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Law Surrounding Liquidated Damages in India

Published on : 14 Oct 2021

Guide on Liquidated Damages in India


An amount that a contracting party offers to pay or a deposit that he agrees to forfeit if he breaches any promise, and both are technically recoverable or retainable as negotiated penalties if the violation happens, having been arrived at through a good faith attempt to estimate in advance the possible harm that will almost certainly result from the breach." 

"Damages for violation by any side can be liquidated under the agreement, but only at a sum that is fair in light of the expected or real harm incurred by the breach," according to the American Law Reports annotation on liquidated damages. 

In its true meaning, "liquidated liability" refers to a monetary settlement for an injury sustained by one party as a result of the other party's violation of the contract. Normally, the extent of the harm is defined in the contract itself as a precondition to prevent any side from breaching or violating the contract. Thus, liquidated damages are a sum of money settled by the sides to a settlement that one will pay to the other if one breaks or backs out of the deal (breaching) or if a complaint occurs as a result of the violation. The following formula should be used to measure liquidated damages: 

  1. The amount of a down payment or a loan. 
  2. The use of formula (such as 10 per cent of the contract amount). 

Only where (1) the condition is either "uncertain" or "difficult to quantify" and (2) the injury is "uncertain" or "difficult to quantify" may damage be liquidated under a contract. 

(2) the figure is fair, taking into account the real or anticipated damage incurred by the violation of contract, the difficulties of demonstrating the loss, and the difficulty of seeking another, appropriate remedy; and 

(3) The awards are formulated in such a way that they act as damages rather than penalties. A liquidated damages provision is invalid if certain conditions are not fulfilled. 

The terms "liquidated losses" and "penalty" should not be used interchangeably. In the event that one of the parties takes action against the other, a responsible Court may impose a penalty. 

"An amount which a party equally intends to pay or lose in the event of a violation, but which is set not as a pre-estimation of the possible real damages but as compensation, the threat of which is intended to avoid the breach," according to the American Law Reports annotation on the penalty. 

The Indian Contract Act of 1872 contains some clauses to include protection in the event of a breach or termination of a contract by either of the contracting parties. 

The Rule: 

The Indian Contract Act, 1872, establishes the fundamental framework of Indian contract law, as well as its compliance and numerous provisions concerning non-performance and contract violation. This research aims to highlight clauses concerning "liquidated damages" in the event of contract violation and to conduct a comparative review between India and England on the subject. Before learning about liquidated penalties, it's necessary to consider the ramifications of contract breaches and the damages awarded in those cases. The related existing laws are Sections 73 and 74 of the Indian Contract Act of 1872

Sections 73 and 74 of the Contract Act contain the following provisions: 

Section 73: Compensation for loss or damage caused by the breach of contract: Where a contract is breached, the party who suffers as a result of the breach is entitled to receive compensation from the party who had violated the contract for the loss or damage caused to him as a result of the breach, which naturally arose in the ordinary course of things by that breach, or which the parties knew to be like when they made the contract. 

Such consideration is not to be provided for any injury or harm suffered as a result of the breach in the distant or indirect sense. 

Section 74: Damages for violation of the contract if a penalty is specified. When a contract is broken, the party complaining about the breach is entitled to receive reasonable compensation from the party who broke the contract, whether or not any damage or loss is proven. 

An explanation is given. Increased interest from the date of default may be considered a penalty stipulation." 

Under English Common Law, parties may specify an amount to be paid in the event of a default, which is irrecoverable if classified as a penalty by the Court, but recoverable if classified as liquidated damages by the Court. The Law of Contracts in India, on the other hand, does not consider any qualitative differences in the form of damages, as Section 74 abolishes the somewhat complicated refinement that existed under Common Law. Damages would be measured in the ordinary manner where there is a punitive provision, and the applicant will be able to recover a sum higher than the stipulated amount. The Court must consider the terms and underlying conditions at the time the contract was made, not at the time the violation happened, in determining the true essence of the contract and the amount of money due. The parties' words are not conclusive, and the Court is not bound by their language. The word would be viewed as liquidated losses if it is claimed to be a penalty but turned out to be a real pre-estimate of loss. 

Supreme Court Decisions: 

The Hon'ble Supreme Court of India has elaborated on the phrase "liquidated damages" on many occasions. 

1. The Hon'ble Supreme Court of India claimed in Fateh Chand v Balkishan Das [reported in (1964) 1 SCR 515]:

Section 74 establishes the legislation on the responsibility for violation of contract where restitution is predetermined by consent of the parties or where punishment is stipulated. However, the statute's scope is not limited to situations in which the aggrieved party seeks redress as a plaintiff. No party receives a special advantage as a result of this section. It simply states that, instead of any term in the contract specifying damages or allowing for forfeiture of property as a punishment, the Court can only grant fair relief to the aggrieved party not exceeding the amount named or penalty stipulated. 

The object of such clauses, particularly in commercial contracts, is to foster certainty. Parties to a contract will set such a number in advance at the time of contracting because it makes it easier to calculate costs, decreases the complexity and cost of proving real injury or failure, and makes it easier to recover losses. It also prevents the challenge of assessing damages, particularly through the effects of the breach is known and the risk of under-compensation; otherwise, the law of remoteness can prevent the party from recovering indirect, substantive damages. It assures the promisee that the promise will be fulfilled in a secure manner. 

2. In the case of Saw Pipes [reported in (2003) 5 SCC 705], the Supreme Court established the following rules for determining "fair compensation" under section 74 of the Contract Act

Before determining if an applicant is entitled to arbitration, the provisions of the contract must be considered; if those terms are unambiguous, the sum specified therein must be paid unless it is determined to be a penalty or otherwise unfair. Section 74 is to be read in conjunction with section 73 in all cases of violation because it is not necessary for a claimant to prove real losses before claiming a decree; a court has the authority to grant "fair compensation" in cases of breach regardless of the nature of such evidence. When it is difficult for the Court to ascertain damages with precision, the Court can safely award the stipulated amount if it is the plaintiffs' true pre-estimate of damages as a measure of fair compensation. 

3. In Chunilal V. Mehta & Sons Ltd. v. Century Spg. & Mfg Co. Ltd. [AIR 1962 SC 1314], it was held that "by arranging for restitution in express words, the right to demand damages under the common law is generally excluded." 

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