Introduction
In the realm of commercial transactions, the terms ‘debt’ and ‘damages’ frequently arise, yet they are often misunderstood or conflated. Both concepts play crucial roles in the enforcement of contractual obligations, devising a strategy for recovery or for defending an action for recovery and resolution of disputes. This article aims to elucidate the distinctions between debt and damages, their significance in commercial transactions, and the implications for parties entering into various types of agreements. By understanding these concepts, businesses can better navigate legal and financial landscapes, ensuring their interests are adequately protected. In part II, we shall elaborate on unliquidated damages, liquidated damages and enforceability LD clauses under Indian Contract Act and in subsequent parts we deal with specific kind of clauses under commercial contracts and drafting considerations.
What amounts to debt and what amounts to damages in terms of the Indian Contract Act, 1872
Concept of damages, liquidated and unliquidated, could be found in s.74 and s.73of the Indian Contract Act, 1872.
There have been multiple judgments on the subject matter. Madras High Court in the case of Newfinds India Ltd. versus Vorion Chemicals and Distilleries Ltd. held that the term “Debt” would refer to a definite sum and does not include any claim for unliquidated damages or for a sum of money which is capable of being ascertained.
The Supreme Court of India has dealt with the concept of debt versus damages, in the cases of Iron and Hardware (India) Company versus Firm Shamlal and Brothers and Union of India versus Raman Iron Foundry.
In the case of Greenhills Exports (Private) Limited versus Coffee Board, Bangalore, The Karnataka High Court summarized the principles from above referred and other decisions relating to debt and damages as under:-
“(i) A ‘debt’ is a sum of money which is now payable or will become payable in future by reason of a present obligation. The existing obligation to pay a sum of money is the sine qua nan of a debt.
“Damages” is money claimed by, or ordered to be paid to, a person as compensation for loss or injury. It merely remains as a claim till adjudication by a Court and becomes a ‘debt’ when a Court awards it.
(ii) In regard to a claim for damages (whether liquidated or unliquidated), there is no ‘existing obligation’ to pay any amount. No pecuniaiy liability in regard to a claim for damages, arises till a Court adjudicates upon the claim for damages and holds that the defendant has committed breach and has incurred a liability to compensate the plaintiff for the loss and then assesses the quantum of such liability. An alleged default or breach gives rise only to a right to sue for damages and not to claim any ‘debt’. A claim for damages becomes a ‘debt due’, not when the loss is quantified by the party complaining of breach, but when a competent Court holds on enquiry, that the person against whom the claim for damages is made, has committed breach and incurred a pecuniary liability towards the party complaining of breach and assesses the quantum of loss and awards damages. Damages are payable on account of a fiat of the Court and not on account of quantification by the person alleging breach.
(iii) When the contract does not stipulate the quantum of damages, the Court will assess and award compensation in accordance with the principles laid down in Section 73. Where the contract stipulates the quantum of damages or amounts to be recovered as damages, then the party complaining of breach can recover reasonable compensation, the stipulated amount being merely the outside limit.
(iv) When a contract provides that on default by a buyer to pay for and take delivery of goods, the seller is entitled to recover the loss incurred on resale, interest on delayed recovery of the price, godown charges, insurance charges and other expenses incurred by the seller till resale, it cannot be said the buyer incurs the liability to pay those amounts automatically, when he fails to take delivery. Failure to take delivery may be due to several valid or lawful reasons which may show that the failure to take delivery is not a ‘default’ or ‘breach’ in which event, no pecuniary liability may fasten on him.
(v) Even if the loss is ascertainable and the amount claimed as damages has been calculated and ascertained in the manner stipulated in the contract, by the party claiming damages, that will not convert a claim for damages into a claim for an ascertained sum due. Liability to pay damages arises only when a party is found to have committed breach. Ascertainment of the amount awardable as damages is only consequential.”
The Delhi High Court in a recent decision in the case of Thar Camps Private Limited versus Mrs. Indus River Cruises Private Limited reiterated the principles as stated above.
In essence, primary obligation under the contract will give rise to ‘debt’ and the secondary obligation coming into existence in terms of contract provisions on breach of primary duty will give rise to ‘claim for damages’.
