Breach of Contract, Liquidated damages and Penalty

contract-clipart-k10338462

Breach of Contract

When a party fails or refuses to perform his part of the contract, it amounts to a breach of contract. A breach may take any of the three forms, namely, (a) where a party fails to perform his obligation upon the date fixed for the performance of the contract; (b) a breach may arise from express repudiation, i.e. where a party states expressly that he will not perform his promise; (c) there is a breach if a party does some act which disables him from performing his obligations.  Of these three forms of breaches, first one is ‘actual breach’ and the second and third may occur before the performance is due and is ‘anticipatory breach’.

Breach of contract by one party discharges the other from the performance of the contract and also entitles the latter to bring an action against the party making the breach and claim damages for the same.

Remedy for Breach of Contract

Though there are remedies like specific performance, injunction, etc, available, for breach of contract, damages are the most appropriate remedy, and sometimes the only remedy, available to a person who suffers because of the breach of contract of the other party.

The parties to a contract may at the time of entering into it provide that in the case of breach the party in default is to pay to the other a certain sum provided in, or ascertainable from, the contract. This sum may be either liquidated damages, in which case it is not to be interfered with by the Court, or a penalty, which covers the loss if proved but does not assess it.

 Consequences of breach of contract and basis of determining compensation

Heading of Chapter VI of the Contract Act,1872 which consists of three sections, viz., Sections 73, 74 and 75 is “Of the consequences of breach of contract”. The consequence of the breach of contract contemplated in Chapter VI of the Contract Act is the liability to pay compensation on the part of the person who has broken the contract and the right of the party, who has suffered by such breach, to obtain compensation. All the three sections provide for compensation in case of breach of contract, not for breach simpliciter, but for ‘loss or damage’.

If the breach has not resulted in any harm, loss or damage to the other party, the question of compensating him or restoring to him something which he has lost would not arise. He is not entitled to such compensation which is not due to the proximate result of such breach because no compensation is to be given for remote or indirect loss or damage sustained because of breach of contract.

That is the reason why Section 73 states ‘compensation for any loss or damage caused to him thereby’. However grievous or serious an act of breach may be, if it does not lead to any loss or damage caused to the other party, Section 73 will not give rise to a right of compensation.

Section 73 reads thus:

“Compensation for loss or damage caused by breach of contract.– 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.

Compensation for failure to discharge obligation resembling those created by contract.– When an obligation resembling those created by contract has been incurred and has not been discharged, any person injured by the failure to discharge it is entitled to receive the same compensation from the party in default, as if such person had contracted to discharge it and had broken his contract.

Explanation.– In estimating the loss or damage arising from a breach of contract, the means which existed of remedying the inconvenience caused by the non-performance of the contract must be taken into account.”

Section 73, which contains the rule regarding the award of damages, is based upon the rule of English Law which was laid down in Hadley v. Baxendale. That rule is as under:

“Where two parties have made a contract which one of them has broken, the damages which the other party ought to receive in respect of such breach of contract should be such as may fairly and reasonably be considered either arising naturally, i.e., according to the usual course of things, from such breach of contract itself, or such as may reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, as the probable result of the breach of it.”

There are two aspects of the above-said rule:

  • Firstly, compensation can be claimed for such loss or damage that arose naturally, in the usual course of things from the breach of contract.
  • Secondly, if the loss did not arise naturally, in the usual course of things, but had arisen because of some special circumstances of the case, then compensation for that can be claimed only if the special circumstances were in the contemplation of both the parties when they made the contract.

Section 74 of the Contract Act, incorporates the rule regarding payment of damages in case the compensation payable on the breach of contract has been stipulated in the contract itself.  The provision is as under:

“Compensation for breach of contract where penalty stipulated for.- Where 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 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.

Explanation.- A stipulation for increased interest from the date of default may  be a stipulation by way of penalty.

Exception.- When any person enters into any bail bond, recognizance  or other instrument of the same nature, or under the provisions of any law, or under the orders of the Central Government or of any State Government, gives any bond for the performance of any public duty or act in which the public are interested he shall be liable, upon breach of the condition of any such instrument, to pay the whole sum mentioned therein.

