Conference on Legal and Technical Aspects in Arbitration

The complexity of construction and infrastructure contracts are increasing day by day due to technological developments, increasing high value infrastructure contracts, global tender process and increased influence of global approaches in the dispute resolution process etc. The only remedy available to compensate the injured in a construction contract related dispute, who was affected by the breach of contract committed by the other party, is by granting damages to cover up his losses occurred due to the said breach. The common law countries take a uniform view that such damages are not to enrich anybody but to compensate their losses. Hence it is necessary for a party to the contract who is claiming damages to explain, quantify and prove the loss incurred by that said breach of contract committed by the opposite party. Here the important challenge for the claimant in such cases shall be to quantify such damages and prove them. In some cases the damages may be very high in value which results in a kind of uncertainty between the parties with regard to the consequences of the breaches. To avoid any such uncertainty, in some construction and other contracts, parties estimate the loss expected to happen in case of a particular type of breach and specifically incorporate a specific formula to quantify a damage or a specific amount, which is called as Liquidated damage. The purpose of this paper is to examine the requirements for granting a legally valid liquidated damage in case of a construction arbitration, as per Indian law.

Liquidated Damages and Indian contract Act, 1872:

The relevant law to examine the legal status of liquidated damages as per Indian law is Indian contract Act, 1872. Even though the term ‘Liquidated Damages’ is not per se defined or dealt with under the said Indian Contract Act, the relevant Sections which set out the elements which constitute Liquidated damages, are Sections 73 and 74 of the above said Act which are extracted below.

Section 73 of Indian Contract Act, 1872:
“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”.

Section 74 of Indian Contract Act, 1872:
“When a contract has been broken, if a sum is named in the contract as the amount to 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 is provided to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named, or the case may be, the penalty stipulated for.”

For a better understanding of the concept of Liquidated damages, it will also be helpful to look at the definition of the said term in The Black’s Law Dictionary, and the same is as under:

“An amount contractually stipulated as a reasonable estimation of actual damages to be recovered by one party if the other party breaches;

also

If the parties to a contract have agreed on Liquidated Damages, the sum fixed is the measure of damages for a breach, whether it exceeds or falls short of the actual damages.”

Purpose of Stipulation of Liquidated Damages in Construction Contracts: In construction contracts the parties can easily anticipate certain breaches which may happen during the course of implementation and can easily estimate the corresponding losses or costs. When a contract is broken by a party, the party who suffers by such breach is entitled to receive compensation for any loss which naturally arise from such breach. If parties anticipate a kind of breach which is likely to happen, while finalising the contract, they can agree for payment of a specific amount which is called as liquidated damage. From the above said definitions it can be easily understood that the parties may fix a sum as liquidated damage for a breach and incorporate it into the contract. When the actual breach happens the actual damage may be either lesser or more than the sum fixed by the parties. In such a situation what is the legal position in India with regard to granting of the liquidated damages and what is the advantage for the parties in incorporating liquidated damages clause instead of leaving it open. What are the restrictions as per law to specify an amount and claim the same from the other party, in case of a breach? The Indian legislature has 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 amounts to be paid in case of breach, and stipulation by way of penalty[1]. The following are the factors which are taken into consideration by the arbitrators and the Courts in India to confirm or reject a claim for liquidated damage by a party in a legal proceeding.

Ascertained and liquidated damages are those freed from obscurity and determined by agreement, or it may be by the court, to indicate a precise amount of indebtedness or damage or precise data from which the sterling value can be obtained ; it being remembered that the contract covenants must be construed as a whole and not in compartments. Thus the sum must be reasonable, not excessive and not inadequate.[2]

The actual objective of a common man in incorporating such a clause with a specific amount in the contract itself as liquidated damages is just to reduce the burden of quantifying and proving the actual damages. But it is not the way the courts look into it because S.74 of the Indian contract Act also specifically states that “not exceeding the amount so named”. Hence it should be understood that the aggrieved party cannot claim the same amount in case of a breach even though there is no loss due to the said breach of the contract.

