Judicial Interpretation of Penalty Clauses

Nine decades on, what Lord Dunedin held in Dunlop Penumatic Tyre Co Ltd V. New Garage & Motor Co Ltd [2] has become a locus classicus. It is probably the most authoritative and comprehensive judgement till date on the subject of penalty clause in commercial contracts. It just goes to show the nature of complexity involved in distinguishing penalties from liquidated damages. To quote the five judges Constitution bench in Fateh Chand V. Balkishan Dass [3] , “The section as it stands today is clearly an attempt to eliminate the somewhat elaborate refinements made under English common Law in distinguishing between stipulations providing for payments of liquidated damage and stipulation in nature of penalty, the Indian legislature has thus sought to cut across the “web of rules” and presumptions under English common Law, by enacting a uniform principle applicable to all stipulations naming amounts to be paid in case of breach, and stipulations by way of penalty.” The intricacy involved in distinction of penalties from liquidated damages is such that till today the courts struggle to clearly distinguish the same which is evident from Supreme Courts latest judgement of BSNL V. Reliance Communication [4] . With this being the rationale’, this article aims at studying the varied interpretations given to the penalty clauses by the courts in India. It also tries to draw parallels and give comparative view of judicial interpretation of penalty clauses made by courts in United States of America, The United Kingdom and certain other civil law jurisdictions.

Section 74 of the Contracts Act and Evolution of Law on penalty clauses in contracts in India.

The Indian Law on Penalties applicable on breach of contract owes its development to judicial interpretation given by the early 20th century judges of the House of Lords. The sole object of section 74 as it originally stood appears to have been to provide for the class of cases to which Kemble V. Farren [5] belongs wherein it has been argued [6] that it was intended to do away with distinction between a penalty and liquidated damage, and in which case the distinction between ‘liquidated damages’ and ‘penalty’ gave rise to so much difference of opinion in the English courts. The legislature with intent to remove the complications that arose in interpretation because of the said judgement added the words ‘or if the contract contains any other stipulation by way of penalty’ via the 1899 amendment to the Contracts Act. It had also been argued in V Venkataramiah Pillai V. PV Subramania Pillai [7] that addition of the words stipulation by way of penalty by the said amendment has considerably enlarged the scope of the section, and has the effect of getting rid of all subtle technicalities on the application of the equitable principles regulating the duty of the court to relieve against penalties.

The 1915 judgement of Lord Dunedin which laid down the tests by which a penalty clause could be differentiated from liquidated damage is significant from an evolutionary perspective. The tests laid down by Lord Dunedin opined that – 1) a sum as given in the contract 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 [8] to have followed the breach, 2) it will 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, and 3) it is a presumption (but not more) 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 several events, some of which may occasion a serious and others but trifling damage.” An important point of observation that has to be highlighted here is “web of presumption” as mentioned above. The “web of presumption” was traditional to English Law, by which we mean: a claimant could not recover in excess of actual loss, if the sum stipulated in the contract was a “genuine pre – estimate” of loss and was therefore a “penalty”. A dual standard that made the entire process of deciphering the sum named to be a “penalty” or “genuine pre – estimate” an arduous task – was a sum stipulated being in terrorem of the offending party did not bar any action for “actual loss” in spite of “actual sum” exceeding the penalty sum [9] . But equally confusing and complex was the fact, that one was entitled to liquidated damages without needing to prove actual loss, but in rare circumstances where the loss exceeded such a sum, he was confined to such a sum.

A judgement which clarified the position taken by the House of Lords in Dunlop Pneumatics’ case was Ford Motor Co. V. Armstrong [10] , wherein a suit was brought against the defendant for breaching one of the several covenants contained in the contract, a sum of 250 pounds was payable. The court in this case held in majority the same was a penalty, since it was arbitrary and substantial sum, and made payable for various breaches differing in kind, some of which might cause only trifling damage. The high amount of the agreed sum in this case showed that it could not be a genuine pre – estimate of loss.

