Liquidated Damages and Penalty

Its illustrations, and they repay reading as a set:

"(a) A contracts with B to pay B Rs. 1,000, if he fails to pay B Rs. 500 on a given day. A fails to pay B Rs. 500 on that day. B is entitled to recover from A such compensation, not exceeding Rs. 1,000, as the Court considers reasonable.

(b) A contracts with B that, if A practises as a surgeon within Calcutta, he will pay B Rs. 5,000. A practises as a surgeon in Calcutta. B is entitled to such compensation, not exceeding Rs. 5,000, as the Court considers reasonable.

(c) A gives a recognizance binding him in a penalty of Rs. 500 to appear in Court on a certain day. He forfeits his recognizance. He is liable to pay the whole penalty.

(d) A gives B a bond for the repayment of Rs. 1,000 with interest at 12 per cent. at the end of six months, with a stipulation that, in case of default, interest shall be payable at the rate of 75 per cent. from the date of default. This is a stipulation by way of penalty, and B is only entitled to recover from A such compensation as the Court considers reasonable.

(e) A, who owes money to B a money-lender, undertakes to repay him by delivering to him 10 maunds of grain on a certain date, and stipulates that, in the event of his not delivering the stipulated amount by the stipulated date, he shall be liable to deliver 20 maunds. This is a stipulation by way of penalty, and B is only entitled to reasonable compensation in case of breach.

(f) A undertakes to repay B a loan of Rs. 1,000 by five equal monthly instalments, with a stipulation that in default of payment of any instalment, the whole shall become due. This stipulation is not by way of penalty, and the contract may be enforced according to its terms.

(g) A borrows Rs. 100 from B and gives him a bond for Rs. 200 payable by five yearly instalments of Rs. 40, with a stipulation that, in default of payment of any instalment, the whole shall become due. This is a stipulation by way of penalty."

Illustrations (f) and (g) are a matched pair and they are set as a question. In (f) the whole of a genuine loan of one thousand rupees becomes due on default: that is an acceleration of an existing liability and is not a penalty. In (g) a loan of one hundred rupees is dressed as a bond for two hundred: the extra hundred is a penalty. The test is whether the clause accelerates a real debt or inflates it.

Broken down

What section 74 covers

• A sum named as the amount to be paid in case of breach, however the parties label it.
• Any other stipulation by way of penalty, which on Fateh Chand is read comprehensively.
• The Explanation: a stipulation for increased interest from the date of default may be a penalty. Illustration (d), where twelve per cent becomes seventy five per cent, is the example.

What the party gets

Reasonable compensation, not exceeding the sum named. Two consequences, and both are examined.

• The named sum is a ceiling, not a floor. The court may and often does award less.
• The court must assess what is reasonable, and cannot simply decree the figure in the contract.

"Whether or not actual damage or loss is proved to have been caused thereby"

The most argued phrase in the section, and the four cases below are the story of what it means. Read with Kailash Nath, the position is that the phrase relieves a claimant from proving the precise amount where loss is difficult or impossible to quantify; it does not dispense with the requirement that a loss be caused at all.

The Exception: bonds for a public duty

A bail bond, a recognizance, or a bond given under a law or a Government order for the performance of a public duty or an act in which the public are interested, is enforceable for the whole sum. Illustration (c), the forfeited recognizance, is the example.

The second Explanation limits it sharply: a person who contracts with Government does not necessarily undertake a public duty. So an ordinary commercial contract with a Government department is governed by the main rule, not by the Exception.

The four cases, in sequence

Fateh Chand v. Balkishan Das, AIR 1963 SC 1405

Facts. By an agreement of 21 March 1949 the plaintiff contracted to sell leasehold rights in land and a building. He received twenty five thousand rupees and delivered possession, the sale was not completed within the stipulated period, and each party blamed the other. He sued to forfeit the twenty five thousand rupees and for possession and compensation for use and occupation.

Held. The expression "the contract contains any other stipulation by way of penalty" applies comprehensively to every covenant involving a penalty, whether for payment of money on breach, for the delivery of property in future, or for the forfeiture of a right to money or property already delivered. Section 74 statutorily imposes on courts a duty not to enforce the penalty clause but only to award reasonable compensation, and where an amount deposited is liable to forfeiture under an express term the court may award only such sum as it considers reasonable, not exceeding the amount specified. In the absence of proof of damage the forfeiture of the twenty five thousand rupees could not stand.

