Concept of Penalty under Indian Contract Law: An Analysis

The Indian Contract Act, of 1872 uses the words penalty under section 74 as:
"Compensation of breach of contract where penalty stipulated for :- When a contract has been broken, if a sum is named in the contract as the amount be paid in case 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 or proved to have been caused 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."

In section 74 the words that have to be emphasized upon are sum is named, penalty. The term sum is named gives out the meaning clearly that the amount that becomes payable in the event of any breach is pre estimated and is provided for in the contract. It is determined in the form of either damages or a stipulated penalty. Further, they sum that is so specified is the reasonable compensation for the breach and in no case the amount can be exceeded from what has been specified in the contract. Thus, in short section 74 talks about liquidated damages and not other kind of damages.

Liquidated damages: (not defined in the Indian Contract act, 1872)
If the sum fixed represents a genuine pre-estimate of the probable damages that is likely to result from the breach, it is liquidated damages.[1] An amount contractually stipulated as a reasonable estimate of actual damages to be recovered by one party if the other party breaches. It means that it shall be taken as the sum which the parties have by contract assessed as damages to be paid whatever maybe the actual damage.[2]

• Oxford Dictionary: a punishment imposed for breaking a law, rule, or a contract.
• Black's Law Dictionary: punishment imposed on a wrongdoer, usu. in the form of imprisonment or fine; esp., a sum of money exacted as punishment for either a wrong to the state or a civil wrong.
• An extra charge against a party who violates a contractual provision.
• Excessive stipulated damages that a contract purports to impose on a party that breaches.

Penalty has been defined to mean 'I promise to pay so much of money if I break certain terms of the contract.'[5] It is 'a sum of money that is manifestly intended to be in excess of the amount which would fully compensate the other party for the loss sustained by him in consequence of the breach of the primary obligation.'[6]

1. Books:
   
   1. Avtar Singh's[7]:
      This book talks extensively about Indian Contract Act 1872 and also discuss about many provisions and topics surrounding it. It is based on court decisions and latest precedents set by the court. It also includes new decisions about the problems related to email related decisions, arbitration arguments and covers various aspects related to agreements, acceptance, legality, mistake etc. However, this book does not cover e-contracts or upcoming new sectors like smart contracts. It also does not cover any limitations governing the act or any amendments suitable for the act given the latest scenario.
      
   2. Dr. R. K. Bangia[8]:
      The book talks about Indian Contract Act in a comprehensive manner. It takes into account the Indian Setting of scenarios and justifies it through cases tailored for the Indian setting. It deliberates the scope of the act and also talks about main provisions governing the act like consideration, promises, communication, revocation etc. It also dives deep into the topic of infancy, estoppel, ratification, and specific performance. It is a detailed book concerning itself with law of contracts along with various doctrines associated with it. However, it fails to establish a modern relevance when talked about the problems faced by people in contract formation in electronic form. Furthermore, it doesn't consider loopholes of various provisions of the Indian Contract Act and provides a global view instead of a tailored Indian view.
      
   3. Dr. S. R. Myneni[9]:
      This book is a detailed manifestation of contracts law. It talks a lot about express and implied terms in a contract along with a clear focus on the exemption clauses. Although it takes a UK centric view upon the topics of contracts discussed in it, it provides a useful comparative narrative as to how the cases are dealt in the European viewpoint and how they differ in the Indian context. However, like the other books, it doesn't reflect the modern technologies being implemented in the field of contracts during the 21st century. It is a well detailed piece of writing which covers most aspects of the contract law but fails to observe the new changes.
      

   On the other hand, the liquidated damages refer to genuine pre-estimate of losses and not a grand exemplification of the amount towards a specific breach.[11] However, it can be seen from the recent development of cases of Section 74 of the Indian Contract Act in the Supreme Court that these decisions are hampering the set peripheries of public and private law.[12]

   One of the most talked about mechanisms of this act is the claim of compensation even though people are not able to prove, whether or not they suffered any actual severe loss. Kailash Nath case has critically subjected the issue to enable Damage or loss suffered as sine qua non for the applicability of Section 74.[13]

   Section 74 becomes an inquisitive case for subjection to a study. The development of Section 74 through the cases of Maula Bux[14] Fateh Chand[15] and Saw pipes.[16] Section 74 has also been held in government contracts that the extent of damages for a breach of contract held for government agencies is based on the inconvenience caused to the public.

