This article is written by Ritika Sharma, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from Lawsikho.com.
Penalties are an effective way to ensure enforcement of a Contractual Duty as it acts as a deterrent in case either party does not perform their part of the obligation. For example, a penalty clause in case of a breach of an agreement states that the defaulter will pay 10 times the amount of breach will be considered as a deterrent so that no party to the contract shall breach due to the heavy penalty.
A penalty clause is an express provision in a contract. It places an obligation upon the party who has breached the contract to provide compensation to the aggrieved party affected by the breach .Here, compensation does not merely mean compensating the aggrieved party for the losses it suffers but also a penalty in case of wilful breach.
To look at whether penalty clauses are valid in India, we first have to look at the English law. The Common law provides that in case any party breaches a contract, it shall pay compensatory damages to the defaulting party to compensate.
The question of whether penalty clauses were valid was long uncertain in the UK. The Supreme Court of the UK in 2015 in a joint case of Cavendish Square Holding B.V. v. Talal El Makdessi  and Parking Eye Limited v. Beavis  laid down a test for enforceability of penalty clauses:
- Whether the Clause in dispute can be classified into a Primary or a Secondary Obligation.
The Court has to first determine whether the obligation is primary or secondary and if the clause pertains to Primary Obligation then it is enforceable.
- Whether the Clause in dispute is Penal?
In case that the Obligation is Secondary in nature, the Court will determine whether the said Clause is penal in nature. If the nature of the clause is to impose a penalty on the breaching party then it is a penalty clause and unenforceable.
The Court in this case also discussed the relevance of circumstances surrounding the contract. Relevance of circumstances surrounding the contract stated that in cases when the parties who negotiate a contract are properly advised of comparable bargaining power, they are the best judges of what is a legitimate provision in the consequences of breach. In such cases, the Courts should be reluctant to get involved .
Traditionally, the only test which was taken into consideration by the UK Courts was whether the damages were a genuine pre-estimate of the breach by the defaulting party. The test back then was to check whether the damages can be justifiable as the amount which is not excessive of the breach.
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Liquidated damages and penalty
Liquidated Damages refer to the amount of damages which the party estimates for the breach of the contract. For example, if A and B get into an agreement that A will pay Rs 5 lakhs to B for the number of shares and A fails to pay then B can only get the amount for estimated damages which is Rs. 5 lakhs. The condition for damages to be liquidated is that it is a genuine pre-estimate of the direct losses which are suffered by the aggrieved party. Before the parties get into a Contract, they make a pre-estimate of the loss which they can suffer due to the breach of the Contract. A party can only ask for Liquidated Damages in cases where the other party has committed a breach which has been adjudicated by the Court or the Arbitrator.
On the other hand, Penalty is damages which are additional to the liquidated damages. The expression ‘penalty’ is an elastic term with many different shades, but it always involves an idea of punishment. The Purpose of a Penalty clause is not to ensure compensation in case of a breach but the performance of a contract. In English Law, the penalty clause is against Public Policy. However, the Indian Courts have been silent on this particular aspect. Section 23 of the Indian Contract Act states that Agreements whose object is opposed to Public Policy is void.
The Indian statue has made a classification on Liquidated Damages and Penalty with reasonability. It means that liquidated damages are reasonable whereas anything which is unreasonable and excessive of the amount of breach is penalty. Liquidated damages or Penalty act as a penalty beyond which the Court cannot give reasonable compensation. 
Current legislation governing penalty clauses regulation
The legislature in India has not stated the validity of penalty clauses. These clauses are governed under Chapter VI of the Indian Contract Act, 1872.
Section 73 of the Act states that compensation for loss is caused by breach of contract. It is defined as “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.
Such compensation is not to be given for any remote and indirect loss or damage sustained by reason of the breach.” It is clear from this Section that the loss should be natural and should arise directly out of the breach of this contract. Further, this Section also discusses the remoteness of damage. Remoteness refers to whether the said damage was directly related to the breach. In cases where the damage is indirect and remote, the Court shall not give compensation to the defaulting party. Penalty clauses on the other hand are penal damages which are more than the loss which is incurred.
