Viability Of Section 74 Of Indian Contract Act In Contemporary Commercial Context

The Penalty Conundrum

To determine whether the sum stipulated in the contract is a 'genuine pre-estimate' or 'penalty' is a question of law and therefore vests in toto within the domain of court of law. Lord Dunedin of England, in Dunlop Pneumatic Tyres Co. Ltd. v. NewGarage of Motor Co. Ltd, prescribed a fourfold test, which has also been endorsed by Indian Courts, to solve this quandary. He posits that the amount stipulated will be held to be a penalty:

1) If the sum stipulated is extravagant or unconscionable in comparison with the greatest loss which could conceivably be proved following the breach; or

2) If the breach consists only in paying not the sum of money, and the sum stipulated is the amount greater than the amount that ought to have been paid; or

3) 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 occasion serious and others but trifling damages: or

4) On the other hand, it is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that consequences of breach are such as to make precise pre-estimation almost an impossibility.

Traditionally, this was the test that English Courts applied to conclude upon the enforceability of the clause for liquidated damages, vide which, if the amount stipulated was not a genuine pre-estimate of likely losses, then the clause was left unenforced leaving the parties free to contend for unliquidated damages. The position of Indian law diverges from this to a certain extent because Section 74 contemplates only the award of reasonable compensation, irrespectively whether the amount stipulated is a genuine pre-estimate or not. Evidently, this stems upon the compensatory nature of damages under Contract law. Notably, this also confers upon the court or arbitral tribunal boundless jurisdiction to award the amount, that it deems reasonable in the facts and circumstances of a particular case. Prima facie this does not raise eyebrows, but the flip side to this position of law is the defeat of the very purport of this section, as discussed earlier, that was to add commercial certainty and reduce litigation.

In accordance with the position of law settled by the Indian Supreme Court ('SC') in Kailash Nath v. Delhi DevelopmentAuthority, only reasonable compensation not more than amount stipulated in the contract can be awarded by the court/tribunal. Secondly, loss is sine qua non for the award of damages under this head, and proof of actual loss is mandatory in all cases except when it is difficult or impossible to prove that the stipulated amount is genuine pre-estimate of damages. In all cases, reasonable compensation will be fixed based on well-known principles of mitigation and causation specified in Section 73. Especially, in cases where the amount stipulated is held to be not the genuine pre-estimate of loss, then the parties are expected to religiously follow the drill specified in Section 73 for the claim of unliquidated damages, not beyond the penalty specified in contract. Therefore, the amount stipulated in the contract is just an upper ceiling or the bar beyond which compensation cannot be awarded. A minute observation of this will lead to the conclusion that while Section 74 fulfils its purpose for the defendant by limiting the damages to the sum stipulated, however, for the innocent party it falls short to remedy the commercial uncertainty, leaving the determination of compensable amount largely within the realm of the court/tribunal.

To further strengthen this argument, the ruling of Apex Court in M/s Construction and Design v. DelhiDevelopment Authority is significant. The case concerned the construction of sewage pumping station within certain time mentioned in the contract. The Appellant failed to adhere by the time limit and was sued for liquidated damages in accordance with the contract. The division bench of Delhi High Court awarded liquidated damages in complete adherence with the contract. The appeal travelled to SC, and the amount awarded was reduced to half in guise of reasonable compensation, despite proof of loss, because the quantum of actual loss was not proved. It is understandable that in construction contracts proof of actual loss is extremely difficult, the court despite being mindful of this held that "the Court has to proceed on guess work as to the quantum of compensation to be allowed in the given circumstances."

There are countless other instances when court/tribunal has jeopardised party autonomy by slicing the amount stipulated in the contract, to cite a few by way of example are M/s Forbes Gokak Ltd. v. CentralWarehousing Corporation and The Chennai Port Trust v. The Chettinad Logistics.

Such instances go right into the tooth of party autonomy and legislature's aim to guarantee commercial certainty to the parties. The court/tribunal largely rewrites or create a new contract to award compensation that it deems appropriate and undermines the interests of parties, which is also latently against the Apex Court ruling in ONGC v. Saw Pipes. It is submitted that parties themselves are best judges to decide on what is appropriate for them in consequence of breach of contract, especially when both sides hold equal bargaining powers and are negotiating at arm's length.

The Contemporary Position In Common Law Jurisdictions

The dance of penalty clause is also premised upon the real intention of the parties. The question often posed is 'whether the parties really intended to deter the breach?' especially in cases where the amount stipulated in the contract does not qualify for genuine pre-estimate of damages. In the absence of guidance from Indian law, the pole star for this grey area is the 2015 judgment of UK Supreme Court in the case of Cavendish Square Holdings BV v. Makdessi. The seven-judge bench, mindful of the complex disposition of contemporary commercial contracts, recognized the liquidated damages clauses that are designed to safeguard commercial interests that are not necessarily compensatory in nature. Therefore, in cases where the amount qualifies neither for genuine pre-estimate nor for penalty (due to lack of intention to deter), but seeks to preserve a larger commercial interest, the clause will be enforceable. To make this possible a novel two-fold test was propounded which posits that clause could be enforceable if:

1) Petitioner had a 'legitimate interest' in the performance of contract by the respondent; and

2) The amount stipulated is not extravagant or unconscionable.

This decision was welcomed with open arms in varied common law jurisdictions namely in Australia, Singapore, Canada, and New Zealand. In Australia one fine example of the same is Paciocco v. Australia and New Zealand Banking Group Ltd., where High Court of Australia considered the payment of late fees charged by banks in credit card contracts, in the light of legitimate interest test propounded in Cavendish. The Court unequivocally held that bank had a legitimate interest in securing prompt repayment, since it would enhance the profitability of its business and attract more customers.

On the same lines, Malaysia, where the Contract law is codified like in India, in Cubic Electronics Sdh. Bhd. v. Mars Telecommunications Sdn. Bhd.^[2], the Federal Court of Malaysia was confronted with the legitimate interest test pertaining to a clause imposing forfeiture of deposits made by prospective buyers in an agreement for sale of a property of Appellant company that was in liquidation. It was held that Appellant company had a legitimate interest in the timely completion of sale of property, that was sought to be protected by the forfeiture clause.

Although, the Indian Courts have not yet had the opportunity to deliberate upon the implications of the Cavendish Judgment, it is humbly submitted that, penalty clause should not be a tool to undermine party autonomy, especially when there is a strong commercial justification for the same. Taking a cue from global trend, when parties with almost equal negotiating powers enter into a contract with their eyes open, a fall out guised as 'reasonable compensation' should not be allowed.

Silhouetted against current business trend globally, the above analysis forecasts doubts on the viability of archaic structure of Section 74. The legislature through 2018 amendment to Specific Relief Act, 1963, by making specific performance of contract a rule, has shown inclination towards respecting party autonomy. The Apex Court in PASL Wind Solutions Private Ltd. v. GE Power ConversionIndia Private Ltd. reaffirmed its strong belief in party autonomy by respecting the choice of domestic parties opting for a foreign forum for arbitration. It seems that India is ready for legislative tweaks in Section 74, which may strengthen it by adding weight to party autonomy and curtailing the scope of judicial interference, so that it lives up to its purport.

The author is an Advocate practicing in Delhi . Views are personal.