Introduction
In our article on “Debt versus Damages and Significance Thereof in Commercial Contracts-Part I”, we have expressed our views that understanding whether the amount specified in the contract is a debt or damages (liquidated or unliquidated) will enable the contracting parties to avail appropriate remedies or to devise a suitable strategy to defend the demand made by the opposite party as the case may be.
While pointing out that if the amount specified in the contract qualifies as the amount of debt, the party claiming such amount does not have to prove breach of contract, any resultant loss and steps taken by it for reducing the amount, we have perfunctorily touched upon the subject of liquidated and unliquidated damages in said article.
In this article, we seek to examine damages under Indian Contract Act (“ICA”), distinction between unliquidated and liquidated damages under ICA and enforceability of liquidated damages clauses contained in commercial contracts in Indian Context. In subsequent parts, we deal with specific kind of clauses under commercial contracts and drafting considerations for enforceability.
Damages under Indian Contract Act (ICA)
- Unliquidated Damages
The expression ‘unliquidated damages’ or ‘liquidated damages’ are not expressly defined under the Indian Contract Act, 1872 (“ICA”); however, Sections 73 and 74 of the said Act deal with the elements of this kind of damages.
S.73 of ICA reads as:-
“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.”
This is a provision that simply provides that in case of breach of contract, the suffering party is entitled to receive compensation for any loss or damage caused owing to breach. The provision deals with a situation where parties have not agreed to any reasonable estimation of loss in case of breach and thus embodies the law on unliquidated damages and award of compensation will require that:-
- Establishment of breach of Contract
- Proof of loss to the nob-breaching party and proof of quantum thereof.
- Proof that the loss caused owing to breach is not an indirect loss or a remote one but a loss that naturally arose from usual course of things from such breach or a loss that parties new at the time of making the contract to be likely to result from breach of it.
- Liquidated Damages
Liquidated damages clauses are to be found in different commercial contracts e.g. LD clause providing for a named sum of damages to be paid in case of delay in completion of EPC contract works, LD clause providing for named sum of damages to be paid in case of generating less power than stipulated in the contract during the course of Operation and Maintenance period in case of O & M of power plant and so on.
As per the Black’s Law Dictionary, the term refers to – “any sum which is contractually stipulated as a reasonable estimation of the loss suffered and the damages to be recovered by one party in case the other defaults; alternatively, if the parties have expressly agreed on the aspect of liquidated damages, the sum they have agreed on stands to be the measure of damages arising out of the breach, no matter how different it is from the actual damages suffered due to the breach.”
S.74 of the ICA deals with aspect of liquidated damages under ICA.
S.74 reads as under:-
“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.”
How is s.74 Interpreted by Indian Courts
While there are multiple judgments on interpretation of s.74 by different courts, we aim to keep the article short and highlight two important judgments of Supreme Court of India (“SCI”) on the subject.
In ONGC v/s Saw Mills Case, SCI held that while adjudicating on the claim for sum named in the contract: –
“(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 consequences 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, Court can award the same if it is genuine pre-estimate by the parties as the measure of reasonable compensation.”
From point number 3 above, it would appear that in case of reasonable sum named in the contract to be paid in case of breach, the non-breaching party is not required to prove that it actually suffered from loss or damages. However, in author’s view, that is not what the court intends to convey. Rather point No.3 is to be read with 4 where the court clarifies that in some contracts it would be impossible to prove actual damages and, in such cases, court would award the sum named in the contract if it is genuine pre-estimate by the parties as the measure of reasonable compensation.
This is also clear from the court referring to the observations contained in the case of Maula Bux v/s Union Of India and observing that: –
“In Maula Bux’s case (supra), the Court has specifically held that it is true that 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 and the Court is competent to award reasonable compensation in a case of breach even if no actual damage is proved to have been suffered in consequence of the breach of contract. The Court has also specifically held that in case of breach of some contracts it may be impossible for the Court to assess compensation arising from breach.”
The observation in point number 3 is intended to apply only in a case where it is impossible to assess actual loss arising from breach and the same is clear also from SCI observation that in the case at hand it would be difficult to prove exact loss or damage which the parties suffer because of the breach thereof resulting in delay in deployment of rigs and change of actual production of gas from platform B-121 and therefore when parties had pre-estimated such loss after clear understanding, such sum should be awarded when such pre-estimate of liquidated damages was not assailed by the respondent as unreasonable assessment of damages by the parties.
In the case of Kailashnath and Associates v/s DDA, SCI categorically observed that the expression “whether or not actual damage or loss is proved to have been caused thereby” means that where it is possible to prove actual damage or loss, such proof is not dispensed with. It is only in cases where damage or loss is difficult or impossible to prove that the liquidated amount named in the contract, if a genuine pre-estimate of damage or loss, can be awarded.
Conclusion and Drafting Consideration on Liquidated Damages Clauses
From the above, it can be concluded that:-
- For a claim under liquidated damages clause, breach of Contract must be established;
- Furthermore, it must be established that liquidated damages clause prescribes a genuine pre-estimate of damages (if this cannot be established court will award only reasonable compensation based on principles found in Section 73 of the ICA that does not exceed the amount stated in the contract).
- It also must be established that damage or loss has actually been suffered.
- Only in cases where damage or loss is difficult or impossible to prove, the liquidated amount named in the contract, if a genuine pre-estimate of damage or loss, will be awarded by the court.
Drafting Considerations for Enforceability
While drafting a contract with liquidated damages clause within it, it is recommended to briefly narrate in the contract that parties agree that in case of breach there is no possibility of ascertaining and proving actual loss that may be suffered and on count of such difficulties or impossibility parties are agreeing to liquidated damages clause which contains genuine pre-estimate of damages. Some background about why it may be impossible to prove actual loss and how the sum named as genuine pre-estimate of damages will even be better and will obviate any arguments about sum being unreasonable or in terrorem or about the possibility of proving actual loss.
*The content of this article is intended to provide general information. No reader or user should act or refrain from acting on the basis of the information written above without first seeking legal advice from a qualified law practitioner.
Author: Ravish Bhatt, Managing Partner, R & D Law Chambers LLP
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*R & D Law Chambers is a firm providing Legal advisory and International and Domestic Tax Advisory services. To know more visit https://rdlawchambers.com/