Essence of a Well-Drafted Liquidated damages Clause in a Contract enabling Parties to claim Liquidated damages in a commercial dispute

Introduction

There exists a stark contrast between the legal principles surrounding liquidated damages and how these clauses are drafted in practice. Though there exists a divergence between those responsible for preparing contract terms and those who must defend them before the court.

It is essential that provision with respect to liquidated damages must be carefully drafted in order to enable the aggrieved party to enforce clause with respect to liquidated damages.

It is pertinent to note that omission of essential elements while drafting a clause with respect to liquidated damages may undermine the very purpose of incorporating a liquidated damages provision in the contract.

However, a well-written liquidated damages clause in a contract increases the chance of obtaining liquidated damages, which will speed up dispute settlement and reduce the time and expense of long-drawn litigation. A well-drafted enforceable clause reduces the workload of courts.

Requirement of drafting a clear and unambiguous liquidated damages clause in a commercial contract

Notably, in order for a liquidated damages clause to be deemed legitimate and enforceable, it must meet the essential elements. Mere presence of liquidated damages clause in a contract does not guarantee that the aggrieved party will be awarded liquidated damages.

The clause should represent a genuine pre-estimate of the potential loss likely to arise from a breach and a clause should also provide for a true pre-estimate of the possible loss that could result from a breach.

The requirement of a clear and unambiguous clause depicting pre-estimate of the possible loss that could result from a breach by a party to contract, has been discussed by the Supreme Court in its various judgments, viz.

(a) ONGC Ltd. v. Saw Pipes Ltd.¹ (ONGC judgment), Supreme Court observed as under:

67. … In such a situation, if the parties have pre-estimated such loss after clear understanding, it would be totally unjustified to arrive at the conclusion that the party who has committed breach of the contract is not liable to pay compensation. It would be against the specific provisions of Sections 73² and 74³ of the Contract Act, 1872. There was nothing on record that compensation contemplated by the parties was in any way unreasonable. It has been specifically mentioned that it was an agreed genuine pre-estimate of damages duly agreed by the parties. It was also mentioned that the liquidated damages are not by way of penalty. It was also provided in the contract that such damages are to be recovered by the purchaser from the bills for payment of the cost of material submitted by the contractor. No evidence is led by the claimant to establish that the stipulated condition was by way of penalty or the compensation contemplated was, in any way, unreasonable. There was no reason for the Tribunal not to rely upon the clear and unambiguous terms of agreement stipulating pre-estimate damages because of delay in supply of goods. Further, while extending the time for delivery of the goods, the respondent was informed that it would be required to pay stipulated damages.

68. From the aforesaid discussions, it can be held that:

(1) Terms of the contract are required to be taken into consideration before arriving at the conclusion whether the party claiming damages is entitled to the same.

(2) If the terms are clear and unambiguous stipulating the liquidated damages in case of the breach of the contract unless it is held that such estimate of damages/compensation is unreasonable or is by way of penalty, party who has committed the breach is required to pay such compensation and that is what is provided in Section 73 of the Contract Act.

(3) Section 74 is to be read along with Section 73 and, therefore, in every case of breach of contract, the person aggrieved by the breach is not required to prove actual loss or damage suffered by him before he can claim a decree. The court is competent to award reasonable compensation in case of breach even if no actual damage is proved to have been suffered in consequence of the breach of a contract.

(4) In some contracts, it would be impossible for the court to assess the compensation arising from breach and if the compensation contemplated is not by way of penalty or unreasonable, the Court can award the same if it is genuine pre-estimate by the parties as the measure of reasonable compensation.

The ONGC judgment⁴ emphasised that reasonable compensation may be awarded even in the absence of proof of actual loss, provided it does not constitute a penalty or appear excessive, particularly when explicitly stipulated in the contract. While terminology such as “penalty” is not conclusive, it can influence the interpretation of the clause and potentially undermine the award of damages. At best, use of term “penalty” should be avoided.

(b) Similarly, in Ghaziabad Development Authority v. Union of India⁵, Supreme Court observed as under:

5. … In case of breach of contract damages may be claimed by one party from the other who has broken its contractual obligation in some way or the other. The damages may be liquidated or unliquidated. Liquidated damages are such damages as have been agreed upon and fixed by the parties in anticipation of the breach. Unliquidated damages are such damages as are required to be assessed. Broadly the principle underlying assessment of damages is to put the aggrieved party monetarily in the same position as far as possible in which it would have been if the contract would have been performed. Here the rule as to remoteness of damages comes into play. Such loss may be compensated as the parties could have contemplated at the time of entering into the contract. The party held liable to compensation shall be obliged to compensate for such losses as directly flow from its breach.

