A Contemporary Re-Examination of the Liquidated Damages Clause

[Lisa Mishra is a V year BALLB student at ILS Law College, Pune]

A contract once breached creates a statutory right for damages in the innocent party. Largely, two distinct heads of damages can be sought: (i) actual loss, and (ii), any loss that has occurred as a result of the breach (as long as both parties were aware of the likelihood of this loss at the time of entering the relationship). While proof of actual loss is a relatively simple task, parties find proving the value of their expectation to be a complex process. Courts and arbitrators often use a significant amount of discretion in granting relief in the nature of expectancy damages. The test for grant of lost profits in India has, in fact, now trickled down to a “reasonable” amount of the party’s expectation. While this presents a convenient solution from the perspective of the adjudicator, the uncertainty does not necessarily inspire confidence in parties seeking relief.

As an alternative to elaborately making out a case for damages, parties insert a liquidated damages clause (“LD clause”) in the contract itself. The effect of such a clause is that in the event of breach by a party, the amount stipulated in the clause becomes payable. This dispenses with the necessity of presenting evidence towards quantification of damages, as the parties have pre-determined the same by mutual agreement. Even though parties may autonomously agree upon a sum that is payable upon default, jurisdictions across the world have recognized that the amount decided cannot be so exorbitant as to disproportionately penalise the breaching the party. Therefore, there is a thin line between a legitimate LD clause seeking damages and a penalty clause. Indian courts have consistently applied the test of “genuine pre-estimate of damages” to determine the validity of an LD clause. However, in 2015, the English Supreme Court rejected this test in an elaborate verdict citing the inability of the test to grasp the needs of sophisticated commercial parties. This post analyses the rationale of the English judgment, and assesses its limited application in India.

A Comparison of the English and Indian law on LD Clauses

In England, a clear distinction was drawn at the very outset between liquidated damages and penalty.[1] That is to say, if the amount stipulated in the clause is primarily a deterrent against non-performance, as opposed to an estimation of damages, it is unenforceable. Further, English courts either uphold an LD clause, or reject it altogether.

In a marked departure from English law, the Indian Contract Act, 1872 abolished the distinction between liquidated damages and penalty. The Supreme Court has made the following observation in this regard:

“Section 74 is clearly an attempt to eliminate the somewhat elaborate refinements made under the English Common Law in distinguishing between stipulations providing for payment of liquidated damages and stipulations in the nature of penalty… The Indian Legislature sought to cut across the rules and presumptions under the English Common Law…”

However, the distinction between liquidated damages and penalty is an inevitable fixture of any proceedings on the matter because, where the amount agreed upon resembles a penalty, it stands to be reduced by the court. This is different from the English rule, wherein the court altogether rejects enforcement of the clause. Despite the effort made to statutorily distinguish the Indian position, the arguments made to uphold the parties’ agreement more or less mirror the English rule. This has led to the creation of a familiar body of jurisprudence that is consistently relied upon to differentiate LD clauses from penalty clauses.[2] The law was summarised in the landmark Supreme Court decision of Kailash Nath Associates v. Delhi Development Authorityas follows:

“Where a sum is named in a contract as a liquidated amount payable by way of damages, the party complaining of a breach can receive as reasonable compensation such liquidated amount only if it is a genuine pre-estimate of damages fixed by both parties and found to be such by the Court. In other cases, where a sum is named in a contract as a liquidated amount payable by way of damages, only reasonable compensation can be awarded not exceeding the amount so stated. Similarly, in cases where the amount fixed is in the nature of penalty, only reasonable compensation can be awarded not exceeding the penalty so stated. In both cases, the liquidated amount or penalty is the upper limit beyond which the Court cannot grant reasonable compensation.”[Emphasis added]

Therefore, only a genuine pre-estimate of damages can be enforced under an LD clause in India. This was also the test followed by English courts until 2015 before the landmark decision in the conjoined appeals in Cavendish Square Holdings BV v. Talaal El Makdessiand ParkingEye Ltd. v. Beavis. The judgment saw a comprehensive discussion of the subject matter, eventually pointing out the inadequacy of the genuine pre-estimation test. Consequently, the bench struck it down and propounded a new test.Interestingly, India is at the same juncture in its understanding of liquidated damages as England was in 2015, before this pivotal decision was pronounced. Since the two jurisdictions are quite similarly placed, it is easy to wonder what has held one back from even acknowledging, let alone deliberating upon, the pitfalls in the present test.

The New Test in Makdessi

Brief Facts

In Makdessi and ParkingEye (before Lord Neuberger, Lord Mance, Lord Clarke, Lord Sumption, Lord Carnwath, Lord Toulson and Lord Hodge), the U.K. Supreme Court combined appeals involving contractual clauses which imposed sanctions in the nature of liquidated damages. The primary question was whether the clauses were unenforceable on account of imposing a penalty. The former appeal was with respect to a commercial contract, whereas the latter considered a consumer contract. This post analyses the decision in Makdessi.

Mr. Makdessi agreed to sell to Cavendish a controlling stake in the holding company of the largest advertising and marketing communications group in the Middle East. The agreement provided that in case Mr. Makdessi violated certain restrictive covenants against competing activities, he would lose the final two instalments payable by Cavendish. Additionally, he would be required to sell his remaining shares to Cavendish at a price excluding the value of goodwill attached to them. Mr. Makdessi breached the restrictive covenants and argued that the clauses stipulating consequences to breach were penalty clauses, and were therefore unenforceable. While the Court of Appeal held in his favour, the Supreme Court allowed the appeal by Cavendish by applying a modified metric to determine the validity of the disputed clauses.