   It is not because of the monetary loss that is suffered by the government agencies at that time.[17] It is important that the multinational giants are not given the free liberty to interpret section 74 as an advantageous position for them in Legal Battles.

   This would prove to be very detrimental to the startups and new players in the market who would be bombarded with compensation of breach whether or not damages are occurred, or loss is suffered. Also, it is important that the clause specifies the difference between liquidated damages in the form of penalty and actual penalty clauses that mean pecuniary compensation.

   The Legislative should also consider that provisions regarding liquidated damages which should come into play while dealing with government contracts. The provision of public inconvenience while dealing with liquidated damages should also be added in the Indian Contract Act 1872.

   Gap in existing literature
   Review of literature suggested that no study have been done in this legal dimension. There is a difference between the two as to the fact that penalty is limited to the extent to which the sum is stipulated in the contract and has been agreed by the parties although it is required to prove the fact that actual damages have accrued or not.

   Whereas damages can be awarded by the court to the extent to which the innocent party has suffered a loss or as per the stipulation in the agreement without ascertaining the fact of the amount of loss that has actually occurred. The reason as to why damages and penalty are confused is mainly due to the liquidated damages which as per the Indian Contract Act have not been differentiated. This study will explain and make some practical ideas based on good legal principles to address the flaws in the "Concept of Penalty Under Indian Contract Law". No other study goes into immense detail about these ideas.

   1. The main assumption of the study is that the existing statutory provision and safeguards are not adequate to provide effective and sufficient meaning to term penalty under Indian Contract Act 1872.
   2. The mechanism for providing compensation is not in a proper manner.
   3. Indian Laws need to be amended to keep pace with international laws of awarding compensation practices.
   4. Damages and penalty are confused mainly due to the liquidated damages as per the Indian Contract Act.
   5. Penalty is the sanction for the breach of the parties imposed in the form of punishment whereas damages are an agreed sum of money that the parties consent to pay in the event of breach.
   6. Damages are reasonable compensation where as penalties are not.
   7. Penalty is for enforcement of the obligation of performance on the said party whereas damages are to compensate the party which suffers a loss due to non performance of the said party.

   The author uses both primary as well as secondary sources. The secondary data is collected from published sources such as various books, Indian and foreign journals, online journals, newspapers, online newspapers, and research articles, and various websites on the subject to collect literature and data for the study and analysis.

   1. Though the parties to a contract who use the words 'penalty' or 'liquidated damages' may prima facie be supposed to mean what they say, yet the expression used is not conclusive. The Court must find out whether the payment stipulated is in truth a penalty or liquidated damages. This doctrine may be said to be found passim in nearly every case.
      
   2. The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage (Clydebank Engineering and Shipbuilding Co. v. Don Jose Ramos Yzquierdoy y Castaneda).
      
   3. The question whether a sum stipulated is penalty or liquidated damages is a question of construction to be decided upon the terms and inherent circumstances of each particular contract, judged of as at the time of the making of the contract, not as at the time of the breach (Public Works Commissioner v. Hills[20] and Webster v. Bosanquet.[21])
      
   4. To assist this task of construction various tests have been suggested, which if applicable to the case under consideration may prove helpful, or even conclusive.

   • It will be held to be penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach. (Illustration given by Lord Halsbury in Clydebank Case.)
     
   • It will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid (Kemble v. Farren [22]). This though one of the most ancient instances is truly a Corollary to the last tests. Whether it had its historical origin in the doctrine of the common law that where A. promised to pay B. a sum of money on a certain day and did not do so, B. could only recover the sum with, in certain cases, interest, but could never recover further damages for non-timeous payment, or whether it was a survival of the time when equity reformed unconscionable bargains merely because they were unconscionable, a subject which much exercised Jessel M.R. in Wallis v. Smith[23] is probably more interesting than material.
     