Explanation.- A person who enters into a contract with Government does not necessarily thereby undertake any public duty, or  promise to do an act in which the public are interested.”

Section 74 provides for measuring of damages in two classes of cases – (i) where the contract names a sum to be paid in case of breach; and (ii) where the contract contains any other stipulation by way of penalty.  In the latter case, the measure of damage is by Section 74, reasonable compensation not exceeding the penalty stipulated for.  The words ‘reasonable compensation’ give a wide discretion to the court in the assessment of damages the only restriction is that the court cannot decree damages exceeding the amount previously agreed upon by the parties.  The discretion of the court in the matter of reducing the amount of damages agreed upon is left unqualified by any specific limitation, though, of course, the expression ‘reasonable compensation’ used in the section necessarily implies that the discretion so vested must be exercised with care, caution and on sound principles.

The effect of section 74 is that a party cannot get the full amount mentioned in the contract as a matter of absolute right or as a matter of course. But if the party proves that he has suffered damage to the extent of the full amount or that the Court considers, even without any proof that the full amount is a reasonable compensation which can be awarded under the circumstances, the Court can award the full amount. One thing is, however certain, that, the party is entitled to get some amount, not exceeding the sum named, which the Court considers as reasonable compensation, whether any actual loss or damage is proved to have been suffered by him.

Section 75 provides for compensation for any damage which a person to a contract sustains through the non-fulfilment of the contract, where he rightfully rescinds a contract.

This section postulates payment of ‘compensation for any damage which is sustained’, even when the contract has been rightfully rescinded by the claimant.

 Liquidated damages

Liquidated Damages is a common law remedy for breach of contract. Common Law has its own rules to deal with contracts wherein a sum is named as the amount to be paid in case of a breach. A sum could be so darned in the contract by way of liquidated damages. The parties could, particularly in cases where the determination of the amount of compensation would be a complicated exercise, or where the quantification would normally be uncertain, assess, fairly and reasonably, the quantum of damages which according to the usual course of things would have to be paid. The parties could beforehand make an assessment and stipulate the sum so assessed in the terms of the contract. In such a case Courts regard them as liquidated damages enforceable at law.

Where the parties in  a contract, stipulated sum of money to be paid as liquidated damages they must be deemed to exclude the right to claim an unascertained sum of money as damages. Liquidated damages are rational damages agreed to between the parties. The essence of liquidated damages is a genuine covenanted, pre-estimate of damage.

The right to claim liquidated damages is enforceable under section 74 of the Contract Act and where such a right is found to exist no question of ascertaining damages really arises. Where the parties have deliberately specified the amount of liquidated damages there can be no presumption that they at the same time intended to allow the party who has suffered by the breach to give a go by to the sum specified and claim instead a sum of money which was not ascertainable or ascertainable at the date of the breach.

Penalty

 When a contract contains a term which, not being an integral part of the contract, is introduced only for the purpose of securing the performance of the contract, that term is penal, and, as such, a penalty is a term which is extraneous and collateral to the actual contract. A penal clause, therefore, must be one which imposes, some penalty for the default, that is to say, which puts the defaulter in a worse position than he would occupy if there were no penal clause.

 If in making provision for breach of contract, the promisee puts a stipulation not by way of reasonable compensation to the promisee on the breach of contract but in order that by reason of its burdensome and oppressive character, it may operate in terrorem(a legal threat, usually one made to compel someone to act without resorting to a legal action)over the promisor so as to drive him to fulfil the contract, then the stipulation is one by way of penalty. The essence of a penalty is a payment of money stipulated as in terrorem of the offending party.

Here the provision for damages assumes the character of gross extravagance or of wanton and unreasonable disproportion to the nature or extent of the injury. Courts of equity would regard the provision as in terrorem and refuse to enforce it. However in those cases also reasonable compensation would be awarded.

 Distinction between Liquidated Damages and Penalty

The law on Liquidated Damages and Penalty are summarised in Cheshire and Fifoot’s Law of Contract at page 556 in the following manner:

“Firstly, it may be a genuine pre-estimate of the loss that will be caused to one party if the contract is broken by the other. In this case, it is called liquidated damages and it constitutes the amount, no more and no less, that the plaintiff is entitled to recover in the event of the breach without being required to prove actual damage.