(c) In State of Karnataka v. Shree Rameshwara Rice Mills⁶, Supreme Court observed as under:

9. … What the Full Bench has failed to notice is that even though the damages become payable on account of breach of conditions of the contract, the liability to pay damages does not fall outside the terms of the contract but within the terms of the contract. The words “any amount that may become due or payable by the first party to the second party under any part of this agreement” have to be read in conjunction with the earlier portion of the clause stipulating liability on the party contracting with the State to pay damages for breach of conditions. Therefore, it follows that though damages become payable on account of breach of conditions of the agreement they nevertheless constitute amounts payable under the contract i.e. under one of the terms of the contract imposing liability to pay damages for breach of conditions. To illustrate the position if the agreement provides for a liquidated sum being paid as damages for breach of conditions instead of a sum to be assessed by the Deputy Commissioner, it cannot be said that the specified damages will not be money due under the contract and hence the damages cannot be recovered under the Revenue Recovery Act. What applies to specified damages will likewise apply to damages which are quantified after assessment. We, therefore, hold that the opinion of the Full Bench insofar as the recovery of damages as arrears of land revenue is concerned is not in accordance with law.

It is noteworthy that a clause providing for liquidated damages must be fair, defensible, and grounded in realistic pre-estimates of loss. The clause ought to be accurate and intended to demonstrate aim of compensating the aggrieved party.

With respect to high-value contracts wherein technical consultants, experts are involved, these professional can assist the parties and draftsmen of potential breaches and estimate the quantum of damages at initial stage of drafting the clause. These professionals should also advise parties regarding need for detailed documentation and calculations since greater the amount of the details and its correlation to the breach is provided in the clause, greater are the chances of the damages being awarded to the aggrieved party.

Essence of succinct pleadings for claim of liquidated damages

Several seminal judgments have stressed the importance of preciseness in pleadings in order to claim liquidated damages from offending party.

In judgment of Fateh Chand v. Balkishan Dass⁷ (Fateh Chand judgment), conclusion reached by the High Court that a forfeiture clause inherently amounted to a deposit for due performance was rejected by the Supreme Court. Supreme Court emphasised that particular pleadings and supporting evidence are necessary for reaching such a determination.

Finding recorded by Supreme Court with respect to aforesaid is reproduced in para 7 of Fateh Chand judgment⁸ and the said para is reproduced as under:

7. … We are unable to agree with the High Court that this amount was paid as security for due performance of the contract. No such case appears to have been made out in the plaint and the finding of the High Court on that point is based on no evidence. It cannot be assumed that because there is a stipulation for forfeiture the amount paid must bear the character of a deposit for due performance of the contract.

In the judgments of Forbes Gokak Ltd. v. Central Warehousing Corpn.⁹ and Belco Enterprises v. DTC¹⁰, Kailash Nath Associates v. DDA¹¹ and in judgment of Hindustan Petroleum Corpn. Ltd. v. Dhampur Sugar Mills¹², the Court have upheld that if the entire amount stipulated is genuine pre-estimate of loss, the actual loss need not be proved.

In judgment of Construction and Design Services v. DDA¹³, Supreme Court held that the burden of proof is on the breaching party to show that no loss was caused due to the breach. The relevant portion of judgment reads as under:

14. … In these circumstances, loss could be assumed, even without proof and burden was on the appellant who committed breach to show that no loss was caused by delay or that the amount stipulated as damages for breach of contract was in the nature of penalty. Even if technically the time was not of essence, it could not be presumed that delay was of no consequence.

Further, the Supreme Court in Kailash Nath Associates v. DDA¹⁴ (Kailash Nath judgment) observed that damage or loss is a sine qua non for payment of compensation for breach of contract. Compensation can only be given only for loss or damage suffered, if the loss or damage is not suffered, law does not provide for a windfall.

Conclusion

Careful drafting of contract and pleadings not only enhances enforceability but also minimises prolonged disputes. Clause with respect to liquidated damages must be carefully drafted in order to enable the aggrieved party to enforce clause with respect to liquidated damages. The underlying idea behind the concept of liquidated damages clause is to not to enforce punitive damages on the defaulting party, rather impose a reasonable compensation for the non-compliance. Omission of essential elements while drafting a clause may undermine the purpose of incorporating the clause in contract. At the time of drafting the clause, the parties must clearly state the intent of parties and events, Method of computation of damages, which would trigger invoking the liquidated damage clause. It is responsibility of the parties to the contract to carefully draft and review the Clause before it is finally inserted in contract. Various judgments of Supreme Court and High Court have discussed that clause providing for liquidated damages should be drafted in such a manner that it depicts a genuine pre-estimate of the potential loss likely to arise from a breach and should also provide for a true pre-estimate of the possible loss that could result from the breach. Further, Supreme Court and High Courts in its judgments have discussed the importance of meticulous drafting of a liquidated damages clause and preciseness in pleadings for enforcement of liquidated damages by aggrieved party from offending party.