Contractual penalty clauses: Supreme Court weighs in :- Shardul Amarchand Mangaldas & Co

Introduction

In 2015 the Supreme Court(1) settled the law on contractual penalty clauses. In essence, the term 'contractual penalty clause' refers to a clause in a contract whereby a party in breach of an obligation under the contract is required to pay the other party an amount which is greater than the reasonable proportion of the damage or loss suffered due to such breach.

This update captures the legal framework surrounding contractual penalty clauses in India.

Contractual penalty clauses in India

While common law has a significant role to play in the development of contractual liability in India, contract law is largely codified under the Contract Act 1872. Chapter VI of the Contract Act deals with the consequences of a breach of contract. Section 73 provides for compensation for immediate and direct loss or damage caused by breach of contract in the nature of unliquidated damages. Section 74 applies to contracts with a predetermined damages clause. However, under this section, the courts will award the aggrieved party only reasonable compensation, not exceeding the pre-estimate or penalty stipulated. In view of the same, two questions arise in relation to a contractual penalty clause:

• Are the damages sought of a penal nature and what is the criteria for determining the same?
• Assuming that a clause is of a penal nature, is it enforceable in India?

Case overview

In 2015 the Supreme Court had to address whether a clause providing for forfeiture of the earnest sum was considered a penalty and whether it was enforceable.

In this case, the respondent (the Delhi Development Authority) allotted plots to the highest bidder in accordance with an allotment agreement, which provided that 25% of the consideration was to be paid upfront by the highest bidder, and the remaining amount was to be paid within a stipulated timeframe. The appellant (Kailash Nath) failed to pay the remaining amount. Consequently, the respondent forfeited 25% of the total amount paid as earnest money. One of the issues before the court was whether the respondent's 25% forfeiture was penal in nature in view of the fact that the respondent had earned profit by re-auctioning the plot. While allowing the appeal, the court set out the following tests:

• If the contract provides for a sum as a liquidated amount payable by way of damages, the liquidated amount will be given only if it is a genuine pre-estimate of damages fixed by both parties and found to be such by the court. The amount awarded cannot exceed the amount stated in the contract.(2)
• In cases where the amount fixed is penal in nature, only reasonable compensation can be awarded, not exceeding the penalty so stated.(3)
• Reasonable compensation will be fixed on well-known principles that apply to the law of contract, which can found in, among other places, Section 73 of the Contract Act.(4)
• Where it is possible to prove actual damage or loss, such proof cannot be discounted. It is only in cases where damage or loss is difficult or impossible to prove that the liquidated amount named in the contract, if it is a genuine pre-estimate of damage or loss, can be awarded.(5)

Comment

The Indian courts have removed the distinction between liquidated damages and penalty insofar as awarding the eventual sum is concerned. In all cases, where there is either a stipulation in the nature of a genuine pre-estimate of damage or a stipulation in the nature of a penalty, the court has jurisdiction to award such sum only as it considers reasonable, but not exceeding the amount specified in the contract (either as a genuine pre-estimate of damage or a penalty).

For further information on this topic please contact Saanjh Purohit, Sanyam Saxena, Aishvary Vikram or Nimrah Alvi at Shardul Amarchand Mangaldas & Co by telephone (+91 11 4159 0700) or email (saanjh.purohit@AMSShardul.com, sanyam.saxena@AMSShardul.com, aishvary.vikram@AMSShardul.com or nimrah.alvi@AMSShardul.com). The Shardul Amarchand Mangaldas & Co website can be accessed at www.amsshardul.com.

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Endnotes

(1) Kailash Nath Associates v DDA (2015) 4 SCC 136.

(2) Supra, Para 43.1.

(3) Supra, Para 43.1.

(4) Supra, Para 43.2.

(5) Supra, Para 43.6.