Liquidated Damages: Settled Law Yet An Unsettling Dispute

Incidentally, it is seen that in most litigation cases arising from standard form contracts, especially those awarded by government agencies, the issue of imposition of liquidated damages continues to be a dominant feature of the dispute between the parties, both in arbitration cases as well as in court proceedings. It is interesting to note that factors giving rise to dispute regarding imposition of liquidated damages in these cases are generally very similar, if not the same. Ironically, while law on this issue is no more res integra and every aspect regarding the employer's right to levy/recover liquidated damages under Section 74 of the Indian Contract Act, 1872 stands settled in various landmark judgments, the practice of levying/recovering liquidated damages by the employer in a most cavalier and routine-like manner and in complete ignorance to the established law of this issue continues even today. In cases of high contract value, the deducted/appropriated amount towards liquidated damages could be substantial and it becomes a major claim/ dispute between the parties.

Therefore, there is a pressing need that in such contracts prior to imposition or recovery of any liquidated damages against the contractor, the employer adheres to the norms and the law set forth on this material issue in various landmark judicial pronouncements of the Supreme Court and the  High Courts, right from the Constitution Bench judgment in Chunnilal V. Mehta & Sons Ltd. v. Century Spinning & Mfg. Co. Ltd.^[1], followed by another Constitution Bench judgment in Fateh Chand v. Balkishan Dass^[2]; and also the law laid down in Maula Bux v. Union of India.^[3]; Union of India v. Raman Iron Foundry^[4]; Hind Construction Contractors v. State of Maharashtra^[5]; State of Karnataka v. Shree Rameshwara Rice Mills^[6]; Arosan Enterprises Ltd. v. U.O.I.,^[7]; BSNL v. Motorola India Pvt. Ltd.^[8]; ONGC Ltd. v. Saw Pipes Ltd.^[9]; J.G. Engineers Pvt. Ltd. v. U.O.I & Another^[10]; Kailash Nath Associates v. Delhi Development Authority & Anr.^[11]; and Welspun Speciality Solutions Ltd. v. Oil and Natural Gas Corporation Ltd. & Ors.^[12]. In these cases, all facets of the legal principles applicable to imposition of liquidated damages have been elucidated and settled. Wherever the imposition of Liquidated Damages has been found to be not in consonance with the established legal principles laid down in these cases, such imposition or recovery of liquidated damages has been held to be illegal and unsustainable in law.

Therefore, to come out with a legally sustainable decision justifying imposition of liquidated damages, regardless of any term contained in the contract authorising the employer to recover liquidated damages consequent upon a delayed performance of the contract (the breach), the following factors and legal principles mandatorily need to be satisfied by the employer:

Entitlement to claim compensation against a breach of the contract by the opposite party is contained in Sections 73 and 74 of the Indian Contract Act 1872. Section 73 of the Contract Act contemplates award of damages for losses suffered by breach of contract by the opposite party, and Section 74 of the Contract Act stipulates that in case a contract is broken and a sum is named in the contract as the amount to be paid in case of such breach, whether or not actual damage or loss is proved to have been caused thereby, the aggrieved party is entitled to receive from the opposite party who has broken the contract, a reasonable compensation not exceeding the amount so named. Reference may be made to the judgment of a Division Bench of  Delhi High Court in Vishal Engineers & Builders v. Indian Oil Corporation Ltd.

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Thus, under Sections 73 & 74 of the Contract Act, before imposing any amount of compensation against a contractor, the primary responsibility of the employer is to fix the liability against the contractor on the basis of cogent facts that the contractor has breached the contract by delaying the performance beyond the stipulated time. Unless such breach is established, the question of imposition of any amount of compensation does not arise at all. In the case of BSNL v. Motorola India Pvt. Ltd. (Supra) while it was contended that the designated authority under the contract had the exclusive right to determine the quantum of liquidated damages and therefore the said issue was not arbitrable, the Supreme Court held that before any such compensation could be levied against the contractor, fixing his liability (of breach) under the contract was BSNL's primary responsibility. In case from the appreciation of facts it was found that the delay was not caused by the contractor, there can be no liability fastened against the contractor to pay any amount of compensation, even if a sum is named in the contract.

It is generally seen that in all cases where contract performance is delayed, immediately after expiry of the stipulated time certain amounts are deducted from the invoices of the contractor on account of liquidated damages in a routine-like and mechanical fashion. Such deductions continue to be made till the maximum deductible amount under liquidated damages clause is achieved, but are subject to a final decision on applicability of liquidity damages at the end of the contract. In most cases, either no final decision on this aspect is made or the decision, if made, does not take into account the delays caused by the employer or by various intervening factors beyond the control of the contractor. The liquidated damages stipulated in the contract is appropriated from the contractor's payable amounts which gives rise to a dispute between the parties. The question which begs an answer is whether the employer's unilateral decision to recover liquidated damages against the contractor in the above manner is legally justified.

