CHAPTER-4

CONCEPT OF FAIRNESS AND REASONABLENESS: A SPECIAL

REFERENCE TO LIQUIDATED DAMAGES AND PENALTY

INTRODUCTION

Section 73 and 74 of the Indian Contract Act, 1872 cannot be discussed in isolation,
as they walk to their destination together. Thus, after a detailed discussion on Section
73 in previous chapter, it will be relevant to discuss Section 74 in detail for the clarity
on the concept of “fairness and reasonableness in the measurement of damages”, as
this section lays down a slightly different rule. The rule is that where a sum is named
in a contract as the amount to be paid in case of breach, regardless whether it is a
penalty or not , the party suffering from breach is entitled to receive reasonable
compensation not exceeding the amount so named. Thus, the named sum constitutes
the maximum limit of liability. This has certain advantages over the English system.
The section dispenses with the necessity of laying down rules for distinguishing
liquidated damages from penalty. Further, according to English Law, the court must
either accept the amount as a whole or reject it as a whole. In India, the court need not
to reject the amount. It may either accept the amount or reduce it to what appears
reasonable.

The term “liquidated damages” is applied to such damages as constitute a liquidated

demand payable in money. If a sum of money is previously agreed upon between the
parties to a contract , to be paid, to either party, in case of breach of such contract
whether or not actual damages is proved to have been caused thereby, it is called
liquidated or stipulated damages which the party complaining of the breach is entitled
to recover.1 Damages are said to be liquidated when they have been agreed and fixed
by the parties. It is the sum, which the parties have agreed by contract as payable on
default of one of them and Section 74 applies to these damages. The right to claim
liquidated damages is enforceable under Sec.74 of the Contract Act and where such a
right is found to exist, no question of ascertaining damages really arises. Where the
parties have deliberately specified the amount of liquidated damages there can be no
presumption that they at the same time intended to allow the party who has suffered

1
Arnold, “Law of Damages”, ed.2nd, (1958), at.p.4.

243
by the breach to give a go-by to the sum specified and claim instead a sum of money
which was not ascertained or ascertainable at the date of the breach. In some cases,
this amount will apply to all breaches, in others only to particular breaches. In some
cases, it will apply to breach by either party, in others only to breach by one particular
party. And sometimes different sums may be stipulated for different breaches,
whether by one or by both parties.

The parties to a contract are rarely in the habit of making provision in the contract for
the damages to be paid on a breach of contract. But if such provisions are contained in
the contract at the time of making the contract, it doesn‟t have any impact on the
application of the rule that damages for breach are intended to compensate for the
actual loss sustained by the plaintiff. Basically, it is the question of proper
construction of the contract, to decide whether a sum fixed under the contract should
be considered as liquidated damages or a penalty. In case, it is interpreted as penalty,
it cannot be recovered, for genuine attempt to liquidate, that is to say, to reduce to the
certainty of the prospective damages of an uncertain amount, where the sum will be
recoverable.

The origin of the rule against penalties found its place in equity, which would relieve
against penalties, cutting them down to the actual damage suffered, but was taken up
and applied by the common law and reinforced by the statute.2 The sum fixed by the
parties, if it is a genuine pre-estimate of the damage, which seems likely to be caused
if the breach provided for would occur will be considered as liquidated damages by
the court. It is a question of construction to be decided upon the terms and inherent
circumstances of each particular contract, judged at the time of making the contract,
not at the time of the breach. 3 Moreover, if it is not an estimate of the probable
damage, the parties had fixed, then that sum because they were agreed in limiting the
damages recoverable to an amount less than that which a breach would probably
cause, it will similarly be accepted by the court.4

Whereas on the other hand, if the sum was fixed in terrorem, the court will consider
the provision to be as a penalty and it will not be enforced. At the time of construction

2
A.W. Brian Simpson, “The Penal Bond”, (1966), 82 L.Q.R., 392, at.p.405.
3
Dunlop Pneumatic Tyre Co. Ltd. v. New Garage &Motor Co. Ltd. (1915), A.C. 79; Phillips Hong
Kong Ltd. v. Att.-Gen o/Hong Kong (1993), 61 B.L.R.41, P.C.
4
Cellulose Acetate Silk Co. Ltd. v. Widnes Foundry (1925) Ltd., (1933) A.C. 20.

