Liquidated and Unliquidated Damages

Under the Indian Contract Act, the word ‘damages’ is understood as compensation under a contract that is paid by the defaulting party to the non-defaulting party. This compensation is awarded to the non-defaulting party to compensate for actionable wrongs of the former. Over the years, courts have categorised damages in several ways, for instance, general, special, nominal, exemplary, aggravated damages, etc.

However, under a contract, the compensation awarded is categorized as liquidated or unliquidated damages awarded as per the terms governing the contract. Under a contract, the parties may agree to pay a certain sum upon breach of the terms of the contract. When the agreement between the parties stipulates the sum payable for non-performance, the damages hence paid are known as liquidated damages. Unliquidated damages are awarded by the courts or arbitral tribunals after assessing the loss or injury caused to the party suffering from such breach of contract.

Introduction

The concept of damages under contracts is as old as that of contractual relationships. During the negotiation of a contract, it is obvious to affix obligations on parties as well as deterrence/penalty for non-fulfillment thereof. Over the years, the concept of damages has evolved statutorily, judicially, and jurisprudentially in different legal systems across the world.

In simple words, damages may be understood as remedy in the nature of monetary compensation that an aggrieved party can claim from the defaulting party when a breach of contract which has resulted in a loss or injury to the aggrieved party occurs.

In India, remedy for such default may be available as specific performance as well as damages subject to certain statutory and contractual conditions. While specific performance is governed by the Specific Relief Act 1963, the award of monetary damages on non-performance is governed by the Contract Act 1872 (“the Act”).

Under the Act, “damages” can be understood as compensation under a contract awarded to the non-defaulting party by the defaulting party for his actionable wrong. Whereas the damages for breach provided in quantified monetary terms in the contract and mutually agreed upon, i.e. Liquidated Damages are governed by Section 74 of the Act, Unliquidated Damages are awarded in the absence of prescribed Liquidated Damages in the contract and are governed by Section 73 of the Act. 

Liquidated Damages under the Indian Contract Law, 1872

Section 74 deals with liquidated damages or stipulated damages. There has to be a breach of the contract for the plaintiff to claim damages. In cases where there may be a reasonable revocation of the contract without any breach of the terms of the contract, the claim for damages should not arise as there is no breach per se.

Damages are normally claimed and awarded to restore the plaintiff’s situation in which he would have been if the breach had not occurred. These damages are generally to be claimed from the party that causes such an infringement. In the event of liquidated damages under Section 74, both the complainant and the defendant may make claims. In the case of liquidated damages, there is compensation assurance as an appropriate compensation is decided upon. Therefore, it would be expected that since the risks of a party causing a breach would be lower, damages are already specified.

Prerequisites to claim Liquidated Damages

•      Breach of Contract

A breach of the contract is a necessary prerequisite for claiming damages, liquidated or unliquidated.[1] Regardless of the degree to which the defendant profits from the contractual arrangement, no claim for damages may arise unless there is a breach of the contract. Additionally, the party committing the breach is liable to compensate for damages. A breach is established only after it is adjudicated upon and proven, and not merely as decided by the parties to the contract.[2]

Damages can also be claimed in the event of an anticipatory breach of contract.[3] In this kind of case, the other party may consent to or rescind the continuation of the contract. In the event of an anticipatory breach of contract, the plaintiff would be allowed to claim damages on establishing the intention to perform the contract before the rescission of the contract.[4]

•       Proof of Damage

It is worth mentioning that the clause “whether or not actual damage or loss is proven to have been caused by it” would not dispense with the establishment of proof in toto for a claim of liquidated damages.[5] This emanates from the understanding that the reasonable compensation agreed upon as liquidated damages in case of breach, is in respect of some loss or injury. Thus, the existence of loss or injury is indispensable for such claim of liquidated damages.

•       Causation

There must be a causal link between the breach committed and the loss or injury suffered for raising a claim for damages and attaching liability. This causal link is created if the defendant’s act of infringement of the contract is the only “real and effective” cause in relation to the injury or damage for which damages are claimed. The “dominant and effective” cause is to be taken into consideration in the presence of multiple causes.[6]

•      Remoteness of Damage

A party injured by a breach of contract may recover only those damages which either “should reasonably be considered as occurring normally or naturally,”[7] i.e. according to the regular course of events” from the breach, or “should reasonably have been considered by both parties at the time they entered into the contract, as the likely result of the breach thereof.”

·         Mitigation

It is worth mentioning that a party claiming damages on breach of a contract ought to have performed or must have been ready to perform the required part of the contract. Hence, the duty to mitigate losses is indispensable before claiming damages.[8]

Difference between Liquidated Damages and Penalty

Indian law recognises no difference between liquidated damages and penalty. The compensation granted cannot exceed the amount specified in the contract. Under Section 74 of the Act, if the parties rectify the damages, the Court will not permit more. However, depending on the case, it may award a lower amount. Therefore, the aggrieved party receives reasonable compensation but no penalty.

The exception to Section 74 which says that if a party enters into a contract with the State or Central Government for the performance of an act in the interest of general public, then a breach of such a contract makes the party liable to pay the entire amount specified in the contract.

Whenever a contract states an amount payable on a certain date and an additional amount if a default occurs, then the additional amount is a penalty. This is because it is unlikely that a mere delay in payment will cause damage. Even if the contract states a sum as ‘penalty’ or ‘damages,’ the Court must determine from the facts of the matter if the amount stated in it is, in fact, a penalty or liquidated damages.