On the aspect of the employer's right to impose liquidated damages, a vital law was laid down by the Supreme Court of India in the case of State of Karnataka v. Shree Rameshwara Rice Mills (Supra) followed in the case of J.G. Engineers Pvt. Ltd. v. U.O.I & Another (Supra) which is invariably ignored by the employer. In the Shree Rameshwara Rice Mills case, the Supreme Court has held that “adjudication upon the issue relating to a breach of a contract and adjudication of assessing damages arising out of the breach are two different and distinct concepts, and the right to assess damages arising out of a bridge would not include a right to adjudicate upon as to whether there was any breach at all. It was held that one of the parties to an agreement cannot reserve to himself the power to adjudicate whether the other party has committed breach.”

The above law was subsequently reiterated by the Apex Court in the J.G. Engineers Ltd. case while holding that “the question whether the other party committed breach cannot be decided by the party alleging breach. A contract cannot provide that one party will be the arbiter to decide whether he committed breach or the other party committed breach. That question can only be decided by only an adjudicatory forum, that is, a court or an Arbitral Tribunal.”

Therefore, despite there being an express term in the contract authorising the employer to levy/recover liquidated damages consequent upon a breach, such decision cannot be taken by the employer on its own. Before making any recovery on this account, the employer must get his right of recovery adjudicated by an arbitral tribunal or a Court.

Many a times, it is also generally perceived by the employers that unlike Section 73 of the Contract Act, wherein the loss suffered on account of breach needs to be necessarily proved, liquidated damages can be recovered under Section 74 of the Contract Act without requiring to prove any loss suffered due to the breach. However, the above understanding is not correct. As per Indian law, under both the provisions, i.e. Sections 73 and 74 of the Contract Act, the requirement of proving the loss consequent to the alleged breach is mandatory for claiming any compensation. The Supreme Court in the case of Raman Iron Foundry case (Supra), (followed in many later judgments) held that a claim for liquidated damages for all practical purposes stands on the same footing as unliquidated damages, and thus, it does not give rise to a debt until the liability is adjudicated and damages assessed by a Court or other adjudicatory authority. It was held that the employer did not have any right or authority to appropriate amounts from the pending bills of the contractor towards satisfaction of a claim for damages against the contractor inasmuch as “the breach of contract does not eo instanti incur any pecuniary obligation, nor does the party complaining of the breach becomes entitled to a debt due from the other party. The only right which accrues at that moment is that the party aggrieved by the breach of contract has a right to sue for damages. Thus when damages are assessed, the court in the first place must decide that the defendant is liable and then it should proceed to assess as to what is the damage”.

The above decision in Raman Iron Foundry case has also been followed in a recent judgement of the Delhi High Court in the case of Thar Camps Pvt. Ltd. v. Indus River Cruises Pvt. Ltd^[14].

In the above context, the employer sometimes seeks refuge by referring to the judgment of the Supreme Court in the case of ONGC Ltd. v. Saw Pipes Ltd. (Supra) to contend that as per the interpretation given therein to Section 74 of the Contract Act, liquidated damages can be levied/recovered without requiring to prove any loss that may have been occasioned to the employer due to the breach.

Unfortunately, the above is a misconstrued perception of the said judgement. The correct interpretation of the said judgment in the ONGC case can be found in the Division Bench judgment of the Delhi High Court in the case of Vishal Engineers (Supra), wherein the ratio has been explained in the following words :

“22. … … All that was said (in the ONGC Case) was that the court was competent to award a reasonable compensation in case of breach even if no actual damage is proved to have suffered in consequence of the breach of contract as in some contracts it would be impossible for the code to assess compensation arising from the breach. … …

23. In our view these observations have to be read in the context of the pronouncement of the constitution bench in Fateh Chand case. … … It cannot be read to mean that even if no loss whatsoever is caused to party it can still recover amounts merely by reason of the opposite party being in breach.”

Thus, as per established law, no liquidated damages can be claimed or recovered by the employer merely on the strength of a term in the contract, unless loss suffered due to a breach is actually proved in an adjudication process.

As fixing of the contractor's liability is the primary obligation of the employer before levying any compensation from him, the employer also needs to evaluate all facts and circumstances of the case to see whether delay in performance of the contract was caused by the contractor, or by he employer himself or due to factors beyond the control of the contractor. In all cases where delay has primarily occurred due to reasons attributable to the employer or due to intervening factors beyond the control of the contractor, and in cases where the performance period is extended by the employer without levying any liquidated damages, the contractor cannot be held to be in breach of the contract, and therefore, not liable for any compensation at all.