Analysis

The judgment in Makdessi starts by describing the rule against penalty as “an ancient, haphazardly constructed edifice which has not weathered well”. However, the Supreme Court did not wish to remove the doctrine in totality because of its long history and its general acceptance across jurisdictions. The effort of the judges in altering the test was to narrow down the disruptive interference of courts in parties’ contractual autonomy.

The modern version of the rule against penalty was first properly articulated in 1915 by Lord Dunedin in Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd. In his speech, Lord Dunedin outlined very detailed tests which went on to achieve the status of a quasi-statutory code in subsequent case law. Among other important principles regarding the contents of an LD clause and the necessity (or lack thereof) of quantification, he stated that a penalty clause was a provision requiring a payment of money which created fear, whereas an LD clause was a genuine pre-estimate of damages.

The largest problem identified by the bench collectively was that the straitjacketed binary between a “genuine pre-estimate” and a “penalty” was not rooted in commercial reality. They found that this “artificial categorisation” was a consequence of an over-literal reading of Lord Dunedin’s test which the judgment itself did not call for. Lord Neuberger and Lord Sumption very crucially observed as follows:

The real question when a contractual provision is challenged as a penalty is whether it is penal, not whether it is a pre-estimate of loss. These are not natural opposites or mutually exclusive categories. A damages clause may be neither or both. The fact that the clause is not a pre-estimate of loss does not therefore, at any rate without more, mean that it is penal. To describe it as a deterrent (or, to use the Latin equivalent, in terrorem) does not add anything. A deterrent provision in a contract is simply one species of provision designed to influence the conduct of the party potentially affected. It is no different in this respect from a contractual inducement.”

With this rationale in mind, the judges considered the unique commercial requirements of sophisticated parties. They preliminarily emphasized the strong initial presumption that parties (especially those of equal bargaining power) themselves are the best judges of a legitimate provision dealing with a breach. LD clauses need not necessarily be concerned solely with the recovery of compensation for losses flowing directly from the breach. A party’s intention in protecting its trade holistically itself gives rise to a commercial justification for a stipulated sum. Remedies provided by the law have limitations, which is usually the reason parties pre-determine the method of curing the situation arising out of default. A remedy must be available to parties which goes beyond providing a simpliciter financial substitute for performance. As was reinforced in the judgment, the purpose of the law of contract is not to punish wrongdoing but to satisfy the expectations of the party entitled to performance. Parties’ modern expectations are too nuanced to be measured against archaic tests. Lord Neuberger and Lord Sumption considered recent decisions in the past few years where judges were inclined to accept a more compendious understanding of relief and appropriately summarised:

“A damages clause may properly be justified by some other consideration than the desire to recover compensation for a breach. This must depend on whether the innocent party has a legitimate interest in performance extending beyond the prospect of pecuniary compensation flowing directly from the breach in question.”

The test finally laid down is as follows:

“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.”

Applying this test in the appeal by Cavendish, the Supreme Court held that the disputed clauses were justified commercially by Cavendish’s legitimate interest in protecting the goodwill of the business. The parties alone would be the best judges of how their interest could be manifested in the contract, and hence, the same must be enforced. In ParkingEye as well, the Supreme Court applied this test of legitimate commercial interest.

Loose Ends

This case has resulted in the creation of a modernised and flexible test that is specifically capable of catering to the needs of the construction industry. While it provides clarity on the law on penalty, it does not exhaustively explain the ambit of legitimate interest. Consequently, there is no way concrete way to understand what is disproportionate to such legitimate interest.

Application in India

Despite the importance of the ruling, Makdessi has been referred to only twice since 2015, once by the Tripura High Court[3] and once by the Customs, Excise and Service Tax Appellate Tribunal, Mumbai (“CESTAT”). While the CESTAT did not compare the judgment with Indian precedents, the Tripura High Court did. After referring to key analysis from the Makdessi judgment, Justice Talapatra ultimately found that the High Court was bound by the Supreme Court’s ratio in Bharat Sanchar Nigam Limited v. Reliance Communication Limited. The test prevalent today is still that of a genuine pre-estimate of damages and does not go beyond that ambit.

The observations made in Makdessi are a clear sign of the changing perception of relief from 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 quantification of loss, grant of expectation damages, etc. It is therefore perplexing that the re-evaluation of such a central aspect in damages has gone largely unnoticed. At minimum, it is incumbent on courts to justify carrying forward the “genuine pre-estimate” test at a time where the needs of parties have evolved significantly.

Lisa Mishra



[1] Astley v. Weldon, (1801) 2 Bos & Pul 346, 350; Kemble v. Farren, (1829) 6 Bing 141.

[2] Fateh Chand; Oil and Natural Gas Corporation Limited v. Saw Pipes Limited, (2003) 5 SCC 705; Maula Bux v. Union of India, (1969) 2 SCC 554; Kailash Nath Associates v. Delhi Development Authority, (2015) 4 SCC 136; Bharat Sanchar Nigam Ltd. v. Reliance Communications Ltd.,  (2011) 1 SCC 394.

[3] Dishnet Wireless Ltd. v. Union of India, (2016) 1 TLR 10.

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