Liquidated Damages and Penalty

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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.


English Law

Under 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 decided 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 has 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 Contract

If 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 Performance

In 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.

  • Injunction

If 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.


Solved Example on Liquidated Damages and Penalty

Ques: 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.

FAQ (Frequently Asked Questions)

Q1. What is the Difference Between Liquidated Damages and Penalty?

A1. The main differences between liquidated damages and penalty are:

  • When the amount fixed is more than the actual loss incurred, it is called a penalty but an amount that is a pre-estimate of the loss is called liquidated damages.

  • If the contract specifies an amount that is payable at a certain date and an additional amount to be paid if a default happens, then the additional sum is a penalty. It is because a delay in payment alone is unlikely to cause damage.

  • To decide if the amount fixed is liquidated damages or penalty is the discretion of the court.

  • The Indian law considers both as synonymous but the English Law differentiates between the two.

  • The penalty is an exaggerated amount to deter the parties from defaulting. Liquidated damages are an actual estimate of the loss.

Q2. What is Quantum Meruit?

A2. Quantum Meruit is a reasonable sum of money paid to a person for his services when an amount for the same has not been specified in the contract.  The clause of Quantum Meruit applies to cases in which a person has partially rendered services that he had to perform and he seeks compensation for the portion of services performed. In such cases:

  • The contract must be discharged.

  • The claim is brought by a party who is not the defaulter.

Damages are compensation for the non-performance of an act or service while Quantum Meruit is reasonable compensation paid for the value of the work done.