Liquidated Damages and Penalty

0
208
Liquidated Damages and Penalty

Damages

As per the black’s law dictionary damages means any monetary claim by, or ordered to be paid to a person as a compensation for any loss or injury incurred by them. In Indian Contract Act, damages are referred when there is a breach of contract i.e. when a party fails to perform the terms of the contract to which he is obligated, then that party has to provide compensation to the other party who has incurred the loss. The main purpose of compensation is to restore the position of the injured or aggrieved party to the economic position it would have been if the contract was not breached.

Liquidated Damages

As per black law dictionary liquidated damages means, “an amount contractually stipulated as a reasonable estimation of actual damages to be recovered by one party if the other party breaches the contract”. Before entering into a contract, the parties stipulate a sum of money which has to be paid by the one who has breached the contract to the other party who has been aggrieved and this sum of money is termed as liquidated damages.

Penalties

A penalty clause is terms of contracts that seek to impose an obligation to pay a sum of money in the event when any of the parties breach the contractual terms. The amount of penalty generally exceeds the amount of damages that could be sustained by the contracting parties. For this reasons, in many jurisdictions penalty clause is not enforceable due to public policy as if it is enforced then the party may profit from the breach of contract by another party.

The UNIDROIT principles of international commercial contracts provide in Article 7.4.13 as follows;

(1) Where the contract provides that a party who does not perform is to pay a specified sum to the aggrieved party for such non-performance, the aggrieved party is entitled to that sum irrespective of its actual harm.

(2) However, notwithstanding any agreement to the contrary specified sum may be reduced to a reasonable amount where it is grossly excessive in relation to the harm resulting from the non-performance and to other circumstances.”

Distinction between English Law and Indian Law

The penalty is used in a contract to secure the performance of the contract whose main purport is to ensure the payment of money which is specified to deter the party from offending. Also where the loss to be recovered is greater than the pre-determined loss then it amounts to a penalty. Whereas liquidated damages are compensatory in nature and are pre-estimated damages. The purpose liquidated damages are to promote certainty especially in the commercial field. This distinction between liquidated damages and penalty is suspended in the Indian Contract Act but the English law upholds the distinction. There are several conceptual differences as to whether the assessment of reasonable compensation made ex-ante (at the time of entering into the contract) is binding or is subject to ex-post (after the breach) review by the court.[1]

English Law

In the English law of contract contracting parties agree in advance the amount of damages that should be paid if a particular contractual obligation is subsequently breached i.e., liquidated damages clause. Where this clause is in operation, the contractual obligation that has been breached is referred to as the primary obligation, and the payment obligation under the liquidated damages clause is called the secondary obligation. But the English law does not recognize the enforceability of “penalty clauses”, i.e. the detriment imposed by the relevant provisions is disproportionately excessive in comparison with the legitimate interest of the innocent party (such as its monetary loss and, where applicable, any wider legitimate interest) in enforcing those provisions.

In England, while dealing with the validity of a stipulation of liquidated damages, the courts proceed on the prospective or ex-ante or first look methodology and, if the court is of the opinion that the amount of compensation fixed at the time of contract is a genuine pre-estimate of the damages which may arise on account of breach, the courts will grant the agreed amount and will not reduce the same even if a retrospective or ex-post or second look taken out after the breach reveals that the amount of damages originally fixed by the parties at the time of the contract is higher than what the evidence has revealed at the trial. Only when the court considers that the amount originally fixed is wholly disproportionate to the damages incurred and is by way of penalty (fixed in terrorem), the English court will grant reasonable damages as revealed at the trial.[2]

The test for determining whether a particular “liquidated damages” clause is, in fact, an unenforceable penalty clause, is simply whether the stipulated sum of liquidated damages was a genuine covenanted pre-estimate of damage that could be caused by breach of the relevant primary obligation. This principle was established a century ago, in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co[3]  which suggested that such provision would be unenforceable if the amount payable was “extravagant, exorbitant or unconscionable.”  This has led to a number of challenges to LDs clauses on the basis that they constituted a penalty.[4]

More recently, the courts in the UK acknowledged that in certain circumstances there may be a “commercial justification” for such provisions even where the amount to be paid appears penal. The Supreme Court has considered the “penalty rule” in Cavendish Square Holding BV v Makdessi[5] and ParkingEye Ltd v Beavis (Consumers’ Association intervening)[6]. The real test to determine the penalty clause is whether the provision goes beyond the relevant party’s “legitimate interest”. The Court stated that “the question of whether it is enforceable should depend on whether the means by which the contracting party’s conduct is to be influenced are “unconscionable” or (which will usually amount to the same thing) “extravagant” by reference to some norm“. The Court went on to state that “the true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter“. Examples of ‘legitimate interests’ which a brand owner might want to protect are intangibles like goodwill, brand reputation, confidential information, trade secrets, and customer loyalty and employee and licensee relationships.[7]

The contract in the Cavendish case was a large business sale transaction between sophisticated and well-advised entities. The Supreme Court acknowledged that where a contract is negotiated between ‘properly advised parties’ of ‘comparable bargaining power’ there is a strong presumption that the parties are the best judges of what should be in the contract and the courts should not interfere.

