Liquidated Damages and Penalty

In one line

Where the contract names a sum payable on breach, India does not ask whether it was a genuine estimate or a threat: it awards reasonable compensation up to that sum either way.

In the words a student can write in an exam: section 74 of the Indian Contract Act 1872 provides that where a contract has been broken and "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 "reasonable compensation not exceeding the amount so named or, as the case may be, the penalty stipulated for." India has therefore abolished the English distinction between liquidated damages and a penalty, and the named sum operates as a ceiling, not as an entitlement.

Why parties name a sum, and why the law does not simply enforce it

Parties fix a sum in advance because proving loss after a breach is slow, expensive and sometimes impossible. A contractor's delay on a public road causes real harm that nobody can quantify to the rupee.

But the same clause can be used as a threat: a sum out of all proportion to any conceivable loss, inserted to frighten the other side into performing. Enforcing that would turn damages into punishment, which is not what the law of contract is for.

English law answered by classifying the clause. If the sum was a genuine pre estimate of loss, it was liquidated damages and enforceable as it stood. If it was in terrorem, that is designed to frighten, it was a penalty and unenforceable, and the claimant had to prove his actual loss.

Indian law refused to classify. Section 74 applies to a sum named as the amount to be paid and to any other stipulation by way of penalty, and gives the same answer to both: reasonable compensation, not exceeding the sum named. The classification exercise, which produced a great deal of English litigation, is simply unnecessary here, and saying so is the first thing an answer on this section should do.

The provision itself

"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.

Exception. When any person enters into any bail-bond, recognizance or other instrument of the same nature, or, under the provisions of any law, or under the orders of the Central Government or of any State Government, gives any bond for the performance of any public duty or act in which the public are interested, he shall be liable, upon breach of the condition of any such instrument, to pay the whole sum mentioned therein.

Explanation. A person who enters into a contract with Government does not necessarily thereby undertake any public duty, or promise to do an act in which the public are interested."