Section 74 of the Act defines Compensation for breach of Contract where penalty is stipulated for. Contracts in which there is a penalty clause, the aggrieved party can only ask for a reasonable compensation from the parties. The word reasonable is not stated but shall be taken up on a case-to-case basis looking at the circumstances of the case, the amount of default, paying capabilities of the parties etc.
Both liquidated damages and penalty follow the doctrine of reasonable compensation. Doctrine of Reasonable Compensation refers to when the compensation is “reasonable”. Reasonability is determined by the facts and circumstances of each case. In case of a breaching party, reasonability may mean the damage suffered.
The Supreme Court of India in various judgements has mentioned the importance of reasonable compensation. In the case of Construction & Design Services v. Delhi Development Authority , the Court stated that the Court must determine the reasonable compensation and then grant it to the injured party.
Enforceability of a penalty clause
In India, the Validity of Penalty Clauses was questioned in various Supreme Court judgements. Generally, penalty clauses are taken in consideration with liquidated damages. In ONGC v Saw Pipes , the Court laid down certain observations referring to Section 73 and 74 of the Act one of which was that “If the terms are clear and unambiguous stipulating the liquidated damages in case of the breach of the Contract unless it is held that such estimate of damages/compensation is unreasonable or is by way of penalty, the party who has committed the breach is required to pay such compensation and that is what is provided in Section 73 of the Contract Act.” The Law not only decides the amount of liquidated damages but also the compensation which is ‘likely’ to arise from the breach of the Contract .
Therefore, the Apex Court had explicitly stated that liquidated damages unless unreasonable or penalty shall be allowed. It further stated that even in case of unliquidated damages, if it is not unreasonable or penal then the Court shall allow compensation which is a genuine pre-estimate of the loss.
In Fateh Chand v Balkishan Das , the Supreme Court similarly stated that the “Duty not to enforce the penalty clause but only to award reasonable compensation is statutorily imposed upon Courts by Section 74.” Contracts with penalty clauses often are unreasonable and put burden on the defaulting party. Parties in case of wilful default might suffer consequences which are much more than their default. It can be said that putting unreasonable penalties on the defaulting party is against Public Policy. In Central Inland Water Transport Corpn. Ltd. V Brojo Nath Ganguly , the Supreme Court said that “Public Policy” and “Opposed to Public Policy” is not defined under the Indian Contract Act and is incapable of a precise definition. Therefore, what is injurious to public good can be the basic definition of ‘Opposed to Public Policy’. Contracts with Penalty Clauses can be said to be against Public Policy because it is harmful to the parties who have defaulted even in cases when the default is not wilful.
Damages are of two types- liquidated and unliquidated. Liquidated damages are defined at the start of the Contract whereas the unliquidated damages refer to when damages have not been pre-estimated but are equal to the amount of breach.
Penalty on the other hand is often added to the Agreement in order to deter the parties to not perform their part of the obligation. In the common law jurisdictions, penalty clauses are not valid. However, the amount of penalty should be excessive and unreasonable.
In India, a variety of cases have been filed with reference to Liquidated Damages and Penalty. Only the amount which is reasonable to the breach shall be provided by the Courts. Therefore, the Indian judiciary makes penalty clauses valid only till the point where it is reasonable and not in excess of the breach.
 Clarke, M. Are penalty clauses enforceable? (2020, June 24). Nelsons Law. https://www.nelsonslaw.co.uk/penalty-clause/
 Hobbs, V. (n.d.). Penalty clauses: Has the Supreme Court finally clarified when a clause may amount to a penalty and is therefore unenforceable? Bird & Bird. https://www.twobirds.com/en/news/articles/2016/uk/penalty-clauses-has-the-supreme-court-finally-clarified-when-a-clause-may-amount-to-a-penalty
 (2015) UKSC 67, https://www.supremecourt.uk/cases/uksc-2013-0280.html
 (2015) UKSC 67, https://www.supremecourt.uk/cases/uksc-2015-0116.html
 AIR 2011 SC 2477
 Sova Ray v. Gostha Gopal Dey, AIR 1988 SC 981
 Rajbir Singh & Anr vs Jaswant Yavdav, 2018 SCC OnLine Del 9042
 (2003) 5 SCC 705
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 AIR 1963 SC 1405
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