244
of the terms „penalty‟ and „liquidated damages‟ when they are included in a contract,
the courts are not bound by the terminology used there, but it will consider the
substance rather than to the form. The parties are at liberty to call the sum specified as
„liquidated damages‟ but if the court considers it to be penalty, then it will be treated
as such. Contrary to this, if the parties have described in this sum fixed as a „penalty‟,
but the court finds it to be genuine pre-estimate of the loss, then it will be treated only
as „liquidated damages‟.5

The recovery of the agreed sum from the party in breach depends upon whether it
constitutes liquidated damages or penalty. When the damages can be recovered as
liquidated damages or when these can be recovered as penalty is a question of fact
and is decided by the courts depending upon the facts and circumstances of each case.
The law related to liquidated damages and penalties, has a very long history, so a brief
description of the development over the centuries in this regard is necessary for the
better understanding of the modern law.

HISTORICAL ASPECT

Originally, the question of penalties arose in relation to the panel bonds. Penal bond is
a bond that requires the obligor to pay a specified sum as penalty if the underlying
obligation is not performed. A penal bond can be termed as penal bill or common-
defeasance bond or conditional bond. Payment of penalty in such a bond is often
required in government contracts. In the context of a penal bond, a bond is the
instrument which binds a party legally to perform a specific act. 6 In strict sense, the
form of a penal bond was a promise absolute to pay a stated sum, which the condition
put into the effect that if the main obligation was performed by certain day, the
promised to pay the money would be considered as void.

The equity courts granted relief by means of restraining any action, which was
brought before it for a penalty, whereas the common law courts recognised and
enforced these penalty bonds. Consequently, the common law courts following suit by
means of a statute of William III in 1697, provided that, in an action upon a bond the
burden of proof was laid on the plaintiff, in such a way that he must allocate one or
more breaches of the obligation upon which the bond was conditioned, and despite the

5
Union Eagle Ltd. v. Golden Achievement Ltd., (1997) 2 W.L.R.341: (1997) A.C.514.
6
www.definitions.uslegal.com/

245
fact that he remained entitled on proving a breach to the judgement for the full
amount of the sum promised in the bond, he could recover only by executing the
amount of the damage is proved to have been sustained by the breach or breaches
allocated, although the judgment would remain as a security for future
breaches.Although the judgement was for the amount promised by the bond, yet this
panel sum was of great significance from the practical point of view that it fixed the
maximum amount which would have recovered upon the bond. This provision has
now vanished from the statute books, and moreover, the purpose of the panel bonds
has also departed from the present scenario. Now, these have an historical interest
only.

Basically, there are two points in this regard, with the help of which the historical
aspect of the concept can be easily understood. These are as follows:-

 Sums agreed to be paid as damages for breach of contract;

 The criterion of the intention of the parties.

A)Sums agreed to be paid as damages for breach of contract

After the introduction of panel bond, the scenario has changed. The position was
reversed as the penalty had been put as the primary obligation in the language of the
agreement. This type of cases first-time appeared in the 18th century, with the
judgement of Lord Mansfield7 by which the law began to take its shape. He observed
as follows: “Agreements secured by penalty or forfeiture, the obligee may either bring
an action of debt for the penalty, and recover the penalty (after which recovery of the
penalty, he cannot resort to the agreement; because the penalty is to be a satisfaction
for the whole) or, if he does not choose to go for the penalty, he may proceed upon the
agreement, and recover more or less than the penalty, totiesquoties”.8This judgement
made it very clear that the plaintiff had an option to elect between suing for the
penalty, or for such damages as he could prove in the ordinary way, although Lord
Mansfield said that equity would relieve against a penalty as opposed to a agreement
“to pay a particular liquidated sum”, but he didn‟t make any suggestion regarding the
fact that, if the plaintiff elected to sue for the penalty, he would not be able to recover
the whole penalty at common law.

7
Lowe v. Peers, (1768) 4 Bur. 2225.
8
Ibid.

246
Until the beginning of 18th century, there was not a single case, which could be
considered as the base of setting up of the principle of liquidated damages. 9 The
proposition (which was found ingrained impliedly in the aforesaid decision) was that
if the sum fixed in the agreement was a pre-estimate of loss, it would not be
considered as penalty and could be recovered as liquidated damages. The option of
election given to the plaintiff in the case of a penalty to sue for the penalty or for
breach of contract ignoring the penalty was retained.10 It was totally a different rule
from those which were applied to the panel bonds was thus laid down, i.e., the
stipulated sum did not fix limit of maximum amount that the plaintiff could recover,
provided that he disregards the penalty and sued in assumpsit for damages.11 Only if
he sued in debt for the penalty itself would he impose a ceiling on his recovery. 12
Regardless of the fact that the statute of William III was applied to the penalty clauses
in contracts as much as to the panel bonds, the rules mentioned above became
established without much being talked about the statute; thus Lord Mansfield did not
achieve success in qualifying his statement in Peers case,13 while referring the statute.
Although, in a good number of cases,14 the statute was introduced in the decisions by
the court and sometimes even specifically, it was pointed out that the statute would be
applicable as much to the penalty clauses in a contract as to the panel bonds,15 yet
usually the statute was ignored. Even Bramwell B had commented on this in a case.16
The observation made by him in this case, was as follows: “So far as the authorities
are concerned, it is incredible that from the first to the last the statute is nowhere
mentioned. It appears as if, the courts have been accurate, as they are forced perhaps
by some remarkable intuition, while not referring to the statute by which they ought to
have been governed. I believe that the reason is that the judges have considered the
terminology “when equity would have relieved”.17

