[Amoga Krishnan. R is an Advocate]
In Cavendish Square Holding BV v. Talal El Makdessi (2015), the United Kingdom Supreme Court eliminated the dichotomy between “genuine pre-estimates” and “penalties” in common law and, with that, recast the contours of the penalty rule. Until then, the reason for the dichotomy at common law between penalties and liquidated damages (“LD”) was that an LD clause was enforceable while a penalty was not. Lords Neuberger and Sumption dyslogistically said this rule was “adventitious”, as a contractual provision could be a pre-estimate of loss, or a penalty, or both, or even neither.
153 years ago, the drafters of India’s Contract Act, 1872 sought to move away from this problematic common law dichotomy. Section 74 of the Indian Contract Act, 1872 (“ICA”) thus stipulated that where a contract named a sum payable on breach, a court will only award reasonable compensation. The provision was agnostic to the character of the provision, i.e., whether it was an LD, a penalty, or something else.
Despite such clear legislative intent, case law has co-opted the phrase “genuine pre-estimate” from common law into section 74, superimposing on the provision the very dichotomy that legislation intended to abolish. As a result, there is no clarity on what constitutes reasonable compensation. This article seeks to humbly add to existing discourse (Swaminathan (2018), Arvind (2024)) on restating section 74.
Overview of Section 74
Section 74 stipulates as follows:
“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.” [Emphasis mine]
In Fateh Chand v. Balkishan Das (1963), JC Shah J observed that section 74 was an attempt to do away with the distinction between LDs and penalties in common law by enacting a uniform reasonable compensation rubric “to all stipulations”. In the author’s opinion, this was a step in the right direction. By saying section 74 applied to all stipulations, the Supeme Court impliedly rejected the idea that there were only two stipulations: LDs and penalties, as in common law. At the time, the locus classicus on stipulated sums in common law was Lord Dunedin’s speech in Dunlop Pneumatic Tyre Co. Ltd. v. New Garage and Motor Co. Ltd. (1914), where he said that the essence of penalty is payment of money “in terrorem” while the essence of LDs is “a genuine covenanted pre-estimate of damage.”
Perplexingly, six years later, the same JC Shah J (who was then Acting CJ) diluted section 74. In Maula Bux v. Union of India (1969), he ruled that where a court is unable to assess compensation, the sum named by the parties may be taken into consideration as the measure of reasonable compensation “if it be regarded as a genuine pre-estimate” but not if it was a penalty. This co-opted the dichotomy in common law to section 74.
In ONGC v. Saw Pipes (2003), MB Shah J ruled that where it was impossible to assess compensation from breach (as was the case there), the court would award the sum named if it is a “genuine pre-estimate” but not if the sum was a penalty or unreasonable. The usage of the term “genuine pre-estimate” once again suggested that section 74 looked to common law.
In Kailash Nath Associates v. Delhi Development Authority (2015), Nariman J restated the law and developed a third category of stipulated sums as below:
- A court will award a “liquidated amount” payable on breach of contract only if it finds that it was a “genuine pre-estimate of damages”.
- “In other cases,” only reasonable compensation not exceeding such liquidated amount will be awarded.
- Where the amount is in the nature of a penalty, only reasonable compensation not exceeding the penalty will be awarded.
Nariman J’s restatement in Kailash Nath was the first time since Fateh Chand where the Supeme Court recognised that section 74 covered all stipulations beyond the traditional dichotomy between LDs and penalties in common law. However, this reclassification into the three categories above was not considered or developed further. In particular, the Supeme Court did not explain how reasonable compensation would be computed for those “other cases” in category (ii). The restatement also continued to refer to “genuine pre-estimate”, suggesting that the common law inquiry was still relevant.
Existing gaps in Section 74 jurisprudence
Case law has elevated the “genuine pre-estimate” rubric to a legal test, which a party claiming the stipulated amount must satisfy. This has two grave implications:
- First, while appearing to be co-opted from common law, Indian law uses the term differently. In Cavendish, Lords Neuberger and Sumption ruled that the “real question when a contractual provision is challenged as a penalty is whether it is penal, not whether it is a pre-estimate of loss”. However, Indian law requires the reverse operation: The claimant must prove that the stipulation is a genuine pre-estimate. This casts an unreasonable burden on the claimant and arguably rewards the contract breaker.
- Second, how a claimant may satisfy a court that a clause is a genuine pre-estimate is not clear. This constrains parties to argue that a clause is a genuine pre-estimate because it not penal—once again superimposing onto Indian law, the traditional common law dichotomy that section 74 sought to disregard.
