Liquidated Damages

Background:

A sum which a party to a contract agrees to pay or a deposit which he agrees to forfeit if he breaks some promise and which, having been arrived at by a good faith effort to estimate in advance the actual damage which would probably ensue the breach, are legally recoverable or retainable as agreed damages if the breach occurs.”

The American Law Reports annotation on liquidated damages states, “Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in light of the anticipated or actual harm caused by the breach.

“Liquidated damages”, in its true sense, means compensation in terms of money for the loss suffered by one party due to the breach of contract by the other side. Normally, the extent to which damage has been caused is specified in the contract itself, as a pre condition to pre empt any breach or violation of the contract by either party. So liquidated damages equals an amount of money agreed upon by both parties to a contract where in one will pay to the other upon breaking or backing out of (breaching), the agreement or if a lawsuit arises due to the breach. Liquidated damages can be calculated by:

1. The amount of a deposit or a down payment.

2. Use of a formula (such as 10% of the contract amount).

Damages can be liquidated in a contract only if

(1) the injury is either “uncertain” or “difficult to quantify”;

(2) the amount is reasonable and considers the actual or anticipated harm caused by the contract breach, the difficulty of proving the loss, and the difficulty of finding another, adequate remedy; and

(3) the damages are structured to function as damages, not as a penalty. If these criteria are not met, a liquidated damages clause will be void.

The term ‘liquidated damages’ should not be misunderstood with the term ‘penalty’. Penalty is awarded by a competent Court, in case one of the parties takes action against the other.

The American Law Reports annotation on penalty states, “a sum which a party similarly agrees to pay or forfeit in the event of breach, but which is fixed not as a pre estimate of the probable actual damages but as punishment, the threat of which is designed to prevent the breach.”

Certain provisions are present in the Indian Contract Act 1872, which provides a safeguard in case of breach or violation of a Contract by any of the contracting parties.

The Law:

The Indian Contract Act, 1872, provides a basic structure of the law of contract in India, its enforcement, various provisions regarding non performance and the breach of contract. This report is aimed to highlight provisions regarding “liquidated damages” in case of the breach of the contract and to bring about a comparative study between India and England regarding it. Thus, before knowing what exactly liquidated damages are, it is important to understand the consequences of breach of contract and the damages awarded in case of breach. “

Sections 73 and 74 of the Indian Contract Act 1872, are the relevant applicable laws.The relevant parts of Sections 73 and 74 of Contract Act are as under:

“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.

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.

Explanation. A stipulation for increased interest from the date of default may be a stipulation by way of penalty.”

Under the English Common Law, parties may name a sum to be payable in case of breach, which if classified by the court as a penalty is irrecoverable but if classified as liquidated damages is recoverable. However, the Law of Contracts in India does not recognize any qualitative difference in the nature of damages, as section 74 eliminates the somewhat elaborate refinement under Common Law. In case of a penal clause, damages will be assessed in the usual way, and the plaintiff may even recover a sum greater than the stipulated amount. In discerning the true nature of the contract and the compensation payable, the court must have regard to the terms and inherent circumstances at the time of the making of the contract and not at the time the breach occurred. The terms used by the parties are not conclusive and the court is not bound by their phraseology. If the term is stated to be a penalty but turns out to be a genuine pre estimate of loss, it will be treated as liquidated damages.

Supreme Court Judgements:

The Hon’ble Supreme Court of India on various occasions have elaborately dealt with the term ‘liquidated damages’.

1) In Fateh Chand v Balkishan Das,[reported in (1964) 1 SCR 515] the Hon’ble Supreme Court of India has stated:

Section 74 declares the law as to liability upon breach of contract where compensation is by agreement of parties predetermined or where there is a stipulation by way of penalty. But the application of the enactment is not restricted to cases where the aggrieved party claims relief as a plaintiff. The section does not confer a special benefit upon any party. It merely declares the law that notwithstanding any term in the contract for determining the damages or providing for forfeiture of any property by way of penalty, the Court will award to the party aggrieved only reasonable compensation not exceeding the amount named or penalty stipulated.

The purpose of such clauses is to promote certainty, especially in commercial contracts. Parties to a contract would fix such a sum in advance at the time of making the contract because it facilitates calculation of risks; it reduces the difficulty and expense of proving actual damage or loss and facilitates recovery of damages. It also avoids the difficulty in assessment, even where the consequences of breach are ascertainable and avoids the risk of under compensation; the party may otherwise not be able to recover indirect, consequential loss by the rule of remoteness. It gives promisee an assurance that he may safely rely on the fulfilment of the promise.

2) The Supreme Court also framed the following guidelines in the case of Saw Pipes [reported in (2003) 5 SCC 705] for arriving at the ‘reasonable compensation’ vide section 74 of the Contract Act:

Before deciding that a claimant is entitled to any compensation the terms of the contract must be considered; where such terms are unambiguous the sum named therein must be awarded unless such sum is found to be by way of a penalty or in any case unreasonable. In all cases of breach, section 74 is to be read with section 73 and therefore it is not essential for a party to prove actual losses before claiming a decree; a court is competent to award ‘reasonable compensation’ in case of breach irrespective of the existence of any such proof. Sometimes it is impossible for the court to determine the damages with certainty in which case the court can safely award the stipulated sum if it is the genuine pre estimate of damages by the parties as the measure of reasonable compensation.

