Penalty and liquidated Damages

A contract sometimes mentions that in case of breach of contract particular sum is payable by the party committing the breach. Payment of a particular sum is stipulated in the contract. It is to be considered by the Court whether such damages mentioned in the form of a particular sum, are by way of ‘penalty’ or by way of ‘liquidated damages’. The injured party is entitled only to the actual damages or reasonable compensation. Where actual loss of damages can be ascertained, such loss or damages will be allowed as compensation. Where actual loss or damage cannot be ascertained, reasonable compensation will be allowed. Onus to prove actual extent of damage is on the aggrieved party.

There is a distinction between penalty and liquidated damages under English law. Indian law makes no distinction between the two.

English law on penalty and liquidated damages:

The sum will be held as ‘penalty’ when it is not based upon reasonable calculation of actual loss, is extravagant and fixed by way of punishment. It is named so high that it operates as a threat and is laid down with intention to secure performance. It is disproportionate to the damages likely to accrue as a result of the breach. It is greater than the genuine estimate of loss which the injured party may suffer. If the sum stated is unreasonable, extravagant or unconscionable, it is penalty. Penalty is a sum payable.

When the amount is fixed by the parties at the time of the formation of the contract on the basis of reasonable and fair calculation after making a genuine pre-estimate of the actual loss likely to result it is liquidated damages or reasonable compensation. It may also be less than the genuine estimate of loss. It is a sum payable by a party as damages the amount of which instead of being left to the determination of the Court is previously determined by the parties themselves at the time of the formation of the contract. It is genuine pre-estimate of damages.

In case of penalty any amount which is reasonable according to the court can be recovered not exceeding the sum mentioned, while n case of liquidated damages, the whole sum is recoverable even though the actual loss may be greater or less than that calculated by the parties.

It has been held that whether a sum is a penalty or liquidated damages is to be judged at the time of making of the contract and not at the time of the breach. However, whether a sum mentioned is a penalty or liquidated damages is to be on the facts of each particular contract.

Therefore, once the Court decides whether a sum is ‘penalty’ or ‘liquidated damages’, then in case of penalty, only reasonable sum would be allowed while in case of liquidated damages, full sum mentioned neither more nor less would be allowed. The Court must either accept the amount in whole or reject it in whole.

Indian Law on penalty and liquidated damages:

As mentioned earlier, Indian law makes no distinction between ‘penalty; and ‘Liquidation’ damages. The courts in India award only a reasonable compensation not exceeding the sum so named in the contract.

When a contract has been broken, if a sum is named in the contract as the amount to be paid in career 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 cause 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 (Sec 74).