The Court also emphasised that the rule against penalties is concerned only with the secondary obligation to pay damages as the remedy for breach of an underlying primary obligation, and is not concerned with the primary obligation itself. This means that the application of the penalty rule may depend on how the relevant obligation is framed in the instrument. Thus, where a contract contains an obligation on one party to perform an act, and also provides that, if he does not perform it, he will pay the other party a specified sum of money, the obligation to pay the specified sum is a secondary obligation which is capable of being a penalty; but if the contract does not impose (expressly or impliedly) an obligation to perform the act, but simply provides that, if one party does not perform, he will pay the other party a specified sum, the obligation to pay the specified sum is a conditional primary obligation and cannot be a penalty. This doesn’t mean, however, that contracting parties can try to avoid the rule against penalties simply by labelling as a primary obligation what is, in reality, a contractual remedy for breach of a primary obligation.

Thus, the English law still does not uphold penalty clause enforceable. The liquidated damages clause that is penal in nature must be expressed as a secondary obligation which only operates once the primary obligation has been breached. Liquidated Damages clauses are generally upheld by the courts, providing they do not constitute a penalty. It now totally depends upon how the parties draft their clauses to mitigate the adverse consequences that might arise from accepting the proposed amount of liquidated damages as the courts are now set to identify a wider legitimate interest of the innocent party in enforcing the impugned clause than merely the need for pecuniary compensation for the loss. Where such legitimate interest is identified, the court might uphold the enforceability of the impugned clause, even if the stipulated amount is such that in the absence of such consequences the court would have treated the clause as a penalty clause and therefore unenforceable.

Indian Law

As per the Indian Contracts Act, 1872, the liquidated damages and penalty payable by the party committing a breach of contract, is based upon the doctrine of reasonable compensation. It is upon the court to adjudge the amount of reasonable compensation.

Section 74 states that if there is a breach of contract, then the innocent party shall receive a sum that was agreed by the parties at the time of entering into the contract from the party in breach. Alternatively, if the parties had stipulated a penalty at the time of entering into the contract, then such a penalty would be payable in case of such breach. The crucial aspect that is necessitated in this section is that the innocent party which is receiving the agreed sum is not required to prove “actual loss or damage” resulting from the breach before receiving the agreed sum. The said section also clarifies that if there is a breach of contract, then the innocent party will receive only reasonable compensation which will not exceed the agreed sum or the penalty stipulated for. Which means that in the event of a breach, the court may choose to award a reasonable sum which can be less or equal to the agreed sum but will not exceed the agreed sum or the penalty that was stipulated under the contract.[8]

The requirement of proving “actual loss or damage” was first tested by the Privy Council in Panna Singh v. Arjun Singh [9], wherein the Privy Council stated that the effect of Section 74 of the Contract Act is to disentitle the plaintiffs to recover simpliciter the sum specified in the contract, whether a penalty or liquidated damages, and hence in a suit by vendors for damages for breach of contract of sale, the plaintiffs must prove the damages they have suffered (sic).

Initially in the case of Fateh Chand v. Bal Kishan Das [10], it mainly eliminated the refinement under English Law in relation to the difference between the payment of liquidated damages and stipulation of penalty.  S.C stated that the aggrieved party is entitled to a reasonable compensation which should not exceed the sum of penalty or the pre-determined amount which have to be paid after the breach of contract. The Court interpreted Section 74 as a legal liability in the case of breach of contract, whether either through pre-estimated agreement compensation is paid as liquidated damages or through penalty. Thus,the applications of these provisions are not confined to the cases where the aggrieved party approaches the court for the relief. The Constitutional Bench, inter alia, clarified that “forfeiture of deposits” will be considered as “penalty stipulated for under the contract” for the purposes of Section 74 of the Contract Act and made it amply clear that for awarding reasonable compensation because compensation for breach of contract can be awarded to make good loss or damage which naturally arose in the usual course of things, or which the parties knew when they made the contract, to be likely result from the breach.

Unlike Panna case, the Court here acknowledged the fact that Section 74 dispenses the requirement of proof of “actual loss or damage” but it emphasised that reasonable compensation would be awarded only in the event there was a legal injury as without the same there was no question of awarding reasonable compensation.

