In order to ensure due performance of certain obligations in the Contract, often provisions for payment of a fixed sum of money, which is known as the L.D., or the Liquidated Damages Clause is specified in the contract. The main objective is to act as an inducement for due performance of a particular contractual obligation or to regulate before hand, in an agreed or in a certain manner, the rights of the parties rather than to lead them to the less predictable remedies otherwise available. The most common provision is to state in round figures what payments are to be made or what the damages are in a certain event. These are classical liquidated damage provisions, which are most commonly found in breach of contracts in relation to contractor’s obligation to complete the work within the specified time.

It however, does not matter whether the contract uses the word penalty as some contracts still do. But if the sum is in reality an estimate of damages or is intended as a limitation of damages not in terrorem. But in all cases if the act is in breach of the contract, the law requires that it must be enquired whether the payment or the forfeiture provided for in the contract is a penalty in a special more modern sense of the word, meaning that in reality it is not an estimate of damage and is excessive. It is therefore necessary to follow a test laid down to distinguish whether the provision in a contract is a penalty or it amounts to liquidated damages or not.

In the case of Dunlop Pneumatic Tyre Co. Ltd. Vs. New Garage & Motor Co. Ltd. reported in (1915) A.C. 79 P.86, the following tests have been provided to clearly distinguish the difference between “Penalty” and “Liquidated Damages;”

(a) 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.

(b) 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. This, though one of the most ancient instances, is truly a corollary to the last test.

(c) There is a presumption (but no more) that it is a penalty when ‘a single sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damages.’

(d) It is no obstacle to the sum stipulated being a genuine pre-estimate of damage that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. On the contrary, that is just the situation when it is probable the pre-estimated damage was the true bargain between the parties.”

It is therefore absolutely necessary that the parties to the contract make a very positive effort in determining as to what in their estimate would be the measure for applying the reasonableness test which is applicable for the pre-estimated amount to be held as not in terrorem but a genuine pre-estimated loss, which the party would suffer in the event of a breach.

Before going into the scope of reduction, which an Arbitrator can make in the pre-estimated figure, it will be of atmost importance to understand how our law views the liquidated damages.

The Indian Contract Act of 1872 under chapter 6, which deals with the consequences of the breach of Contracts, under Section 74, specifies what compensation is to be paid for breach of Contract where penalty is stipulated for damages. The Section reads thus;

“Section 74 Compensation for breach of contract where penalty stipulated for-

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 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”.

What is significant in the aforesaid provision is the following;

1. When a contract is broken.
2. If a sum is named in the contract as the amount to be paid in case of such breach.
3. If the contract contains any other stipulation by way of penalty.
4. The party complaining breach is entitled, “Whether or not actual damage or loss is proved to have been caused, to receive from the party who has broken the contract “reasonable compensation” not exceeding the amount so named.” or
5. The penalty stipulated for.

Therefore every arbitrator is entitled to ascertain from the fact situation before him as to what has been specified in the LD Clause is the pre-estimate being a genuine pre-estimate or in terrorem if it is proved that it is a reasonable compensation, then whether or not the actual damage or loss is proved, the Arbitrator is bound by the terms of the contract to award the liquidated damages to the party who has suffered the breach.

After the coming into effect of the Arbitration and Conciliation Act of 1996, it is absolutely clear that every award of an arbitrator has to be in accordance with the terms of the contract for construction of the contract and the intention of the parties is to be gathered from the words used in the agreement and if the agreement has been drafted by the experts then there is no reason that the words could be interpreted to give any different meaning than for the purpose for which they are employed.