An important assessment that could be made as to law in India concerning damages and penalties is that there is no qualitative difference in the nature of liquidated damages and unliquidated damages, as what section 74 has done post 1899 amendment is to eliminate elaborate refinement made under common law between stipulations providing for payments of liquidated damages and stipulations in nature of penalty. A very important distinction that needs to be drawn at this juncture, is a claim for liquidated damages stands on the same footing as a claim for unliquidated damages, and a party in breach of contract does not incur eo instanti a pecuniary liability. The injured party is only entitled to bring an action for damages, and have them adjudicated upon.

Later the Supreme Court in Chunilal V. Mehta Vs Century Spining and Mfg Co Ltd [11] clarified the distinction that exists between liquidated and uniquidated damages where the question before the court was mere fact that damages for breach being very difficult to assess, does not rule out the possibility that the agreed sum cannot be liquidated damage and wherein it was held that where the parties to a contract have provided for compensation in express terms, the right to claim unliquidated damage to that extent is necessarily excluded.

In the case of Fateh Chand V. Balkishan Dass [12] , the Supreme Court was faced with the question whether s. 74 applies to stipulations for forfeiture of amounts deposited or paid under the contract, the Attorney General appearing on behalf of the defendant, brought new exposition on the subject. The Attorney General argued that section 74 undoubtedly says that the aggrieved party is entitled to receive compensation from the party who has broken the contract, whether or not actual damage or loss is proved to have been caused by the breach. Further it was argued that there is however no warrant for assumption made by some High Courts in India, that section 74 applies only to cases where the aggrieved party is seeking to receive some amount on breach of contract and not to cases where upon breach of contract an amount received under the contract is sought to be forfeited. And to cement the logic that expression “contract contains any other stipulation by way of penalty” also includes forfeiture of right to money or property already delivered, the Attorney General substantiated by citing two cases, one a judgement by Bombay High Court in Abdul Gani & Co V. Trustees of the Port of Bombay [13] where it was observed by the court that sum which is named in the contract either as penalty or liquidated damages is a sum which has not already been paid but is to be paid in case of breach of contract. The court in this regard highlighted the intent of legislature, by highlighting the fact that legislature has chosen to qualify ‘stipulation’ as any other ‘stipulation’ indicating that the stipulation must be of nature of an amount to be paid and not an amount already paid prior to entering into a contract. The other judgement that was cited by Attorney General was Madras High Court’s judgement on Natesha Aiyar V. Appavu Padeyschi [14] wherein the court held that section 74 applies where a sum is named as penalty to be paid in future cases of breach, and not to cases where a sum is already paid and by a covenant in the contract is liable to forfeiture. Finally Attorney General stated in this regard that High Courts in these cases have stressed upon the words “to be paid in case of breach” which forms part of the first condition under section 74, and have ignored “the contract contains any other stipulation by way of penalty” which forms the second condition to section 74 which was added by the 1899 amendment, and that second condition widens the operation of the section so as to make it applicable to all stipulations by way of penalty including stipulations by way of forfeiture of amounts paid or deposited under a contract. Similar questions where agitated in Maula Bax V. Union of India [15] and later in Union of India V. Rampur Distillery & Chemical Co Ltd [16] as to forfeiture of earnest money deposited under a contract. Justice Shah (acting CJ) reiterating his views from Chunilal V. Mehta V. Century Spinning & Mfg Co Ltd [17] in Maula Bax’s case where Justice Shah was of the view that section 74 only dispense with the proof of “actual damage or loss cause” and section does not justify the award of compensation, when there was no actual loss, in spite of the fact that section 74 read sum named under a contract is recoverable “whether or not actual damage or loss is proved to have been cause”. Subsequently in case of Shree Hanuman Cotton Mills V. Tata Aircraft Ltd [18] , the Supreme Court allowed forfeiture of earnest money only when such intent could be deciphered in the contract. An ‘interesting fact’ to note here is that Supreme Court in Rampur Distillery’s case held that deposit could not be forfeited or reasonable compensation to be recovered unless attempt is made to establish that it had suffered any loss or damage on account of breach, whereas later the Supreme Court in ONGC Ltd V. Saw Pipes Ltd [19] and Jagson International Ltd V. Oil and Natural Gas Corporation Ltd [20] has held that it is not necessary for the aggrieved party to lead evidence to show the amount of loss suffered by it unless the breaching party came to court and proved no loss or damage had been suffered in consequence of said breach. Having stated above the ‘interesting fact’ being the onus of proof of breach has shifted from plaintiff to the defendant in the latter cases decided by the Supreme Court.

