What is Liquidated Damages and Penalty?
In the event of a breach of contract, the party at default must pay liquidated damages and penalty to the aggrieved party. Liquidated damages and penalty clauses are not synonymous and there is a difference between the two. These terms are often used interchangeably and sometimes create confusion even in the court of law. Let’s understand in detail the laws that govern them and the differences between the two.
Difference Between Liquidated Damages and Penalty
When two or more parties enter into a contract, the contract may include the amount of compensation to be paid by the defaulting party. In the event of the non-performance of the contract, the enforceability of the compensation and the acceptance of that amount as the damages differ as per the English Law and the Indian Contract Act.
Liquidated damages are implied as a reasonable portrayal of misfortunes in circumstances where genuine damages are hard to find out. As a general rule, liquidated damages are intended to be reasonable, rather than corrective.
Liquidated damages might be alluded to in a particular agreement proviso to cover conditions where a party faces a misfortune from resources that don't have a direct financial connection. For example, assuming a party in an agreement were to spill production network valuing data that is crucial to a business, this could fall under liquidated damages.
A typical model is a plan stage for another item that might include meeting with outside providers and specialists notwithstanding an organization's representatives. The hidden plans or plans for an item probably won't have a set market esteem. This might be valid regardless of whether the ensuing item is vital to the advancement and development of an organization.
These plans might be considered to be proprietary innovations of the business and profoundly delicate. Assuming the plans were uncovered by a displeased representative or provider, it could incredibly hamper the capacity to create income from the arrival of that item. An organization would need to make an assessment ahead of what such misfortunes could cost to remember this for a liquidated damages condition of an agreement.
What are Some Specific Contemplations?
It is conceivable that a liquidated damages proviso probably won't be authorized by the courts. This can happen on the off chance that the financial measure of liquidated damages referred to in the proviso is remarkably disproportional to the extent of what was impacted by the penetrated contract.
Such limits keep an offended party from endeavoring to guarantee an unconfirmed extreme sum from a respondent. For example, an offended party probably won't have the option to guarantee liquidated damages that add up to products of its gross income assuming the break just impacted a particular piece of its activities.
The idea of liquidated damages is outlined around remuneration identified with some mischief and injury to the party, rather than a fine forced on the litigant.
The courts commonly necessitate that the gatherings included make the most sensible appraisal feasible for the liquidated damages condition at the time the agreement is agreed upon. This can give a feeling of comprehension and consolation of what is in question assuming that part of the agreement is penetrated. A liquidated damages proviso can likewise give the gatherings included a premise to haggle from for an out-of-court settlement.
English LawUnder the guidelines of the English law, the amount stated in the contract can be treated either as a penalty or liquidated damages.
Liquidated Damages - If the amount fixed and specified in the contract by the parties is a genuine estimate of the losses accruing in case of a future breach of contract, then it is considered liquidated damages. In this case, the parties to the contract unanimously agree that the amount decided is fair compensation for the breach.
Damages - If the amount fixed is irrespective of the actual loss and is specified to deter the other party from committing a breach of the contract, then it is a penalty. In such a case, the amount fixed is not taken into consideration and the aggrieved party cannot claim an amount more than the actual loss suffered.
Indian Law
As per the liquidated damages clause under the Indian Law, there is no apparent distinction between liquidated damages and penalty. In the event of the breach of a contract, the suffering party cannot claim an amount more than the actual loss incurred. According to section 74 of the Indian Contract Act, 1872, if an amount has been specified as compensation in the contract, the court will not allow a compensation more than that amount. However, the compensation awarded can be less than the amount specified in the contract if the actual losses incurred are less than the amount fixed. As per the Contract Act, the party at loss receives a reasonable amount of compensation. In case an amount has not been fixed by the parties, the court takes upon itself to assess the loss and decides a reasonable compensation as per the liquidated damages provision.
Exception: If a party enters into a contract with the central or the state government for the performance of an act in the interest of the general public, then the defaulting party must pay the entire amount mentioned in the contract in case of a breach.
Liquidated Damages and Penalties in Construction Contracts
This term is commonly applied in construction contracts. If a contractor does not complete the project in time, he is liable to pay the liquidated damages. The employer is not required to prove the loss suffered and liquidated damages become due.Remedies Other Than a Liquidated Damages Clause There are certain other remedies available to the suffering party apart from claiming damages. Rescind a ContractIf one party breaches the contract then the other party can treat the contract as being rescinded. To rescind a contract means to revoke or cancel it. While the other party is discharged from all obligations, he can also claim damages. According to section 75 of the Indian Contract Act, if a party rescinds a contract rightfully, then he can claim compensation for any losses sustained due to the non-performance of the contract.Claim Specific PerformanceIn some contracts, paying damages is not considered adequate compensation. The court can instruct the party committing the breach, to perform the promise as was agreed upon in the contract. This is called a specific performance.InjunctionIf a party enters into a contract to not do something but goes against it and performs that action, then the Court can issue an injunction order to refrain the party from doing what he had promised to not do.
