India: Imposition Of Liquidated Damages Is Not The Prerogative Of The Employer

"Damages" for breach of contract refers to the compensation for any damage or injury or inconvenience suffered by the other party as a consequence of the breach. Aggrieved party can claim damages as a matter of right but the court has the discretion in determining the 'quantum' of damages. Common law principles governing the grant of damages are codified in Section 73-75 of the Indian Contract Act, 1872 [hereinafter referred as "The Act"].

Employers generally have the Liquidated Damages [hereinafter referred as 'LD'] clause in contracts. Such clauses provide that in case of breach, say on the account of delay in completion of work, LD will be levied or imposed as a consequence thereof. Such stipulations are covered under Section 74 of the Act. The court is not bound to award the amount mentioned in contract as damages but can award a reasonable compensation not exceeding the amount mentioned.

The moot questions being explored by this article are: i) when the employer can impose 'LD'? ii) Whether the employer is entitled to realise the LD so imposed? This article aims at understanding court's approach in levying and realizing LD in the case of works/ construction/building contracts.

1. Employer's right to impose Liquidated Damages or Penalty

As explained in the above paragraphs, LD is essentially damages predetermined by the parties at the time of making of contract irrespective of whatever actual damages may be. These damages may be for breach of entire contract or breach of a particular term in the contract.18 Parties can have different amount for the breach of different terms of the contract. In J G Engineers Pvt. Ltd v. Union of India19 the Hon'ble Supreme Court held that a party can impose LD only if the other party has committed the breach and that must have been adjudicated by the court or arbitrator.

It is pertinent to note here that the employer cannot unilaterally determine the breach and impose LD. There has to be an adjudicatory process provided in the contract, the courts in absence of such process have refused to enforce the clauses authorizing the employer from quantifying the damages on its own.20 Thus, before the breach is adjudicated by court or arbitrator the employer cannot impose any LD on the contractor. If he does so, the same will be illegal or perverse.21

Also, the employer cannot impose the LD without giving the defaulting party a reasonable notice to remedy the 'delay' or 'breach'.22 The requirement of giving notice is not a mere formality. The employer is obligated to give a detail notice stating clearly the breach complained of, time to remedy such breach and consequences in case the breach is not remedied within the specified period.

2. Liquidated Damages or Reasonable Compensation

As noted earlier that section 74 provides that on the account of breach the party is entitled to either the fixed sum or penalty or the reasonable compensation not exceeding the amount of sum agreed or penalty stipulated in the contract. The Hon'ble Apex Court in Kailash Nath v. Delhi Development Authority23 laid down the guidelines for determining whether parties are entitled to 'liquidated damages or reasonable compensation'. For the sake of brevity the basic principles are summarised below:

  1. Sum named in the contract is payable as the liquidated damages only if it is 'genuine pre-estimate of damages' otherwise the parties is entitled to only reasonable compensation not exceeding the fixed sum mentioned in the contract;
  2. If any penalty is stipulated in the contract then only reasonable compensation is awarded not exceeding the amount so fixed for the penalty;
  3. In case the court decides to award reasonable compensation, the basic principles of section 73 shall apply in assessment of compensation;
  4. Proof of damage or loss is a sine qua non for grant of reasonable compensation under Section 74 and such proof is dispensed only if damages are difficult or impossible to prove and liquidated damages are genuine pre-estimate of damages.

Thus, the employer is entitled to claim LD only if the court/arbitrator finds that these are genuine pre-estimate of damages otherwise he will be entitled only for reasonable compensation assessed according to the well settled principles of Section 73.

2.1. Whether the sum claimed is a Penalty or Liquidated damages?

Penalty in a contract is a payment stipulated as in terrorem or as a punishment. The purpose of penalty is not compensating the other party but to ensure the performance of contract. It is necessary to determine whether the fixed amount payable on breach is 'penalty' or 'LD' because in case it is a penalty the employer will be entitled only to a reasonable compensation otherwise it is entitled to LD if that is a genuine pre-estimate of damages.24

3. No Damages payable when liquidated damages awarded

Where the parties to a contract have included a specified sum of money to awarded as damages in case of breach of contract, and then it must be taken to exclude the right to claim an unascertained sum of damages. The right to claim LD is enforceable under section 74 of the Contract Act and where such a right is found to exist no question of ascertaining damages really arises.25

The effect of Section 74 is that a party to the contract is not entitled to the full amount specified under the contract unless the employer proves that it has really suffered damages to the extent of full amount or where the Court considers that the full amount is reasonable compensation that may be awarded in the circumstances of the case.

4. Forfeiture of employer's right to impose LD

The employer's right to realize LD is forfeited in certain circumstances such as:

  1. Waiver: When there is a breach of contract, the employer can either elect to affirm the breach and claim LD or ignore the same and grant continuation of the contract. In case he chooses not to elect the breach as repudiatory breach, he is disentitled to claim LD. He would have said to waive off his right to claim LD and the right to claim the same will be forfeited.26
  2. Employer himself is at fault: Where a clause in the contract stipulated levy of LD if the work is not done with due diligence and the delay occurred due to failure on part of the employer to supply materials in the required time. It was held that imposition of damages by the employer could not be justified.27

Conclusion :

LD is consequential of breach of contract. It is imperative for the employer to first establish the breach and then impose LD. As discussed earlier, party alleging the breach cannot determine the breach on his own and stipulations in the contract providing for imposition of LD without an adjudicatory process are void in terms of Section 28 and Section 74 of the Act. Thus, a unilateral imposition of LD without adjudication of the breach is not only legally tenable but also commercially unsound. The imposition and realization of LD due to delay in completion of a part of contract financially overburden the constructor and in due course results in non-completion of whole contract. Hence, employer prerogative to impose LD is not unfettered but restrictive.

Footnotes

18. Engineering Projects (India) Ltd v. B K Constructions, AIR 2012 Kant 35 (DB).

19. J G Engineers Pvt. Ltd v. Union of India, AIR 2011 SC 2477.

20. Bharat Sanchar Nigam Ltd v. Motorola India Pvt. Limited, (2009) 2 SCC 337.

21. Indian Oil Corporation v. Lloyds Steel Industries, (2007) 4 ArbLR 84 (Del).

22. Kailash Nath Associates v. Delhi Development Authority, (2015) 4 SCC 136.

23. Id.

24. Belco Enterprises v. DTC, OMP No. 498/ 2007, Delhi High Court decided on 21 January 2010.

25. Sir Chunilal V. Mehta and Sons Ltd. vs. Century Spinning and Manufacturing Co. Ltd., 1962 Supp. (3) SCR 549

26. J G Engineers Pvt. Ltd v. Union of India, AIR 2011 SC 2477, in this case there was delay in completion of work and respondent granted the extension without levying LD.

27. Oil and Natural Gas Commission v. Shyam Sunder Agarwalla and Co., AIR 1984 Gau 11.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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