Liquidated Damages Cannot Be in The Nature of Penalty: If the liquidated damage clause contemplated by the contract to be paid in case of its breach, is by way of penalty, Section 74 of the Indian Contract Act is attracted. The arbitrator or a court which finds a liquidated damages clause incorporated in a contract, is in the nature of penalty, then it is duty bound to apply the provisions of the above said S.74.

While dealing with the concept of liquidated damages and the penal nature of it, the question frequently arise is ‘what are the differences between liquidated damage and a Penalty’. The answer is that the LD is the estimate of the expected loss, pre-assessed and agreed to between the parties at the time of making a contract, as likely to arise from the breach. On the other hand, a Penalty is a stipulation in the contract in the nature of ‘terroram’. Hence a Penalty can be defined as a stipulation to award and impose an amount which is so disproportionate or excessive that no prudent person would consider the same as a reasonable pre-assessment of damages arising out of the breach. For example, a stipulation in the contract providing that the party in breach would be liable to pay fifty times of the contract price to the aggrieved party in case of a breach is a liquidated damage clause in the nature of Penalty. Therefore, even though both the LD and Penalty clauses are based on the stipulations mentioned in the contract itself, there is an important distinction between the two terms. Hence legally sustainable LD represents reasonable stipulation of likely losses, a Penalty is far from being reasonable and is intended to threaten the other party and to secure performance of the contract at any cost.

The question whether a particular stipulation in a contractual agreement is in the nature of a penalty has to be determined by the court against the back ground of various relevant factors, such as the character of transaction and its special nature, if any, the relative situation of the parties, the rights and obligations accruing from such a transaction under the general law and the intention of the parties in incorporating in the contract the particular stipulation which is contended to be penal in nature. If on such a comprehensive consideration, the court finds that the real purpose for which stipulation was incorporated in the contract was by reason of its burdensome or oppressive character, it may operate in terrorem over the promisor so as to drive him to fulfil the contract, then the provision will be held to be one by way of penalty.[3]

But in case where the regulatory mechanism of the government of India is involved and where the actual damages cannot be quantified and proved the Supreme Court of India took a different view.

“Lastly, it may be noted that liquidated damages serve the useful purpose of avoiding litigation and promoting commercial certainty and, therefore, the court should not be astute to categorise as penalties the clauses described as liquidated damages. This principle is relevant to regulatory regimes. It is important to bear in mind that while categorising damages as “penal” or “liquidated damages”, one must keep in mind the concept of pricing of these contracts and the level playing field provided to the operators because it is on costing and pricing that the loss to BSNL is measured and, therefore, all calls during the relevant period have to be seen. (See Communications Law in India by Vikram Raghavan at p. 639.) Since Clause 6.4.6 represents pre-estimate of reasonable compensation, Section 74 of the Contract Act is not violated. Thus, it is not necessary to discuss various judgments of this Court under Section 74 of the Contract Act[4].

In a very recent Judgment delivered by the Supreme Court of India reconfirmed the settled law that if damage or loss is not actually suffered by a party, he cannot claim the liquidated damages since it is provided in the contract since, the law does not provide for a windfall. It also reconfirmed that the party seeking the liquidated damages have to prove the loss and the only exception is in the case where the actual loss cannot be quantified.[5]

In cases where parties arrive at a settlement with regard to a particular dispute, which ended up in a court decree, later one of them cannot be allowed to challenge the same on the ground that one of the terms in the settlement is penal in nature. The Supreme Court of India in Deepa Bhargava case held “Even assuming that the term stipulating payment of interest in the event of entire amount was not paid within a period of six months is penal in nature, the executing court is bound by the terms of the decree”[6]

Who Can Finalise The Liquidated Damages? In some Government contracts the contractual clauses provide for an adjudication mechanism by which the competent authority will quantify the losses of the owner and impose the liquidated damages on the contractor. These types of contractual provisions and corresponding quantification of damages are approved by the courts, if the mechanism provided can be seen as an impartial mechanism. In such cases arbitrators or courts cannot go into the sustainability of such damages, if the parties have excluded the liquidated damages part from the scope of the arbitration clause. The Hon’ble Supreme Court of India in Viswanath Sood case held that “We are therefore inclined to hold that the opening part of clause 25 clearly excludes matters like those mentioned in clause 2 in respect which any dispute is left to be decided by a higher official of the department. Our conclusion, therefore, is that the question of awarding compensation under clause 2 is outside the purview of the arbitrator and that the compensation, determined under clause 2 either by the Engineer in charge or on further reference by the Superintending Engineer will not be capable of being called in question before the Arbitrator[7]”.  