Why it matters here. It brings forfeiture clauses inside section 74 and establishes reasonable compensation as a ceiling.

Maula Bux v. Union of India, AIR 1970 SC 1955

Facts. The appellant contracted to supply goods and deposited money as security for due performance, the contract providing that the deposit stood forfeited on default. He defaulted, the Government rescinded and forfeited the deposit, and he sued to recover it.

Held. Forfeiture of reasonable earnest money under a contract of sale does not fall within section 74. But where the party in breach has undertaken to forfeit a sum already paid to the other party, the undertaking is in the nature of a penalty and section 74 applies, so the party complaining is entitled only to reasonable compensation, which the court must assess. The words "whether or not actual damage or loss is proved to have been caused thereby" cover those classes of contract where the court cannot assess the loss.

Why it matters here. It draws the line between earnest money and a security deposit, and it is the answer to a forfeiture problem.

Oil and Natural Gas Corporation Ltd. v. Saw Pipes Ltd., AIR 2003 SC 2629

Facts. Delivery of casing pipes was delayed by a general strike in Europe. The buyer deducted a stipulated sum as liquidated damages. An arbitral tribunal held the deduction bad because no loss had been proved, and the award was challenged.

Held. Where the contract names a genuine pre estimate of damages, and where it is difficult or impossible for the court to assess the actual loss, the named sum may be awarded as reasonable compensation under section 74 without separate proof of loss; but the sum stipulated remains the ceiling and the court's task is still to award reasonable compensation. The Court reviewed Fateh Chand, Maula Bux and the Privy Council in Bhai Panna Singh.

Why it matters here. It is the case usually cited for the proposition that proof of actual loss is not always required, and it must be read with the next one.

Kailash Nath Associates v. Delhi Development Authority, (2015) 4 SCC 136

Facts. An auction purchaser of land paid earnest money. After a delay to which the authority itself had contributed, the authority forfeited the earnest money and resold the plot at a higher price than the original bid.

Held. Section 74 gives reasonable compensation for loss or damage caused by the breach, and where no loss at all is caused, no compensation can be awarded. Forfeiture of earnest money is permissible only where the money is genuinely earnest and the forfeiture is reasonable, and it cannot stand where the party forfeiting has suffered no loss. On the facts the authority had resold at a higher price and therefore had no loss.

Why it matters here. It is the restatement that governs section 74 today, and it is the corrective to a broad reading of ONGC v. Saw Pipes: damage or loss remains the foundation of a section 74 claim. The two are reconciled by distinguishing between a loss that is hard to quantify, where the named sum may be awarded, and a case of no loss at all, where nothing is.

India and England compared

A worked example

Ishaan contracts with a builder, Jaya, for a shop fit out to be completed by 1 September, the contract providing that Jaya shall pay ten lakh rupees if she is late.

• She finishes on 1 November and Ishaan claims the ten lakh. Section 74 applies. He is entitled to reasonable compensation not exceeding ten lakh, and the court assesses it. He does not automatically get the ten lakh.
• He proves he lost four lakh in rent for the two months. A court would ordinarily award around that figure, well within the ceiling.
• He proves no loss at all, because he had no tenant and was not ready to trade. On Kailash Nath no compensation can be awarded, because section 74 compensates for loss or damage caused by the breach and none was caused.
• His loss is real but impossible to quantify, for instance damage to the goodwill of a new business. On ONGC v. Saw Pipes and the closing words of section 74, the named sum may be awarded as reasonable compensation without separate proof of the amount, the sum remaining a ceiling.
• Ishaan had paid Jaya three lakh as a deposit and the contract says he may forfeit it on her default. On Fateh Chand a forfeiture clause is a stipulation by way of penalty within section 74, so he may retain only such sum as is reasonable, and on Maula Bux a security deposit is treated differently from reasonable earnest money.
• The contract provides that on default the rate of interest on the retention money rises from twelve to sixty per cent. The Explanation applies: a stipulation for increased interest from the date of default may be a penalty, and illustration (d) is directly in point.
• Jaya had given a bond under a State Government order for the performance of a public work. The Exception may apply, in which case the whole sum is payable. But the second Explanation warns that contracting with Government does not by itself make the duty a public one.

