Resolving liquidated damages - Indian perspective paves a way forward

ONGC had placed an order with Saw Pipes to supply equipment for offshore exploration to be purchased from European manufacturers.  Unexpectedly, a steel mill workers’ strike in Europe delayed delivery, but timely delivery was essential per the applicable contract clause in the agreement. ONGC granted a time extension but invoked the contract clause to recover liquidated damages by withholding $3,04,970.20 (US dollars) from total payment to Saw Pipes for the equipment.  Disputing the claim, Saw Pipes referred the issue to arbitration and a court case followed.¹ 

But, in the end, the judge denied the payment, observing that an award for liquidated damages, in this case, violated statutory provisions, and could not reflect the public interest. Furthermore, if the court did not exercise its authority to set aside such awards, it would violate the administration of justice. ² 

The court viewed the case as a response to Indian law that was shifting to the English model.  This transitioning model assumes that the damages must be estimated at the time of the contract signing. Therefore, any estimate for damages must be paid even though the innocent party incurs fewer or no damages after the breach and at the trial. We could define this court’s perspective as an ex-ante³ or first-look model. 

This case is clearly a sign of India’s changing perception of relief from the contractual breach. Statutorily, India was a step ahead in allowing parties to determine consequences upon default. Indian courts have also been generous in their approach toward quantifying a loss, or granting expected damages, etc.

It is therefore perplexing that this re-evaluating of such a central aspect of damages has gone largely unnoticed. At a minimum, it is incumbent on courts to justify carrying forward the genuine pre-estimate test after the needs of parties have already evolved and changed significantly. 

Considering this, we could argue that the judge correctly commented about the Temlock v Errill case in 1987⁴ saying, ”Proof of a failure is always impossible to obtain, and a pre-arrangement saves time and money in the event of a dispute.”

First, understand the clarity of terms within their context

The term liquidated damages⁵ is defined “as an estimate of otherwise intangible or hard-to-define losses to one of the parties.” It is a provision that allows for the payment of a specified sum should one of the parties be in breach of contract.⁶

The term contract defined under Section 2(h)(1) of the Indian Contract Act (ICA) states “An Agreement enforceable by law is a contract”.⁷

The term agreement defined under Section 2(e)(2) of ICA says, “Every promise and every set of promises, forming the consideration for each other, is an agreement”.⁸ 

The definition of promise under Section 2(b)(3) of ICA  says, “When the person to whom the proposal is made signifies his assent thereto, the proposal is said to be accepted. A proposal, when accepted, becomes a promise.”

The term enforceable by law is not defined under the ICA. To become a contract, an agreement needs to be enforceable by law which means that it must raise certain legal obligations. In other words, an agreement must be within the scope of law otherwise it will not form a contract under ICA.

Indian contract law on liquidated damages

In India, liquidated damages are dealt with under Indian Contract Act, 1872⁹ within section 73 and section 74.  The relevant parts of the sections are as follows:

Section 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 compensation for any loss or damage suffered – damage which naturally arose in the usual course of things from such breach, or damage which the parties knew, when they developed the contract, would likely result from the breach of the contract.

“Such compensation is not to be given for any remote and indirect loss or damage sustained by reason of the breach.”

Section 74: “Compensation for breach of contract where penalty is stipulated: 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 entering 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.

In the case of a delay, it is standard practice to provide a clause for the deduction of liquidated losses in key contracts. The aim of such provisions is to predetermine the amount owed as damages between the parties in the event of a delay in completion.

English Law vis-à-vis Indian Law

• The penalty is used in a contract to secure the performance of the contract whose main purport is to ensure the payment of money which is specified to deter the party from offending. Also, where the loss to be recovered is greater than the pre-determined loss, then the loss amounts to a penalty.
• Whereas liquidated damages are compensatory in nature and are pre-estimated damages. The purpose of liquidated damages is to promote certainty, especially in the commercial field. This distinction between liquidated damages and penalty is suspended in the Indian Contract Act, but the English law upholds the distinction. There are several conceptual differences as to whether the assessment of reasonable compensation made ex-ante (at the time of entering into the contract) is binding or is subject to ex-post (after the breach) review by the court.¹⁰

English Law

• The test for determining whether a particular liquidated damages clause is, in fact, an unenforceable penalty clause, is simply whether the stipulated sum of liquidated damages was a genuine covenanted pre-estimate of damage that could be caused by a breach of the relevant primary obligation. This principle was established a century ago, in the case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co.¹¹ The court suggested that such a provision would be unenforceable if the amount payable was “extravagant, exorbitant or unconscionable.”  This has led to a number of challenges to the liquidated damages clauses, because they are based on a constituted penalty.
• More recently, the courts in the UK acknowledged that in certain circumstances a commercial justification might exist for such provisions even where the amount to be paid appears penal. For example, the UK Supreme Court has considered the penalty rule in Cavendish Square Holding BV v Makdessi¹² and Parking Eye Ltd v Beavis (Consumers’ Association intervening)¹³. The real test to determine the penalty clause is whether the provision goes beyond the relevant party’s legitimate interest.