Under the key standard of opportunity of agreement, the gatherings to an agreement have an expansive right to specify in their understanding how much damages recoverable in case of a break, and the courts will for the most part implement such an arrangement, inasmuch as the sum settled upon isn't, not really set in stone to be an unlawful punishment, and isn't generally violative of public strategy.
It is by and large concurred that a liquidated damages arrangement doesn't disregard public approach when, at the time the gatherings go into the agreement containing the provision, the conditions are to such an extent that the real damages liable to move from an ensuing break would be hard for the gatherings to assess or for the nonbreaching party to demonstrate, and the total settled upon is planned simply to repay the nonbreacher for the other party's inability to perform.
Then again, a liquidated damages arrangement will be held to abuse public strategy, and subsequently won't be implemented, when it is expected to rebuff, or rebuffs, a party for penetrating the agreement, or when there is an enormous uniqueness between the sum payable under the arrangement and the genuine damages prone to be brought about by a break, with the goal that it basically looks to force execution of the hidden understanding by punishing non-execution and making a break restrictively and absurdly exorbitant.
In such cases the proviso, rather than setting up damages that rough or are corresponding to the mischief prone to move from a specific break, really comprises a punishment, and, since corrective conditions are by and large unenforceable, arrangements having this impact are pronounced invalid; and this is for the most part obvious even where the arrangement is haggled in with a sense of sincere resolve, at a manageable distance and between gatherings of equivalent bartering power.
Solved Example on Liquidated Damages and PenaltyQues:
Steve promises to deliver 150 kgs of apples to Martin at 50 rupees per kg in three installments. He delivers the first two installments but fails to deliver the last one. Is Martin obligated to pay him for the first two installments?
Ans: Although Steve has not delivered the last installment of apples, Martin is obliged to pay him for the first two installments of apples according to the principle of Quantum Meruit.
FAQs on Liquidated Damages vs. Penalty: Explained
1. What are liquidated damages in a contract?
Liquidated damages are a pre-determined sum of money that parties to a contract agree to pay as compensation for a specific breach. This amount represents a genuine and reasonable pre-estimate of the potential loss that would be difficult to calculate at the time of the breach. The primary purpose is to compensate the injured party, not to punish the breaching party.
2. What is a penalty clause in a contract?
A penalty clause stipulates an amount to be paid upon breach of contract that is excessive and disproportionate to the actual or anticipated loss. Its main objective is to deter a party from breaching the contract by making it financially punishing to do so. Courts often view such clauses as 'in terrorem' (to create fear) and may not enforce them.
3. What are the key differences between liquidated damages and a penalty?
The main differences relate to their purpose and legal enforceability:
- Purpose: Liquidated damages are a genuine pre-estimate of losses, while a penalty is an extravagant amount intended to deter a breach.
- Amount: Liquidated damages represent fair compensation, whereas a penalty is a disproportionately large sum compared to the likely loss.
- Enforceability: Courts generally enforce valid liquidated damages clauses but often deem penalty clauses unenforceable as they go against the principle of fair compensation.
4. How does the Indian Contract Act, 1872, treat liquidated damages and penalties?
Under Section 74 of the Indian Contract Act, 1872, there is no distinction between liquidated damages and a penalty. The law states that if a contract specifies a sum to be paid in case of a breach, the injured party is entitled to receive reasonable compensation, not exceeding the amount stipulated. The court will award compensation based on the actual loss incurred, which can be less than, but not more than, the amount mentioned in the contract.
5. Can you provide a real-world example of liquidated damages?
A common example is found in a construction contract. If a contractor agrees to complete a building by a specific date and fails to do so, the contract might stipulate they must pay the owner ₹50,000 for each day of delay. If this amount is a reasonable estimate of the owner's losses (like lost rent), it is considered liquidated damages. If the amount were an exorbitant ₹5,00,000 per day, it would likely be considered a penalty.
6. Why do courts sometimes refuse to enforce a clause specifying damages?
Courts refuse to enforce a pre-specified damages clause if they determine it is a penalty rather than a genuine pre-estimate of loss. A clause is considered a penalty if the amount is extravagant and unconscionable in comparison to the greatest loss that could conceivably result from the breach. The goal of contract law is to compensate, not to punish, and enforcing a penalty would unjustly enrich the non-breaching party.
7. What is the difference between liquidated damages and actual damages?
The primary difference lies in their determination. Liquidated damages are an amount agreed upon in advance by the parties within the contract, serving as a pre-estimate of the loss. In contrast, actual damages (or compensatory damages) are the amount of loss that the non-breaching party must prove to the court after the breach has occurred. Liquidated damages clauses are used when actual damages are hard to foresee or prove.
8. Apart from damages, what other remedies are available for a breach of contract?
When a breach of contract occurs, the injured party may seek remedies other than monetary damages. Key remedies include:
- Specific Performance: An order from the court compelling the breaching party to perform their exact contractual obligation, common in contracts involving unique items like real estate.
- Injunction: A court order that prohibits a party from performing a specific act, often used to enforce a promise not to do something.
- Rescission: The cancellation of the contract, which returns both parties to the position they were in before the contract was made.
