Unweaving Liquidated Damages – Chaos Post Kailash Nath

INTRODUCTION:

The Indian Contract Act ("ICA") gives a statutory framework to both unliquidated and liquidated damages ("LD") in Section 73 and 74, respectively. While the law on unliquidated damages have had a foundation established through judicial precedents, law on LD and its assessment have been given diverse interpretations with passage of time. While the basic requirement laid down in Section 74 requires proving of a real loss to seek LD as reasonable compensation, Kailash Nath Associates v Delhi Development Authority reported in (2015) 4 SCC 136 seemed to have watered down the statutory provision of Section 74 and created an enigma - whether LD are to be analyzed based on elements of Section 73 of ICA i.e., whether it is a mandatory requirement to establish actual loss and quantify thereafter?

BACKGROUND MATRIX:

A peak into judicial history, reveals and rightly so that the categorization under Sections 73 and 74 of ICA is clear and distinct and that applicability of LD has been preserved with certain practical constraints.

LD is a quantified sum in written contracts where the parties genuinely pre-estimate damages in cases of specific act/breach and is governed by the provisions of Section 74 of ICA.

Whether an amount is a genuine pre-estimate or is a penal clause are based on factors as laid down in PK Achutan AIR 1957 Ker 47 (Pr. 6) and approved in KP Subrama Sastri (1987) 2 SCC 424:

1. Character of transaction and its special nature,
2. Relative situation of the parties,
3. Rights and obligation accruing from such of transaction, and
4. Intention of the parties.

Since 1960s till 2010s, the Courts have taken a view that:

1. Under Section 74 ICA, it is not justified that an award of compensation is given when breach does not lead to any legal injury
2. That Section 74 ICA, does not dispense with proof of actual loss/damage i.e. quantification
3. That granting of LD to parties who has not suffered actual loss/damage would lead to 'unjust enrichment', which is not permissible de jure.
4. When quantification is not possible, sum named by parties, if, genuine pre-estimate, the same may be taken into consideration as the measure of reasonable compensation, but not if the sum is in the nature of a penalty.

Reference may be made to Fateh Chand AIR 1963 SC 1405 (Pr. 10); Indian Oil vs. Lloyds Steel 2007 (4) Arb. LR 84 (Pr. 41); Maula Bux (1969) 2 SCC 554 (Pr. 6); ONGC vs. Saw Pipes Ltd (2003) 5 SCC 705 (Pr. 68)

THE KAILASH NATH CHAOS:

In 2015, Supreme Court while delivering the Kailash Nath judgement held:

The Kailash Nath judgement seems to imposes a burden upon a party claiming LD:

1. to show actual damage or loss suffered.
2. to show quantification of such damage or loss.
3. Where showing actual quantification is an impossibility, then to show genuine pre-estimate.

As such two stages of burden upon claiming party in effect has diluted the value/importance of section 74 of ICA.

The Kailash Nath case is often perceived to be a spinner to the settled statutory law of LD. Reliance of Kailash Nath, in a rather isolated way, have paved path for interpretations leading to the belief that there is change in law or that Saw Pipes, the forerunner of Kailash Nath, is no longer a good law. [MBL Infrastructure Limited vs. Ircon International Limited; Ultratech Cement 2018 (3) ARBLR 394) Bom (Pr. 74, 77, 79)].

2018 onwards, there have also been several judgements where the Courts have taken a rather practical approach/interpretation of Kailash Nath judgement [Reference to Dhiraj Lakhamashi, 2022 SCC OnLine BOM 1712 (Pr. 19, 24); Devichand Construction, 2022 SCC OnLine Ker 826 (Pr. 7, 10)]:

1. Claiming party to proof in the general sense
2. Estimation/quantification of damage at the time of entering in the contract is in itself evidence of a genuine pre-estimate.
3. Putting a cap on quantification is additional evidence of a genuine pre-estimate
4. Hence no burden upon Claiming party to show genuine pre-estimate
5. No burden upon Claiming party to establish actual loss/quantification unless to the contrary is pleaded/show by party disputing liquidated damages:

THE CLARITY:

The object behind enactment of Section 74 of ICA was to cover situations where at the time of entering into express written contract, parties genuinely believe that:

1. Certain situation may arise during performance in future.
2. Such situations are well defined
3. In such situation, either it will be impossible to assess actual loss or parties do not want to go through adjudicating process of assessment of actual loss
4. Parties quantify the damage and in some cases put a cap on same
5. It is a commercial decision and risk taken with open eyes.

As such, a practical approach to LD, which is not influenced by equity, is the need of the hour. Parties have autonomy to decide on terms and such autonomy under commercial transactions should be maintained. Exceptions may be taken where situation or possibility of unjust enrichment, etc. may be apparent with the burden of proving the same being upon the party disputing LD.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.