The court went on to state that “the true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter.”

• Thus, the English law still does not uphold penalty clause enforceable. The liquidated damages clause that is penal in nature must be expressed as a secondary obligation which only operates once the primary obligation has been breached.

Liquidated Damages clauses are generally upheld by the courts, providing they do not constitute a penalty. It now totally depends upon how the parties draft their clauses to mitigate the adverse consequences that might arise from accepting the proposed amount of liquidated damages.  This is because the courts now identify a wider legitimate interest of the innocent party than merely the need for pecuniary compensation for the loss. If the court identifies this legitimate interest, the court might uphold the enforceability of the impugned clause -- even if the stipulated amount is such that in the absence of such consequences, the court would have viewed the clause as a penalty clause – and is therefore unenforceable.

Indian Law

• In accordance with the Indian Contracts Act, 1872, the liquidated damages and penalty payable by the party committing a breach of contract, is based upon the doctrine of reasonable compensation --, an amount which is up to the court to decide. 
• Pursuant to Section 74,the requirement of proving “actual loss or damage” was first tested by the Privy Council in Panna Singh v. Arjun Singh¹⁴, wherein the Privy Council stated that “the effect of Section 74 of the Contract Act is to disentitle the plaintiffs to recover simpliciter the sum specified in the contract, whether a penalty or liquidated damages, and hence in a suit by vendors for damages for breach of contract of sale, the plaintiffs must prove the damages they have suffered.”
• The decisions in Fateh Chand¹⁵ mainly eliminated the refinement under English Law in relation to the difference between the payment of liquidated damages and the stipulation of penalty.  The Supreme Court stated that the aggrieved party is entitled to “a reasonable compensation which should not exceed the sum of penalty or the pre-determined amount which have to be paid after the breach of contract).”

And Maula Bux¹⁶  states, “Where the court is unable to assess the compensation arising from the breach, the sum pre-determined by the parties if it is regarded as a genuine may be taken into consideration as the measure of reasonable compensation, but not if the sum named is excessive and 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.”

These were followed in several other similar judgments of the Supreme Court.

• The most significant among these is the case of Oil & Natural Gas Corporation Limited v. Saw Pipes Limited (Saw Pipes. The Court held that, "if the compensation named in the contract for such breach is genuine pre-estimate of loss, there is no question of proving such loss or such party is not required to lead evidence to prove actual loss suffered by him.”
• Pursuant to Saw Pipes, the Supreme Court passed its decision in Kailash Nath Associates v. DDA (Kailash Nath).¹⁷ The Court held that, in the expression “whether or not actual damage or loss is proved to have been caused thereby” means that where it is possible to prove actual damage or loss, such proof is not dispensed with. It is only in cases where damage or loss is difficult or impossible to prove that the liquidated amount named in the contract, if a genuine pre-estimate of damage or loss, can be awarded.
• Before the amendment of 1899, all Indian cases followed the common law perspective, but the amendment broadened the purview of Section 74. The clause “any other stipulation by way of penalty” was inserted in Section 74, which was first addressed in the case of Fateh Chand v. Bal Kishan Das. In the case of Kailash Nath, the apex court held that Sec.74 does not extend to the jurisdiction of granting relief in cases of penalty when the provision of the section does not apply in terms. Where in earlier cases the court stated that Section 74 extends to those cases where there are extreme circumstances.”
• Under English Common Law, parties may name a sum to be payable in case of a breach.  When this sum is identified by the court as a penalty, the amount is unrecoverable.  However, if this amount is classified as liquidated damages, it is recoverable.

