Breach of any contract is failure to fulfil its contractual obligations

Introduction

Breach of any contract is mostly due to failure of one party to fulfil its contractual obligations. There are several remedies available on breach and sections 73 and 74 of the Indian Contract Act, 1872 deal with one of them i.e. payment of damages. In other words, these two sections lay down the law in India with respect to the mode of assessing damage to be paid by the defaulting party in case of breach.

Damages as a remedy

Damages is the sum paid to the plaintiff by the defendant for the loss or injury suffered by the former through the latter’s breach. The essential difference between the two terms “compensation" and “damages" needs a mention here. The Indian Contract Act uses the word “compensation" while the contract laws of countries like UK and USA use “damages" for the same purpose. Thus, the terms are synonymous as far as the laws of contract, specific relief and torts are concerned. However, under the land acquisition laws in our country, the word “compensation" is used to denote the sum paid to the land owner(s) in lieu of losses incurred by him due to surrendering of his/their land to the concerned government agency and in this context, it cannot be used interchangeably with “damages".

There are two modes of paying damages-one is to allow the court to calculate them on the basis of legal principles after the breach has occurred and the other is to stipulate a sum in the contract at the time of entering into it which must a genuine pre-estimate of the loss to be suffered. These are known as unliquidated and liquidated damages respectively. Since this article dwells at length on the concept of liquidated damages, it is pertinent to have a brief account of the other form of damages here. When damages are not predetermined/ assessed in advance, then the amount recoverable is said to be unliquidated (i.e. to be agreed or determined by the court in the event of breach). Such damages are sufficiently uncertain because they are not mathematically calculable or are subject to a contingency (i.e. breach).

However, in any case, the sum is not to be paid immediately on breach. In fact, the aggrieved party does not even possess such a right then. The only right he has then is the right to sue for damages. Thus, no pecuniary liability arises till the court holds the defaulting party liable and directs him to pay the amount.

Liquidated damages (Ss. 73 & 74)

Section 73

The first paragraph provides that where a party sustains a loss on account of breach of contract, he is entitled to receive, from the party who has broken the contract, compensation for such loss or damage [1] . Such compensation can be recovered for the loss or damage:

That arose as a natural consequence of such breach; or,

Which the parties knew at the time of the contract as a probable consequence of such breach

The second paragraph provides that no compensation is payable for any remote loss. The third paragraph deals with applying section 73 in case of quasi-contracts. The Explanation part states that while assessing the damage, the means available to the person suffering the loss in mitigating such loss must be given due consideration. The test to be applied to know if efforts to mitigate the loss were taken or not is to view the issue from the perspective of a prudent man i.e. whether the aggrieved party did what a prudent man would have done if the entire expense was to fall on him.

Finally, the illustrations to the section represent the general rules that can be followed while interpreting the section. [2] It is worthwhile to note here that such illustrations deal with only movable property. However, this does not mean that they do not apply to immovable property. A party who suffers from any such breach is entitled to recover from the party responsible for the breach, compensation for any loss or damage caused to him thereby which naturally arises in the usual course of things from such breach. [3] Thus, the principles as to damages enunciated in this section are applicable even in respect of agreements relating to immovable properties [4] , but does not apply to agreements void for any reason [5] .

Section 74

There are two things involved in section 74:

Losses which are too remote or indirect (thus, prohibited under section 73) can also be claimed under section 74 if they have been provided for in the contract.

Both liquidated damages and penalty clauses can be enforced.

However, the only test they need to pass is that the amount should be ‘reasonable’. Otherwise, the court will reduce it to a reasonable sum, but will not reject it in toto. Further, while deciding if the amount specified in the contract is in the nature of liquidated damages or penalty, the court should not be guided only by the terms used in the document because what is mentioned as liquidated damages might turn out be penalty on a detailed study. Penalty is actually an amount paid as in terrorem while liquidated damages are a covenanted genuine pre-estimate of damages.

