This article is written by Janhavi Arakeri, 1st-year student of Symbiosis Law School, Noida. She discusses the meaning, purpose and differences between Liquidated and Unliquidated Damages.
A price called Weregild was placed on every human being and every piece of property in the Salic Code among the Saxons. If someone was injured or killed or if someone had their property or belongings stolen, the guilty person would have to pay weregild as restitution to the victim’s family, or to the owner of the property. The concept of Damages has been evolved from this.
A court usually awards the sum that would restore the injured party to the economic position they expected from the performance of the promise or promises on a breach of contract by a defendant. Parties can come into a contract for liquidated damages to be paid by one of the parties for infringement of the contract. Under common law, a liquidated damages clause would not be implemented if the sole purpose of the term is to punish an infringement (in this case it is called penal damages).
What are Damages?
Damages, in simple terms, refer to a form of compensation due to a breach, loss or injury. As explained by Fuller and Perdue, damages may seek protection of “expectation interest”, “reliance interest” or “restitution interest”.
Damages have attained importance particularly in commercial transactions and also as punitive measures for the violation of the rights of the persons concerned. The nature of the damages awarded across different regions varies widely. They are commonly granted in cases of tort or contract breach.
What are the types of Damages available?
- General and Special Damages
Damages that emerge in the natural course of events are known as general damages, whereas special damages refer to those that emerge under circumstances that were reasonably anticipated by the parties when they entered into the contract.
- Nominal damages
This may be granted even though there is no actual loss or injury caused to a party against whom an infringement has been caused, or in cases where there’s been a violation of a legal right, without having to prove any actual damage.
- Substantial damages
Contrary to nominal damages, substantial damages are awarded when the extent of contract breach is proven, but there are calculation uncertainties.
- Aggravated and exemplary damages
Such damages are often of a nature that they exceed the damages obtained, mainly resulting from the mala fide behavior of the respondent.
- Liquidated and unliquidated damages
In the case of contracts, parties might agree to pay a certain amount on breach of the contract. When such provisions are created in the contract, they are known as liquidated damage. On the other hand, unliquidated damages are granted by the courts on the basis of an assessment of the loss or injury caused to the party suffering such breach of contract.
Liquidated Damages under the Indian Contract Law, 1872
Section 74 deals with liquidated damages, relating to stipulated damages. Thus, there has to be a breach of the contract In order for the plaintiff to claim damages. In cases where there may be a reasonable revocation of the contract without any breach of the terms of the contract, the claim for damages should not arise as there is no breach per se.
Contract comes into being
The contract has a specific amount as compensation or penalty that would be generated in the event of a breach of the contract
Breach of Contract
Compensation by the breach-causing party. The compensation shall be appropriate and not more than the amount determined as liquidated damages in the contract.
Damages are normally claimed and awarded to restore the plaintiff’s situation in which he would have been if the breach had not occurred. These damages are generally to be claimed from the party that causes such an infringement. In the event of liquidated damages under Section 74, both the complainant and the defendant may make claims. In the case of liquidated damages, there is compensation assurance as an appropriate compensation is decided upon. Therefore, it would be expected that since the risks of a party causing a breach would be lower, damages are already specified.
What are the prerequisites to claim Liquidated Damages?
- Breach of Contract
It is the necessary prerequisite for claiming damages, whether liquidated, unliquidated or anything else. Therefore, regardless of the degree to which the defendant makes a profit from the contractual arrangement, there can be no claim for damages unless there is a breach of the contract. In addition, the party committing the breach is liable to compensate for damages.
To establish a breach, it has to be adjudicated upon and be proved, and not merely decided by the parties.
Damages can also be claimed in the event of an anticipatory breach of contract. In this kind of case, the other party may consent to or rescind the continuation of the contract. In the event of an anticipatory breach of contract, the plaintiff would be allowed to claim damages on establishing the intention to perform the contract prior to the rescission of the contract.
- Proof of Damage
It is worth mentioning that the clause “whether or not actual damage or loss is proven to have been caused by it” would not dispense with the establishment of proof in toto for a claim of liquidated damages. This emanates from the understanding that the reasonable compensation agreed upon as liquidated damages in case of breach of contract is in respect of some loss or injury; thus, the existence of loss or injury is indispensable for such claim of liquidated damages.
There must be a causal link between the breach committed and the loss or injury suffered for a claim of damages and attaching liability. This causal link is said to have been created if the defendant’s act of infringement of the contract is the only “real and effective” cause in relation to the injury or damage for which damages are claimed ; the “dominant and effective” cause is to be taken into consideration in the presence of multiple causes.
- Remoteness of Damage
A party injured by a breach of contract may recover only those damages which either “should reasonably be considered as occurring normally or naturally, i.e. according to the regular course of events” from the breach, or “should reasonably have been considered by both parties at the time they entered into the contract, as the likely result of the breach thereof.”
