Liquidated Damages and Penalty: Explained

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This article has been written by Niti Shah studying BLS/LLB from Pravin Gandhi College of  Law, University of Mumbai. The right to claim Penalty or Liquidated damages is because of ‘Breach of Contract’ which is a legal term. Hence, it is appropriate to understand this term.

What is meant by Breach of Contract?

Breach of contract usually occurs only when a party to the contract violates any of its laws mentioned in the contract such that it infringes on the other party.  It may even hamper a party to execute its duties. A violation can be both whole or in part of the agreement. It should satisfy the below mentioned four conditions before a breach of contract can be upheld by a court of law: 

  • The contract should have a valid offer, acceptance. The capacity to enter into a contract must also be present in terms of age and mental ability, intent, and object of the contract.  
  • A plaintiff who is seeking penalty or liquidated damages should satisfy the court that the defendant has infringed the terms of the agreement, and consequently monetary loss has occurred. 
  • The Plaintiff has to full all the duties required of him as per the contract.
  • The Plaintiff has to notify the defendant in writing of the breach that has been committed.

 Some Types of Breaches are:

  • Material breach:  A material breach is the most significant one which is required to destroy the value of the contract.  It also includes the right to sue; it also relieves the party from performing his part of the contract. 
  • Partial breach:  This is not a significant breach and does not relieve the aggrieved party from executing his share of duties. 
  • Anticipatory breach:  When a party suspects from acts undertaken that the other party is willing to do his duties specified under the contract.

Liquidated Damages

 ‘Liquidated damages’ is an “ amount legally stipulated as an estimation of actual damages to be recovered by one party if the other party breaches the contract; also if the parties to a contract have agreed on Liquidated Damages, the sum fixed is the measure of damages for a breach, whether it exceeds or falls short of the actual damages.”  

Liquidated damages are a calculated amount based on expected breaches. Whereas unliquidated damages cannot be calculated, maybe because of unknown factors that cannot be predicted in advance.  As the Liquidated damages are assessed, hence the parties to the contract are aware of the consequences that follow a breach of an agreement. The damages are awarded to protect the commercial interest of the parties.  They are so quantified so that the economic status of the affected party remains unaffected by the breach.

However, it cannot act as a source of enrichment. On the contrary, it must remain within the confines of what is called reasonable.  

The Burden of Proving Monetary Loss

Section 106 of the Indian Evidence Act says that it is binding upon the person to know the fact to prove the same.it means that the burden to prove loss due to breach of contract rests with the affected party. The only exception is when the loss is noticeable but it is impossible to prove. 

Can liquidated damages be awarded without proof of breach?

 Section 74 of the Indian contract Act contains an expression which says that the parties complaining of the breach is entitled, whether or not actual damage or loss is proved to have been caused thereby” 

The above expression does not mean that even when actual loss or damage can be ascertained still it will be waived, and the party wrongfully shall be entitled to the estimated Liquidated damages. it is only applicable in cases where it is difficult or nearly impossible to prove the actual loss. Even then, the court shall first ascertain that it is impossible to prove damages in this case.

Penalty

An understanding of Liquidated damages which is a genuine loss that has been computed for breach of a contract.  if the certain amount fixed is without any regard to possible loss but is mostly intended to refrain the other party from committing the breach, it is called a penalty.  The specified sum is very extravagant and hence does not appropriate with the damage likely to occur. Penalty operates as a punishment and not compensation for loss endured.

Interpretation of S 74 by The Indian Courts

In case the amount is set out by the way of penalty, proof of damages is required. The Court will award to the party aggrieved only reasonable compensation not exceeding the amount named or penalty mentioned. Or absolutely, damages cannot be bestowed beyond really sustained.  Contrarily, the penalty is defined as a sum calculated disproportionately to a loss in value.  

Important features of Liquidated damages in commercial contracts  

  • It is always drafted with mutual consent. 
  • Breaches are usually listed. 
  • It foresees the loss in advance and protects the parties
  •  It is always legally enforceable. 
  •  It is a Simple dispute resolution process. 
  • Fear of liability makes a person’s performance. 
  • Once liability is proven or admitted the clause comes into subsistence. 
  • Liability and compensation are known entities.
  • Provides stability to the contract.
  • In any wrongful termination claim, the operator does not need to prove either its entitlement to loss of profits or the value of its loss of profits claim.

Difference Between a Penalty and Liquidated Damages

The penalty is something that is usually used in a contract for securing the performance of the contract. The main purpose of the same is to make sure the money is paid. Also where the loss has been recovered is greater than the pre-estimated loss then it amounts to a penalty. Whereas liquidated damages are always compensatory in nature and are pre-estimated damages. The purpose of liquidated damages is to promote certainty in the commercial field. Liquidated damages are based on the pre-estimate of the loss, whereas the penalty is based on the doctrine of reasonable compensation.

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