Avoiding Costly Mistakes: The Importance of Liquidated Damages
Aakanksha Agarwal
3rd Year, B.B.A. LL.B(H),
Shri Ramswaroop Memorial University, Lucknow
Suraj Gupta
4th Year, B.A.LL.B(H),
Shri Ramswaroop Memorial University, Lucknow
Anushka Gupta
2nd Year, B.A.LL.B(H),
Amity University, Lucknow
Introduction
In every contract there exists a presumption that the contract obligations and duties would be fulfilled without any breach. According to the Indian Contract Act,1872 the obligations must be fulfilled otherwise it may result in breach of contract further resulting in causing damages.
However, breach is not defined anywhere in the Indian Contract Act,1872, but in Section 39 it is said that if the other party has refused to perform the contract duties then the party is breaching the contract and he is liable for providing damages.
What are Damages?
Damages are compensation or payment for the hurt caused to one party by the other party by any means that caused damage to his mental health, physically or any other.
For e.g.- Car accidents, breach of contract, wrongful termination, etc.
What are liquidated damages?
In a contract when the obligations and duties are not fulfilled by any means or any cause or any circumstance then it is a “breach of contract” and then the party breaching the contract pays an adequate amount to the other party as damages and it is sometimes predefined known as liquidated damages.
In other words, liquidated damages are a contractual provision that defines/specifies the amount of compensation/damages one party will receive if the other party fails to fulfil the contract.
For example, A contractor agrees to complete a project in 16 weeks and signs a contract that if he fails to do so he will pay Rs.1,00,000 in liquidated damages.
Section 74 of The Indian Contract Act, 1872
In India the latest law governing the liquidated damages are Section 73 and 74 of The Indian Contract Act,1872.
Section 74 says that when a contract is broken the party which suffers due to the breach is entitled to receive damages/compensation by the party causing breach for any loss or damage caused. The compensation provided must be reasonable and not exceed the amount named in the contract.
Illustration
A contracts with B to give him a sum of Rs.10000 on a day and if he fails A will pay Rs.20000 to B. A fails to pay B on such a day so A is liable to pay Rs.20000 to B and not more than that.
Exception to Section 74
If the contract is attached with a bail bond, or any other legal instrument then the other party is not liable for compensation if the contract is breached but is entitled to get a punishment under the document attached and the party will be punished.
One exception is also the public utility services. Sometimes issues arise and delays happen which are beyond the control of the service provider.
In various cases liquidated damages are not provided under this section as they cannot be proved.
Whether the damage must be proved or not for LD (Liquidated Damages)
In various cases the damage must not be proved as in cases where the actual loss/damage is already mentioned in the facts and can be foreseen by the court, whereas sometimes you have to prove such as in cases where the damage which is actually caused is mentioned in the facts of the suit filed for breach but cannot be foreseen by the court or cannot be observed by the court by just reviewing the facts.
Various case laws could be taken for reference such as;
Illustration:
- A contracts with B for buying 3kg of cotton and tells B to deliver it by 30th of December 2024, B accepts the contract but breaches it at the time of accomplishment. B delays the supply and supplies the cotton on 4th March 2025. A needed the cotton at 2nd June 2025 so actually A was not suffering any loss and B was not liable for paying any damages/compensation.
A filed a case against B for breach of contract saying that the clause for breach said that B will pay INR Rs. 200000 as compensation on breach. But the court after reading and knowing all the facts said that A has not suffered any actual loss/damage, therefore he is not liable for any compensation.
How much amount is to given? Can it exceed the amount reasonable?
The amount mentioned in the contract is the maximum amount which can be given as compensation to the aggrieved party. However, the court decides based on the actual loss or damage proved that how much compensation must be provided as liquidated damage.
The damages provided cannot be more than the reasonable amount or the amount mentioned in the contract at the time of enforcing the contract.
When the decided amount is more than the actual damage
Whenever the amount of compensation is more than the decided amount then it is a questionable thing that if the amount is reasonable or enforceable or not.
In the case of Fateh Chand v. Balkishan Das AIR 1963, The Apex Court, while discussing the meaning of liquidated damages, said that if the amount mentioned in the contract is genuine and not extra or over demanded then it can be considered reasonable and enforceable. But if the amount is not genuine then it would be like a penalty.
In case if the decided amount is more than the loss/damage caused to the aggrieved party the concept of forfeit and waiver can come into existence. In Sir Chunilal V. Mehta And Sons, Ltd vs The Century Spinning And Manufacturing AIR 1962, a special leave was granted by the Supreme court, and it was seen that where the parties to contract have decided the amount of liquidated damages, there can’t be a presumption that simultaneously, they intended to allow plaintiff to disregard the sum so specified and claim instead an amount which is not reasonable and certain at the date of breach.