   • There is a presumption (but no more) that it is penalty when 'a single lump sum is made payable by way of compensation, on the recurrence of one or more or all of several events some of which may occasion serious and others but trifling damage '(Lord Watson in Lord Elphinstone v. Monkland Iron and Coal Co.[24])
   1. If the sum payable is so large as to be far in excess of the probable damage on breach, it is almost certainly a penalty.
   2. If the same sum is expressed to be payable on any one of a number of different breaches of varying importance, it is again probable a penalty, because it is extremely unlikely that the same damage would be cause by these varying breaches.
   3. Where a sum is expressed to be payable on a certain date, and a further sum in the event of default being made, this later sum is prima facie a penalty, because mere delay in payment is unlikely to cause damages.
   4. It is to be noted that the mere use of the word 'liquidated damages' is not decisive, for it is the task of the Court and not of the parties to decide the true nature of the sum payable.[25]

   Difference between Damages (not Liquidated Damages) and Penalty.
   Penalty is the sanction for the breach of the parties imposed in the form of punishment whereas damages are an agreed sum of money that the parties consent to pay in the event of breach. Damages are reasonable compensation where as penalties are not.

   Penalty is for enforcement of the obligation of performance on the said party whereas damages are to compensate the party which suffers a loss due to non performance of the said party.

   This is the generic difference but "the distinction has been abolished in India. The courts award reasonable compensation not exceeding the stipulation. The courts knock down agreements which are unconscionable and extravagant."[26] "Section 74 is clearly an attempt to eliminate the somewhat elaborate refinements made under the English Common Law in distinguishing between stipulations providing for payment of the liquidated damages and stipulations in the nature of penalty. the Indian Legislation sought to cut across the web of rules and presumptions under the English Common Law by enacting a uniform principle applicable to all stipulations naming the amount to be paid in case of breach and stipulations by way of penalty."[27]

   Current legislation governing penalty clauses regulation
   The legislature in India has not stated the validity of penalty clauses. These clauses are governed under Chapter VI of the Indian Contract Act, 1872.

   Section 73 of the Act states that compensation for loss is caused by breach of contract. It is defined as "When a contract has been broken, the party who suffers by such breach is entitled to receive, from the party who has broken the contract, compensation for any loss or damage caused to him thereby, which naturally arose in the usual course of things from such breach, or which the parties knew, when they made the contract, to be likely to result from the breach of it. Such compensation is not to be given for any remote and indirect loss or damage sustained by reason of the breach."

   It is clear from this Section that the loss should be natural and should arise directly out of the breach of this contract. Further, this Section also discusses the remoteness of damage. Remoteness refers to whether the said damage was directly related to the breach. In cases where the damage is indirect and remote, the Court shall not give compensation to the defaulting party. Penalty clauses on the other hand are penal damages which are more than the loss which is incurred.

   Section 74 of the Act defines Compensation for breach of Contract where penalty is stipulated for. Contracts in which there is a penalty clause, the aggrieved party can only ask for a reasonable compensation from the parties. The word reasonable is not stated but shall be taken up on a case-to-case basis looking at the circumstances of the case, the amount of default, paying capabilities of the parties etc.

   Both liquidated damages and penalty follow the doctrine of reasonable compensation. Doctrine of Reasonable Compensation refers to when the compensation is "reasonable". Reasonability is determined by the facts and circumstances of each case. In case of a breaching party, reasonability may mean the damage suffered.

   The Supreme Court of India in various judgements has mentioned the importance of reasonable compensation. In the case of Construction & Design Services v. Delhi Development Authority[28], the Court stated that the Court must determine the reasonable compensation and then grant it to the injured party.