Where the court is unable to assess the compensation arising from the breach, the sum pre-determined by the parties if it is regarded as a genuine may be taken into consideration as the measure of reasonable compensation, but not if the sum named is excessive and in the nature of a penalty. Where loss in terms of money can be determined, the party claiming compensation must prove the loss suffered by him[11].

In ONGC case[12], inter alia, Supreme court laid down an obiter dicta that if the parties have contemplated a named sum as a genuine pre-estimate of the damages that would be payable in case of breach, then in the occurrence of such breach no “actual loss or damage” needs to be proved and it would be up to the party who claims that there is no loss that has ensued from breach of contract has to adduce evidence to support its claim.

If we were to analyse Principles (3) and (4) of ONGC case independently, we may arrive at a bizarre conclusion that Principle (3) seems to suggest that in every case of breach of contract, the person aggrieved by the breach is not required to prove “actual loss or damage” before he or she can claim a decree; and in Principle (4), the Supreme Court lays down a contrary view that if the breach is of such a nature where it is impossible to prove actual loss or damage, then the sum agreed by the parties as genuine pre-estimate will be awarded.

If Proposition (3) is read in isolation from Proposition (4), it gives an impression that the agreed amount of damage will have to be paid even if, ex-post (after a breaching of contract), enquiry by the court reveals a lesser amount of damage suffered or even if no damages are suffered. But, if Propositions (3) and (4) are not separated and if Proposition (4) is merged in Proposition (3) at the end, it will be clear that the above-said clause in the section needs to be interpreted in a disjunctive manner to cover two different classes of contracts, one in which it is possible to ascertain the money value of the legal injury and another in which it is not possible to ascertain the money value of the legal injury.

Thus, the expression “whether or not actual damage or loss is proved to have been caused thereby” means that where it is possible to prove actual damage or loss, such proof is not dispensed with. It is only in cases where damage or loss is difficult or impossible to prove that the liquidated amount name in the contract, if a genuine pre-estimate of damage or loss, can be awarded.[13]

In the case of BSNL v. Reliance[14], where there was a dispute relating to the Caller Line Identification device, and as was recovered that the calls of CLI have been manipulated which invoked a method of computing charges and hence resulted in BSNL, levying a charge of Rs. 9.89 cr. on Reliance. By applying the same maxim, i.e., the use of pre-estimation loss as the best indicator of reasonable compensation which was propounded in the case of Fateh Chand, the court observed that the damages to be provided should be based on the concept of reasonable compensation. While categorising damages as “penal” or “liquidated damages”, one must keep in mind the concept of pricing of these contracts and the level playing field provided to the operators because it is on costing and pricing that the loss to the promisee (BSNL) is measured and, therefore, all calls during the relevant period have to be seen. Since Clause 6.4.6 of interconnection agreement represents the pre-estimate of reasonable compensation, Section 74 of the Contract Act is not violated.

Before the amendment of 1899, all Indian cases followed the common law perspective, but the amendment broadened the purview of Section 74. The clause “any other stipulation by way of penalty” was inserted in Section 74, which was first addressed in the case of Fateh Chand v. Bal Kishan Das[15]. In the case of Kailash Nath[16], the apex court held that Sec.74 does not extend to the jurisdiction of granting relief in cases of penalty when the provision of the section does not apply in terms. Where in earlier cases the court stated that Section 74 extends to those cases where there are extreme circumstances.

Under English Common Law, parties may name a sum to be payable in case of a breach, which is classified by the court as a penalty is irrecoverable but if classified as liquidated damages is recoverable.31 However, the Law of Contracts in India does not recognise any qualitative difference in the nature of damages, as section 74 eliminates the somewhat elaborate refinement under Common Law. The removal of this distinction avoids a quagmire of complex classifications, thereby binding the court only to award any ‘reasonable compensation’ that it sees fit, not exceeding the damages stipulated in the contract.[17]

Similarities between English and Indian Law

The circumstances under which penalty is awarded in Indian law and English are similar. Though there is a difference between liquidated damages and penalty in English law but Indian law also recognizes the cases where damages are provided as a penalty or not. As the amount decided by the contracting parties at the time of entering into a contract will be reduced by the courts if it appears by the way of penalty, else the amount as liquidated damages is payable. Moreover, the first explanation to the section uses the word “penalty”. It provides that “a stipulation for increased interest from the date of default may be a stipulation by way of penalty.” [18]Therefore, both legal regimes protect the interest of the contracting parties and prevent the payment of penalties that may be excessive.

