Law of Liquidated Damages
and Penalty
Relevant Provisions under the Indian Contract Act,
1972:
Section
73 - Compensation
for loss or damage caused by breach of contract. 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.
Compensation for failure to discharge obligation resembling those created by
contract
Section
74 -
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.
Under Section 74 of the Contract Act, the party
claiming breach of contract is entitled to receive reasonable compensation
whether or not actual loss is proved to have been caused by such breach. In
view of the ruling in ONGC vs. Saw Pipes, wherever there is a
pre-determined amount for the damages, in such a situation the said amount can
be deducted by way of liquidated damages by way of specified amount payable by
the respondent. Thus, if the compensation is named in the contract by way of
penalty, consideration would be different and the party is only entitled to
reasonable compensation for the loss suffered. But if the compensation named in
the contract for such breach is genuine pre-estimate of loss which the parties
knew when they made the contract to be likely to result from the breach of it,
there is no question of proving such loss or such party is not required to lead
evidence to prove actual loss suffered by him.
The above provisions enact principles upon
which damages are to be awarded by the Courts in India
Case Laws:
1. The Supreme Court, in Fateh
Chand v. Bal Kishan Das AIR 1963 SC 1405 called Section 74 as the
provision cutting through the maze of rules evolved by English Courts over a
period of time to distinguish between what is considered a genuine
pre-determination of damages and what is penalty and, therefore, not
enforceable. The Court held as follows: -
“10. Section 74 of the Indian Contract Act deals with the measure of
damages in two classes of cases (i) where the contract names a sum to be paid
in case of breach and (ii) where the contract contains any other stipulation by
way of penalty. We are in the present case not concerned to decide whether a
contract containing a covenant of forfeiture of deposit for due performance of
a contract falls within the first class. The measure of damages in the case of
breach of a stipulation by way of penalty is by Section 74 reasonable
compensation not exceeding the penalty stipulated for. In assessing damages the
Court has, subject to the limit of the penalty stipulated, jurisdiction to
award such compensation as it deems reasonable having regard to all the
circumstances of the case. Jurisdiction of the Court to award compensation in
case of breach of contract is unqualified except as to the maximum stipulated;
but compensation has to be reasonable, and that imposes upon the Court duty to
award compensation according to settled principles. The section undoubtedly
says that the aggrieved party is entitled to receive 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. Thereby it merely dispenses with
proof of “actual loss or damage”; it does not justify the award of compensation
when in consequence of the breach no legal injury at all has resulted, 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 to result from the breach.
15. Section 74 declares the law as to liability upon breach
of contract where compensation is by agreement of the parties pre-determined,
or where there is a stipulation by way of penalty. But the application of the
enactment is not restricted to cases where the aggrieved party claims relief as
a plaintiff. The section does not confer a special benefit upon any party; it
merely declares the law that notwithstanding any term in the contract
predetermining damages or providing for forfeiture of any property by way of
penalty, the court will award to the party aggrieved only reasonable
compensation not exceeding the amount named or penalty stipulated. The
jurisdiction of the court is not determined by the accidental circumstance of the
party in default being a plaintiff or a defendant in a suit. Use of the
expression “to receive from the party who has broken the contract” does not
predicate that the jurisdiction of the court to adjust amounts which have been
paid by the party in default cannot be exercised in dealing with the claim of
the party complaining of breach of contract. The court has to adjudge in every
case reasonable compensation to which the plaintiff is entitled from the
defendant on breach of the contract. Such compensation has to be ascertained
having regard to the conditions existing on the date of the breach.
16. There is no evidence that any loss was suffered by the
plaintiff in consequence of the default by the defendant, save as to the loss
suffered by him by being kept out of possession of the property. There is no
evidence that the property had depreciated in value since the date of the
contract provided; nor was there evidence that any other special damage had
resulted. The contact provided for forfeiture of Rs 25,000 consisting of Rs,
1039 paid as earnest money and Rs 24,000 paid as part of the purchase price.