   Enforceability of a penalty clause
   In India, the Validity of Penalty Clauses was questioned in various Supreme Court judgements. Generally, penalty clauses are taken in consideration with liquidated damages. In ONGC v. Saw Pipes[29], the Court laid down certain observations referring to Section 73 and 74 of the Act one of which was that "If the terms are clear and unambiguous stipulating the liquidated damages in case of the breach of the Contract unless it is held that such estimate of damages/compensation is unreasonable or is by way of penalty, the party who has committed the breach is required to pay such compensation and that is what is provided in Section 73 of the Contract Act."

   The Law not only decides the amount of liquidated damages but also the compensation which is 'likely' to arise from the breach of the Contract[30].

   Therefore, the Apex Court had explicitly stated that liquidated damages unless unreasonable or penalty shall be allowed. It further stated that even in case of unliquidated damages, if it is not unreasonable or penal then the Court shall allow compensation which is a genuine pre-estimate of the loss.

   In Fateh Chand v. Balkishan Das[31], the Supreme Court similarly stated that the "Duty not to enforce the penalty clause but only to award reasonable compensation is statutorily imposed upon Courts by Section 74." Contracts with penalty clauses often are unreasonable and put burden on the defaulting party. Parties in case of wilful default might suffer consequences which are much more than their default. It can be said that putting unreasonable penalties on the defaulting party is against Public Policy.

   In Central Inland Water Transport Corpn. Ltd. V. Brojo Nath Ganguly[32], the Supreme Court said that "Public Policy" and "Opposed to Public Policy" is not defined under the Indian Contract Act and is incapable of a precise definition. Therefore, what is injurious to public good can be the basic definition of 'Opposed to Public Policy'. Contracts with Penalty Clauses can be said to be against Public Policy because it is harmful to the parties who have defaulted even in cases when the default is not wilful.

   Rescission of Contract:

   Quantum Meruit:

   • Contract is discharged
   • The claim is brought by the party who has not defaulted.
   • When an agreement is found to be void or it becomes void
   • If a party does some work or renders services without the intention of doing so 'free of charge'.
   • If there is a contract to render services (express or implied) but there is no mention of remuneration.
   • When one party refuses to perform a contract.
   • The contract is divisible and the party who has not defaulted has enjoyed the benefit of the part-performance.
   • The contract is indivisible and for a lump sum but the performance is not proper. In such cases, the party performing the contract can claim the lump sum and the other party can deduct a certain amount for the bad work done.
     

   Suit for Specific Performance:

   Suit for Injunction:

   Section 75 of the Indian Contract Act, 1872
   According to this section, if a party rightfully rescinds a contract, then he can claim compensation for any losses or damages sustained due to non-performance of the contract.

   Example: Peter is a drummer and enters into a contract with John, a nightclub owner. According to the contract, Peter agrees to play at John's club every Friday and Saturday night. The agreement is for the next two months against a payment of Rs 5,000 per night. On the fourth night, Peter wilfully absents himself from the club and John rescinds the contract. Since he does so rightfully, John can claim compensation for the damages sustained due to Peter's non-fulfillment of his promise.

   Possible outcome and limitation of study
   There is a difference between the two as to the fact that penalty is limited to the extent to which the sum is stipulated in the contract and has been agreed by the parties although it is required to prove the fact that actual damages have accrued or not. Whereas damages can be awarded by the court to the extent to which the innocent party has suffered a loss or as per the stipulation in the agreement without ascertaining the fact of the amount of loss that has actually occurred.

   It can also exceed the amount that has been mentioned in the contract. Penalty whereas can't exceed or be claimed in excess of the sum that has been named in the contract between the parties. Penalty is awarded in case of breach and it is not in the form of compensation. "Damages are reasonable compensation whereas penalties are not." Thus, an aggrieved party should claim for damages which can put them in a better position in order to get the amount even for the mental trauma etc. that has been suffer by the innocent party due to breach.

   1. The stipulation providing for damages is by way of penalty, it can grant reasonable compensation upon proof of damages.
   2. In case of penalty damages need to be proven.
   3. Damages are a reasonable compensation whereas penalties are not.

