The Principle of Liquidated Damages: Balancing Compensation and Penalty in Contract

The Principle of Liquidated Damages: Balancing Compensation and Penalty in Contract

Author: Nayan Kumar Agarwal

Editor: I Sharan

Introduction 

There is a presumption in every contractual agreement that the parties will carry out their share of the duties and obligations stated therein. According to Section 37 of the Indian Contract Act, 1872 (soon to be referred to as the “Act”), parties to a contract are required to carry out or offer to carry out their respective promises, unless the Act’s or another law’s provisions remove or otherwise excuse such performance. This isn’t always the case, though. For this reason, in the event of a “breach” of contract, the parties must have some form of remedy, which allows them to file a lawsuit.

The Act contains no definition of a breach; still, according to Section 39, the promisee can end the agreement if one of the parties has either refused to perform or is made incapable of fulfilling his promise in full. However, the tale is not over yet. The Act also provides “compensation” for loss or damage to the party complaining of the breach, since it is common for the other party to suffer losses arising in due course from a party’s non-performance or breach of contract.

What are liquidated damages? 

Liquidated damages are the terms used in contracts that specify how much must be paid in the event that a party breaches the agreement. The liquidated losses clause is described as “a contractual provision that finds in advance the measure of losses in case a party breaches the contract” by Black’s Law Dictionary. These clauses are the parts of the agreement that address specific situations in which either party might be found to have violated the agreement. For instance, failure to perform due to a delay, differences in a certain quantity or quality standard, etc. In contracts including these damages, determining compensation is made simple because the parties have previously agreed upon an amount during the contract’s formation. 

Section 74 of the Indian Contract Act

The Indian Contracts Act’s Section 74 deals with liquidated damages. According to this rule, the party that is hurt by a breach and is entitled to reasonable compensation, which cannot exceed the amount set forth in the contract, is the one who is listed as payable in the event of a breach, regardless of whether there is a penalty or not. Therefore, the amount represents the upper limit of duty. You can understand it by examining the following examples.

Essential conditions to claim liquidated damages 

The presence of a legal contract

First and foremost, there needs to be a legally binding contract between the parties. When both parties freely consent and there is a valid consideration, a contract is deemed legal. The Indian Contract Act of 1872 basically states that a contract must meet every criterion for a valid agreement, including an acceptable offer and acceptance, competent parties, the parties’ purpose to create a legal obligation, valid consideration, a lawful object, etc.

Violation of the agreement
Second, one or more of the contracting parties must violate the agreement. This basically indicates that any clause in the contract must be broken. Put differently, there can be no claim for damages if there isn’t a breach. Additionally, the plaintiff

Clause of Liquidated Damages

A contract indicating such a violation must be secured against a specified sum of compensation.

Reasonable Relationship with the Actual Damage

For the liquidated damages clause to be enforceable, enough reward must be requested. Excessive and unethical agreements are typically rejected by the courts. Therefore, the courts have the authority to lower the award amount to what makes sense under the circumstances. In ONGC v. Saw Pipes Ltd., the Supreme Court ruled that the court must award compensation that is less than the contract’s stipulated liquidated damages and that it must be based on a reasonable assessment of the consequences of the contract’s breach if the claimant (party seeking damages) lacks proof or an honest estimate.

What are Liquidated Damages and Penalty?

If a contract is broken, the party who defaults is obligated to compensate the injured party with liquidated damages and a penalty. Penalty clauses and liquidated damages are two different things. They are not convertible. Even in legal proceedings, these terms are occasionally used the same and lead to errors. Let’s examine the laws that control them in depth as well as the distinctions between the two.

 Difference Between Liquidated Damages and Penalty

A contract between two or more parties may specify the amount of money that one of them will have to pay. The Indian Contract Act and English Law have different rules on the enforceability of pay in the case of non-performance and the acceptance of that sum as damages.
When actual damages are difficult to determine, liquidated damages are presumed to be a fair depiction of losses. Liquidated damages are typically meant to be compensatory in nature rather than remedial.

