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Reassessing Liquidated Damages In Commercial Contracts: A Illusion Without Proven Loss

When the contract's terms are breached or the commitment made is breached, the contract is said to have been breached. Breach of contract´┐Ż is a prerequisite for a claim of damages, whether liquidated, unliquidated or otherwise. As a result, regardless matter how much advantage the defendant derives from the contractual arrangement, there can be no claim for damages until the contract is breached. To be established, a violation must be assessed and proven, not just agreed upon by the parties.

The Law of Damages under Indian Contract Act, 1872:

Sections 73 and 74 of the Act deal with breach of contractual duties. Damages originating from a breach of a contractual duty that results in losses to the aggrieved party are dealt with under Section 73 of the Act. This section does not compensate for indirect or distant loss resulting from this infringement and the damages which are awarded to the complained party are of an unliquidated character after an evaluation of the loss and harm incurred. Section 74 deals with liquidated damages, which occur when a contract specifies the amount of damages to be paid in the event of a breach of the contract.

Liquidated Damages:

A liquidated damages (LD') clause is defined as a contractual provision that specifies in advance the measure of damages if a party breaks the agreement, ´┐Ż according to Black's Law Dictionary. However, if the contract is validly terminated, the matter of claiming for damages should not arise without infringement on the terms of the contract, as there is no infringement per se. If there is no legal harm to the party, no compensation may be awarded.

In Kailash Nath Associates v. Delhi Development Authority and Others, the Supreme Court stated that where a contract provides for liquidated damages, such amount can be received in full only if the amount of damages suffered by the aggrieved party is comparable to such a pre-established amount of damages. The court further stated that the quantum of damages awarded by the court shall never exceed the amount specified in the contract in the form of liquidated damages./

The term under Section 73 of the Indian Contract Act presupposes that damages are only payable if a loss is caused by the breach. The concept is, successfully stated, - no loss of harm from the breach. Therefore, for an LD case, i.e. the right to claim LD the aggressive party must demonstrate that the offended party has incurred some resulting damage.

To put it another way, even the LD cannot be claimed if it is proven that the violation caused no real losses, as ruled by the Delhi High Court in Indian Oil Corporation v. Messrs Lloyds Steel Industries Limited. In this instance, the Court determined that the contractor's simple delay in completing and commissioning the terminal in Jodhpur did not enable IOC to recover Liquidated Damages because there was no loss suffered by IOC.

The Court concluded that considerably after the construction date (31.3.1996), the pipeline was reaching the Jodhpur terminal (in 31.8.1996), and without the terminal being pipelined it could not be put on a commercial basis.

Proof of Damage for a Claim of Liquidated Damages:

First of all, irrespective of the degree of the damage, a breach of contract must take place before damages can be claimed. In other words, there can be no justification for damages if the parties do not violate the contract. Furthermore, in order to obtain damages, the claimant must demonstrate that he or she has experienced a loss.

In Fateh Chand v. Balkishan Dass, the Supreme Court required the parties to demonstrate the extent of loss or harm incurred as a result of the breach of terms of the contract. In Maula Bux v. Union of India, the Hon'ble Supreme Court of India decided that the court has the authority to give appropriate compensation in a breach of contract action even if no real loss is proven to have been incurred as a result of the breach of contract.

However, the court also stated that in the event of a violation of particular contracts, it may be difficult for the court to determine compensation for the breach. In this situation, if a true pre-estimate is to be seen as the measure of an acceptable compensation, the amount appointed by the parties may be taken into account, but not if the amount determined is in the nature of a penalty.

Breach of Contract doesn't Result in Damages:

In Raheja Universal Pvt. Ltd. v. B.E. Bilimoria & Co. Ltd., the Bombay High Court affirmed the judgment of a Single Judge who had set aside the arbitral award on the grounds that the award for awarding of liquidated damages were issued despite no proof of loss or damages being produced.

Citing the case of the division bench in Kailash Nath's case, the Supreme Court held that:
  1. The amount referred to as liquidated damages are reasonable compensation, determined by both parties, and should be a true pre-estimation of any damages the court finds to be such.
  2. No damages awarded shall exceed the amount so designated or such obligation shall exceed the fine.

It further cites Kailash Nath, where the Supreme Court explained the wording in section 74 of the Contracts Act whether or not it can be proved that actual damage or loss was caused´┐Ż and concluded that, only in case of actual damage caused due to a breach of contract that cannot be proved or calculated, the court will take the liquidation amount as predetermined. If the damages may be calculated, they must be quantified and specified in the pleadings.

Difference between LD and a Penalty:

The LD while is a pre-calculated loss agreed upon by the parties at the time of contracting, as expected to occur as a result of the breach. A penalty, on the other hand, is a contract stipulation in the nature of terroram. A penalty, in general, is a provision that is a stipulation to award an imposition that is so disproportionate or exorbitant that no rational person would see it as a reasonable estimate of damages resulting from the breach.