Essential conditions to claim liquidated damages
There are several conditions that are required to claim liquidated damages on breach of contract. These are: –
- Existence of a valid contract
- Breach of contract
- Clause of Liquidated damages
- Reasonable relationship with actual damages.
Is actual loss necessary for liquidated damages?
When one party breaches the contract then another party can seek damages (compensation) even if they can’t prove that they suffered actual loss. In other words, the aggrieved party can claim damages even if they are not able to show how much exactly they lost. However, there are some important limitations:
- The damages sought are reasonable and not excessive. It means the party cannot claim extra amount of damages than the actual loss unless provided by court.
- If the damages are too high, then the court can say it as penalty and may not consider it. This is because the purpose of damages is to provide compensation for the loss and not to punish the party who broke the contract.
- The court will examine the actual loss suffered and will provide fair and reasonable compensation accordingly.
In other words, you need to show that you suffered a loss but you need not to prove the magnitude of the loss suffered. The court will examine and provide fair and reasonable compensation according to the extent of loss occurred.
When no loss is caused or loss not proven
As we have seen that in the case of Fateh Chand and Maula Bux the court said that the aggrieved party must get a reasonable amount of compensation as liquidated damages, if the damages are required to prove then. In Union of India V. Motor& General Sales Ltd. (2019) delay was caused in delivering an amount of goods and the issue was aroused that if these provisions would attract the provisions of Section 74 of Indian Contract Act,1872. The Bombay High court refused to provide any amount of reasonable compensation to the aggrieved party as there was no actual loss or at least a loss proved.
Importance of Liquidated damages
The liquidated damages clause is a vital element in a contract. It serves as a risk management tool for future differences. In case one party breaches the contract the other party would have the rights to claim damages for the loss incurred through this clause.
- Certainty and Transparency
The Liquidated damages clause helps the party to define damages quickly, easily and efficiently as it is pre-defined and clear leaving no uncertainty regarding the exact amount to be provided as damages in the breach of a contract, thereby facilitating an easy and efficient way for problem resolution and eliminating the need for lengthy disputes or negotiations and costly litigation.
- Avoid disputes and ensure plaintiff safety/security
The existence of this clause are helpful because they provide protection to the plaintiff for any future conflicts and also avoid disputes by having a clear amount of damages as LD. It makes the contract efficient and make it easy to enforce the contract. It provides safeguard against potential losses and uncertainty to ensure plaintiff’s security.
Is Public utility services an exception to Section 74 of The Indian Contract Act 1872
In India the essential services/ public utility services like electricity, water, and transportation are considered necessary for the well-being of the community. These services are regulated by laws that ensure that these services are provided smoothly. If these services are interrupted or not provided as promised, then the aggrieved party can claim compensation.
In general, the Indian Contract Act, Section 74 limits the amount of compensation that can be claimed. However, the essential services are an exception made by the court.
This exception allows the aggrieved party to claim compensation across/beyond the normal limits if:
- The interruption affects the well-being of the community.
- The public utility service provider is at fault.
Rationale:
The rationale behind the exception is that public utility services are essential services for the well-being of the community, and any interruption or breach of services can have far reaching consequences. By allowing/providing for extra compensation, courts hold service provider accountable/responsible and encourage them to prevent any kind of interruption(disruption) and provide reliable services, resulting in prioritizing community needs.
Case Law
The exception to Section 74 in cases involving public utility services has been recognized by various courts in India, including the Supreme Court. For example:
- In the case of Maharashtra State Electricity Board v. Sterlite Industries (India) Ltd. (2001), the Supreme Court held that in cases involving public utility services, the court may award compensation or damages beyond the normal limits prescribed under Section 74.
- In the case of Delhi Jal Board v. Delhi Water Supply and Sewage Disposal Undertaking (2010), the Delhi High Court held that public utility services are essential services, and any breach of service may entitle the affected party to compensation or damages beyond the normal limits prescribed under Section 74.
Conclusion
Liquidated damages are important in a contract for its enforcement as they hold the parties responsible for breach of contract, ensures fair compensation and simplify the process of dispute resolution. There are some guidelines mentioned in Section 74 of The Indian Contract Act,1872; damages must be reasonable and no excessive penalties must be mentioned.
Also there are court interpretations which says that pre- determined damages must be reasonable and not excessive, and there is an exception for the public utility services. Summarizing it we can say that liquidated damages promote contractual certainty, risk management and reduces dispute resolution time.