It is worth mentioning that a party claiming damages on breach of a contract ought to have performed or was ready to perform the required part of the contract. Hence, the duty to mitigate losses is indispensable before claiming damages.
What is the difference between Liquidated Damages and Penalty?
Indian law sees no difference between liquidated damages and penalty. The compensation granted cannot exceed the amount specified in the contract. If the parties rectify the damages, the Court will not permit more, according to Section 74 of the Indian Contract Act, 1872. Depending on the case, however, it may award a lower amount. The suffering party, therefore, receives reasonable compensation, but no penalty.
The exception to Section 74 which says that if a party enters into a contract with the State or Central Government for the performance of an act in the interest of the general public, then a breach of such a contract makes the party liable to pay the entire amount specified in the contract.
- If the amount payable exceeds the likely damage on breach of the contract, it is a penalty.
- Whenever a contract states an amount payable on a certain date and an additional amount if a default occurs, then the additional amount is a penalty. This is because it is unlikely that a mere delay in payment will cause damage.
- Even though the contract states a sum as ‘ penalty ‘ or ‘ damages, ‘ the Court must determine from the facts of the matter if the amount stated in it is, in fact, a penalty or liquidated damages.
- The essence of the penalty is the payment of money as the defaulting party’s terrorem. On the other hand, liquidated damages are the true pre-estimate of the damage.
- Although English law differentiates between a penalty and liquidated damages, there is no such distinction in India. The Indian courts focus on granting the suffering party appropriate compensation that does not exceed the amount set out in the contract.
Should Liquidated Damages Clauses be included in Agreements?
Liquidated damage clauses can benefit both owners and operators. Through restricting the amount of damages that an operator may claim, such clauses allow owners to delineate their risks and minimize the time, cost and risk of litigating issues pertaining to the operator’s entitlement and value of his / her claim for loss of profits. Owners can also use their negotiating power to limit the amount of damage payable to the operator to one or more years of lost profits.
Section 73 deals with actual damages resulting from infringement of the contract and the injury arising from such infringement which is in the nature of unliquidated damages since such damages are granted by the courts on the basis of an evaluation of the loss or injury caused to the party against which the infringement occurred.
Contract comes into being
Breach of Contract
Loss or damage as a consequence of this breach
The loss or damage should have arisen out of circumstances that were foreseeable by the parties or should be of the nature that it resulted due to a natural course of events; nothing unusual
Compensation for such loss or damage by party breaching the contract
How do Unliquidated Damages work?
Damages that are claimed for losses unforeseeable are called Unliquidated Damages. These damages are commonly awarded for cases involving a breach of contract. These damages apply to any breach of contract that does not contain a liquidated damages clause. It can, however, be difficult to estimate the compensation amount to be claimed by the complainant since the amount is “unliquidated.”
Industries like construction and engineering generally deal with liquidated damages and not unliquidated damages.
In order to award unliquidated damages to the plaintiff, the court opts for a compensatory approach:
- Recover the loss incurred by the complainant
- Return the complainant to the position he had before the breach
- Minimize penalizing the respondent
- Avoid enhancing the complainant’s position over and above where it would have been if the breach did not take place
The losses incurred by the plaintiff must be the result of the natural consequence of breaching of the contract. This will be taken into consideration while determining the award money.
Prior to entering into an agreement, the parties must mention any specific or unusual loss, if contemplated, in the contract. This will help avoid feuds and also increase recovery chances. The types of losses and the extent to them must have been foreseeable before signing the contract. Although not necessary, it is advised that the losses be foreseeable.
If in a case, the plaintiff was able to foresee the potential losses being sustained as a result of the breach of contract and did not take any measures to mitigate the losses even if they were available, the court will only award compensation proportionate to the losses incurred in case the measures had been taken. The plaintiff cannot let the losses accrue when measures by an ordinary person’s effort can reduce or prevent the losses.
Note: The court may award damages for moral losses. Nevertheless, it can be difficult to calculate and prove how much moral loss a party has sustained.
Parties must, in all cases, clearly mention their objectives in the contract. This prevents all the feuds and ambivalence caused by confusion and ambiguity. They can either state the unliquidated damages clause or simply remove the clause. In general contracts, “NIL” is specified for liquidated damages for those who do not wish to claim it. This also means that unliquidated damages are also not applicable.
What are the advantages and disadvantages of Unliquidated Damages?
Including a provision for unliquidated damages in a contract will most certainly prove to be an advantage. It helps the client recover losses which were, before the breach of the contract, unforeseeable or tough to estimate. However, this results in the contractor having an unknown liability. In addition to this, the client is obligated to prove his/her actual loss when the breach takes place. The client will also be obliged to prove that the losses are a natural result of the breach of contract, and not “remote”.