For example, a provision in the contract that the breaching party should pay ten times the contract price to the injured party in the event of a breach is essentially a penalty. Therefore, although LD, as well as a penalty, are based on the provisions mentioned in the contract, there is a clear distinction between the two terms. The LD represents a reasonable provision for possible losses, a penalty that is unreasonable and is intended to secure contract performance.

Remoteness of Damage:

Section 73 of the Act includes two rules established in the case of Hadley & Anor v Baxendale & Ors. First, the damage suffered by the other party in connection with such a breach of contract may occur naturally, i.e., depending on the general circumstances, fairly and reasonably due to the breach of the contract itself should be considered. Secondly, such damages may have been reasonably assumed to have been in consideration for both parties at the moment of entering into the contract itself.

The amount of such damages given is at the judicial discretion of the court since, under section 73 of the Act, damages are not fundamentally liquidated. Although this section provides that damages given must be reasonably foreseeable and not remote or indirect due to the breach, it does not provide for the procedure for calculating such damages.

Whether the Use of Expression Genuine Pre-Estimate of Likely Damages´┐Ż is essential or Indicative of a Stipulation in the Nature of LD?

More often than not, the opposition party to the imposition of LD argues, unless it employs the term real pre-estimation of probable losses´┐Ż in the contract clause, which is to be stated as an imposition of LD, it is not deemed to be a provision of LD.

The parties then try, in order to avoid damages as provided for in the contract, to equate every such provision with the penalty. The quantity of harm included must show whether a provision is in the nature of an LD or is a stipulation as a penalty. The mere use of the phrase genuine pre-estimate damages agreed between the parties´┐Ż has no bearing on the substance of the contract. The Court in which such a provision is contested must make a decision based on the facts and circumstances of each case, as well as the relevant contractual clause. It must pass the reasonable estimate of the parties criteria to qualify as an LD provision.

Can the Liquidated Damages be Reduced Proportionately Depending upon the Status of Performance of the Contract Till the Date of Imposition of Liquidated Damages?
Another issue that courts and arbitrators are debating is whether the amount of Liquidated Damages stipulated in the contract can be lowered proportionately based on the quantity of work completed up until the date of the breach.

While it is true that the party claiming LD must establish the losses it has actually experienced and restrict its claim to that amount alone, rather than the whole amount of approved Liquidated Damages, it is also true that the party claiming LD must prove the losses it has truly suffered. However, it would be incorrect to claim that the LD provision would be proportionately decreased based on the level of performance attained up to the date of the breach. This would be the equivalent of rewriting the contract, which is illegal. Furthermore, such a concept runs against the core premise of the LD, which is that the parties make informed decisions at the time of contracting and provide for pre-estimated damages.

Whether LD can be recovered without Proving Actual Loss?

The courts have repeatedly held that the provision for LD is no different from the provision for non-liquidated damages and that in both cases, LD and non-liquidated damages, the breach and damage must be proven as held in Egon Zhender International Pvt. Ltd. v. Namgayal Institute for Research on Ladakhi Art and Culture. However, where it is difficult for the Courts to determine the compensation arising from the breach in specific circumstances, the Court might award the entire liquidated damages if it is deemed to be a true pre-estimate by the parties as a measure of appropriate compensation.

The Supreme Court ruled in Oil & Natural Gas Commission v. Saw Pipes Ltd that:
the Arbitral Tribunal was incorrect in declining to award LD in favour of ONGC due to a lack of proof of real damages. The Supreme Court ruled that ONGC's real gas output was affected by the delay in deploying rigs. The Apex Court ruled that it would be impossible to show precise loss under such arrangements, and after concluding that the compensation provided for in the contract was not excessive, the Court supported ONGC's imposition of LD on Saw Pipes Ltd.

Because Section 74 provides fair recompense for damage or loss caused by a breach of contract, the Section's application is predicated on the occurrence of such damage or loss. However, as long as it performs a compensating role, liquidated damages should be permitted without the need to establish precise losses.

Thus, if a sum is stated in a contract as a liquidated amount due as damages, the party complaining of a violation can only obtain such liquidated amount as fair compensation if it is a genuine pre-estimate of losses established by both parties and deemed to be such by the court. In cases where the amount fixed is in the nature of a penalty, only reasonable compensation not exceeding the stated penalty can be awarded. The liquidated sum or penalty is the top limit in both situations above which the Court cannot provide fair compensation.

Written By:
  1. Aayush Akar, National Law University Odisha
  2. Ritika Bansal, Maharaja Agrasen Institute of Management Studies, IP University

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