A specific agreement proviso may mention liquidated damages to address cases in which a party suffers losses from resources that aren’t directly related to money. In this case, presuming a

Typically, a model serves as a step for planning another item, which may involve talking with experts and outside sources in addition to an organization’s officials. Unknown plans or designs for a product most likely won’t have a fixed market value.

This may be true even if the resultant item is not essential to the development and growth of a company. These plans may be regarded as highly sensitive secret innovations of the company. If the schemes were discovered by an irate agent or supplier, it could severely hamper the ability to generate revenue from the delivery of that item. For the purpose of a liquidated damages clause in an agreement, an organization would have to estimate the potential cost of such events in advance.

Liquidated Damages and Penalties in Construction Contracts 

This phrase is often seen in contracts related to building. A contractor is liable for paying liquidated damages if the project is not finished on schedule. Liquid losses are due and the employer is not needed to provide proof of the loss incurred. Other Remedies to a Liquidated Damages Clause In addition to asking for damages, the victim may also pursue certain other remedies. End a Contract The opposite party may consider the deal to be rescinded if one party violates it. A contract can be dismissed, which means it can be cancelled. In addition to being released from any duty, the opposite party may pursue damages. A party can cancel a contract in line with section 75 of the Indian Contract Act if he does so lawfully.

Case Law’s

Kailash Nath Associates v. Delhi Development Authority and Another (2015)

Facts

In this instance, the DDA held a public land auction. Those who won had to put down a certain amount as earnest money, which would be lost if any of the terms and conditions of the auction were broken or not followed. After paying the earnest money and requesting—and getting granted—a longer deadline for the balance, Kailash Naith, the appellant, had the land put up for auction. In order to obtain the specific execution of the contract and a return of the earnest money, the applicant sought the court.

Issues

Is it possible that contracts requiring the loss of earnest money in the event of a breach of contract are subject to Section 74 of the Act?

Judgement

According to the ruling of the Supreme Court, in cases where a contract includes provisions for liquidated damages, the entire amount of such damages is available only if the party that was harmed suffered damages that were comparable to the set amount of damages. It was also noted that the amount of restitution granted by the court could not, under any situation, go beyond the sum specified in the contract. In this case, the court held that the appellant had not broken any terms of the contract, hence no fine could be applied to cause the earnest money to be lost in accordance with Section 74 of the Act. When there is no damage and a breach occurs, the law does not provide for a windfall.

 Sir Chuni Lal Mehta & Sons v. Century Spinning and Manufacturing Co., AIR 1962 SC 1314 

Facts 

This case nervous a managing agency agreement for the sale of goods in which the respondent in error terminated the agreement before the agreed-upon period could expire. As a result, the appellants filed a lawsuit to recover damages for breach of contract, based on the agreed-upon amount.

Issue 

The computation and legality of damages for a breach of contract were in question.

Judgement 

It was noted that in cases where both sides have expressly stated in writing the number of liquidated damages, there cannot be a presumption that they also intended to give the plaintiff liberty to exceed the amount specified and replace a sum that could not have been determined or found on the date of the breach. The court went on to say that the general law naturally excludes the right to damages claims because the payment is provided for in clear terms. As a result, the buyer’s breach of contract gave rise to the seller’s right to damages, which included the difference between the contract price and the used price.

CONCLUSION & COMMENTS

Including a provision for liquidated damages helps the overall efficacy of the contracts in the rapid pace of contemporary business and commerce, when time and resources are crucial. Because all potential effects of breaching the contract have been thoroughly considered and agreed upon, the contracting parties can now engage in agreements with more confidence. These kinds of provisions encourage openness and, in the end, mutual trust between the parties.
Yet it’s critical to comprehend that the contract must have a precise and fair provision for liquidated damages. The necessity for careful writing is further underscored by the possibility that certain terms would be ruled void by the courts for being unclear or requiring high expenses. Thus, courts and those who design contracts need to

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