, should not be thus impaired.”

Join the discussion

Your email address will not be published. Required fields are marked *