Thus, current jurisprudence on section 74 is as adventitious as pre-Cavendish common law. Swaminathan (2018) argues that the LD-penalty dichotomy that the drafters of section 74 were keen to avoid has been read into section 74 by Indian courts. He attributes this to the imprecise drafting of an amendment in 1899 to section 74, by which the words “or if the contract contains any other stipulation by way of penalty” were inserted. These words were intended to expand section 74 beyond clauses where only in solido sums were named as payable (such as the payment of a higher rate of interest). But it ended up foisting the common law dichotomy on section 74.
Arvind (2024) argues that the genuine pre-estimate test is “problematic”. He offers four propositions to restate the law:
- First, the relevant inquiry should be what sum would amount to reasonable compensation.
- Second, the sum named in the contract can be treated as reasonable compensation if four conditions are satisfied: (a) the transaction is a bona fide commercial transaction, (b) the sum is proportional to a legitimate commercial purpose, (c) the sum, if framed as a formula, is not outside the parties’ reasonable expectations at the time of contracting, and (d) even in the absence of economic loss, the aggrieved party has lost a contractual right.
- Third, unless all the above conditions are satisfied, compensation only for actual loss should be awarded.
- Fourth, the difficulty in ascertaining actual loss may be overcome with reference to typical losses suffered in similar cases.
Principles that should inform a restatement of Section 74
By virtue of having the common law dichotomy superimposed into section 74, there is a tendency to compute reasonable compensation in accordance with the pecuniary loss caused to the aggrieved party. The inquiry should, however, be broader than that.
Reasonable compensation ought to be assessed by considering the underlying contractual interest that has been harmed. If this contractual interest is only pecuniary (as in sale of goods cases, such as Maula Bux), then compensation for only pecuniary (or actual) loss is required. However, if the interest extends beyond the pecuniary, then a strict reference to pecuniary losses may not be sufficient. If parties have already expended time and effort and stipulated the value of this interest in the contract, then that figure ought to be the starting point. In all cases, the court would have the power to scale down the compensation.
There are at least two reasons to support this reading:
- First, there are deliberate differences between the drafting of sections 73 and 74. Section 73 codifies the common law rule in Hadley v. Baxendale. It says when a contract has been broken, the aggrieved party is entitled to receive “compensation for any loss or damage caused to him thereby….” This distinguishes between the breach of contract and compensation for loss or damage caused by the breach of contract. By contrast, section 74 does not speak of the aggrieved party being reasonably compensated for any loss or damage caused by the breach. The provision simply says the aggrieved party is entitled to reasonable compensation when the contract names a sum payable. Accordingly, there is basis to argue that section 74 is not restrictively concerned with just the pecuniary loss caused by the breach. Accordingly, compensating the harm caused to a party’s contractual interest with reference to the sum fixed by the parties would still be reasonable compensation.
- Second, case law from High Courts (“HC”) suggests that they are moving towards this type of inquiry. In Dhiraj Shah v. Madhav Karmarkar (2022), the Bombay HC upheld an award which directed a developer to pay stipulated monthly charges and contractual “penal charges” to the owners of a plot following the developer’s delay in providing the owners with permanent alternative accommodation. The developer had argued that the owners ought to have proved their losses. Dismissing this objection, Kulkarni J held that the contract was based on the principle that a party deprived of a home should be adequately compensated, and that a clause entitling it to rent, “penal rent”, etc. was not ill-conceived.[1] Similarly, in Quadrant Televentures v. ATC Telecom (2024), the Delhi High Court upheld an award granting a claim for “exit penalties” in light of a breach of a lock-in stipulation in a telecoms master services agreement. The arbitral tribunal had held that lock-ins act as a security and cover the costs invested by parties—thus protecting a party’s contractual interests.
Conclusion
The reasonable compensation rubric in section 74 sowed the legislative seeds for a unique legal framework on stipulated damages. In order to capitalise on this vision, jurisprudence must focus on developing doctrine that can be applied to all categories of stipulated sums, without being trapped by the traditional dichotomy between LDs and penalties.
– Amoga Krishnan. R
[1] Though the case was appealed, the parties settled. See Dhiraj Lakhamshi Shah v. Madhav Hari Karmarkar, Commercial Appeal (L) No. 28352 of 2022 along with Interim Application No. 4296 of 2022 and Commercial Appeal (L) No. 29351 of 2022 along with Interim Application No. 4298 of 2022 (unreported).