Damages as commonly understood, is compensation to a party to put it back in the same position in which it would have been, had the other party not committed a breach. But damages is not a means to unjust enrichment.

The law on damages is governed by Sections 73 and 74 of the Indian Contract Act, 1872 ("Contract Act"). Under section 73 of the Contract Act, when a contract is broken, the party who suffers such breach is entitled to receive from the defaulting party compensation for any loss or damage caused on account of such breach. However, such compensation shall be given only for the loss which arose naturally in the usual course of things, or those which could be contemplated by the parties to be likely to result because of the breach. Such compensation is not to be given for any remote and indirect loss or damage sustained by reason of the breach.

Sometimes, the parties to a contract, at the time of making the contract, agree to the amount of compensation payable in the event of the breach of contract. Such a position is normally seen in all construction contracts. The amount of compensation which is agreed at the stage of entering into the contract may either be Liquidated Damages ("Liquidated Damages") or penalty. If the compensation payable is a genuine pre-estimate of the damages, it is known as Liquidated Damages. On the other hand, if the compensation is extravagant and disproportionate to the likely loss or if it is fixed with a view to discourage the breach of contract, it is known as penalty.

Though the term 'Liquidated Damages' is not defined under the Contract Act, Section 74 of the said Act, provides the essentials of what constitutes Liquidated Damages. The extract of the relevant section is reproduced below:

"Section 74- 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 provided to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named, or the case may be, the penalty stipulated for".

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 the parties and found to be such by the court. For instance, an EPC (engineering, procurement and construction) contract may provide that if the contractor is unable to complete the contract on time, a certain percentage of the total contract price shall be paid as compensation. Such amount would be termed as Liquidated Damages. When a sum is mentioned in a contract as a liquidated amount payable by way of damages, only reasonable compensation can be awarded not exceeding the amount mentioned in the contract. Similarly, in cases where the amount fixed is in the nature of penalty, only reasonable compensation can be awarded not exceeding the penalty mentioned. In both the cases, courts cannot grant compensation beyond the liquidated amount or penalty mentioned in the contract.

There is a distinction between liquidated damages and penalty. If the intention of the stipulation is to assess and quantify the damages and compensation for the breach of the contract, then the stipulation is said to be Liquidated Damages whereas, if the intention behind the contract stipulation is to secure the performance of the contract by the imposition of a fine, then the stipulation is a penalty.

The general principles set out in the Contract Act i.e. Section 73 shall apply while computing damages. Reasonable compensation will be fixed on well-known principles that are applicable to the law of contract, which are to be found in Section 73 of the Contract Act. Since Section 74 awards reasonable compensation for damage or loss caused by a breach of contract, damage or loss caused is a sine qua non for the applicability of the section.

Though the principles of Section 73 apply in case of Liquidated Damages, courts may award full Liquidated Damages in cases where it is impossible to assess damages or prove the same provided such amount is found to be a genuine pre-estimate of damages1. It is however, pertinent to note that though the principles of Section 73 apply in as far as the quantum of damages is concerned, the requirement of proof is much lower in cases of Liquidated Damages as actual loss suffered need not necessarily be established.

The expression "whether or not actual damage or loss is proved to have been caused thereby" means that where it is possible to prove actual damage or loss, such proof is not dispensed with. It is only in cases where damage or loss is difficult or impossible to prove that the liquidated amount named in the contract, if a genuine pre-estimate of damage or loss, can be awarded2.

The two core issues arising with respect to Section 74 are that the proof of loss suffered by the aggrieved party remain even though the extent of it may not be necessary to prove. Therefore, loss is a criterion for an award for damages3. It is pertinent to note that a party cannot claim the full amount of Liquidated Damages as a matter of right and is only entitled to recover damages to the extent of losses proved by it.

Unlike English law which provides that if a stipulation is in the nature of a penalty, the clause becomes void, Indian law provides that courts are duty bound to award reasonable compensation even in the case of penalty. However, such amounts should be reasonable and not exceeding the amount specified in the contract.4

It is relevant to note that determination of breach and subsequent imposition of Liquidated Damages cannot be unilaterally imposed by the Employer. The contract between the parties is required to contain an adjudicatory process for imposing Liquidated Damages. In absence of such an adjudicatory process, courts have refused to enforce the clauses authorising the employer from quantifying the damages on its own5. Thus, the employer cannot impose any Liquidated Damages on the contractor before the breach is adjudicated by the court or an arbitrator. In case the same is done, it shall be considered illegal.

The expression "whether or not actual damage or loss is proved to have been caused thereby" means that where it is possible to prove actual damage or loss, such proof is not dispensed with. It is only in cases where damage or loss is difficult or impossible to prove that the liquidated amount provided in the contract, if a genuine pre-estimate of damage or loss, can be awarded6

Liquidated Damages can be used as a facilitator to promote certainty in construction contracts. Such pre-estimates of compensation help the parties in calculation of risks and simplify the task of recovery of damages. While Section 74 of the Contract Act requires the aggrieved party to show legal injury to be able to claim compensation, it does not intend for the injured party to prove the exact loss that it has suffered. It is sufficient for the aggrieved party to merely show that hurt or damage was caused. Thereafter, it is for the court to determine the extent of loss that was suffered by the aggrieved party and then applying the reasonable man standard to further determine and award such compensation as is deemed to be sufficient in that particular case, subject to the maximum stipulation provided for within the contract itself.

Thus, it may be concluded that the idea behind incorporation of the clause pertaining to Liquidated Damages in contracts is to stipulate a reasonable compensation at the time of drafting of the contract in order to avoid assessment of actual damages at a later stage. The incorporation of such clause at the very inception also gives an assurance to the parties to the contract that the obligations under the contract shall be complied with. The underlying premise is to place the aggrieved party in the same position as it would have enjoyed had the contract been performed and reasonable steps would have been taken to mitigate the losses.

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[1] ONGC v Saw Pipes 2003 SCC 705

[2] Mahangar Telephone Nigam Ltd. Vs. Tata Communications Ltd Civil Appeal No. 1766 of 2019

[3] Pure Pharma Ltd. v. Union of India, 2008 SCC OnLine Del 739

[4] Fateh Chand v. Balkishan Das AIR 1963 SC 1405

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

[6] Kailash Nath Associates v DDA (2015) 4 SCC 136

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