This article is written by Sabyasachi De,  a student of Calcutta University.

Before enactment of  the Indian Contract Act, the laws on the subject were not at all uniform all over the British India and these were extremely uncertain in its application. The Indian Law Commissioner observed that a Judge was, to a great extent, working without guidance of any positive law   and upon a conviction  that his decision would be such as he thinks to be in consonance with ‘justice, equity and good conscious’. In this backdrop, the Indian Contract Act was framed to ensure uniform practice of the rules and it came into force on 1^st September, 1872.

 Sec. 73 of the Indian Contract Act, 1872, deals with compensation for loss or damage caused by breach of contract. When a contract has been   broken, the party who suffers by such breach is entitled to receive from the party who has broken the contract, compensation for any loss or damage caused to him thereby, which naturally arose in the usual course of things from such breach , or which the parties  knew , when they made the contract, to be likely to result from the breach of it.

The parties to a contract may include therein, provision for payment of a sum of money by either party, if in breach of contract in stated, or any ways, to the other party as compensation for loss thereby caused.  Such a provision is deemed to be a liquidated damages provision if it stipulates genuine pre-estimate of the loss, as contemplated by the parties, that would probably flow from the breach. But a similar provision is regarded as a penalty provision if it does not attempt to assess the loss that would cause on breach of contract, but is imposed as a threat and as a punishment in the event of breach.

Whether a provision is one or the other is a question of interpretation, the words used not being conclusive. If a provision is held to be one for liquidated damages, that sum is payable on breach without proof of loss.  If it is held to be one for a penalty, the innocent party can only recover for loss proved, not exceeding the penal sum or may ignore the penalty provision sue for damages and recover for proved losses, either more or less than the penalty stated.

Parties may also provide that either or both may terminate the contract, or do some other act affecting performance, on payment of a specified sum, in which case the sum is payable, without question whether it is liquidated damages or penalty.

As per Black’s Law Dictionary, Liquidated damage is an amount contractually stipulated as a reasonable estimation of actual damages to be recovered by the party if the other party breaches. If the parties to a contract have agreed on liquidated damages, the sum fixed is the measure of damages for a breach, whether it exceeds or falls short of the actual damages. Liquidated damage is also termed as ‘stipulated damage’ or ‘estimated damage’ .

The Effect

The amount recoverable in case of a penalty is not the sum named, but the damages actually incurred. The amount recoverable as Liquidated damages is the sum named as such . In construing these terms  Judges will not accept the phraseology of the parties; They  may call the sum specified ‘ liquidated damages’, but if the judge finds it to be penalty, he will treat it as such . (William R Anson, Principles of the Law of Contract, 470 , Arthur L. Corbin, ed 3 Am. Ed. 1919)

The distinction between a penalty and genuine liquidated damages, as they are called, is not always easy to apply, but the courts have made the task simpler by laying down certain guiding principles. In the first place, if the sum payable is large as to be far in excess of the probable damage on breach, it is almost certainly a penalty.

Secondly, if the same sum is expressed to be payable on a number of different breaches of varying importance, it is again probably a penalty, because it is extremely unlikely that the same damage would be caused by these varying breaches.

Thirdly, where a sum is expressed to be payable on a certain date and a further sum in the event of  default being made, this later sum is prima facie a penalty, because mere delay in payment is unlikely to cause damage.

Finally,  mere use of the word ‘ liquidated damages’ is not decisive, for it is the task of the court and not of the parties to decide the true nature of the sum payable.

(P.S. Atiyah, An Introduction to the Law of Contract, 316-17, 3^rd ed. 1981)

Section 73 of the Indian Contract Act relates liquidated damages to breaches of contracts and not to torts. AIR 1927 Nag 75 (75). Claim on breach of contract comes under Sec. 73 and not tort.

Whether a particular act is a tort or breach of contract depends upon the nature of duty that is violated. Where the duty is imposed by law , the act of violation will amount to tort. On the other hand, if the duty is imposed by parties themselves, the act of violation will be a breach of contract.

The general principle which is embodied in Sec. 73 is that when there is a breach of contract, the party who suffers by the breach is entitled to recover compensation from the other party for the loss caused to him by the said breach.. AIR 1955 , Andhra 148(151) (DB) ; 1965 All LJ 969 (970).

Sec. 74  of the  Indian Contract Act deals with compensation for breach of contract where penalty stipulated for.

When a contract has been broken, if a sum is named in the contract as the amount to be paid in case of such breach, or if the contract contains any

other stipulation by way of penalty , the party complaining of the breach is entitled, whether or not actual damage or loss is     proved to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named, or as the case may be , the penalty stipulated for.