To put it in nutshell, what the Indian law on damages lays down is that parties are free to stipulate a sum in their contract to be paid on breach. If that sum is a genuine pre-estimate of the loss to be suffered, it is liquidated damages, but if it is not in any way commensurate to such loss, it is termed as penalty. Farnsworth’s [6] comments in this regard are worth mentioning. He has observed that in comparison to the bargaining power which parties enjoy in negotiating their substantive contractual rights and duties, their power to bargain over their remedial rights is surprisingly limited. They are not at liberty to name an extravagant sum having no relation to the breach, for fear of it being construed as a penalty. It is interesting to contrast this with the law relating to consideration. A man may sell his car for a handful of marbles, and the law cares not, as long as he is satisfied. Yet the law would give no peace to a man who claims ten thousand rupees for failure to deliver a handful of marbles, branding such a clause penal.

One more important question that crops up in this discussion is whether a party is entitled to anything more than what has been stipulated in the liquidated damages clause. This was answered in negative in the case of Sir Chunnilal Mehta &Sons Ltd. v. Century Spinning & Manufacturing Co. Ltd. [7] It was stated in the case where the parties name in a contract a 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.

Part II

ONGC v. Saw Pipes [8] – A critical analysis

Facts

The respondent company is engaged in the business of supplying equipment for offshore oil exploration and maintenance. It had offered to supply to the appellants, on agreed terms and conditions, casing pipes of certain specifications which the latter had also accepted. The goods were required to be supplied on or before 14 November 1996. In pursuance of the same, the respondent placed an order with an Italian supplier for supply of raw materials that were necessary for manufacture of the pipes. However, owing to a general strike prevalent all over Europe during that period, the suppliers could not deliver the raw materials on time. The respondent, therefore, requested the appellant for an extension of 45 days time for execution of the order in view of the reasons beyond its control. This request was acceded to by the latter however, with a specific statement that an amount equivalent to liquidated damages for delay in supply of pipes would be recovered from the respondent. In consequence of the same, the appellant made payment after deducting a particular amount as liquidated damages. The respondent disputed this and the matter was sent for arbitration which decided against the appellant. The appeal filed before the High Court was also in favour of the respondent. Hence, ONGC appealed before the Hon’ble Supreme Court in which the Court first discussed extensively its jurisdiction to set aside an award under section 34 of Arbitration and Conciliation Act, 1996 and also the various grounds on which interference was permissible. The same have not been discussed here as they are irrelevant to the present article. The other questions of law in the judgement (pertaining to liquidated damages) are as follows:

Analysis of the judgement

If the terms of the contract stipulating the liquidated damages are clear and unambiguous, the party committing the breach is required to pay the sum u/s. 73.

The first issue under the concept of liquidated damages was whether the court could pass an order that goes against the liquidated damages clause stipulated in the contract. The counsel for the appellant, relying on the decision of Delta International Ltd. v. Shyam Sunder Ganeriwalla &Anr. [9] , argued that for the purpose of construction of contracts, the intention of the parties is to be gathered from the words they have used and there is no intention independent of that meaning.

The court completely agreed with him that the contract in the present case was one that fully reflected the intention of the parties which they possessed at the time of entering into it. It also referred to its own decisions given in the cases of Modi & Co. v. Union of India [10] and Provash Chandra Dalui& Anr. v. Biswanath Banerjee & Anr. [11] to substantiate the point. In these cases too, it was held that the court cannot do much where the words in the contract are clear.

Thus, by upholding the validity of the clear terms of the contract in the present case, the court has merely followed its tradition of preferring the unambiguous words of the contract over any other (oral or otherwise) understanding between the parties. It is a settled law that the parties to a contract can create for themselves special rights and obligations such as providing for themselves the measure of damages for breach [12] . Also, if the parties themselves fix the value of their right, that amount is a proper measure of damages [13] . In fact, section 62 of the Sale of Goods Act, 1930 is a statutory recognition of this right, under which it is open to parties to a sale of goods to provide their own measure of damages in cases of breach [14] .

