What are Liquidated Damages?
Liquidated Damages means compensation in terms of money. What kind of compensation? Compensation for the loss or damage suffered by either party in a contract. However, only when such loss or damage occurs due to the breach of contract. Generally, the extent of the damage is specified in a contract. It is done as a precondition to pre-empt the breach or any violation of the contract by either party. Hence, Liquidated damages are the amount of money paid by the party on breach of contract. However, there are methods of calculating liquidated damages in general:
- The amount of Deposit or Downpayment
- By using a formula (10% of the contract amount)
The American Law Reports annotation on liquidated damages states.
“Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in light of the anticipated or actual harm caused by the breach.”
The Indian Contract Act, 1872 regulates the contracts in India. However, it also lays down various provisions regarding breach and compensation in a contract. This article aims at ‘liquidated damages’, so in that regard Section 74 of the act is applicable.
Section 74: Compensation for breach of contract where penalty stipulated for.
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 proved to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named or, as the case may be, the penalty stipulated for.
As we discussed above, “liquidated damages”. sum stipulated to meet the breach of contract. As per the rule, on breach of contract, the affected person has every right to get reasonable compensation. however, the compensation must not exceed the amount so stipulated in the contract. Also, it must be noted that the compensation should not be misunderstood with the penalty. A penalty is given by the competent court in case of breach of contract. Moreover, it is not necessary if the damage or loss is actual. Even just with the breach of any condition such compensation can be claimed.
The Hon’ble Supreme court of India on various occasions has elaborately discussed the term ‘Liquidated Damages’.
- In Fateh Chand v Balkishan Das, the Supreme Court stated Section 74 declares the liability upon breach of contract where compensation is already decided by the party. This section does not confer any special privileges at any party. However, It only declares that notwithstanding any term in a contract for determining damages, the court will compensate the aggrieved party. Whereas, the compensation cannot exceed the stipulated amount or penalty.
- In Chunilal Mehta & Sons Ltd. v. Century Spg. & Mfg Co. Ltd.[reported in 1962], the court reiterated that “by providing for compensation in express terms the right to claim damages under the general law is necessarily excluded”.
- In Saw Pipes cases (reported in 2003), SC laid down some guidelines for reasonable compensation as follows:-
- The court must consider the terms of the contract before providing compensation. Moreover, unless the terms in the contract are ambiguous or unreasonable, the aggrieved party can claim the decided sum.
- Section 74 must be read with Section 73, therefore it is not necessary to prove any actual loss or damage. Also, a court is competent to award ‘reasonable compensation’ irrespective of any proof of breach of contract.
- Sometimes it is impossible to determine damages for court. In such a case, the court can award the stipulated amount as compensation. However, such amount must be genuine or reasonable.
“Liquidated Damages” is a safeguard in all contracts. In the absence of such a clause, a breach can lead to prolonged litigation which results in unnecessary spending. Also, it will waste the valuable time of the judicial mechanism. However, it is common practice to add such clauses in a contract these days. The intention of such a clause is to pre-determine the sum payable in the event of delay in completion. Moreover, the court can not provide for liquidated damages if the sum stipulated is a penalty rather than a genuine pre-estimate of loss.
The purpose of such clauses is to promote certainty, especially in commercial contracts. Parties to a contract would fix such a sum in advance at the time of making the contract. Because it facilitates the calculation of risks. Also, it reduces the difficulty and expense of proving actual damage or loss. And also facilitates the recovery of damages. However, it avoids the difficulty in assessment, even where the consequences of the breach are ascertainable. Whereas, The party may not be able to recover the indirect, consequential loss by the rule of remoteness. It gives promisee an assurance that he may safely rely on the fulfillment of the promise by the promisor.
- (1964) 1 SCR 515
- AIR 1962 SC 1314
- (2003) 5 SCC 705