The common feature between English law and Indian law is depicted in the decision of Supreme Court in Chunilal V. Mehta and Sons Ltd. Vs. Century Spg & Mfg Co. Ltd,[19] where it has been held that “by providing for compensation in express terms the right to claim damages under the general law is necessarily excluded“. This ensures the right to freedom to contract of the parties and the same was the view of UK Supreme Court in Cavendish case.

In England, while dealing with the validity of a stipulation of liquidated damages, the courts proceed on the prospective or ex-ante or first look methodology and, if the court is of the opinion that the amount of compensation fixed at the time of contract is a genuine pre-estimate of the damages which may arise on account of breach, the courts will grant the agreed amount and will not reduce the same even if a retrospective or ex-post or second look taken out after the breach reveals that the amount of damages originally fixed by the parties at the time of the contract is higher than what the evidence has revealed at the trial. Only when the court considers that the amount originally fixed is wholly disproportionate to the damages incurred and is by way of penalty (fixed in terrorem), the English court will grant reasonable damages as revealed at the trial.[20]

In a recent judgment of the Supreme Court in Saw Pipes[21], the Court formulated four propositions of law. There is a view that after Saw Pipes14, there is a change in the Indian law, shifting to the English model of prospective or ex-ante or first look model and that where an estimate of damages is made at the time of contract, the same has to be paid even though, after the breach and at the trial, lesser damages or no damages are proved to have been incurred by the innocent party.


[References]

[1]Justice M Jagannadha Rao,’ Liquidated Damages and Penalties: Ex Ante or Ex Post Methodology” (2013) 1 SCC J-1.

[2] A Justice M Jagannadha Rao,’ Liquidated Damages and Penalties: Ex Ante or Ex Post Methodology” (2013) 1 SCC J-1.

[3]Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co 1915 AC 79.

[4]https://www.lexology.com/library/detail.aspx?g=ea8c9ddb-c2da-401d-886c-c807ce38fcf1 accessed 1 April 2018.

[5]Cavendish Square Holding BV v Makdessi [2015] UKSC 67.

[6]ParkingEye Ltd v Beavis (Consumers’ Association intervening) [2015] 3 WLR 1373.

[7]https://www.twobirds.com/en/news/articles/2016/global/brandwrites-may/new-rules-on-liquidated-damages-c lauses-under-english-law accessed 30 May 2018.

[8] Arun Subash, ‘Legal Requirement of Proving Actual Loss or Damage Under Section 74 of the Contract Act, 1872’ 2018) PL March 84.

[9]Panna Singh v. Arjun Singh (1929) 30 LW 281.

[10]Fateh Chand v. Bal Kishan Das (1964) 1 SCR 515.

[11]Maula Bux v Union of India (1969) 2 SCC 554.

[12]ONGC Ltd v Saw Pipes Ltd (2003) 5 SCC 705.

[13]Kailash Nath Associates v DDA (2015) 4 SCC 136.

[14]BSNL v Reliance Communication Ltd (2011) 1 SCC(Civ) 192.

[15]Fateh Chand v. Bal Kishan Das (1964) 1 SCR 515.

[16]Kailash Nath Associates v DDA (2015) 4 SCC 136.

[17] Nadia Gracias and Siddhima Kotak, ‘The Saw Pipes Judgment by’ (2005) 4 Law Rev GLC 106.

[18] Dr. Avtar Singh, Law of Contract and Specific Relief (11thedn, EBC Publishing (P) Ltd, 2013).

[19]Chunilal V. Mehta and Sons Ltd. v. Century Spg&Mfg Co. Ltd 1962 AIR 1314.

[20] A Justice M Jagannadha Rao,’ Liquidated Damages and Penalties: Ex Ante or Ex Post Methodology” (2013) 1 SCC J-1.

[21]ONGC Ltd v Saw Pipes Ltd (2003) 5 SCC 705.

Previous articleMale Rape – An important issue
Next articleRule of Mitigation of Damages
Sakshi Agarwal
I am Sakshi Agarwal from Dr. Ram Manohar Lohiya National Law University, Lucknow pursuing B.A. L.L.B. (Hons.). Having no legal background, the inspiration to study law came from the society and with the support of my parents I became the path breaker of my family. Being in my initial years of college, all the subjects at present like Law of Contracts attract me but I always keep reading Constitutional Law. The economics arena has always been my strength and in my career I would like to link economics with law. Apart from this, I do adjudicating and mooting. I love to listen to people and when it comes to debate, it’s the best opportunity to learn by listening. At law school, I have developed a keen interest in researching. At all the times, whether it’s working, studying or just sitting idle I aim to find happiness. Something I love a lot apart from reading books and watching movies, is travelling. I’m always excited about it and never miss a chance to explore new places and be adventurous.