Secondly, it may in the nature of a threat held over the other party in terrorem– a security to the promisee that the contract will be performed. A sum of this nature is called a penalty, and it has long been subject to equitable jurisdiction. Courts of equity have taken the view that, since the penalty is designed as mere security for the performance of the contract, the promisee is sufficiently compensated by being indemnified for his actual loss, and that he acts unconscionably if he demands an amount which, though certainly fixed by agreement, may well be disproportionate to the injury. The rule, therefore, is that a plaintiff who brings an action for the enforcement of a penalty can recover compensation only for the damage that he has in fact suffered. He is not entitled to recover the sum stated in the contract if has not, in fact, suffered so much loss.”

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 courts are entitled to find out whether the payment stipulated is in truth a penalty or liquidated damages.

Sometimes there is a very thin line dividing provisions relating to liquidated damages and penalty. A distinction as to whether the stipulation is one by way of liquidated damages or penalty has been summed up by the House of Lords in Dunlop Pneumatic Tyre Co. Ltd. Vs New Garage and Motor Company Ltd. as follows:

  1. The essence of a penalty is a payment of money in terrorem of an offending party; the essence of liquidated damages is a genuine pre-estimate of damages.
  2. The parties who use the expression `penalty’ or ‘liquidated damages’ may prima facie mean what they say, yet the expressions are not conclusive.
  3. The question whether a sum is a penalty or liquidated damages is a matter of construction of the particular contract, to be judged at the time of its execution and not at the time of its breach.
  4. To assist in this task of construction, various tests have been suggested, which if applicable to the case under construction may prove helpful or even conclusive.

Some such tests are –

  • the sum stipulated shall be a penalty if it is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to follow from the breach;
  • it would be a penalty if breach consists only in not paying sum of money and sum stipulated is greater than the sum which ought to have been paid;
  • There is a presumption (but no more) that it is a penalty when single sum made payable by way of compensation, or occurrence of one or more or all of such events, which may occasion serious damage or trifling damage; and
  • It is no obstacle to sum stipulated being a genuine pre-estimate of damage that consequences of breach are such as to make precise pre-estimation almost impossible.

The rules for distinguishing between a penalty and liquidated damages, as given in Halsbury’s Laws of England 2nd Edition, Part IV, paragraphs 183-184, at pages 141-145, are as follows :

  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. Where the parties themselves, call the sum made payable a penalty, the onus lies on those who seek to show that it is liquidated damages to prove that such was the intention.
  2. It will be held to be a 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.
  3. 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.
  4. There is a presumption (but no more) that it is a penalty when ‘a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of the several events, some of which may occasion serious and others but trifling damage’.
  5. Where a contract contains a variety of stipulations and the amount of damages for the breach of each stipulation is unascertainable, or not readily ascertainable, then the sum payable on the breach of any of the stipulations is liquidated damages. The fact that the stipulations are of different degrees of importance is not of itself sufficient to show that the sum payable is a penalty, except where some of the stipulations are of such a character that the damages which can possibly arise from a breach of any of them would be very insignificant compared with that fixed by the parties.
  6. Where a contract contains only a single stipulation, on the breach of which a specified sum, whether large or small, is to become payable, such a sum is liquidated damages especially where there are no adequate means of ascertaining the precise damage which may result from the breach; but if the single stipulation is only of very trivial importance or can only give rise to nominal damages, and the sum payable is considerable, the disproportion between the two may be so great as to make it plain that the sum was fixed as a penalty.

 

 

Advertisements

About maheshspeak

I write randomly on law, jurisprudence, polity, travel, food and anything else interesting. You can also visit my personal homepage at maheshsreenivasan.com
This entry was posted in Contracts, Law, Legal, Uncategorized and tagged , , , , , . Bookmark the permalink.

1 Response to Breach of Contract, Liquidated damages and Penalty

  1. Pingback: Termination of Contract | maheshspeak

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s