Later, in Robophone Facilities Ltd V. Blank [21] , Diplock LJ captured the spirit of agreed damages clause, where he stated that court would be doing an ill turn to parties, where penalty clauses are designed to protect, and it is impractical for the parties to agree at outset and to predict fair and agreeable quantum of damages. He also stated that it makes good business sense for parties to a contract to know the financial consequence of breach on their part, which by doing so they can anticipate their position at time of breach and avoid cost of litigation.

Comparative Position of Law on Penalty clauses under Commercial Contract.

There are only a few areas left where there is still a substantive difference between Common Contract Law and Civil Contract Law. One of those areas happens to be that of enforcement of liquidated damages and more particularly of penalty clauses.

Common Law has not always been reluctant to enforce penalty clause and forfeitures stipulated by the contracting party. It has been argued [22] that there is evidence to show contrary to popular beliefs that till the late 17th Century and the development of the rule of presumptions by the Court of Chancery, which declared them to be unconscionable, penal bonds were readily enforced by the Common Law Courts. With the adoption of equity rule as party of delivering justice by the later courts, led to the enactment of statues in both England and United States which forbid enforcement of penalty clauses.

Under American Contract Law, contract clauses are scrutinized by the courts which compare them with conventional damages. The courts on finding that agreed damages being grossly excessive and / or disproportionate to the damage incurred by the injured party may declare such clause as penalty and unenforceable. The courts on declaring such clauses to be penalty are at liberty to award conventional damages to the injured party, as if the contract was silent in the first place as to existence of such an agreed damage clause. Further it has been held in the case of Fisher V. Schmeling [23] it does not preclude an injured party from seeking for conventional damage on voiding a liquidated damage clause, if stipulated damage does not cover his loss.

In the case of Banta V. Stamford Motor Co [24] a case comparable to Dunlop Pneumatic Case in significance, two condition were formulated which must hold for stipulated damage to be enforceable –

The stipulated amount must be reasonable (i.e. not grossly disproportionate) in light of the harm anticipated by the parties or the actual harm caused by the breach. However if there is no actual loss, stipulated damages are usually not enforced.

It is difficult or impossible to measure – and thus prove – the presumable loss (due to subjective valuation, uncertainty, difficulty of producing proof of damages, or any other measurement problem)

On comparison of the English Common Law on Contract to the American Contract Law it has been argued [25] that the important difference being English Common Law does not look for a ‘reasonable’ estimation of damage (a reasonableness that would be judged ex – post), but rather attempts for a genuine bona fide attempt of the parties to assess the damages ex – ante. There arises the problem as precise pre – estimation is an almost impossibility at the time of drafting the contract.

An assessment of the European Civil Law on Contracts yields that penalty clauses have been enforceable in Europe since the Roman times. [26] Over time Roman law had been amenable to enforcement of excessive penalty clauses. However with rise of Church as the supreme rule making authority and proportional growth in prominence of Canon Law, an interesting connect that emerged in this context is that Cannon Law’s emphasis on morality and the protection of debtor led to more equitable solution such as restricting the penalty to double the value of the injury suffered by aggrieved party in a contract. At present even though there exists no reason under civil law for distinguishing penalties from liquidated damages, however over the years courts have retained the discretion to reduce penalties to a reasonable amount. But such circumstances arise only if the promisor asks for it. An example of this doctrinal shift from traditional Roman law can be found in the German Civil Code (BGB) wherein the reasonableness of the penalty clause can be judged by the court and where the judge has the power to limit excessive penalties.

An earlier observation [27] of the French Civil Code vis – a – vis Roman Law made has revealed their view on penalties applicable under contracts were much alike. The 1975 amendment to statue, has since given discretionary powers to the judge to “increase or decrease the penalty if it is derisory or manifestly excessive”, thereby putting it on the same footing with other European Civil Codes i.e. German Civil Code (BGB).