3) In the case of Chunilal V. Mehta &Sons Ltd. v. Century Spg. & Mfg Co. Ltd.[reported in AIR 1962 SC 1314], where it has been held that “by providing for compensation in express terms thes right to claim damages under the general law is necessarily excluded”.

Applications:

“Liquidated damages” is a safeguard to be adopted in all contracts. Proper indication of this term in the contract can lead to prolonged litigation resulting in unwanted spending by the parties to the contract besides wasting the valuable time of the judicial mechanism.

It is common practice in main contracts to include a provision for the deduction of liquidated damages in the event of delay. The intention of such clauses is to pre determine between the parties the sum payable by way of damages in the event of a delay in completion.

In contrast subcontracts rarely provide for liquidated damages in the event of delay by the subcontractor.

The primary reason for this is straight forward. An employer is in a relatively easy position to compute the level of damages which it is likely to suffer in the event of delay in completion of the project as a whole. The main contractor on the other hand cannot readily anticipate the damage it will suffer in the event of delay by a subcontractor, for that damage will come from a variety of sources dependent upon the nature, circumstances and timing of the delay. The losses suffered by the main contractor may embrace damages imposed by the employer, direct costs incurred in providing its own additional resources, and claims from other subcontractors and suppliers.

The courts have been ready to intervene to enforce liquidated damages provisions, recognising that there are benefits to both parties in making such provisions.

In Temlock v Errill in 1987, the Judge said “there is every reason why parties to building contracts should agree to liquidated damages for non completion. Proof of such loss is often difficult to achieve and agreement in advance is a saver of disputes.”

It has also long been recognised in the industry that the courts will not enforce the liquidated damages provision if the sum stipulated is found to be a penalty rather than a genuine pre estimate of the loss.

Principle:

The principle of requiring payments to represent damages rather than penalties goes back to the Equity courts, where its purpose was to protect parties from making unconscionable bargains or overreaching their boundaries. Today section 2 718(1) of the Uniform Commercial Code deals with the difference between a valid liquidated damages clause and an invalid penalty clause.

Parties entering into a contract has to take safeguards to inbuilt the relevant Clause containing the applicable laws (i.e. Sections 73 and 74 of the Indian Contract Act 1872) by properly indicating the liquidate damages in the eventuality of breach/violation of the contract by either side, to ensure smooth conduct of the terms and conditions as contained in the agreement rather than approach a Court of Law at a subsequent date to determine a penalty for the breach or violation of any of the conditions contained in the agreement.

ADVANTAGES

Liquidated damages clauses possess several contractual advantages. First, they establish some predictability involving costs, so that parties can balance the cost of anticipated performance against the cost of a breach. In this way liquidated damages serve as a source of limited insurance for both parties. Another contractual advantage of liquidated damages clauses is that the parties each have the opportunity to settle on a sum that is mutually agreeable, rather than leaving that decision up to the courts and adding the costs of time and legal fees.

Global context

In the United States, the courts tend not to enforce the Liquidated Damages clauses when the stipulated amount exceeds the actual loss, as it has seemed to them that in the case of breach of contract, Justice requires nothing more than compensation by the amount of the harm suffered…therefore, courts have created a limitation on freedom of contract. (CORBIN on Contracts Vol.5, PAR1057)

The courts in England and Australia are more inclined to honor freedom of contract, enforce the clauses of the contract regardless of the actual loss, after testing foreseeability of the “genuine pre estimate of loss”

If the Liquidated Damages clauses are held to be a penalty and therefore void, the general rule in England is that the clause may be completely disregarded, and the Employer may sue for actual damages, which may exceed the sum stated in the Liquidated Damages clause. Famous Delay Cases:

Below, some cases are briefed where the Legal Stand in respect of Liquidated Damages is shown to have varied under different laws.

The Galoo Case (UK)

The principles underlying the award of liquidated damages as considered by the Court of Appeal in Galoo v. Bright Graham Murray [1995], where the issue in the Galoo case was whether a firm of accountants and auditors were liable for the trading losses incurred by a company which had continued to trade relying upon the negligent audit work done by the firm. No doubt it could be proved that if the firm had done its work properly the company would have stopped trading and therefore would have avoided the subsequent trading losses The question was whether this was enough to establish the causal link between the breach of contract (i.e. the careless audit) and the loss complained of. The Court of Appeal held it wasn’t. ”

…if a breach of contract by a Defendant is to be held to entitle the Plaintiff to claim damages, it must first be held to have been an “effective” or “dominant” cause of his loss. It is necessary to distinguish between a breach of contract, which causes a loss to the Plaintiff, and one that merely gives the opportunity for him to sustain the loss.

The case, though not directly a construction dispute case but it raised the question of the legitimacy of a default by one party to a contract, to the other party’s default.

The St. Jones College Case (Australia)

It is worth mentioning the St. Jones college case, where the Australian contractor could not be relieved from his initial agreement to complete the works on time, on the grounds that the delay was not his fault.

The Utley James Case (US)

In the case of Utley James, the court in the United States did not assess the contractor with responsibility for delay that did not affect the critical path.

SUMMARY

(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, partly 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 preestimate by the parties as the measure of reasonable compensation.