Penalty and Liquidated Damages

Written by  //  February 28, 2011  //  Corporate Law and Business  //  25 Comments

The importance in commercial law of the easy enforceability of particular contractual devices cannot be overstated, and the payment of damages on breach of contract is a good illustration. If the law applied the usual mechanism of proving loss for every claim, a claimant will often be unable to recover damages effectively and expeditiously. To avoid the inconvenience that this causes, the English courts developed the doctrine of liquidated damages by which the parties could agree in advance that a breach of contract would trigger the payment of a fixed sum of money as damages. Since this was the intellectual foundation of the doctrine, it followed that a sum disproportionate to foreseeable loss (“penalty”) could not be given effect to in the same way. The rule meant that if the sum stipulated was found to be a “penalty”, the claimant had to prove loss in the usual way, although if actual loss exceeded the sum named as penalty, he could recover the higher sum. Conversely, if the sum stipulated was found to be a reasonable estimate and therefore liquidated damages, the claimant was confined to that sum, even if actual loss exceeded it. This branch of the law became considerably complex in England, since it was difficult to predict into which category a contractual provision for the payment of damages would fall. Interested readers may refer for a more elaborate discussion to the leading decision in Dunlop Pneumatic Tyre.

The Indian legislature obviated the need to resort to the difficult exercise of distinguishing between a penalty and liquidated damages by enacting the simple rule in s. 74 of the Contract Act that a court may award “reasonable compensation” not exceeding “the sum named” in the contract as payable in the event of breach, or any other stipulation by way of penalty. As the Constitution Bench put it in Fateh Chand, the Indian legislature dispensed with this “web of presumptions”. I have discussed elsewhere the significance of the 1899 amendment in light of the recent decision of the Supreme Court in BSNL v Reliance. It suffices here to note that, subject to one important qualification, it is unnecessary to distinguish between a penalty and liquidated damages in India. The qualification is that s. 74 allows a court to award such reasonable compensation “whether or not actual damage or loss is proved to have been caused”, and the Supreme Court has held that the sum named in the contract will be taken to represent reasonable compensation in any case where it is unable to assess actual loss (Maula Bax v Union of India AIR 1970 SC 1995). In short, in a significant number of cases, the claimant is entitled to the benefit of a liquidated damages clause without further ado. However, the Court has also held that this benefit is unavailable if the sum is thought to represent a penalty – not, as in English law, because that makes it unenforceable, but because there is then no reason to consider that the sum reflects “reasonable compensation”.

The significance of this distinction has been considered by the Delhi High Court in its recent judgment in Sudhir Gensets v Indian Oil Corporation. The appellant, Sudhir Gensets [“SGL”] had agreed to supply certain equipment to IOC by a specified deadline, and Clause 13 of the contract provided that it would pay liquidated damages of 0.5 % of the value of the goods delayed per week, subject to a maximum of 10 % of the total value. SGL, for a variety of reasons, could not supply in time, and a finding of fact was made that the fault was not that of IOC. Accordingly, IOC deducted (the significance of this is considered at the end) a sum of about Rs. 10 lakh, and SGL challenged it in arbitration proceedings on the ground that IOC had not adduced proof of loss.

Before the High Court, obvious reliance was placed by IOC on the language of s. 74, and the proposition advanced was that it is unnecessary to offer proof of loss. The High Court, after a detailed reference to the decision of the Supreme Court in ONGC v Saw Pipes, accepted this contention, holding that the figure in question represented the value the parties placed on the loss IOC would suffer on account of any delay in delivery. The Court rightly clarified that this result would not follow if the sum named in the contract is found to be a penalty, because there is then no room to assume that it represents a reasonable estimate of losses or “reasonable compensation” for the purpose of awarding damages under s. 74. The following observations are apposite:

28. This is also so provided under Section 74 of the Contract Act. As such, 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 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 [emphasis added].

A final point must be made. It is interesting to notice in this case that Clause 13 provided that the vendor would pay the said sum as liquidated damages, and not that the purchaser could withhold or deduct that sum. Is there a difference between a claim to damages on the completion of the cause of action, and the crystallised right to enforce the claim once it is part of a decree? In Union of India v Raman Iron Foundry, the Supreme Court held (in a different context) that there is, albeit in a different context, and therefore declined to construe a contractual provision as allowing the deduction of mere claims. That case was overruled in Kamaluddin Ansari v Union of India and it is accepted that a contract can in any event provide for a claim to be appropriated prior to crystallisation – although whether the IOC-SDL contract did so is not clear.

25 Comments on "Penalty and Liquidated Damages"

  1. Dhananjaya May 30, 2011 at 7:37 am ·

    Nice piece Niranjan. Is there any literature/case law on how to ascertain whether an amount stipulated to be paid in a contract is by way of penalty or by way of liquidated damages?

  2. dr.pkaditya April 21, 2012 at 5:07 am ·

    Really great views. Kindly comment on the following narration in a contract:

    “Security deposit of Rs. xx lacs shall be for the due and faithful performance of the contract and shall stand forfeited as compensation for any loss resulting from failure of the contractor to fulfill obligations in executing the work”.

    Is there any scope for demanding amount more than the above xx lacs ?

  3. Indo Ispat August 4, 2012 at 2:04 pm ·

    we need judgement no & date of Hon`ble Supreme Court on liquidity damage (L.D.) on delay delivery of material.
    Since , we suffering same problem from Govt.Orgns, Since 2000, which are deducting (L.D) from our bill without proof of loss certificate from their user. Subsequently made our payment beyond order terms.and abnormal delay continue violate payment terms ,
    Due to this ,we suffering both side losses to pay interest to our bank for their made delay payment and deducted Govt. Orgns and never pay interest to us for their made delay payment.
    We are SSI unit kindly cooperate us to avoid to become a sick unit.
    Kindly Regards,
    Indo Ispat,
    Jagat Jain.

  4. P.K. Rathi September 18, 2013 at 7:26 am ·

    In turn key contract there is a clause according to which progress to be monitored every six months ans if progress is less by 20% vis-a-vis milestones then penalty @ 0.1% on shortfall shall be levied till shortfall is made up. Employer did not monitor progress as per schedule but levied penalty after a period of one year. Can he do so ? If not reference of rulings is required.

  5. P.K. Rathi October 4, 2013 at 5:07 am ·

    In works contracts both parties to contract fail to perform their part of obligations, but employer exercise his power and levy penalty on the contractor and starts recovery of penal amount. Can he do so? Do we have decisions of Courts to prove that the action of the Employer is illegal.

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