What it does NOT mean

"The named sum is automatically payable." It is a ceiling. The court awards reasonable compensation, which may be much less.

"No loss need be proved under section 74." Kailash Nath holds that where no loss at all is caused, nothing is payable. The statutory words relieve the claimant of proving the amount in cases where it cannot be assessed.

"India follows the liquidated damages and penalty distinction." It has abolished it for the purposes of section 74.

"A forfeiture clause is outside section 74." Fateh Chand holds that section 74 covers every covenant involving a penalty, forfeiture included.

"Earnest money and a security deposit are the same." Maula Bux distinguishes them: reasonable earnest money forfeited under a contract of sale is outside section 74; a security deposit for due performance is within it.

"Any bond given to Government attracts the Exception." The second Explanation says a person contracting with Government does not necessarily undertake a public duty.

Quick revision

• s.74: where a sum is named as payable on breach, or the contract contains any other stipulation by way of penalty, the party complaining gets reasonable compensation not exceeding that sum, whether or not actual damage or loss is proved.
• India has abolished the liquidated damages and penalty distinction. The named sum is a CEILING.
• Explanation: increased interest from the date of default may be a penalty. Illustration (d), twelve per cent to seventy five per cent.
• Illustrations (f) and (g): acceleration of a real debt is not a penalty; inflation of the debt is.
• Exception: bail bonds, recognizances and bonds for a public duty are enforceable for the whole sum. Illustration (c). But contracting with Government is not by itself a public duty.
• Fateh Chand, AIR 1963 SC 1405: s.74 covers every penalty covenant, including forfeiture; the court's duty is to award reasonable compensation, not to enforce the clause.
• Maula Bux, AIR 1970 SC 1955: reasonable earnest money is outside s.74; a security deposit is inside it.
• ONGC v. Saw Pipes, AIR 2003 SC 2629: where loss is difficult or impossible to assess, the named sum may be awarded without separate proof.
• Kailash Nath Associates, (2015) 4 SCC 136: where no loss at all is caused, no compensation can be awarded. This governs.

Test yourself

1. State section 74 and explain how it differs from English law. Where a contract has been broken and a sum is named as the amount to be paid on breach, or the contract contains any other stipulation by way of penalty, the party complaining is entitled, whether or not actual damage or loss is proved, to reasonable compensation not exceeding the sum named or the penalty stipulated. English law distinguished a genuine pre estimate, enforceable as liquidated damages, from a penalty, which was unenforceable. India applies one rule to both and makes the named sum a ceiling.

2. Is proof of loss required under section 74? Loss must be caused, though its precise amount need not always be proved. Kailash Nath Associates v. Delhi Development Authority, (2015) 4 SCC 136, holds that where no loss at all is caused no compensation can be awarded. ONGC v. Saw Pipes, AIR 2003 SC 2629, holds that where loss is difficult or impossible to assess the named sum may be awarded as reasonable compensation without separate proof of the amount.

3. What did Fateh Chand decide about forfeiture clauses? That the words "any other stipulation by way of penalty" apply comprehensively to every covenant involving a penalty, including the forfeiture of a right to money or property already delivered. Section 74 imposes on the court a duty not to enforce the penalty clause but to award only reasonable compensation not exceeding the amount specified, so in the absence of proof of damage the forfeiture of twenty five thousand rupees could not stand.

4. Distinguish earnest money from a security deposit. On Maula Bux v. Union of India, AIR 1970 SC 1955, earnest money is a deposit made by a purchaser to be applied towards the price and, until then, as evidence of his intention to buy; its forfeiture under a contract of sale, if the amount is reasonable, does not fall within section 74. A sum deposited as security for the due performance of a contract, which the party in breach has undertaken to forfeit, is in the nature of a penalty, so section 74 applies and only reasonable compensation may be retained.

5. Explain illustrations (f) and (g) to section 74. In (f) a genuine loan of one thousand rupees is repayable by five instalments with a stipulation that the whole becomes due on default; that merely accelerates an existing liability, is not a penalty, and the contract may be enforced according to its terms. In (g) a loan of one hundred rupees is secured by a bond for two hundred payable by instalments with the same acceleration clause; the additional hundred inflates the debt, so the stipulation is by way of penalty and only reasonable compensation may be recovered.