The defendant has conceded that the plaintiff was entitled to forfeit the
amount of Rs 1000 which was paid as earnest money. We cannot however agree with
the High Court that 13 percent of the price may be regarded as reasonable
compensation in relation to the value of the contract as a whole, as that in
our opinion is assessed on an arbitrary assumption. The plaintiff failed to
prove the loss suffered by him in consequence of the breach of the contract
committed by the defendant and we are unable to find any principle on which
compensation equal to ten percent of the agreed price could be awarded to the
plaintiff. The plaintiff has been allowed Rs 1000 which was the earnest money
as part of the damages. Besides he had use of the remaining sum of Rs 24,000,
and we can rightly presume that he must have been deriving advantage from that
amount throughout this period. In the absence therefore of any proof of damage
arising from the breach of the contract, we are of opinion that the amount of
Rs 1000 (earnest money) which has been forfeited, and the advantage that the
plaintiff must have derived from the possession of the remaining sum of Rs
24,000 during all this period would be sufficient compensation to him. It may
be added that the plaintiff has separately claimed mesne profits for being kept
out possession for which he has got a decree and therefore the fact that the
plaintiff was out of possession cannot be taken, into account in determining
damages for this purpose. The decree passed by the High Court awarding Rs
11,250 as damages to the plaintiff must therefore be set aside.”
2. In the case of Maula Bux v. Union
of India AIR 1970 SC 1955, the Supreme Court rejected the contention
that quantified amounts spelt out in a contract for supply of potatoes to the
Central Government, were, in the circumstances of the case, genuine
pre-determination of what the damages were likely to be and held that such
conditions were unenforceable penalties. The Court also noticed that that the
Central Government did not make any effort to establish the quantum of damage
suffered by it. It approved the previous ruling in Fateh Chand case.
3. Similarly, in M.L. Devendra Singh v. Syed
Khaja 1973 (2) SCC 515 (affirmed in P. D'Souza v. Shondrilo
Naidu,(2004) 6 SCC 649) the Court accepted the same approach and further
emphasized that mere stipulation of some amount would only be a piece of
evidence, but inconclusive by its very nature:
"20. The fact that the parties themselves
have provided a sum to be paid by the party breaking the contract does not, by
itself, remove the strong presumption contemplated by the use of the words
„unless and until the contrary is proved‟. The sufficiency or insufficiency of any evidence to
remove such a presumption is a matter of evidence. The fact that the parties
themselves specified a sum of money to be paid in the event of its breach is,
no doubt, a piece of evidence to be considered in deciding whether the
presumption has been repelled or not. But, in our opinion, it is nothing more
than a piece of evidence. It is not conclusive or decisive.”
4. In Oil and Natural Gas Corporation Ltd
v. Saw
Pipes Ltd. AIR 2003 SC 2629, the Hon’ble Supreme Court inter alia observed as under:
“From the aforesaid Sections, it can be held that when a contract has
been broken, the party who suffers by such breach is entitled to receive
compensation for any loss which naturally arise in the usual course of things
from such breach. These sections further contemplate that if parties knew when
they made the contract that a particular loss is likely to result from such
breach, they can agree for payment of such compensation. In such a case, there
may not be any necessity of leading evidence for proving damages, unless the
Court arrives at the conclusion that no loss is likely to occur because of such
breach. Further, in case where Court arrives at the conclusion that the term
contemplating damages is by way of penalty, the Court may grant reasonable
compensation not exceeding the amount so named in the contract on proof of
damages. however, when the terms of the contract are clear and unambiguous then
its meaning is to be gathered only from the words used therein. In a case where
agreement is executed by experts in the field, it would be difficult to hold
that the intention of the parties was different from the language used therein.
In such a case, it is for the party who contends that stipulated amount is not
reasonable compensation, to prove the same.”
Further, in the
aforesaid case, the Court summarized the legal position as follows
“(1) Terms of the contract are required to be taken into
consideration before arriving at the conclusion whether the party claiming
damages is entitled to the same.
(2) 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,
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.
(3) Section 74 is to be read along with Section 73 and,
therefore, in every case of breach of contract, the person aggrieved by the breach
is not required to prove actual loss or damage suffered by him before he can
claim a decree. The court is competent to award reasonable compensation in case
of breach even if no actual damage is proved to have been suffered in
consequence of the breach of a contract.
(4) In some contracts, it would be impossible for the court
to assess the compensation arising from breach and if the compensation
contemplated is not by way of penalty or unreasonable, the court can award the
same if it is genuine preestimate by the parties as the measure of reasonable
compensation.”
In view of the above, a penal clause in an
agreement has been characterized as a stipulation unreasonable which the courts
would refuse to recognize, or give effect to. This necessarily implies that the
amount of damages far exceeds what can be “reasonable compensation” in the
given facts of the case. However, the Court would not, unless it is convinced
that such condition far exceeds the genuine estimate of reasonable damages,
interdict with the penalty condition, which the parties have agreed to include
in the contract.
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