'Liquidated Damages' means that it shall be taken as the sum which the parties have by the contract assessed as damages to be paid whatever may be the actual damage. The parties to the contract may agree at the time of contracting that, in the event of a breach, the party in default shall pay a stipulated sum of money to the other, or may agree that in the event of breach by one party any amount paid by him to the other shall be forfeited. It is a genuine pre-estimate of damages likely to flow from the breach. However, this liquidated damage shall be distinguished from the term penalty which is an amount intended to secure performance of the contract.
Penalty And Liquidated DamagesOften the term 'liquidated damages' is mistaken or rather confused with the term 'penalty'. Thus, understanding the terms, we can clearly distinguish between the two.
A penalty can be said to be a sum so stipulated in terrorem (with the object of coercing the party into performing the contract), and thus an amount qualifies to be a penalty if the sum named is extravagant and unconscionable. It is also a penalty if the breach consists in paying of money and the sum stipulated is greater than the sum which ought to have been paid. However, liquidated damages are a genuine, covenanted pre-estimate of damages as seen above. They are both to be so judged on the facts of each case.
The question whether a particular stipulation in a contract is in the nature of the penalty has to be determined by the court against the background of various relevant factors, such as the character of transaction and its special nature, if any, the relative situation of the parties, the rights and obligations accruing from such a transaction under the law and the intention of the parties incorporating in the contract, the particular stipulation which is contended to be penal in nature. If on such a comprehensive consideration, the court finds that the real purpose for which the stipulation was incorporated in the contract was that by reason of its burdensome or oppressive character, it may operate in terrorem over the promisor so as to drive him to fulfil the contract, and then the provision will be held to be of Penalty.
Section 74 of the Indian Contract Act reads as follows: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.
In Fateh Chand v Balkishan Das, the Supreme Court stated:Section 74 declares the law as to liability upon breach of contract where compensation is by agreement of parties predetermined 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 for determining the 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 purpose of such clauses is to promote certainty, especially in commercial contracts. Parties to a contract would fix such a sum in advance at the time of making the contract because it facilitates calculation of risks; it reduces the difficulty and expense of proving actual damage or loss and facilitates recovery of damages. It also avoids the difficulty in assessment, even where the consequences of breach are ascertainable and avoids the risk of under-compensation; the party may otherwise not be able to recover indirect, consequential loss by the rule of remoteness. It gives promisee an assurance that he may safely rely on the fulfilment of the promise.
The Supreme Court also framed the following guidelines in the Saw Pipes case for arriving at the 'reasonable compensation' vide section 74 of the Contract Act:Before deciding that a claimant is entitled to any compensation the terms of the contract must be considered; where such terms are unambiguous the sum named therein must be awarded unless such sum is found to be by way of a penalty or in any case unreasonable. In all cases of breach, section 74 is to be read with section 73 and therefore it is not essential for a party to prove actual losses before claiming a decree; a court is competent to award 'reasonable compensation' in case of breach irrespective of the existence of any such proof. Sometimes it is impossible for the court to determine the damages with certainty in which case the court can safely award the stipulated sum if it is the genuine pre-estimate of damages by the parties as the measure of reasonable compensation.
Position In England
Under English Common Law, parties may name a sum to be payable in case of breach, which if classified by the court as a penalty is irrecoverable but if classified as liquidated damages is recoverable. 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. In case of a penal clause, damages will be assessed in the usual way, and the plaintiff may even recover a sum greater than the stipulated amount. In discerning the true nature of the contract and the compensation payable, the court must have regard to the terms and inherent circumstances at the time of the making of the contract and not at the time the breach occurred. The terms used by the parties are not conclusive and the court is not bound by their phraseology. If the term is stated to be a penalty but turns out to be a genuine pre-estimate of loss, it will be treated as liquidated damages.
Conclusion: Common Features Between English And Indian Law
After seeing the various provisions both under Indian law and English law we can conclude the common analogy between them. Yet the distinction between liquidated damages and penalty is not all together 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 to be by way of penalty. Otherwise the whole of it is recoverable as liquidated damages.
Secondly, the first explanation to this 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. Still another common feature between the English common law and Indian law is shown by the decision of the Supreme Court in Chunilal V. Mehta &Sons Ltd. v. Century Spg. & Mfg Co. Ltd., 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.
1. (1964) 1 SCR 515
2. (2003) 5 SCC 705
3. AIR 1962 SC 1314
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