Examples of Debt versus Damages in different types of Commercial Contracts and significance thereof
While the concept is of importance in almost any kinds of commercial contracts ranging from Agency Agreements to Intellectual Property Licensing Agreements and from EPC contracts to Operation and Maintenance Contracts, we aim to provide few of the examples of the same.
- Loan Agreement
Typically, the loan agreement between the bank/financial institution and the corporate or individual borrower will have a stipulation for payment of interest. Loan agreements also carry a provision for a penal interest and/ or late payment fee required to be paid for default in timely payment of the instalments. While there will be sector specific guidelines (In this case guidelines of RBI regarding charging of the penal interest/additional amount), it will be always beneficial to understand whether the particular amount is debt or damages.
While the agreement for payment of interest is a primary obligation of borrower in consideration of the loan having been disbursed by the bank and will amount to debt, as far as the penal interest or late fee for delay in making the payment(we have encountered cases with late fee/ penal interest even in north of 70% of principal per annum) is concerned, the same is a secondary obligation prescribed in contract coming in play in case of breach of primary obligation to make timely payment. Such penal interest/ late fee, therefore, in our view will amount to damages or penalty in terms of section 74 of the Indian Contract Act.
Implications
Realizing that such penal interest will not constitute a debt simpliciter will enable the borrower to challenge classification of account as NPA, initiation of action under SARFAESI Act by the bank, resist a proceeding of CIRP under Insolvency and Bankruptcy Code or resist any other recovery proceedings and dispute information given by the bank regarding alleged defaults and outstanding amount to CIBIL which may otherwise spoil credit score of a borrower.
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- EPC Contracts
In case of Engineering, Procurement and Construction Contracts, it is a standard practice for the client/owner of the project to provide specified deadline for completion of the project and commissioning thereof. Almost all EPC contracts will have the clause for liquidated damages providing for damages in the amount of incremental damages for specified percentage of the total contract value depending on the delay. For example, a clause might provide that all the works under a fixed value contract of hundred crore rupees will have to be completed by a specific date and in case of delay in completion and commissioning of the works, for each weeks’ delay, the liquidated damages payable will be to the extent of 1% of the contract value with the maximum amount of liquidated damages not exceeding 10% of the contract value. In certain clauses, the sum of the amount will be specifically stated rather than expressing the same in terms of the percentage of the contract value.
While such specified sum gives an impression that in case of delay the amount will be required to be paid as a debt, it will be important to understand that the obligation to make the payment or the claim for such amount will come in existence on account of alleged breach of the contract by the contractor and therefore the claim for such amount will be the claim for damages and not for the sum of money required to be paid as primary obligation and the same will not amount to debt.
Implications
This will have implications in resisting the demands made by the client and also in resisting the invocation the bank guarantees given by the contractor to the client in certain cases depending on the words used in the bank guarantee consent and the reading of the contract as a whole.
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- Oil and gas industry and Take or Pay clauses
It is peculiar of oil and gas industry that the operator of the block/development area of oil/gas will enter into sales agreement which will provide for offtake of specified quantity of oil or gas and will also provide that if specified quantity as stipulated in the contract is not off-taken by the purchaser, it will anyway make the payment at the rate stipulated in the contract to the supplier of gas stroke oil.
While there is much of a debate about whether the amount stipulated in such take-or-pay clauses is “Debt” or “Damages” and there are different decisions from different courts across the globe with no absolute law having been laid down in this regard by the Supreme Court of India, we believe that such clauses will be in the nature of damages and the demand and take-of-pay clauses can be successfully resisted if all the conditions of establishing and proving the damages are not satisfied. We intend to separately write in detail about the take-or-pay clauses and enforceability thereof.
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Why should a Contracting Party care about whether a specified sum is Debt or Damages?
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.
In case 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 due as against the case of damages in the proceedings for recovery of debt and it can even directly approach the National Company Law Tribunals for initiation of Corporate Insolvency Resolution Process against a Corporate Debtor based on default.
In case of claim for damages, the party claiming damages can be compelled to conjointly show the breach of contractual obligation, resultant loss and that it took sufficient steps for mitigation of the loss rather than simply relying on contract clauses.
*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/