But when there is no adjudicatory process provided for quantification of the damages the courts have refused to accept the contract clauses authorising the owner to quantify the damages and excluding that matter from arbitration. In BSNL[8] case the Supreme Court of India held 

“26. Quantification of liquidated damages may be an expected matter as argued by the appellants, under Clause 16.2, but for the levy of liquidated damages, there has to be a delay in the first place. In the present case, there is a clear dispute as to the fact that whether there was any delay on the part of the respondent. For this reason, it cannot be accepted that the appointment of the arbitrator by the High Court was unwarranted in this case. Even if the quantification was expected as argued by the appellants under Clause 16.2, this will only have effect when the dispute as to the delay is ascertained. Clause 16.2 cannot be treated as an expected matter because of the fact that it does not provide for any adjudicatory process for decision on a question, dispute or difference, which is the condition precedent to lead to the stage of quantification of damages.

34.  The appellants contended that have the unilateral right to determine the liquidated damages under Clause 16.2 and that the quantum of liquidated damages decided by the appellants, even if it is exorbitant, would be final and cannot be challenged. We find the contention of the respondent that if the said contention of the appellants is supported, it would mean that a party would be held liable to damages of whatever amount the other party demands without recourse to a remedy, to be relevant and should be given due importance. Such a contention by the appellants would be in violation of Section 28 and Section 74 of the Contract Act”.

Is It Necessary To Prove Actual Damage or Loss For Claiming Liquidated Damages? The expression of S.74 “Whether or not actual damage or loss is proved to have been caused thereby” can normally create an impression that actual damage or loss need not be proved in cases relating to liquidated damages, which is not true. It need not be proved in cases where it is not possible to prove the actual loss or damage cause because of the said breach. But in cases where it is possible to prove the actual loss, parties are not exempted from proving that. Because in the endeavour of the court to finalise and grant the reasonable damages such an assistance from the party will make the court to grant the correct amount of damages. In the cases where the party claiming full liquidated damages without any proof for actual loss, the party which is found to have committed breach can examine witnesses and produce documents to demonstrate the claim of the party is excessive, unreasonable and penal in nature.  In a landmark judgment in Maula Bux Vs union of India[9] the Supreme Court of India declared the law as follows:

“It is true that in every case of breach of contract the person aggrieved by the breach is not required to prove loss or damage suffered by him before he can claim a decree, and the court is competent to award reasonable compensation in case of breach even if no actual damage is proved to have been suffered in consequence of the breach of contract. But the expression “whether or not actual damage or loss is proved to have been caused there by” is intended to cover different classes of contracts which come before the courts. In case of breach of some contracts it may be impossible for the court to assess compensation arising from breach, while in other cases compensation can be calculated in accordance with established Rules. Where the court is unable to assess the compensation, the sum named by the parties if it be regarded as a genuine pre-estimate may be taken into consideration as the measure of reasonable compensation, but not if the sum named is in the nature of a penalty. Where loss in terms of money can be determined, the party claiming compensation must prove the loss suffered by him.”

