Law of Liquidated Damages and Penalty (S.74 of the Indian Contract Act)
When the contract mentions a ‘specific amount’ to be paid as compensation in case of breach :
- Whether that amount is ‘conclusive’ and bars any enquiry by the court into actual loss/damages suffered;
- Whether the claiming party is obviated from proving the ‘actual loss’;
- Whether the claiming party is also obviated from proving ‘any loss’ as a consequence of breach of the contract;
These are the questions that this post seeks to answer.
Since our Contract Law is derived from English Cases, let us first begin at the beginnings and briefly examine the English Law in this regard :-
The parties to a contract may determine beforehand the amount of compensation payable in the event of breach. According to English law, a sum so fixed may fall in any of the following categories :
- Liquidated damages, or
If the sum fixed represents a genuine pre-estimate of probable damage that it likely to result from the breach, it is liquidated damages. A sum less than the amount of probable damage is also regarded as liquidated damages. The whole of such sum is recoverable.
In the latter cases, the money stipulated is in terrorem, i.e an extravagant and unconscionable amount, totally out of sync with the actually loss that could be conceived in the case, quoted as a deterrent with a view to discourage breach of contract.
In such a case the court can reject the named amount, and damages will be calculated in accordance with ordinary principles. The fixed figure does constitute the maximum ceiling, and can never be exceeded though.
Indian Law strikes a slightly different note. Section 74 reads as under :-
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.
Explanation.—A stipulation for increased interest from the date of default may be a stipulation by way of penalty.]Section 74 of the Contract Act
On a bare reading it appears that the Indian Law has steered clear of the distinction between Penalty and Liquidated Damages, and makes two things clear :-
- The amount mentioned by the parties constitutes the upper limit;
- Within that ceiling, a reasonable compensation is to be awarded.
Some other important points :
- Prior to invoking right to damages, the injured party will have to prove breach of contract on the part of the other party.
- The Court has to make its own assessment of the amount of loss causes by the breach. It cannot blindly follow the contract clause in awarding damages without any adjudication (Uma Minerals v. Malabar Cements Ltd, AIR 2003 Ker 146);
- Contrary to misconception – Distinction between liquidated damages and penalty is not altogether irrelevant to the section.
- Its relevance, in the first place, arises from the fact that the amount contemplated by the parties will be reduced only if it appears by way of penalty. Otherwise the whole of it is recoverable as liquidated damages.
- Secondly, this is also implicit from the use of word ‘penalty’ in first explanation of the section, which allows exorbitant rate of interest to be construed as penalty and consequently diluted.
Some case studies.
Fateh Chand v. Balkishan Dass, AIR 1963 SC 1405 (Constitution Bench) Out of Earnest Money- only ‘Reasonable Amount’ liable to be forfeited.
Facts : Agreement for sale of certain land/house for Rs. 1,12,500. Rs. 1000 was payable as earnest money and Rs. 24,000 on delivery of possession. These payments were made and buyer was put in possession. Agreement further provided that if buyer failed to pay the balance price and get sale deed registered, sum of Rs. 25,000/- would stand forfeited. Buyer defaulted.
Held : The court allowed forfeiture of Rs. 1000 in the facts of the case, as the same was found to be reasonable, but conclusively held that only such amount is liable to be forfeited as is found to be reasonable.
Chunilal V. Mehta & Sons Ltd. V. Century Spg and Mfg. Co. Ltd. (1962 Supp (3) SCR 549)
‘By providing for compensation in express terms (S.74) the right to claim damages under the general law (S.73) is necessarily excluded.’
- Agreement for appointment of managing agents.
- Remuneration Rs. 6000 per month or 10 % of gross profits of a year, whichever was more.
- In the event of premature termination, their compensation not less than Rs. 6000 per month for the whole of the unexpired period.
- They were removed before the expiry of term and compensation @ 10 % of gross profits for unexpired term was sought.
SC held : the agents were entitled to Rs. 6000 per month as per the contract and not 10 % gross profits. By naming damages, the general application of principles of damages stood excluded.
WHETHER ACTUAL LOSS NECESSARY ?
- Chunilal (supra) first held that ‘proof of actual loss or damage’ is not necessary, however there should be legal injury as a result of the breach. Proof of some loss is, therefore, necessary.
- This was reaffirmed by the SC in Maula Bux v. Union of India (1969) 2 SCC 554.
Case Study – Maula Bux v. Union of India (1969) 2 SCC 554.
Facts : A supplied to the government deposited a certain amount of money as security for performance of the contract. Contract breached. Government rescinded the contract and sought to forfeit the entire Security Deposit. The government argued that it is not incumbent on them to prove ‘actual loss or damage’.
Held : The words ‘whether or not actual damage or loss is proved to have been caused thereby’ apply only in those cases where it is not possible to prove monetary value of the loss, and, therefore, value fixed by parties may be taken as a reasonable measure of compensation.
