Balancing Contractual Autonomy vis-à-vis Application of Section 74 of the Contract Act, 1872: Part I

[Lavanya Pathak and Pallavi Mishra are advocates practicing at the Delhi High Court.]

The concept of ‘liquidated damages’ and ‘penalty’ was originally intended to be omitted from the realm of the Indian law by careful usage of the phrase “sum named in the contract” under section 74 of the Contract Act, 1872 (“Contract Act”). However, following the amendment brought about in 1899, the scope of section 74 was enlarged with the introduction of the phrase “or…any other stipulation by way of penalty”. While it appears that the intent of the amendment was to continue to refrain from introducing the English law distinction between liquidated damages and penalty, the Indian courts by implication have overridden the inherent legislative intent by interpreting the section in a manner which in fact did bring the Indian law at par with the English law [Shivprasad Swaminathan, ‘De-inventing the Wheel: Liquidated Damages’, Penalties and the Indian Contract Act, 1872’ (2018) Vol. 6 No. 1 The Chinese Journal of Comparative Law 103-127].

Recently, the judgements handed down by High Courts (discussed below) have revisited the law settled by the Supreme Court (“SC”) in ONGC v. Saw Pipes (“Saw Pipes”) and Kailash Nath Associates v. Delhi Development Authority (“Kailash Nath”). The article analyses the judicial precedents to understand the incorporation of English law principles within the scope of section 74 and further examines (i) whether the requirement to lead evidence of ‘loss suffered’ in cases where the contract itself stipulates a provision for stipulated sums as a genuine pre-estimate of loss defeats the legislative intent; and (ii) whether contractual autonomy has in fact been compromised with the courts interpreting and awarding ‘reasonable compensation’ to deny parties the benefit of a clause incorporated as a genuine pre-estimate of damages.

Concept of Damages under Section 74 of the Contract Act

Section 74 declares the law regarding liability upon breach of contract where compensation is pre-determined by way of an agreement between the parties, or where there is a stipulation by way of penalty. For ease of reference, the provision is reproduced hereunder:

74. Compensation for breach of contract where penalty stipulated for:- 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.

As early as in Fateh Chand v. Balkishan Dass (“Fateh Chand”), the Constitution Bench of the SC sought to distinguish Indian and common law on damages, clarifying that the former had attempted to ‘eliminate the elaborate refinements’ made under the English law. While interpreting section 74, the judgement delineated the scope of the provision into two classes of cases: (i) where the contract names a pre-determined sum to be paid in case of breach and (ii) where the contract contains any other stipulation by way of penalty.

However, as Swaminathan argues, on a careful reading of Fateh Chand, it is evident that the judgement in fact ended up bringing in the liquidated damages-penalty dichotomy into Indian law, though the term ‘liquidated damages’ itself was not used [op cit Swaminathan]. Justice Shah read “whether or not actual damage or loss is proved” as merely dispensing with the ‘proof’ of loss, and, not loss itself, justifying the award of ‘reasonable compensation’ in the case of breach of a stipulation by way of penalty. Interestingly, Justice Shah grounded the denial of payment stating that the “(d)uty not to enforce the penalty clause but only to award reasonable compensation is statutorily imposed upon courts by Section 74”. This reasoning, far from ‘eliminat[ing] elaborate refinements’, set the scene for departing from the legislative intent of avoiding the liquidated damages-penalty dichotomy under the Indian law.

Following Fateh Chand, a 3-judge bench of the SC in Maula Bux v. UoI (“Maula Bux”) acknowledged the fact that in some cases it may be impossible for the court to assess compensation, in which case, the sum named in the contract should be regarded “as the measure of reasonable compensation, but not if the sum named is in the nature of penalty”. Justice Shah reaffirmed the line of argument as was taken in Fateh Chand, thereby incidentally making the liquidated damages-penalty dichotomy a part of the Indian law, without actually employing the term ‘liquidated damages’ [op cit Swaminathan at 112-113].

The modern summary of the law on the point is provided by ONGC v. Saw Pipes. Justice MB Shah stated that where parties have agreed for recovery by way of inclusion of a clause stipulating genuine pre-estimated liquidated damages, the courts should refrain from interfering unless it arrives at a conclusion that the clause contemplating damages is by way of penalty. Besides adjudicating the matter along the lines of the liquidated damages-penalty dichotomy introduced by Fateh Chand and Maula Bux, Saw Pipes cautioned the courts from categorising as penalty the clauses which presented an agreement executed by experts in the field. The SC held that the party was entitled to the stipulated sum without any proof of loss as the contractual clause was in the nature of ‘liquidated damages’, which was a genuine pre-estimate of damage. At this point, there is no doubt that the liquidated damages and penalty were deemed as two different categories squarely applying the English law principles, which the drafters of the Contract Act had originally sought to do away with [op cit Swaminathan at 113].

Following the judicial trend, the reluctance of courts to interfere and exercise jurisdiction over disputes concerning award of liquidated damages in cases arising out of contract was authoritatively laid down in BSNL v. Reliance Communications (“BSNL”). Chief Justice Kapadia placed reliance on Chitty on Contracts to understand the test to be applied to distinguish a clause stipulating genuine pre-estimate of damages from penalty clauses. The judgement inter alia noted that whether a provision is to be treated as a penalty is a matter of construction to be resolved by asking whether at the time the contract was entered into, the ‘predominant contractual function’ of the provision was to deter a party from breaking the contract or to compensate the innocent party for the breach.

Further, in Construction and Design Services v. DDA (“DDA”), the SC while squarely applying the categorical pronouncement in Saw Pipes, held that loss could be assumed even without proof and the burden was on the alleging party to prove that the clause stipulating pre-determined damages was in the nature of penalty. 

Flowing from section 74, the above precedents clearly demonstrate a judicial practice of distinguishing and categorising damages as ‘penalty clauses’ or ‘clauses stipulating genuine pre-estimate of damages.’ Given the circumstances, usually in complex contractual relationships, parties stipulate a sum to be paid in the eventuality of breach of the contract. Typically, the understanding between the parties is that such a clause encapsulates a reasonable estimate of anticipated or actual losses suffered on account of breach of the contract.

The latest in the line of prominent precedents discussing the issue of liquidated damages and penalty under section 74 is Kailash Nath, where the SC seeks to codify and re-state the underlying principles of this area of law. It may be noted that while in Saw Pipes, BSNL and DDA the SC appears to be guarded in policing stipulated sums unless they are in terrorem, Kailash Nath tilts the scale towards stringent assessment of reasonableness of compensation making it a “sine qua non” for award of damages under section 74. Justice Nariman specifically referring to the phrase “whether or not actual damage or loss is proved to have been caused thereby” held that the proof of damage is not dispensed with where it is possible to lead evidence establishing actual damage or loss. Thus, Kailash Nath seems to deviate from Saw Pipes in as much as “…compensation can only be given for damage or loss suffered. If damage or loss is not suffered, the law does not provide for a windfall”. The resulting position is that even in cases where the parties negotiate the insertion of a clause keeping in view an anticipatory breach of contract and estimated losses, the court requires the party to prove the damage suffered, thereby tilting the burden upon the suffering party to prima facie establish loss rather than the breaching party leading evidence to establish absence of damage or penal nature of the clause.  

[continued in Part II]

Lavanya Pathak & Pallavi Mishra

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