The essence of penalty is the payment of money as the defaulting party’s terrorem. On the opposite hand, liquidated damages are the true pre-estimate of the damage.

Although English law differentiates between a penalty and liquidated damages, there is no such distinction in India. Indian Courts focus on granting the suffering party appropriate compensation that does not exceed the amount set out in the contract.

Role of Liquidated Damages in an Agreement

Liquidated damages clause can benefit both the owners and the operators. By restricting the amount of damages that an operator may claim, it allows the owner to delineate risks and minimize time, cost, and risk of litigating issues pertaining to the operator’s entitlement and value of his / her claim for loss of profits. Owners can also use their negotiating power to limit the amount of damage payable to the operator to one or more years of lost profits.

Unliquidated Damages

Section 73 deals with actual damages resulting from infringement of the contract and the injury arising from such infringement which is in the nature of unliquidated damages since such damages are granted by the courts on the basis of an evaluation of the loss or injury caused to the party against which the infringement occurred. 

How do Unliquidated Damages work?

Damages that are claimed for unforeseeable losses are called Unliquidated Damages. These damages are commonly awarded for cases involving a breach of contract. These damages apply to any breach of contract that does not contain a liquidated damages clause. It can, however, be difficult to estimate the compensation amount to be claimed by the complainant since the amount is “unliquidated.” Industries like construction and engineering generally affect liquidated damages and not unliquidated damages.

In order to award unliquidated damages to the plaintiff, the court opts for a compensatory approach:

  • Recover the loss incurred by the complainant
  • Return the complainant to the position he had before the breach
  • Minimize penalizing the respondent
  • Avoid enhancing the complainant’s position over and above where it would have been if the breach did not take place.

The losses incurred by the plaintiff must be as a result of the natural consequence of breach of contract. This will be taken into consideration while determining the compensation awarded.

Prior to entering into an agreement, the parties must mention any specific or unusual loss, if contemplated, in the contract. This will help avoid feuds and also increase chances of recovery. The type and extent of losses must have been foreseeable before signing the contract. Although not necessary, it is advised that the losses be foreseeable.

If the plaintiff was able to foresee the potential loss resulting from breach of contract but did not take any measures to mitigate the losses, the court will only award compensation proportionate to the losses incurred if the measures had been taken. The plaintiff cannot let the losses accrue when measures by an ordinary person’s effort could have reduced or prevented the losses. The court may award damages for moral losses. Nevertheless, it can be difficult to calculate and prove how much moral loss a party has sustained.

Parties must, in all cases, clearly mention their objectives in the contract. This prevents all feuds and ambivalence caused by confusion and ambiguity. They can either state the unliquidated damages clause or just remove the clause. In general contracts, “NIL” is specified for liquidated damages for those who do not wish to claim it. This also means that unliquidated damages are also not applicable.

Advantages and Disadvantages of Unliquidated Damages

Including a provision for liquidated damages in a contract will most certainly prove to be an advantage. It helps the client recover losses which were, before the breach of the contract, unforeseeable or tough to estimate. However, this results in the contractor having an unknown liability. In addition to this, the client is obligated to prove his/her actual loss when the breach takes place. The client will also be obliged to prove that the losses are a natural result of the breach of contract, and not “remote”.

Conclusion

Liquidated damages are a pre-agreed amount of money that is set out in advance in the contract. It fixes the sum payable as damages if the contractor breaches the contract – typically by failing to complete the construction works by the completion date set out in the contract. Liquidated damages are calculated on a daily or a weekly basis.

Unliquidated damages are damages that are payable for a breach, the exact amount of which has not been pre-agreed. The sum to be paid as compensation is said to be ‘at large’ and is determined after the breach occurs, by a Court.

One of the advantages of liquidated damages is that there is no need to prove the actual loss since the clause provides a pre-estimation of the damages to be paid. In addition to helping in fast recovery of damages, this helps to provide certainty to the parties.

The advantage of unliquidated damages is that it allows for recovery of losses which may have been impossible to foresee or to estimate with any certainty before the breach.

Frequently asked questions.

  1. What is section 73 and section 74 of the Indian Contracts Act 1872?
  2. What are the prerequisites to claim Liquidated damages?
  3. What is the difference between Liquidated damages and Penalty?
  4. Should Liquidated Damages Clause be included in Agreements?
  5. How do Liquidates Damages work?
  6. What are the advantages and disadvantages of Unliquidated Damages?

References


  • [1] Managing Director, Army Welfare Housing Organisation v. Sumangal Services Pvt. Ltd. (2004) 9 SCC 619.
  • [2] P Radhakrishna Murthy v. NBCC Ltd. (2013) 3 SCC 747; J.G. Engineers (P) Ltd., v. Union of India (2011) 5 SCC 758.
  • [3] Jawaharlal Wadhwa & Another v. Haripada Chakroberty (1989) 1 SCC 7.
  • [4] Foran v. Wight (1989) 168 CLR 385, 408 (Mason CJ); see also, State of Rajasthan v. Ferro Concrete Construction P. Ltd. (2009) 12 SCC 1.
  • [5] . ONGC v. Saw Pipes (2003) 5 SCC 705.
  • [6] Gray v. Barr [1971] 2 All ER 949 (CA); Kanchan Udyog v. United Spirits Limited (2017) 8 SCC 237.
  • [7] Hadley v. Baxendale (1854) 9 EX 341; M. Lachia Setty Ltd. v. Coffee Board (1980) 4 SCC 636.
  • [8] Murlidhar Chiranjilal v. Harishchandra Dwarkadas (1962) 1 SCR 653.

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