In the present case, loss could be determined. The government having led no evidence to prove : Whether prices paid to alternate source of supply were less or more than the contract price, therefore, the Government was not entitled to any compensation for the breach.
Applying Maula Bux (supra) damages have been declined in a catena of cases where no loss was proved, or infact a profit was made subsequent to the breach of the contract. (See : Ennore Port Ltd v. Hindustan Construction Co Ltd. (2005) 4 Mad LJ 86; State of Orissa v. Calcutta Co Ltd. AIR 1981 Ori 206).
Other Points relating to S.74.
- Principle of S.74 applicable to amount quoted in consent decrees (Parvati Bai v. Ayodhia Pd. Jain, 1985 MPLJ 703) In this case it was held that a consent decree is a contract and any penalty clause therein can be read down. It went on to the extent of saying that “the executing court shall always have the power to apply equitable principles embodies in Section 74 and relieve a party to a contract against any term in the decree which operates as penalty”
(Ed. Comment : Students of Civil Procedure may want to examine whether such an approach on part of the executing court amounts to going behind the decree, on which there is a specific mandate. Students may also examine as to the role of court passing the consent decree, whether that court should ensure that no penalty/excessive damage clause creeps in the agreement. What would be the brief of the court passing such decree would also be interesting to examine)
Whose Burden is it to prove loss, or absence of loss, as the case may be.
It appears from the decision in Chunilal (supra) that it is for the party claiming damages to prove the quantum of damages.
However, a somewhat discordant note was struck by the SC in ONGC Ltd. V. Saw Pipes Ltd. (2003) 5 SCC 705 wherein the court held that “Burden of Proving that no losses were actually caused to the other party was on the party committing breach. The Court said that it was not necessary for the party to lead evidence to show the amount of loss suffered by it unless the breaching party came to the court and proved that no loss was in-fact caused.
The case involved public utility services and has been a precedent in such cases ever since.
Section 74 and Public Contracts – Latest Trends.
It was also held in ONGC (supra) that in cases relating to public utility, that by itself, could be a ground for compensation, even without proof of actual loss, as in such cases, the damage to the public at large is difficult, if not impossible to quantify and is assumed; it falls now on the party breaching the contract to prove that the clause is in the nature of a ‘penalty’ and no, or less damage actually occasioned.
In Saw Pipes (supra) the SC has, therefore, contemplated the onus shifting to the defendant to establish the absence of loss/damage and not other way round. It is rightly observed in the said judgment that where the contract in question is one relating to a public utility and for instance the loss/damage to the public on account of delay in due execution, the loss on account of the breach is not amenable to precise quantification and assessment.
The principle laid down in ONGC v. Saw Pipes Ltd. (2003) 5 SCC 705 has been reaffirmed recently by the SC in M/S Construction and Design Services v. DDA (2015) 14 SCC 263 in a case involving public utility/town planning/civic/public amenities contract and lapse in its performance, where amount named in contract was held to be conclusive and binding. This case related to a public utility and had contained an express finding to the effect that the contractor had failed to execute the work (construction of sewerage pumping station) (para 14). It is in this context that the Supreme Court held that if the entire amount stipulated is a genuine pre-estimate of damages, actual loss need not be proved (para 16). The Court further premised this conclusion on a finding that the evidence of precise amount of loss may not be possible.
[Ed. Comment : Upon fair reading of the relevant paragraphs of the judgment passed by the Supreme Court in the case of Construction and Design Services (supra), it is clear that the Supreme Court has retained the power of the court to examine as to what extent the party complaining the breach is entitled to compensation in the event of breach in the contract involving public utility service containing pre-estimated damages and the same is rightly so in view of the provision of Section 74 of the Act]
However, in cases not involving public amenities, courts have fallen back on the traditional principles of Fateh Chand (supra) and Maula Bux (supra). A recent example is Kailash Nath Associates v. DDA & Anr. (2015) 4 SCC 136 where earnest money paid was held not liable to be forfeited and ordered to be returned with interest, as DDA subsequently auctioned the land to other party at almost 5 times the price, and also because breach on the part of the appellant was not proved. Besides, the court also held that this was a case where bid did not fructify into an actual agreement, and Section 74 of the Contract did not apply at pre-contract stage, therefore, restitution ought to be made and not grant of damages. In this case notably, it was not the case of DDA that it had suffered any damages on account of alleged breach of conditions/non payment by the appellant, infact it had made a killing out of the subsequent auction.
Latest in the Delhi High Court on this :-
A Recent Delhi High Court decision where liquidated damages have been denied on account ‘no loss’ is : Punj Lloyd v. Gail India Ltd. 2016 SCC OnLine Del 2542
A latest judgment by the Delhi High Court on payment of reasonable damages, within the maximum ceiling, on non-proof of fact that contract related to public serves is : ATC Telecom Tower Corporation Pvt Ltd. V. Videocon Communications Ltd. 2016 SCC OnLine Del 5237.