The legal position with regard to a claim for liquidated damages is as follows 

1. no claim for such damages is maintainable unless the promisee is proved to have sustained loss due to the default of the promisor ;
2. whatever the quantum of loss so sustained, the claim cannot exceed the sum stipulated in the contract ;
3. only reasonable sum can be awarded as damages which in a given situation may be less than the sum stipulated ;
4. what is reasonable sum depends on facts ;
5.  court may proceed on the assumption that the sum stipulated reflects the genuine pre-estimate of the position as to the probable loss and such clause was intended to dispense with the proof thereof  ;  and it will always be open to the promisor to show that no loss was suffered or that estimate so made is falsified by the change in the situation or that the loss suffered was less.

Ref. ILR (1975) Bom 580 (DB) , AIR 1982 Ker 281 (288) (DB), 1982 Ker LT 73

Liquidated damages must be the result of a genuine pre-estimate of damage and they do not include a sum fixed as a penal provision or threat .Ref. AIR 1954 Madh B 84 (86), AIR 1955 Pat 215 (221) (DB), AIR 1965 Andh Pra 33 (35, 36) (DB).

3. The essence of a penalty is payment of money stipulated as a threat while the essence of liquidated damage is a genuine covenanted pre estimate of damages.  AIR 1981 Orissa 206 (209) (DB).

4. If in making provision for breach of contract, the promisee puts in a stipulation not by way of reasonable compensation to him on breach of contract but in order that by reason of burdensome or oppressive condition demanding harsh obedience causing distress or anxiety over the promisor so as to drive him to fulfill the contract , then the stipulation is one by way of penalty and not as a liquidated damages.

Ref. (1990) 2 Ker LJ 424 (426).

5. When it comes to the question of forfeiture of the security money because of the breach of contract, the sum forfeited does not ipso facto becomes reasonable compensation if actual loss can be proved.

If the party complaining of the breach is in a position to adduce evidence whereby the court can arrive at the amount of reasonable compensation then without proof of such reasonable compensation the damages will not be decreed. In such circumstances, the amount mentioned in the contract would be amount to a penalty and such an amount is not receivable as reasonable compensation. But if the parties mention in the contract, a figure which is their pre-estimate of the actual damages and if the party complaining of the breach is unable to assess the compensation because the same cannot be calculated in accordance with the established rules in the facts and circumstances of the particular case, then the amount named in the contract itself would be considered as evidence of reasonable compensation. Under the circumstances, it becomes liquidated damages as is commonly known in English Common Law.

Ref. AIR 1973 Cal 550 (558, 559).

6. Where liquidated damages are entered in a contract itself as payable in the event of breach, then in order to be entitled to damages the plaintiff shall have to prove his damages irrespective of the specified amount stated in the contract.

AIR 1981 AP 153 (DB) 1 Andh W R (HC) 393

7. Penalty differs from stipulated damages within the meaning of Sec. 74.

  1961 Jab LJ 141 ; 1960 MPLJ 1379.

8. The distinction between penalty and liquidated damages has been abolished by the Indian Contract Act and now in every case, except bail bonds or where bond is given for the performance of any public duty or act which involves public interest , in which a sum is named as damages to be paid in case of breach of contract, the court which adjudicates the suit is not bound to award more than ‘reasonable compensation’  exceeding the amount so named.

AIR 1963 SC 1405 (1410, 1411) , AIR 1970 SC 1955 (1958).

9. Where the stipulated sum does not compensate for the actual loss suffered, the plaintiff has an option of either suing on penalty clause or sue for breach of contract and recover damages in full.

AIR 1971 Raj 229 (231), 1971 Raj LW 194, ILR 1969(2) 482.

10. Thus, parties to a contract may stipulate at the time of its formation that on the breach of the contract, by either of them, a certain specified sum will be payable as damages. Such a sum may amount to either ‘liquidated damages’ or a ‘ penalty’.

‘ Liquidated damages’  represent a sum fixed  or ascertained by the parties in the contract , which is fair and genuine pre-estimate of the probable loss that might ensue as a result of the breach.

The English Law gives effect to ‘liquidated damages’ but  relieves a party against ‘penalty’.

In the Indian Contract Act , no such distinction is observed. The Courts in India allows only ‘reasonable compensation ’ under sec. 74. Therefore, in India while parties to a contract may use the words ‘penalty’ or  ‘liquidated damages’ interchangeably. The Court is not bound by the phraseology used for ‘equity looks for intent rather than to the form’. It must ascertain whether a sum is in truth a penalty or liquidated damage.

An  Illustration :

 A contracts with B to pay Rs. 1000 if he fails to pay B Rs.500 on a given date. A fails to pay Rs. 500 on that day. B is entitled to receive from A such compensation not exceeding Rs. 1000 as the Court considers reasonable.