The Supreme Court on Penalties and Liquidated Damages

In
its recent judgment in
Kailash Nath Associates v DDA,
the Supreme Court has considered some important questions relating to section
74 of the Indian Contract Act 1872. As its conclusions appear to depart
from some well-known principles of contract law, the case warrants close attention.
Section 74, of course, provides that the claimant in a breach of contract case
is entitled to ‘reasonable compensation’ not
exceeding
the sum named in the contract as payable in the event of breach. This
was an (intentional) departure from the distinction traditionally drawn by the
common law (or, to be more precise, equity) between penalties and liquidated
damages. As this Blog
has noted, section 74 has given rise to difficult questions in recent years.

The
dispute in Kailash Nath arose out of
an auction conducted by the Delhi Development Authority (‘DDA’). Kailash Nath Associates’ (‘KNA’) bid for one of the plots was accepted. It paid Rs. 78 lakhs
as earnest money. The conditions of auction provided that DDA was entitled to
forfeit this amount (which represented 25% of the sale price) ‘in case of any
default, breach or non-compliance of any of the terms and conditions of the
auction…’ One of these terms was that KNA had to pay the remaining 75% within
three months. This KNA was unable to do, but DDA, at its request, extended the
deadline on the understanding that KNA would pay 18% interest. Eventually, some
six years after the bid was accepted, DDA decided to forfeit the earnest money
and cancelled the allotment. It then re-auctioned the property and was able to
sell it for around Rs. 11 crores, nearly three times the amount KNA had agreed
to pay. KNA sought specific performance and, in the alternative, a refund of
the earnest money. The specific performance claim failed but the single judge
held that it was entitled to a refund. The Division Bench reversed the single
judge and dismissed KNA’s claim.

In
the Supreme Court, Nariman J gave two reasons for allowing KNA’s appeal. The
first was that there was actually no breach of contract which entitled DDA to forfeit
the earnest money. This is not a question of law: it turned on the effect of
DDA granting extensions to KNA. Nariman J held that this effectively extended
the three-month deadline set out in the conditions of auction; since KNA had
not refused to perform before the expiry of the extended deadline, it was not
in breach, and the DDA was not entitled to forfeit the earnest money. If the
Court had stopped there, its conclusion would undoubtedly have been correct,
though one might wonder why it had granted leave. However, Nariman J went on to
say that DDA was not entitled to forfeit the earnest money even on the assumption that KNA was in breach of contract in
failing to pay the 75%, on two grounds. First, article 14 of the Constitution
prevents a public authority from simply appropriating Rs. 78 lakhs where it has
suffered no loss (since it was able to re-sell at a higher price); and
secondly, and more importantly for our purposes, the forfeiture is barred by
section 74 of the Contract. One may respectfully doubt the cogency of the first
point: even if article 14 applies, it is not easy to see why it is ‘arbitrary’
for a public authority to do what (on this hypothesis) the law of contract
permits it to do. If the law of contract allows the claimant, in certain
circumstances, to recover damages even though it suffered no loss—and sometimes it undoubtedly does—the fact that the claimant happens to be a
public authority seems irrelevant. So it is the second ground that is the more
significant.

Why
would section 74 bar the forfeiture of earnest money? It is important to
remember that it is being assumed for the purposes of this argument that
forfeiture was permitted by the contract, ie, that KNA’s failure to pay
within three months did constitute a breach of contract. In the common law, the
courts have generally been reluctant to apply the penalty rules to forfeiture
clauses of this kind: as
Eder
J

pointed out recently, these clauses have usually been readily enforced. Early
Indian cases, notably Abdul Gani,
also took the same view, but the scope of section 74 was considerably expanded
by an amendment introduced in 1899. The amendment was made to address a
particular problem that had arisen at the time about the applicability of the
provision to contractual stipulations requiring the borrower, in the event of
default, to pay a higher rate of interest from the date of the original loan.
The 1899 amendment inserted the words ‘or any other stipulation by way of
penalty’; in Fateh Chand, a Constitution
Bench held that it therefore also applied to forfeiture clauses and not merely
to payments to be made on breach. In Kailash Nath, the Court has held unequivocally that all earnest money clauses are subject to
section 74, if triggered by breach, clarifying that certain observations to the
contrary in Maula Bux were not necessary
for the purposes of deciding that case.

The
only difficulty with the Court’s reasoning is the proposition that section 74
applies only in the event of breach. There is no doubt that this is true, so
far as it goes: section 74 opens with the words ‘where a contract has been
broken…’ However, the question is whether the Indian courts retain equitable
jurisdiction to grant relief against penalty clauses even if section 74 does
not apply in terms. There is some support in the early cases for this
proposition, but the Supreme Court in Kailash
Nath
appears to have assumed that this jurisdiction does not exist. It was,
of course, unnecessary to decide this point given the question before the
court; and its observations can therefore be treated as obiter. But the point remains unresolved in India and it is one that warrants close consideration.

It
may be of interest to note that the UK Supreme Court is scheduled to hear
argument on 21
July
in one of the most important penalty cases of recent times: Makdessi v Cavendish.

About the author

V. Niranjan

2 comments

  • Sir, the critique that the public authority will be able to sell at a higher price is problematic for two reasons: (1) the obvious one that this is theretical; (2) when the lowest bidder backs out, there are two major problems associated with it: (a) the CVC guidelines and almost all govt. tendering procedures mandate re-tendering if the L1/H1 bidder as the case may be backs out. This means that the public authority has to expend costs towards man-hours, re-tendering and advertising (b) the second negative effect which follows from the first is that it inevitably leads to delay in completion of the project or in the present case, delay in receipt of the value of plot/ building. The function of LD is to typically address these aspects. The larger point is that a more nuanced perspective needs to be given to the LD issue.

    Further, I also hypothesise that we should look beyond the LD Law of the economies UK and USA where the quantum of public works has always been relatively less (?) unlike in India. From this perspective, I think Kailash Nath is in the right direction.

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