Another relevant aspect that needs to be borne in mind is that it has been held in various judgments that in contracts where time was either not intended to be of the essence, or it did not remain to be of the essence of contract, no liquidated damages can be levied. As held by the Supreme Court in the cases of Hind Construction Contractors (Supra) and Arosan Enterprises (Supra), if the contract contains terms providing for extension of time for completion or payment of damages in the event of delay, it cannot be said that time was intended to be of the essence of contract. Moreover, if the performance period is extended by the employer without levying any penalty of liquidated damages, it is to be held that time was not of essence in the contract. In all such cases where time is not of the essence, no liquidated damages can be applied against the contractor, and therefore, any decision by the employer contrary to the above legal position is liable to be struck down by the arbitral tribunal or the court as illegal.

In another recent judgement of the Supreme Court in the case of Welspun Speciality Solutions case (Supra), there were certain delays on part of the contractor and extension of time on seven occasions was granted by the employer. On the first two occasions, extension of time was granted without imposition of liquidated damages, and subsequent extensions were granted with liquidated damages. The Court upheld the arbitral award on the ground that since time was not of the essence of contract in the case, liquidated damages could not have been levied against the contractor. It was also held that since the employer had not levied liquidated damages on the first occasion while granting extension of time, the employer was deemed to have waived it's right to levy liquidated damages against the contractor. It was held that once liquidated damages were waived at the time of the first extension, subsequent extensions could not be coupled with liquidated damages unless a clear intention flowed from the contract between the parties to this effect.

Importantly, in the said case, it was also held that while the employer was not entitled to recover liquidated damages as time was not of the essence of contract, he still was entitled to claim compensation under the 2nd para of Section 55 of the Contract Act, 1872 towards the loss that he may have suffered due to the delayed performance of the contract. Of course, the employer must prove the loss suffered due to the delayed performance of work, as proving the loss is a sine quo non to his right to claim compensation.

The next important question is whether the employer in all cases of breach by the contractor can recover the maximum liquidated damages amount mentioned in the contract? On the aspect of measure of liquidated damages consequent upon a breach, the Supreme Court of India has exhaustively laid down the law in Kailash Nath Associates case in the following words:

“43. On a conspectus of the above authorities, the law on compensation for breach of contract under Section 74 can be stated to be as follows:

43.1. Where a sum is named in a contract as a liquidated amount payable by way of damages, the party complaining of a breach can receive as reasonable compensation such liquidated amount only if it is a genuine pre-estimate of damages fixed by both parties and found to be such by the Court. In other cases, where a sum is named in a contract as a liquidated amount payable by way of damages, only reasonable compensation can be awarded not exceeding the amount so stated. Similarly, in cases where the amount fixed is in the nature of penalty, only reasonable compensation can be awarded not exceeding the penalty so stated. In both cases, the liquidated amount or penalty is the upper limit beyond which the Court cannot grant reasonable compensation.

43.2 Reasonable compensation will be fixed on well-known principles that are applicable to the law of contract, which are to be found inter alia in Section 73 of the Contract Act.

43.3. Since Section 74 awards reasonable compensation for damage or loss caused by a breach of contract, damage or loss caused is a sine qua non for the applicability of the Section.

43.4. The Section applies whether a person is a Plaintiff or a Defendant in a suit.

43.5. The sum spoken of may already be paid or be payable in future.

43.6. The expression "whether or not actual damage or loss is proved to have been caused thereby" means that where it is possible to prove actual damage or loss, such proof is not dispensed with. It is only in cases where damage or loss is difficult or impossible to prove that the liquidated amount named in the contract, if a genuine pre-estimate of damage or loss, can be awarded.

43.7. Section 74 will apply to cases of forfeiture of earnest money under a contract. Where, however, forfeiture takes place under the terms and conditions of a public auction before agreement is reached, Section 74 would have no application.”

On the basis of the above discussion, it is apparent that a decision levying liquidated damages can be legally sustainable only if it meets the above legal requirements. Regardless of the contract containing a term for levy or recovery of liquidated damages by the employer consequent upon a delayed performance of the contract, the employer or the authority, firstly, has no legal right to unilaterally decide as to which party has committed the breach. This issue can only be adjudicated by an adjudicatory forum, i.e. a court or an arbitral tribunal. Secondly, merely on the strength of a term in the contract liquidated damages cannot be recovered or appropriated by the employer. Thirdly, in cases where time is not of the essence, liquidated damages cannot be applied against the contractor for delay. Fourthly, in cases where time extension for completion is granted without levy of liquidated damages, the employer is deemed to have waived its right to claim liquidated damages, unless the parties have agreed under the contract for applicability of liquidated damages even after such extension of time for completion of contract. Fifthly, even in cases of breach by the contractor, only reasonable damages can be awarded to the employer upto the maximum amount if liquidated damages named in the contract. And lastly, in cases where time is not of the essence, the employer can still claim compensation under the 2^nd Para of Section 55 of the Contract Act, 1872 provided it proves the loss suffered. A decision imposing liquidated damages which does not conform to the above law and legal principles in not legally sustainable and will be liable to a challenge in arbitration proceedings or in a Court of law.

The author  is an Advocate & Views are personal.