This article is written by Sarabjit Singh, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from Lawsikho.com. Here he discusses “Difference between penalty and liquidated damages – relevance of liquidated damages clause in commercial contracts”.

Right to claim Penalty or Liquidated damages is preceded by ‘Breach of Contract’ a legal term.  Therefore, it is appropriate to understand this term. 

What is breach of contract?

Breach of contract occurs when a party to the contract infringes or violates any of its provisions such that it is detrimental to the other party’s cause.  It may even inhibit a party to execute its share of duties. A violation could be whole or in part of the agreement. Before a breach of contract can be upheld by a court of law, it should satisfy the below mentioned four conditions. 

1. The contract should be valid embodying offer, acceptance, capacity to contract in terms of age and mental ability, intent and object of the contract.  
2. A plaintiff seeking penalty or liquidated damages should satisfy the court that the defendant has violated the terms of the agreement, and consequently monetary loss has been inflicted. 
3. The Plaintiff has fulfilled all the duties required of him as per the contract.
4. The Plaintiff has notified the defendant in writing of the breach committed. 

Types of breaches

Material breach:  A material breach is one that is significant enough to destroy the value of the contract.  In addition to the right to sue, it also relieves the aggrieved party from performing his part of the contract. 

Partial breach:  One that is not significant and does not absolve the aggrieved party from executing his share of duties. 

Anticipatory breach:  When a party foresees’ or suspects from acts undertaken that the other party is intentionally not willing to do his duties specified under the contract. 

Remedy for breach

A suit for damages can be filed under ‘The Indian Contract Act 1872’(ICA) Relevant sections 73 & 74 of ICA are extracted under: – 

 “73. 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”.

“74. 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.”

On discerning the above provisions, the following relevant features are noticed:

1. The aggrieved party shall receive compensation for the breach.
2. The parties to the contract anticipated such breaches at the time of drafting the agreement. 
3. Pre-estimated amount of Compensation/penalty is inscribed in the agreement and the aggrieved party shall not receive compensation/penalty beyond that amount. 

Liquidated Damages (ld)

Black’s Law Dictionary defines ‘Liquidated damages’ as, “An amount contractually stipulated as a reasonable estimation of actual damages to be recovered by one party if the other party breaches the contract; also 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.”  The word ‘reasonable’ is significant because the monetary claim should be as close as possible to the real loss.  

LD is a pre-estimated amount calculated based on known or expected breaches.  Whereas unliquidated damages cannot be calculated precisely, probably because of unknown factors that cannot be predicted or conceived in advance.  Since the LD have been quantified, so the parties to the contract are aware of the consequences that follow a breach of a condition. The very purpose of awarding LD is to protect the commercial interest of the parties.  They are so quantified that the economic status of the affected party remains the same as if the breach had not occurred. 

However, LD cannot be allowed to become a source of enrichment.  On the contrary, it must remain within the confines of what is called reasonable.  Instances, where it can be accurately calculated, LD awarded, is the actual monetary loss and not the full amount of agreed LD. Therefore, it is reemphasized that access to full LD amount is not a default provision but is limited by actual loss.

Burden of proving monetary loss

Under section 106 of the Indian Evidence Act, it is incumbent upon the person having knowledge of a fact to prove the same.  Meaning, thereby that the burden of proving loss due to breach of contract chiefly rests with the affected party. The only exception is when the loss is noticeable but is difficult or impossible to prove. 

Can liquidated damages be awarded without proof of breach?

Section 74 of ICA contains the expression, the party complaining of the breach is entitled, whether or not actual damage or loss is proved to have been caused thereby….” 

The above expression does not mean that even when actual loss or damage can be ascertained still it will be waived, and the wronged party shall be entitled to the pre-estimated LD.  Instead, it is only applicable in cases where it is difficult or nearly impossible to prove the actual loss. Even then, the court shall first ascertain if the pre-estimated damage or loss is authentic and only then adjudicate.  Support for the same can be found in Kailashnath Associates v. DDA (2015) 4 SCC 136

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“ It held that under Section-74 damage or loss caused is a pre-condition for applicability of the said provision. The Bench reiterated that the expression “whether or not actual damage or loss is proved to have been caused thereby” does not imply that even where it is possible to prove actual damage or loss, such proof is dispensed with. It is only in cases where damage or loss is difficult or impossible to prove, that liquidated amount named in the contract can be awarded, provided the same represents a genuine pre-estimate of damage or loss. The Bench reiterated the most basic principle on the award of damages viz. that compensation can only be given for damaged or loss suffered; if no damage or loss is suffered, the law does not provide for a windfall.”

Additionally, in Delhi High Court [Indian Oil Corporation Vs. Messrs. Lloyds Steel Industries Limited]; The honourable court held that even when a breach has been proved, but if it has not resulted in actual loss then LD can be denied.  

Another example of the same can be seen from Delhi High Court judgment in [Haryana Telecom Ltd. v. Union of India].  In the instant case, the Government had floated a tender for the supply of electricity cables.  However, the contractor failed to supply the cables on time, forcing the Government to procure them from a different source.  Subsequently, cables purchased were at a discounted price than offered by the contractor. The court observed that since no loss was incurred by the Government; therefore, an award of damages for breach could not be sustained. 

Penalty

Being fresh with understanding LD which is a projected genuine loss that has been computed for breach of condition in a contract.  However, if the amount fixed is without any regard to possible loss but is mostly intended to deter the other party in order to refrain from committing the breach, it is a penalty.  The specified sum is unconscionable, extravagant and does not appropriate with the damage likely to occur. Penalty operates as a punishment and not compensation for loss endured.

How have Indian Courts interpreted S. 74 of ICA? 

On a combined reading of the two apex court judgments, Oil and Natural Gas Corporation Ltd. v. Saw Pipes Ltd. & Fateh Chand v Balkishan Das, the expression “…or if the contract contains any other stipulation by way of penalty,…” contained in S. 74 of ICA is construed to mean: – 

1. “In case amount stipulated is by way of penalty, proof of damages is required.” 
2. “The Court will award to the party aggrieved only reasonable compensation not exceeding the amount named or penalty stipulated.”

Or absolutely, damages cannot be bestowed beyond really sustained.  Contrarily, the penalty is defined as a sum calculated disproportionately to a loss in value.  

Relevance of liquidated damages clause in commercial contracts

Several of the important features of LD Clause in commercial contracts: –  

1. It is drafted with mutual consent. 
2. Breaches are listed. 
3. Protects the parties to the contract from foreseen losses that can be evaluated in advance.
4. Legally enforceable. 
5. Simple dispute resolution process. 
6. Fear of liability induces performance. 

1. Once liability is proven or admitted the clause comes into subsistence. 
2. Liability and compensation are known entities.
3. Provides stability to the contract.
4. In any wrongful termination claim, the operator does not need to prove either its entitlement to loss or profits or the value of its loss or profits claim.

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