Later, in an effort to bring uniformity in the way contracts are made and interpreted in Europe, The Principles of European Contract Law (PECL) were developed. Article 9. 509 of the said ‘principles’ titled “Agreed Payment of Damages” states that –

Where the contract provides that a party who fails to perform is to pay a specified sum to the aggrieved party for such non-performance, the aggrieved party shall be awarded that sum irrespective of its actual loss [28] .

However, despite any agreement to the contrary the specified sum may be reduced to a reasonable amount where it is grossly excessive in relation to the loss resulting from the non-performance and the other circumstances [29] .

Thus, in principle it has achieved in combining the best of what the two schools on European law has to offer.

4. Observations on BSNL V. Reliance Communications Ltd

In the present case, the dispute arose out of a 1997 BSO Interconnect Agreement (“BIA”) and the subsequent amendment that the two companies had entered into. In other words this was a network sharing agreement. Later in 2003, the BSO scheme was substituted with the “Unified Access Service Provider” regime. Followed by an amendment to “BIA” in 2006 with retrospective operation of the same from 2003, it provided for charges to be levied by BSNL on Reliance Communications for calls made on its network, depending on the nature of its calls (Local, International, etc). The key factor in this dispute was the apparatus “Caller Line Identification” (“CLI”) used by the party which was not only used by the parties as means of identifying the caller but for billing purposes too.

In 2004, BSNL discovered through enquiries made that certain (“CLI”) numbers occurred more frequently, suggesting either “CLI” had been tampered with, or international calls were being masked as domestic calls by manipulating “CLI”.

BSNL invoked clause 6.4.6 of the BIA agreements, which allowed for computation of charges and the use of highest applicable charges for a period of two months before the calls. BSNL imposed a damage of Rs 9.89 crores on Reliance.

Having sufficiently stated the background of the case, the question that arose before the full bench of the Supreme Court was whether clause 6.4.6 of the BSO agreement penal or genuine pre-estimate of damage?

In a single concurring judgement written by Chief Justice Kapadia held that clause 6.4.6 is a reasonable pre – estimate of damages as making unauthorised calls destroys the principle of “level playing field” thereby rendering BSNL competitiors to offer lower rates for International calls.

The observation of this case being BSNL in its arguments have contended that clause 6.4.6 is one of the several obligations that exists between the said parties contingent upon happening of a certain event (in this case detection of unauthorised calls), it is not relevant to consider at this juncture whether the said clause is a penalty or genuine pre-estimate. Though it was possible for the court to reach the conclusion that legality of the clause was in consonance with section 74, but section 74 regulates events upon breach. But ipso facto there was no breach of contract; merely happening of a certain event i.e. detection of unauthorised calls and same had been contented by BSNL stating that it was irrelevant to determine whether clause 6.4.6 is a penalty or not because such characterisation is irrelevant to a “sum payable on the happening of event other than breach”. Second observation is that assuming clause 6.4.6 does engage section74, there arises no need to characterise the sum as penalty or genuine pre-estimate as in both cases under said provision “reasonable damages” stand to be awarded. The relevant consideration for analysis could be inferred from the Fateh Chand’s case. And finally it is submitted that in this present case Supreme Court has enforced penalty for happening of an event i.e. detection of unauthorised calls, without there being breach of contract in the first place.

Conclusion

Over the years the task of distinguishing penalties from liquidated damage has become complicated and laborious one. With a great deal of extremely confusing precedents contradictory at various levels including the latest judgement by the Supreme Court in BSNL case it has rightly been argued [30] that common law rules for distinguishing between penalties and liquidated damages managed to get the worst of both worlds. They achieve neither certainty of the principle of literal enforcement as there exists uncertainty as to which category the clause will fall, nor the civil laws principle of enforcement subject to reduction.

It is submitted that way out might have been provided in disguise by Supreme Court’s enforcement of penalty in the BSNL case. It has been argued [31] in this regard that most efficient policy on stipulated damage would require a differentiation between abusive and efficient penalty clauses. Courts should enforce penalty clauses in general and they should annul only those clauses which are abusive and do not appear to engender a specific economic role. Hence, it could only be said that the appearance of this doctrinal shift is not bad in the scheme of things provided it could once and for all end the uncertainty between penalties and liquidated damages.