   In India, a variety of cases have been filed with reference to Liquidated Damages and Penalty. Only the amount which is reasonable to the breach shall be provided by the Courts. Therefore, the Indian judiciary makes penalty clauses valid only till the point where it is reasonable and not in excess of the breach.

   • Charles T. Mccormick, Handbook On The Law Of Damages 146 (1935).
   • Avtar Singh's Law Of Contract And Specific Relief (12th edn., 2017)
   • Dr. R. K. Bangia Contract I (Allahabad Law Agency, Haryana, 6th edn., 2009)
   • Dr. S. R. Myneni Contract I General Principles (Asia Law House, 2nd edn., 2021).
   1. Avtar Singh, Law Of Contract And Specific Relief 452 (Eastern Book Company, 9th edn., 2005).
   2. Wallis V. Smith (1882) 21 Ch D 243, P. 267
   3. Robophone Facilities Ltd. V. Blank [1966] 3 All Er 128, Pp 137,140.
   4. Charles T. Mccormick, Handbook On The Law Of Damages 146 (1935).
   5. Gaumont British Pictures Corpn Ltd. V. Alexander [1936] 2 All Er 1686, P. 1693 Per Potter J.
   6. Photo Production Ltd. V. Securicor Transport Ltd. [1980] Ac 287, [1980] 1 All Er 556, P. 557 Per Lord Diplock (Hl).
   7. Avtar Singh's Law Of Contract And Specific Relief (12th edn., 2017)
   8. Dr. R. K. Bangia Contract I (Allahabad Law Agency, Haryana, 6th edn., 2009)
   9. Dr. S. R. Myneni Contract I General Principles (Asia Law House, 2nd edn., 2021).
   10. Indian Contract Act, 1872, §74, No.9, Acts Of Parliament, (1872).
   11. Yasmin Barber, Penalty Clause Vs Liquidated Damages, Gannons Solicitors, (04th Nov. 2022, 11:41 Am), URL: https://www.gannons.co.uk/insights/penalty-clause-vs-liquidated-damages/
   12. Jeet H. Shroff & Ifrah Shaikh, The Public Utility Contract Exception In India Law: Awarding Damages Without Proof Of Actual Loss, Lse Blogs (04th Nov. 2022, 11:41 Am) URL: https://blogs.lse.ac.uk/southasia/2021/08/23/the-public-utility-contractexception-in-indian-law-awarding-damages-without-proof-of-actual-loss/
   13. Kailash Nath Associates V. Dda, (2015) 4 SCC 136.
   14. Maula Bux V. Union Of India, 1970 Air 1955
   15. Oil & Natural Gas Corporation Ltd V. Saw Pipes Ltd, 2003 (2) Ctc 282
   16. Fateh Chand V. Balkishan Das, 1963 Air 1405.
   17. Melwood Construction Corp. V. State, 481 N.Y.S.2d 289 (N.Y. Ct. Cl. 1984).
   18. Clydebank Engineering & Shipping Co. V. Don Jose Ramos Yzquierdoy Castaneda, (1905) Ac 6.
   19. (1915) Ac 79: (1914-15) All Er Rep. 739, Hl.
   20. (1906) A.C. 368
   21. (1912) A.C. 394
   22. 1829, 6 Bingham, 141
   23. (1882) 21 Ch D 243
   24. (1886) 11 Ac 332: 181
   25. P.S. Atiyah, An Introduction To The Law Of Contract 316-17 (3rd edn., 1981)
   26. Pueshpendra Motilal Singh V. Commercial Automobile, (1999) 2 Mplj 319 At P. 324.
   27. Fateh Chand V. Balkrishna Das, AIR 1963 Sc 1405.
   28. MANU/SC/0313/2015
   29. (2003) 5 SCC 705
   30. Sudhir Gensets Ltd v. Indian Oil Corporation Ltd, (2011) 177 DLT 438
   31. AIR 1963 SC 1405
   32. 1986 AIR 1571

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