Waiver of proof of loss

The second contention of the appellant was that proof of actual loss suffered by delay in supply of pipes was not necessary because the parties had expressly agreed that recovery of damages for breach of contract was not by way of penalty but by a genuine pre-estimate of damages. As against this, the respondent relied on the case of Bhai Panna Singh v. Bhai Arjun Singh & Ors. [15] wherein it was held that the plaintiffs must prove the damage they have suffered before claiming liquidated damages. However, the court failed to agree with it.

Referring to the decisions in the cases of Fateh Chand v. Balkishan Das [16] and Maula Bux v. Union of India [17] and also sections 73 and 74, the Apex court held that if parties have inserted the clause of liquidated damages, there may not be any necessity of leading evidence for proving damages unless the court arrives at the conclusion that no loss is likely to occur because of such breach. In fact, the burden of proving “no likely loss" is on the defaulting party. It said that a plain reading of the aforesaid two sections would clearly show that the emphasis of the legislature is on “reasonableness" of the sum and not on “proof of loss". It further held that proof of damages is required only where the court arrives at the conclusion that the term contemplating damages is by way of penalty and therefore, reasonable compensation not exceeding the amount so named has to be granted.

Another argument of the appellant which led the court to conclude that the arbitral award was vitiated was that when the respondent asked for 45 days extension, the same was granted with a provision that liquidated damages would be recovered. Despite this condition, the respondent supplied the goods indicating that the respondent was agreeable to payment of liquidated damages. However, the tribunal had failed to take note of this.

Observations

Liquidated damages

Essentials

Based on the principles laid down in the cases of Maula Bux v. Union of India [18] and ONGC v. Saw Pipes [19] , following can be deduced to be the essential requisites of a valid liquidated damages clause:

Such provisions must be clearly drafted;

The calculations to arrive at the final figure must be easy to follow;

To avoid the situation of the court reducing the amount, the aggrieved party should be ready to prove that it is certainly a genuine pre-estimate of the loss or damage to be suffered.

Advantages

They promote certainty;

Actual proof of loss is not required (unless the court opines that no loss is likely to occur due to such breach);

Avoids the difficulty in assessment and the risk of under-compensation.

Penalties

It is most humbly submitted that the court’s view with respect to penalties that where the court arrives at the conclusion that the term contemplating damages is by way of penalty, it may grant reasonable compensation not exceeding the amount so named in the contract on proof of damages [20] , is not in consonance with the provisions of section 74. This section does not draw any distinction between liquidated damages and penalties with respect to proof of loss. Therefore, brining in a bias which the legislature itself has not contemplated is not correct in law.

Conclusion

On a close analysis of the case, it can be safely concluded that Apex court has, in this judgement, certainly summarized the law relating to liquidated damages as prevailing in India. Actual proof of loss was waived under section 74 even before this judgement was delivered. However, this decision has held in strong words that where the terms of the contract are clear with respect to the consequences of breach, then that has to be upheld and the court cannot do much about it. Proof of loss would be required to be shown by the party claiming damages only where the court arrives at the conclusion that there is no loss likely to occur because of such breach.

Also, a note of caution for the purchaser needs a mention here. This is because this decision should not act as an encouragement for them to invoke the liquidated damages clause each time the supplier fails to perform his part. Where the purchaser is keen on getting the contracted work completed with due diligence, he should understand that the only purpose of inserting such a clause is to ensure that the work is done on time. It should not be misunderstood to be a clause that would provide additional revenue to him. Thus, he should be careful before invoking such a clause as it might bring the complete work to a halt. It must be resorted to only when the purchaser is sure that the supplier will be unable to perform it within the agreed time. Many a time, as in the present ONGC [21] case, the supplier’s failure might be due to factors that are beyond his control. In all such cases, the purchaser should not be in a hurry to proceed against the other party, but must try to investigate the causes of delay and explore other ways to get the work completed on time. He should realise that his aim is not to get entangled in legal disputes, but to get the work done within the stipulated time-frame.