Liquidated Damages and Penalty

When a breach of contract occurs, liquidated damages and/or penalty is payable. While the terms, penalty and liquidated damages might sound similar, there is a clear line of distinction between them. In this article, we will look at the laws that govern the compensation payable in the event of a breach of contract.

Liquidated Damages and Penalty

If the parties to a contract specify the amount of compensation payable in case of a breach of contract, then will the Court accept this figure as a measure of damage? This scenario is handled differently by the English and Indian laws. Let’s look at each of them:

English Law

As per the English law, the amount specified can be interpreted either as liquidated damages or penalty.

• Liquidated damages: If the amount fixed by all parties is a genuine estimate of the loss by a future breach of contract, then it is liquidated damages. Thus, all parties to the contract agree that the amount is fair compensation for the breach.
• Penalty: If the amount fixed by all parties is unreasonable or used to force the performing party to fulfill the obligation, then it is a penalty. In such cases, the amount is disregarded and the suffering party cannot claim more than the actual loss.

Indian Law

The Indian law makes no distinction between liquidated damages and penalty. The compensation awarded cannot exceed the amount mentioned in the contract. According to Section 74 of the Indian Contract Act, 1872, if the parties fix the damages, the Court will not allow more. However, it may award a lesser amount, depending on the case. Hence, the suffering party gets reasonable compensation but no penalty.

There is an exception to Section 74 which states that if a party enters into a contract with the State or Central government for the performance of an act in the interest of the general public, then a breach of such a contract makes the party liable to pay the entire amount mentioned in the contract.

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How to differentiate between Liquidated Damages and Penalty?

Here are some principles to help you distinguish between a penalty and liquidated damages:

• If the sum payable is far in excess of the probable damage on breach of the contract, then it is a penalty.
• If a contract mentions an amount payable at a certain date and an additional amount if a default happens, then the additional sum is a penalty. This is because a mere delay in payment is unlikely to cause damage.
• Even if the contract specifies a sum as ‘penalty’ or ‘damages’, the Court needs to discern from the facts of the case if the amount mentioned therein is, in fact, a penalty or liquidated damages.
• The crux of the penalty is the payment of money as a terrorem of the defaulting party. Liquidated damages, on the other hand, are the true pre-estimate of the damage.
• While the English law distinguishes between a penalty and liquidated damages, in India, there is no such distinction. The Indian Courts focus on awarding a reasonable compensation to the suffering party which does not exceed the amount fixed in the contract.

Other Remedies Available

Interestingly, claiming damages is not the only remedy for a breach of contract. Here are some other remedies available to suffering parties:

1] Rescission of Contract

Rescission means revocation, cancellation, or repeal of a law, order, or agreement. If one party breaches the contract, then the other party can treat the contract as rescinded. Also, he is discharged of all obligations under the contract. Further, he can claim compensation for damages, if any.

Example: Peter agrees to deliver 50 bags of cement to John on July 01, 2018. John agrees to pay Rs 10,000 on receipt of the same. However, Peter fails to deliver the cement on the specified date. Hence, John is absolved of his obligation to pay the price. Further, he can claim compensation for losses suffered in procuring the cement from another seller.

2] Quantum Meruit

Quantum Meruit means a reasonable sum of money paid to a person for services rendered when the amount is not specified in a legally enforceable contract.

In such cases, the law infers a promise to pay since the service rendered indicates an understanding between both parties. Quantum Meruit covers a case where the party who provides the service has completed part, but not all of the work that he was bound to do and seeks compensation for the value of the work done. There are two important conditions that must be met for this rule to be applied:

• Contract is discharged
• The claim is brought by the party who has not defaulted.

In simple words, Quantum Meruit allows compensating a party for the value of work done or services rendered. While damages are compensatory in nature, Quantum Meruit is restitutory since it is a reasonable compensation awarded on the implication of a contract to remunerate.

A Quantum Meruit claim arises in the following cases:

• When an agreement is found to be void or it becomes void
• If a party does some work or renders services without the intention of doing so ‘free of charge’.
• If there is a contract to render services (express or implied) but there is no mention of remuneration.
• When one party refuses to perform a contract.
• The contract is divisible and the party who has not defaulted has enjoyed the benefit of the part-performance.
• The contract is indivisible and for a lump sum but the performance is not proper. In such cases, the party performing the contract can claim the lump sum and the other party can deduct a certain amount for the bad work done.

3] Suit for Specific Performance

There are cases where damages are not an adequate remedy upon the breach of a contract. In such cases, the Court may, in its discretion on a suit for specific performance, instruct the defaulting party to perform the promise as per the terms of the contract.

4] Suit for Injunction

If a party has promised not to do something vide a contract but is negating these terms, then the Court can issue an injunction order to restrain the party from doing what he has promised not to do.

Example: Peter is a famous Bollywood actor. He signs a contract with John, a producer. In the contract, he agrees to work exclusively for him for the next 2 years. However, he enters into a contract with Oliver, another producer, to act in his upcoming movie. The Court can issue an injunction order restraining Peter from working with any other producer.

Section 75 of the Indian Contract Act, 1872

According to this section, if a party rightfully rescinds a contract, then he can claim compensation for any losses or damages sustained due to non-performance of the contract.

Example: Peter is a drummer and enters into a contract with John, a nightclub owner. According to the contract, Peter agrees to play at John’s club every Friday and Saturday night. The agreement is for the next two months against a payment of Rs 5,000 per night. On the fourth night, Peter wilfully absents himself from the club and John rescinds the contract.

Since he does so rightfully, John can claim compensation for the damages sustained due to Peter’s non-fulfillment of his promise.

Solved Example on Liquidated Damages and Penalty

Q: Peter and John entered into a contract under which Peter promises to deliver 100 bags of rice to John at Rs 500 each. He also promises to deliver these bags in two installments of 50 each. He delivers the first batch of 50 bags but fails to supply the second. Will John have to pay for the first 50 bags?

Ans: Yes, according to the Quantum Meruit John has to pay for the 50 bags that he has received even though Peter has not performed the complete obligation.