Section 28(3) of the Arbitration and Conciliation Act of 1996 is absolutely clear when it lays down as follows:-

CHAPTER VI

MAKING OF ARBITRAL AWARD AND TERMINATION OF PROCEEDINGS:

28. Rule applicable to substance of dispute.-

(1) Whether the place of arbitration is situate in India,

(a) In an arbitration other than an international commercial arbitration, the arbitral tribunal shall decide the dispute submitted to arbitration in accordance with the substantive law for the time being in force in India;

(b) In international commercial arbitration,-

(i) The arbitral tribunal shall decide the dispute in accordance with the rules of law designated by the parties as applicable to the substance of the dispute;

(ii) any designation by the parties of the law or legal system of a given country shall be construed, unless otherwise expressed, as directly referring to the substantive law of that country and not to its conflict of laws rules;

(iii) Failing any designation of the law under clause (a) by the parties, the arbitral tribunal shall apply the rules of law it considers to be appropriate given all the circumstances surrounding the dispute.

(2) The arbitral tribunal shall decide ex aequo et bono or as amiable compositeur only if the parties have expressly authorized it to do so.

(3) In all case, the arbitral tribunal shall decide in accordance with the terms of the contract and shall take into account the usages of the trade applicable to the transaction.

The law as it stands today in India is settled by the Hon’ble Supreme Court of India in this regard in the case of Oil & Natural Gas Corporation Ltd. Vs. Saw Pipes Ltd., reported in 2003 (5) SCC 705. In para 61 of the Judgment, the Hon’ble Supreme Court has held – I quote;

“61. The next question is whether the legal proposition which is the basis of the award for arriving at the conclusion that ONGC was not entitled to recover the stipulated liquidated damages as it has failed to establish that it has suffered any loss is erroneous on the face of it. The Arbitral Tribunal after considering the decisions rendered by this Court in the cases of Fateh Chand, Maula Bux and Rampur Distillery arrived at the conclusion that:-

in view of these three decisions of the Supreme Court, it is clear that it was for the respondents to establish that they had suffered any loss because of the breach committed by the claimant in the supply of goods under the contract between the parties after 14.11.1996. In the words we have emphasized in Maula Bux decision, it is clear that if loss in terms of money can be determined, the party claiming the compensation ‘must prove’ the loss suffered by him”.

The Hon’ble Supreme Court further in para 64 of the Judgment came to the following conclusion – I quote:-

“64. It is apparent from the aforesaid reasoning recorded by the Arbitral Tribunal that it failed to consider Sections 73 and 74 of the Indian Contract Act and the ratio laid down in Fateh Chand criers wherein it is specifically held that jurisdiction of the court to award compensation in case of breach of contract is unqualified except as to the maximum stipulated; and compensation has to be reasonable. Under Section 73, when a contract has been broken, the party who suffers by such breach is entitled to receive compensation for any loss caused to him, which the parties knew when they made the contract to be likely to result from the breach of it. This section is to be read with Section 74, which deals with penalty stipulated in the contract, inter alia (relevant for the present case) provides that 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, the party complaining of breach is entitled, whether or not actual 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. Section 74 emphasizes that in case of breach of contract, the party complaining of die breach is entitled to receive reasonable compensation whether or not actual loss is proved to have been caused by such breach, Therefore, the emphasis is on reasonable compensation. If the compensation named in the contract is by way of penalty, consideration would be different and the party is only entitled to reasonable compensation for the loss suffered. But if the compensation named in the contract for such breach is genuine pre-estimate of loss which the parties knew when they made the contract to be likely to result from the breach of it, there is no question of proving such loss or such party is not required to lead evidence to prove actual loss suffered by him. Burden is on the other party to lead evidence for proving that no loss is likely to occur by such breach. Take for illustration: if the parties have agreed to purchase Cotton bales and the same were only to be kept as stock-in-trade. Such bales are not delivered on the due date and thereafter the bales are delivered beyond the stipulated time, hence there is breach of the contract. The question which would arise for consideration is – whether by such breach the party has suffered any loss. If the price of cotton bales fluctuated during that time, loss or gain could easily be proved. But if cotton bales are to be purchased for manufacturing yarn, consideration would be different.

