INTRODUCTION

The quest of the contracting parties to secure themselves against breaching acts of the opposite contracting party led to the conceptualization of "Liquidated Damages". Pertinently, the contracting parties may agree to payment of a certain sum on breach of the contract. This compensatory measure devised by the contracting parties is recognized under Section 741 of the Indian Contract Act, 1872 (Contract Act), which prescribes for payment of a reasonable sum to the non-defaulting party.

The reasonability of the amount named in the contract payable on the occurrence of default, is reckoned from the terms of the contract identifying such compensatory measure as "genuine pre-estimation of loss to be suffered by non-defaulting party in case of occurrence of default by another party". The parties thus having pre-estimated the amount of compensation, the same attains eligibility as 'reasonable' under Section 74 of the Contract Act.

So far, the recognition of compensatory measure under 'Liquidated Damages' in India is confined only to the threshold of pecuniary compensation named in the contract, unlike in Common Law Countries where the compensatory measures under 'Liquidated Damages' have been recognized beyond the amount named in the contract, based on the legitimate interest of the parties involved in the contract.

This article endeavours to highlight the progression of law in Common Law Countries to accommodate within the concept of 'Liquidated Damages' the compensatory measures beyond the stipulations in the contract to secure the legitimate interest of the parties involved in the contract.

ORIGIN AND PROGRESSION OF THE LAW OF LIQUIDATED DAMAGES:

The concept of 'Liquidated Damages' evolved from the Common Law, and finds elaborate discussions in the Judgment of House of Lords in Dunlop Pneumatic Tyre Co Ltd v. New Garage and Motor Co Ltd.2 (Dunlop) wherein it was held that provision for liquidated damages will be enforceable only if, at the time of drafting of contract:

  • It was difficult to determine the damages that would accrue if a contemplated breach occurred; and
  • The amount of the liquidated damages provision was a reasonable estimate of the actual suffered damage.

Keeping pace with the gradual commercial progression, the United Kingdom Supreme Court (UKSC) in 2015, recognized the necessity of 'liquidated damages' to secure the legitimate interest of contracting parties, while rendering judgment in Cavendish Square Holding BV v. Makdessi (Cavendish) 3 . The court discussed the vintage law on liquidated damages, crystallised by Lord Dunedin of the House of Lords in Dunlop in 1915, and found the Dunlop tests to be inadequate to deal with liquidated damages clauses in modern commercial contracts. The court found that the Dunlop tests were meant for assessing ordinary damages and could no longer be considered sufficient to deal with liquidated damages clauses of a more complex variety found in contemporary contracts. The UKSC devised a novel test for the modern commercial contracts to the effect that a provision for liquidated damages deserves to be enforced provided that the detriment imposed is not out of all proportion to the legitimate commercial interests the aggrieved party has in the enforcement of the primary obligations under the contract. The progression from Dunlop to Cavendish is briefly explained as follows:

DUNLOP TEST

In Dunlop, the House of Lords crystallised the legal position on liquidated damages in the form of four tests designed to distinguish valid liquidated damages provision from one attracting the vice of being in the nature of penalty and hence unenforceable:

  1. If the sum stipulated is extravagant and unconscionable in comparison with the greatest loss arising from the breach that could conceivably be proved, then the clause is in the nature of a penalty.
  2. If the breach complained of is non-payment of an amount and the clause in question stipulates payment of a greater amount as a remedy, then the clause will be treated as penalty.
  3. There is a presumption that the clause amounts to a penalty when a single lumpsum amount is directed to be paid by way of remedy for the breaches which consist of one or more or all of several events, some of which may occasion serious and others trifling damage.
  4. If it is impossible to pre-estimate the quantum of damages, then it is probable that the amount named in the clause is a genuine pre-estimate of damages and, hence, a valid liquidated damages clause.

CAVENDISH

In Cavendish, the UKSC held that the legal position in Dunlop, while adequate in deciding cases arising from standard consumer contracts involving normal damages, the same was found insufficient to secure the interest involved in commercial contracts of a more complex variety. The court recognised that, in several contemporary contracts, liquidated damages clauses are designed to safeguard commercial interests which go beyond the recovery of damages, purely compensatory in nature. The court held that the legitimate supra-compensatory, commercial interests merited enforcement unless found to be extravagant or unconscionable.

INDIAN PERSPECTIVE ON LIQUIDATED DAMAGES

In the Indian perspective, the Supreme Court of India in Kailash Nath Associates v. DDA4 , while drawing upon six decades of judicial interpretation of Section 74 of the Contract Act, laid down the following:

  1. A party is entitled to nothing beyond reasonable compensation under the liquidated damages clauses and the stipulated amount is merely the upper limit that can be awarded.
  2. Liquidated damages can be recovered only in cases where actual loss has been suffered, not otherwise. The law guards against both punishment and profit as motivations for liquidated damages.
  3. In ordinary cases, the claimant must prove such loss through evidence.51 It is only in rare and exceptional cases of difficulty or impossibility of proof, that the stipulated amount may be awarded, if found to be a genuine pre-estimate of damage.
  4. Reasonable compensation shall be determined as per settled contract law principles enshrined in Section 73 of the Contract Act, 1872.

As regards evolution of law on 'Liquidated Damages', the position in Malyasian Law is relevant in the Indian context. The Federal Court of Malaysia (its apex court) discussed the Cavendish implications in the case of Cubic Electronics Sdn. Bhd. (in liquidation) v. Mars Telecommunications Sdn. Bhd.5 , while dealing with the issue of "legitimate interest" test in the context of a clause imposing forfeiture of deposits made by prospective buyers in an agreement for sale of a

property of a company in liquidation. The court held that the concepts of "legitimate interest" and "proportionality" in the Cavendish approach were relevant in deciding what amounted to "reasonable compensation" within the meaning of Section 75 of the Contracts Act, 1950, which is pari-materia with the Indian Contract Act.

CONCLUSION

Unlike common law jurisdictions like UK and Australia where the general law governing contracts has remained uncodified, the Indian position on liquidated damages is governed by statute, which renders judicial manoeuvre confined within the statutory scheme only. Pertinently, the adoption of Cavendish approach in the Indian commercial contractual arena would largely depend upon the Indian legislature imbibing the same.

With the globalization of commercial participation and receding boundaries amidst nations promoting commercial activities of their respective citizen, it is high time that the Indian legislature is persuaded to consider the approach of "supra-compensatory commercial interests", as professed in Cavendish for evolution of the law of 'Liquidated Damages'. This will certainly provide a level playing field attracting global players to explore commercial participation in India with more confidence.

Footnotes

1 Section 74 Indian Contract Act, 1872 - Compensation for breach of contract where penalty stipulated for.

2 Dunlop Pneumatic Tyre Co. Ltd. v. New Garage & Motor Co. Ltd., [1915] A.C. 79 (HL)

3 Cavendish Square Holding BV v. Makdessi [2016] A.C. 1172 : 2015 UKSC 67

4 Kailash Nath Associates v. DDA (2015) 4 SCC 136

5 Cubic Electronics Sdn. Bhd. (in liquidation) v. Mars Telecommunications Sdn. Bhd. (2019) 2 CLJ 723 (Malaysia)

Originally Published December 2021

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