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This article is written by Saurabh Mishra, a student of HNLU.

Payment of damages is a good illustration of easy enforceability of contractual devices which is of paramount importance in commercial law. When a contract is entered between parties, the parties insert a clause in the contract determining the sum to be payable in the event of breach. If such a sum is genuine pre-estimate of loss it is termed as liquidated damage and if it bears no resemblance to the loss suffered, it is termed as penalty. It has been observed that bargaining power which the parties have while negotiating the substantive contractual rights and duties is far greater than bargain over remedial rights. Parties are not at liberty to charge exorbitant sum as breach for contract.

The Indian legislature has not made any distinction between penalty and liquidated damages by incorporating a simple rule that a court may award “reasonable compensation” not exceeding the sum named in the contract as payable in the event of breach, or any other stipulation by way of penalty. It is important to point out that a sum named in the contract will be taken to represent reasonable compensation in circumstances where it is difficult to assess the actual loss. The courts have also adopted an approach where they have made this benefit unavailable if the sum is seem to represent penalty as it will not be a “reasonable compensation” .

The purpose of awarding damages under Indian law is to place the aggrieved party with the help of money in the same position in which the party would have, had there been no breach taken place. Indian contract act forbids unjust enrichment under the garb of claiming compensation for a breach.

Position in England

Under English law, penalties are not recoverable. In the case of a penal clause, damages will be assessed in the usual manner and plaintiff may even recover a sum greater than the stipulated amount. The courts while deciding the amount of compensation payable must give regard to terms of the contract and circumstances under which the contract was entered.

In the case of Dunlop Pneumatic Tyre Co. Ltd v. New Garage and Motor Co. Ltd law relating to penalty clauses was explained. It held that

  1. The sum will be a penalty if it exceeds the greatest loss that could have been proved to have followed from the breach.
  2. The clause will be penal if its breach entails not paying a sum of money and amount to be paid as damages exceeds the sum which ought to have been paid.
  • When a single lump sum is made payable in all cases of breach, then there is a presumption in favour of the sum being treated as penalty.

In English law, a liquidated damages clause will enable a plaintiff to recover the stipulated sum without proving the damages or irrespective of any actual damage or when the actual damage is smaller than the stipulated sum. The purpose of fixing a sum is to allow recovery of damage without difficulty.

 

Difference between Liquidated Damages and Penalty

If the terms of the contract provide for an amount of liquidated damages which represents a mutual, genuine pre-estimate of the probable extent of the harm, the courts have been generally to keen to enforce such clause and award the entire agreed sum. However, if the clause is merely intended to secure performances of the contract by fixing a sum which exceeds the likely loss the court shall award only a reasonable amount. The question of determining a particular clause as penalty clause or liquidated damages is answered by considering various factors such as intention of the parties, terms and circumstances of the contract, purpose of the clause.

Liquidated damages reflect a reasonable estimate of the contracting parties of the loss to be suffered in case of breach of contract whereas penalty is devoid of any such estimation. It is understood that courts would be guided by the doctrine of reasonable compensation in case of breach of contract containing a penalty clause.

A penalty is a stipulation in the contract which is disproportionate or excessive that no prudent person would consider the same as reasonable assessment of damages arising out of breach.   Penalties can be charged on specific events only like delay in supplies, delay of completion of work. Penalties cannot be general in nature. Liquidated damages are easier to impose than penalties.

Summary of Law Relating to Damages in India

ONGC v. Saw Pipes [1],

The Supreme Court while discussing the concept of Liquidated Damages stated that:

  1. Terms of contract are required to be taken into consideration before arriving the conclusion whether the party claiming the damages is entitled to same.
  2. If terms of the contract are clear and unambiguous stating the liquidated damages in case of breach and they are not unreasonable or in the nature of penalty the party committing the breach is required to pay compensation according to section 73 of the Indian Contract Act.
  • Section 74 is to be read along with section73 and, therefore in every case of breach of contract, the aggrieved person is not required to prove actual loss or damage suffered by him before he can claim a decree. The court is armed with power to award reasonable compensation even in the cases if no actual damage is proved to have been suffered in the consequence of breach of a contract.
  1. If courts fail to assess the compensation contemplated or if the compensation is not by way of penalty or unreasonable, Court can award the same if it is genuine pre-estimate by the parties as measure reasonable compensation.

Fateh Chand v. Balkishan Das[2]

In the instant judgment, Supreme Court adopted the view that under the common law a genuine pre-estimate of damages by mutual agreement is regarded as stipulation naming liquidated damages. The aggrieved party is entitled to receive the compensation from the party who has broken the contract, whether or not actual damage or loss is proved to have been caused by the breach. It dispenses with proof of “actual loss or damages”.  Section 74 of the Indian Contract Act does not justify the award of compensation when no legal injury has resulted after breach.  Compensation for  breach of contract can be awarded to make good of the loss or damage which naturally arose in the usual course of things or which the parties  when making the contract were aware of.

After ONGC v. Saw Pipes [3] and Sudhir Gensets Ltd. v. Indian Oil Corporation[4] law relating to damages in India has taken a new course which can be summarized in following paragraphs:

  • The terms of the contract will be taken into consideration before concluding as to whether the party claiming the damages is entitled to seek
  • If the terms clearly stipulate the liquidated damages for breach of contract, then unless the damages are unreasonable or constitute penalty, the party which committed the breach must pay such compensation as per Section 73 of the Indian Contract
  • Section 74 of the act is to be read along with section 73 of the Act. Hence, in case of breach, the aggrieved party need not prove actual loss or damage.
  • In circumstances where it is impossible to assess the compensation arising from breach the court can award an amount which reflects a realistic pre-estimate as the measure of the compensation.

Conclusion

When it comes to liquidated damages and penalties, the courts have shown a tendency to rule that liquidated damages should be reasonable compensation, In case of penalties damages will have to be proved. The court can refuse to pass the compensation if no loss is likely to occur because of the breach.

If in the opinion of the court, the damages are in a nature of penalty, the court has the power to grant reasonable compensation not exceeding the amount mentioned in the contract on proof of damages. The courts have unqualified jurisdiction to award compensation in case of breach of contract, but the compensation must be reasonable. The aggrieved party is entitled to receive compensation from the defaulting party whether or not actual damage or loss is proved.

 

[1] 2003(5) SCC 705.

[2] AIR 1963 SCC 1405.

[3] Id.

[4]  MANU/DE/0347/2011 – FAO 253 / 2008

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