The most important reason why businesses enter into a written contract is to ensure certainty in their future endeavors by laying down their contractual rights and liabilities. All the clauses in a contract are drafted with a view to ensuring that each party honors their respective obligations under the contract. However, it is not always the case. Many-a-times parties fail to honor their commitments thereby making the Liquidated Damages Clause one of the most crucial clauses in any contract not only where time is of the essence of the contract, but even otherwise.
Liquidated Damages are essentially in the nature of compensation predetermined by the parties at the time of the making of the contract irrespective of what the actual damages may be in the future. It is based upon a genuine pre-estimation of the damages likely to be incurred in case of breach by either of the parties. The primary intention behind the enactment of such a clause in a contract is to enable the parties to anticipate their respective liabilities and risks involved in case of breach thereby, providing certainty as to their rights and obligations under the contract.
Such a clause is also meant to avoid the difficulty of proving actual damages at the time of dispute as the damages payable are pre-determined at the time of the contract itself. Thus, it not only removes ambiguity in transactions but is also meant to save a lot of time, resources, and energy that the contracting parties can dissipate on potential disputes by proving, enforcing, and deciding on the quantum at a later stage.
In India, the law on liquidated damages is laid down under Section 74 of the Indian Contract Act, 1872. It provides that damages, not exceeding the amount stipulated in the contract, irrespective of the actual damage/loss having been proved must be given to the injured party on breach of the contract. The Section thus does away with the distinction between liquidated damages and penalty. In all cases, the court decides the amount of compensation that is reasonable, irrespective of the amount being towards liquidated damages or by way of penalty. The courts in India interpret the Liquidated Damages stipulated in an agreement to be the ceiling limit of the damages, whereby the actual and reasonable damages payable are to be adjudicated by the courts.
On the contrary to the position under Indian Law, under the English Common law, the court’s limited role is to categorize the Damages clause as being either by way of liquidated damages or by way of penalty. The parties may lay down any amount towards damages and in cases where it is found by the courts to be towards Liquidated Damages, it is recoverable in full whereas, on the contrary, if the same is found to be towards penalty, it is irrecoverable.
Such being the case, parties can attain the element of certainty in commercial contracts by way of making a choice of law governing the contract to be different from the procedural law when the subject matter of the dispute is under arbitration.
Therefore, drafting the Liquidated Damages Clause with caution and with thorough understanding and estimation of the losses assumes even more importance. A carefully drafted clause can save the potential parties from rendering the Liquidated Damages Clause unenforceable. Attempts must be made to calculate the potential losses and only a genuine pre-estimate must be laid down in the contract. Any exorbitant amount that is by way of penalty or even otherwise must be avoided, stipulating only a reasonable amount of loss estimated as the Liquidated Damages payable by the defaulting party.
# Contracts # Liquidated Damages # Genuine Pre-estimate # Supreme Court
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