65. In Maula Bux’s case19 plaintiff Maula Bux entered into a contract with the Government of India to supply potatoes at [be Military Headquarters, U.P. Area and deposited an amount of Rs.10,000 as security for due performance of the contract. He entered into another contract with the Government of India to supply at the same place poultry eggs and fish for one year and deposited an amount of Rs.8500 for due performance of the contract. The plaintiff having made persistent default in making regular and full supplies of the commodities agreed to be supplied, the Government rescinded the contracts and forfeited the amounts deposited by the plaintiff, because under the terms of the agreement, the amounts deposited by the plaintiff as security for the due performance of the contracts were to stand forfeited in case the plaintiff neglected to perform his part of the contract. In context of these facts, the Court held that it was possible for the Government of India to lead evidence to prove the rates at which potatoes, poultry, eggs and fish were purchased by them when the plaintiff failed to deliver “regularly and fully” the quantities stipulated under the terms of the contracts and after the contracts were terminated. They could have proved the rates at which they had to be purchased and also the other incidental charges incurred by them in procuring the goods contracted for. But no such attempt was made. Hence, claim for damages was not granted.

66. In Maula Bux case19 the Court has specifically held that it is true that 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 can claim a decree and the court is competent to award reasonable compensation in a case of breach even if no actual damage is proved to have been suffered in consequence of the breach of contract. The Court has also specifically held that in case of breach of some contracts it may be impossible for the court to assess compensation arising from breach.

67. Take for illustration construction of a road or a bridge. If there is delay in completing the construction of road or bridge within the stipulated time, then it would be difficult to prove how much loss is suffered by the society/State. Similarly, in the present case, delay took place in deployment of rigs and on that basis actual production of gas from platform 13-121 had to be changed. It is undoubtedly true that the witness has stated that redeployment plan was made keeping in mind several constraints including shortage of casing pipes. The Arbitral Tribunal, therefore, took into consideration the aforesaid statement volunteered by the witness that shortage of casing pipes was only one of the several reasons and not the only reason which led to change in deployment of plan or redeployment of rigs Trident II platform B-121. In our view, in such a contract, it would be difficult to prove exact loss or damage which the parties suffer because of the breach thereof. In such a situation, if the parties have pre-estimated such loss after clear understanding, it would be totally unjustified to arrive at the conclusion that the party who has committed breach of the contract is not liable to pay compensation. It would be against the specific provisions of Sections 73 and 74 of the Indian Contract Act. There was nothing on record that compensation contemplated by the parties was in any way unreasonable. It has been specifically mentioned that it was an agreed genuine pre-estimate of damages duly agreed by the parties. It was also mentioned that the liquidated damages are not by way of penalty. It was also provided in the contract that such damages are to be recovered by the purchaser from the bills for payment of the cost of material submitted by the contractor. No evidence is led by the claimant to establish that the stipulated condition was by way of penalty or the compensation contemplated was, in any way, unreasonable. There was no reason for the Tribunal not to rely upon the clear and unambiguous terms of agreement stipulating pre-estimate damages because of delay in supply of goods. Further, while extending the time for delivery of the goods, the respondent was informed that it would be required to pay stipulated damages.

68. From the aforesaid discussions, it can be 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 hold 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 Section 73 of the Contract Act.

(3) Section 74 is to be read along with Section 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 lie can claim a 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, tile court can award the same if it is genuine pre-estimate by the parties as the measure of reasonable compensation.

69. For the reasons stated above, the impugned award directing the appellant to refund the amount deducted for the breach as per contractual terms requires to be set aside and is hereby set aside.”

Before I close, I may also point out that a review filed against the aforesaid Judgment of the Hon’ble Supreme Court has been declined by the Hon’ble Court.

Therefore, the scope of reduction in Liquidated Damages would be dependant upon the reasonableness of the L.D., and the Arbitrator can only reduce it to a reasonable amount after giving reasons for its being unreasonable. But otherwise the L.D. Clause cannot be interfered with and has to be applied as binding between the parties.

Dated: 08.12.2006