In a recent Judgement dated 9^th January 2015 in Kalish Nath Associates case[10] Supreme Court of India held as follows:

“The expression “Whether or not to prove actual damage or loss”, such proof is not dispensed with”

Compensation must be reasonable: Balck’s law Dictionary defines compensation as “indemnification, payment of damages, making amends, making whole, giving an equivalent or substitute of equal value that which is necessary to restore an injured party to his former position. Hence necessarily something must have happened as a result of the breach of the contract which requires an act of restoration. Hence a party to claim liquidated damages as specified in the contract, must have incurred measurable or unmeasurable loss due to the breach of contract by the other party. Even though the contract has named an amount as the liquidated damages in case of a breach, to get qualified to claim the said liquidated damages the breach must have been established. After establishing breach the amount named as a liquidated damage need not be granted by the court in full, the court is duty bound to find and grant a reasonable compensation but not beyond the named amount, on the facts and circumstances of the case. The permissible contentions to the opposite party objecting to the granting of the liquidated damages can be (i) No breach of contract (ii) The named liquidated damages is excessive and not reasonable (iii) there was no loss or injury to the party claiming damages. 

In one of the leading cases between ONGC Vs SAW Pipes[11] Supreme Court of India in view of Sections 73 and 74 of Contract Act,1872 clearly held that

1. Terms of the contract are required to be taken into consideration before arriving at the conclusion whether the party claiming damages is entitled to the same
2. 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, party who has committed the breach is required to pay such compensation and that is what is provided in S.73 of the Contract Act
3. Section 74 is to be read along with S.73 and, therefore, in every case of breach of contract, the person aggrieved by the breach is not required to prove actual loss or damage suffered by him before he claims the decree. The court is competent to award reasonable compensation in case of breach even if no actual damage is proved to have been suffered in consequence of the breach of a contract.  
4. In some contracts it would be impossible for the court to assess the compensation arising from breach and if the compensation contemplated is not by way of penalty or unreasonable, the court can award the same if it is genuine pre-estimate by both the parties as the measure of reasonable compensation. 

Hence even in cases where the liquidated damages are provided in the contract, the arbitrator/ court should grant only reasonable damages below the named amount.

In a recent judgment dated 4^th February, 2015 Hon’ble Supreme Court of India while deciding a case between M/S. Construction & design services Vs Delhi Development Authority[12] reconfirmed that the court must determine the reasonable compensation and then grant it to the injured party. It held as follows:

“18. Applying the above Principle to the present case, it could certainly be presumed that delay in executing the work resulted in loss for which the respondent was entitled to reasonable compensation. Evidence of precise amount of loss may not be possible but in the absence of any evidence by the party committing breach, the court has to proceed on guess work as to the quantum of compensation to be allowed in the given circumstances. Since the respondent also could have lead evidence to show the extent of higher amount paid for the work got done or produce any other specific material but it did not do so, we are of the view that it will be fair to award half of the amount claimed as reasonable compensation.

Whether Notice Obligatory Before Claiming Liquidated Damages? To claim liquidated damages with regard to delayed execution of the work as prescribed in any contract, the party claiming the liquidated damages must demonstrate that the time is the essence of the contract and the other party breached the contract by not completing it, within the time specified in the contract. In case if time is not the essence of the contract or by conduct of the parties the said time limit got extended without fixing another date or for any reason the time was not the essence of the contract, then the injured party should give a notice to the other party, giving reasonable time to complete the work and make time as the essence of the contract. If such a notice was not given in the contracts where time is not the essence of the contract, then liquidated damages cannot be claimed. In a recent judgment of the Supreme Court of India dated 9^th January 2015 in M/S. Kalilash Nath Associaes Vs Delhi Development Authority[13] it was held as follows

“21. Based on the facts of this case, the single judge was correct in observing that the letter of cancelation dated 06.10.1993 and consequent forfeiture of earnest money was made without putting the appellant on notice that it has to deposit the balance 75% premium of plot within a certain stated time. In the absence of such notice, there is no breach of contract on the part of the appellant and consequently earnest money could not be forfeited”.

Where Liquidated Damages Are Not Payable? Liquidated damages even though specifically mentioned in the contract, is ceased to be payable where the owner has waived the right to claim the same. In J.G. Engnieers case[14] at the time of extending the completion date to execute the contract, the owner did not impose liquidated damages on even though there was a provision in the contract and further allowed escalation costs to the contractor and hence the owner seems to have waived the right to claim liquidated damages.