However, the Law of Contracts in India does not recognize any qualitative difference in the nature of damages, because section 74 eliminates the somewhat elaborate refinement under Common Law. The removal of this distinction avoids a quagmire of complex classifications, thereby binding the court only to award any reasonable compensation that the court sees fit, but the amount is not to exceed the damages stipulated in the contract.¹⁸

The common feature between English law and Indian law is depicted in the decision of Supreme Court in Chunilal V. Mehta and Sons Ltd. Vs. Century Spg & Mfg Co. Ltd¹⁹ where it has been held that “by providing for compensation in express terms the right to claim damages under the general law is necessarily excluded.”  This ensures that the parties are free to claim damages under the law. The UK Supreme Court held this view in Cavendish case.

But in all cases should the courts allow the full amount of liquidated damages?

The answer to the above question is obviously no!  Just because the stipulation of liquidated damages is available in the contract, the aggrieved party cannot claim the full amount of liquidated damages as a matter of right. Any entitlement would be to recover damages only to the extent of actual losses proved to have been suffered by the aggrieved party.

In cases where no actual loss has been proven -- but undeniably, losses occurred --  the courts would not be powerless to award reasonable damages to the aggrieved party. A party could encounter a situation i.e., where the nature of contract does not provide for assessing damages. In such a situation, the court would be empowered to grant full amount of liquidated damages providing the pre-estimate of damages agreed between the parties are fair and reasonable. [Herbicides (India) Ltd. vs. Shashank Pesticides Pvt. Ltd. 180 (2011) DLT 243].²⁰

TO SUMMARIZE

In conclusion, when the court formulated four propositions of law in the Saw Pipes case, the judge recognized a change in the Indian law that would affect how damages would be awarded to the damaged party.  Indian law was shifting to the English model to the ex-ante or first look model which means that when an estimate of damages is made at the time of contract, damages must be paid even if -- after the breach and at the trial – lower damage amounts or no damages were proven.  

Clearly the perception is changing regarding relief from the contractual breach. Statutorily, India was a step ahead in allowing parties to determine consequences upon default. Indian courts have also been generous in their approach towards the quantification of loss, or the grant of expectation damages, etc. It is therefore perplexing that the re-evaluation of such a central aspect of damages has gone largely unnoticed. At minimum, it is incumbent on courts to justify carrying forward the “genuine pre-estimate” test when the needs of parties have evolved significantly.

It is rightly stated by the judge said in Temlock v Errill in 1987,”Proof of a failure is always impossible to obtain, and a pre-arrangement saves time and money in the event of a dispute.”

ABOUT THE AUTHOR

The author is an Executive Director with Grant Thornton Bharat LLP . Mohit has more than two decades of rich experience in areas of risk management, dispute resolution , commercial management , growth and strategy. Grant Thornton is one of the leading management and development consultancy firm which is part of the Grant Thornton International and is operational in more than 140 countries through more than 62000 professionals.

ABOUT GRANT THORNTON

Grant Thornton is one of the leading management and development consultancy firms that is part of Grant Thornton International and operates in more than 140 countries via more than 62,000 professionals worldwide.

END NOTES

1. Ref. Legal Services India.com article titled, ONGC v. SawPipes  
2. Ref. Pleaders perspective in article titled Analyzing the case of ONGC v. Saw Pipes Aug 1, 2021 - LawSikho 
3. Ref: essay titled Unruly Horse on a Run published in LawTeacher, 14 June 2019
4. Ref. Temlock v Errill
5. Ref. Caseline report titled Oil and Natural Gas Corporation Ltd v. Saw Pipes Ltd,
6. “Ex-ante refers to future events (or at the time), such as the potential returns of a particular security, or the returns of a company. Transcribed from Latin, it means ‘before the event.’” See Investopedia article titled Ex-Ante for further definition and explanation
7. Liquidated damages Investopedia definition: within the article titled What Are Liquidated Damages (LDs)? How They Work, With Example
8. Breach of Contract Explained: Types and Consequences,
9. Indian Contract Act, 1872 defined by Wikipedia
10. Justice M Jagannadha Rao,’ Liquidated Damages and Penalties: Ex Ante or Ex Post Methodology” (2013) 1 SCC J-1
11. Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co 1915 AC 79
12. Cavendish Square Holding BV v Makdessi [2015] UKSC 67
13. Parking Eye Ltd v Beavis (Consumers’ Association intervening) [2015] 3 WLR 1373
14. Panna Singh v. Arjun Singh (1929) 30 LW 281
15. AIR 1963 SC 1405
16. 1969 (2) SCC 554
17. (2015) 4 SCC 136
18. 4 Law Rev GLC 106
19. Chunilal V. Mehta and Sons Ltd. v. Century Spg&Mfg Co. Ltd 1962 AIR 1314
20. Indian Kanoon report