By Jeevan Ballav Panda and Satish Padhi

Introduction 

Liquidated Damages are a common feature in most commercial contracts particularly in any major service contract. However, there does not exist much clarity on the legal framework surrounding liquidated damage clauses (“LD Clause”) particularly from an enforcement perspective. 

Questions range from how is an LD Clause different from a penalty clause? When is an LD Clause construed as a penalty clause under Indian law? What is the onus of proof requirement for a party making a claim under an LD Clause? Is there a requirement to prove actual loss like a claim under Section 73 of the Indian Contract Act 1872 (“Contract Act”) or is the threshold of proof different? How does the burden of proof requirement play it out in an LD Clause?

This piece focuses on answering such questions and analyses three important judgments of the Supreme Court which sets out the framework pertaining to LD Clauses. that being the Constitutional Bench decision in Fateh Chand vs Balkishan Das (“Fateh Chand”), the Three Judge bench decision in Maula Bux vs Union of India (“Maula Bux”) and the Division Bench decision in Oil & Natural Gas Corporation Ltd vs Saw Pipes Limited (“Saw Pipes”). 

Constitutional Bench Decision of the Supreme Court in Fateh Chand

The Constitutional Bench in Fateh Chand was dealing with a clause in a sale deed which provided that, if for any reason the vendee fails to get the sale-deed registered by the date stipulated, the amount of Rs. 25,000 (Rs. 1,000 paid as earnest money and Rs. 24,000 paid out of the price on delivery of possession) would stand forfeited. 

The above condition which provided for forfeiture of Rs 24,000 was considered by the 5 judge bench to be a stipulation in the nature of penalty rather than an liquidated damage. The Court held it to be covered under Section 74 of the Contract Act since it contains the phrase, “as the case may be, the penalty stipulated for.” The Court observed as follows: 

“The expression if the contract contains any other stipulation by way of penalty widens the operation of the section so as to make it applicable to all stipulations by way of penalty, whether the stipulation is to pay an amount of money, or is of another character, as, for example, providing for forfeiture of money already paid.”

The Court speaking though JC Shah J went to rule that for an LD Clause which is in the nature of a penalty, reasonable compensation not exceeding the amount stipulated has to be awarded depending upon what the Court considers to be reasonable. 

Also, while interpreting the phrase, “whether or not actual damage or loss is proved to have been caused thereby”, the Court held that it merely dispenses with the requirement of proof of actual loss or damages but nonetheless the necessity that there has been a legal injury suffered by the party is a prerequisite before awarding compensation under Section 74 of the Contract Act. 

Three Judge Bench decision in Maula Bux

The Supreme Court in this case was again dealing with a situation of forfeiture of an amount that has already been paid under a contract and adjudicated that such a fact situation would be a penalty covered under Section 74 of the Contract Act. 

Significantly, while interpreting the phrase, “whether or not actual damage or loss is proved to have been caused thereby”, it observed the following:

“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 case of breach even if no actual damage is proved to have been suffered in consequence of the breach of contract. (…)

Where the Court is unable to assess the compensation, the sum named by the parties if it be regarded as a genuine pre-estimate may be taken into consideration as the measure of reasonable compensation, but not if the sum named is in the nature of a penalty. Where loss in terms of money can be determined, the party claiming compensation must prove the loss suffered by him.”

From the above observations of the 3 Judge Bench of the Supreme Court speaking though JC Shah J, it is clear that the Court has held that in situations where it would be difficult to assess compensation, the sum named by the parties can be considered to be a genuine pre-estimate and as a reasonable compensation to be paid in situations where the clause is an LD Clause.

Division bench decision of the Supreme Court in Saw Pipes

The Court was dealing with a contract which provided for the following LD Clause:

“Recovery from the contractor as agreed liquidated damages are not by way of penalty, a sum equivalent to 1% (one percent) of the contract price of the whole unit per week for such delay or part thereof (this is an agreed, genuine pre- estimate of damages duly agreed by the parties) which the contractor has failed to deliver within the period fixed for delivery in the schedule, where delivery thereof is accepted after expiry of the aforesaid period. It may be noted that such recovery of liquidated damages may be upto 10% of the contract price of whole unit of stores which the contractor has failed to deliver within the period fixed for delivery”

While interpreting the contours of the above LD Clause, the Court speaking through MB Shah J laid down certain key pointers relevant for interpretation of LD Clause being the following:

• “If parties knew when they made the contract that a particular loss is likely to result from such breach, they can agree for payment of such compensation.” The Court went on to observe that in such a situation, the necessity of leading evidence is discretionary, and it may not be required in situations unless the Court concludes that no loss is likely to occur because of the event which triggered the LD Clause. 
• It went on to hold that: “when parties have expressly agreed that recovery from the contractor for breach of the contract is pre-estimated genuine liquidated damages and is not by way of penalty duly agreed by the parties, there was no justifiable reason for the arbitral tribunal to arrive at a conclusion that still the purchaser should prove loss suffered by it because of delay in supply of goods.”
• Most importantly, it was stated that in situations where the LD Clause is a pre-estimate, the burden would be on the other party to lead evidence for proving that no loss is likely to occur by such breach. 

Did Saw Pipes decide contrary to larger bench decision of Fateh Chand?

The Constitutional Bench in Fateh Chand had observed that Section 74 merely dispenses with proof of “actual loss or damages” but the requirement of demonstrating legal injury still persists under Section 74. Therefore, the Saw Pipes ruling that when parties have agreed to a genuine pre-estimate in the LD Clause, there may not be any requirement of proving evidence to prove loss unless the Court comes to conclusion that there may not be any legal injury suffered by a party claiming the benefit of LD Clause, appears to be consistent with the decision of Fateh Chand. 

Concluding Thoughts: What does Fateh Chand, Maula Bux and Saw Pipes hold for LD Clauses?

From a conjoint reading of the observations and rulings in the 3 (three) decisions of the Supreme Court, it can be stated that parties may be able to take benefit of an LD Clause and the requirement of proof that is strictly applicable to a Section 73 situation may not be applicable under an LD Claim particularly where the parties have expressly stated that the estimate of damages is a pre-estimate that is agreed between the parties and is not in the nature of a penalty. 

However, to overcome the Maula Bux observations of the Supreme Court where the 3 Judge Bench has ruled that, “the sum named by the parties if it be regarded as a genuine pre-estimate may be taken into consideration as the measure of reasonable compensation” if the Court is unable to assess the compensation, the parties may consider adding an acknowledgment by the parties that it would be impossible or extremely difficult to exactly quantify such loss and therefore, the estimate is to be considered as a genuine pre-estimate in the event a breach leads to trigger of an LD Clause. 

About the Authors: Jeevan Ballav Panda is a Partner and Satish Padhi is a Senior Associate with the Dispute Resolution Team of Khaitan and Co and are based out of New Delhi. They can be reached at jeevan.ballav@khaitanco.com and satish.padhi@khaitanco.com respectively. 

Views expressed in this article are personal and are not attributable to the Firm in any manner.