9
Astley v. Weldon, (1801) 2 B. & P. 346; Wallis v. Smith (1882) 21 Ch D 243.
10
Supra note 7.
11
Winter v. Trimmer (1762) 1 W.B.I. 395.
12
Harrison v. Wright (1811) 13 East 343, at.p.348, as per Lord Ellen Borough.
13
Supra note 7.
14
Supra note 9; see also, Harrison v. Wright (1811) 13 East 343, at.p.341, as per Lord Ellen Borough
CJ.; Davies v. Penton (1827) 6 B. & C 216,at.p.224, as per Holroyd and Littledale JJ.; Elphinstone
v. Monkland Iron Co Ltd (1886) 13 R (HL) 98; Clydebank Engineering and Shipbuilding Co. v.
Don Jose Ramos Yzquierdoy Castaneda (1905) A.C. 6,at.p.10.
15
Betts v. Burch (1859) 4 H. & N. 506 at.p.510; Wall v. RederiaktieholagetLuggude, (1915) 3 K.B.
66, at.p.72.
16
Ibid.
17
Ibid.

247
Until 20th century, the statute had disappeared, even before the repeal of the relevant
provision in it, in such a way, that although the results reached in the cases were
consonant with its requirements, it was in practice a dead letter.18

B) The criterion of the intention of the parties

For some time, the courts tried to give good reasons for their inferences in these
contracts by stating that they were just executing the intention of the parties and such
kind of claims required them to give a quick look to the phraseology used in the
contract. Even in Astley‟s case,19 neither the term “liquidated damages” nor the term
“penalty” had been used in the contract, but later on, in Smith‟s case,20 a clause was
held to be a penalty clause because it was considered that the use of such term would
help to prevent the quote from holding that the provision was for liquidated damages,
whereas, contrary to this, was held in Reilly‟s case,21 where it was stated that no case
had been adduced in which a clause had been held to be a penalty where the parties
had used the terminology of liquidated damages.

On the other hand, there was a landmark case,22 where an amount expressly fixed by
the parties to be liquidated damages, was held to be a penalty by the court, proved the
insolvency of such an interpretation by the court. Later on, it was slowly recognized23
and moreover, there was no comprehensively developed test which could take the
place of the test of the intention of the parties. In the end of 19th century, in case of
Wilson v. Love,24 rightly pointed out by the Learned Judge as follows: “The history of
the judgments appears to lead to the conclusion that the courts made a mistake when
they departed in regard to these cases from the general rule that the effect ought to be
given to the terms of the agreement entered into by the parties, and that, when once
the rule was departed from, it became excessively difficult to arrive at any clear rule
on the subject.” And, indeed, the numerous nineteenth-century cases show some
confusion and not uncommon difficulty in reconciling a factor, which must be

18
Cf. Sparrow v. Paris (1162) 7 H. & N. 594, at.p.599.
19
Supra note 9.
20
Smith v. Dickenson, (1804) 3 B. & P. 630.
21
Reilly v. Jones, (1823) 1 Bing. 302.
22
Kemble v. Farren, (1829) 6 Bing.141.
23
Boys v. Ansell (1839) 5 Bing.N.C 390, at.p.396.
24
Wilson v. Love, (1896) 1 Q.B. 626, C.A., at.p.633.

248
acquainted with when relying on them as precedents.25 Conceivably, today they are of
real value only as illustrations of stereo-type situations.

DEVELOPMENT OF MODERN LAW

In the beginning of the 19th century, the law has been reaffirmed for today in a
number of reliable decisions of the House of Lords and Judicial Committee. 26 The
purpose of putting such clauses in agreements is to promote certainty and especially
in commercial contracts, where parties are able to protect themselves, the court is
likely to take the view that what the parties have agreed should normally be upheld
and to take care not to set so stringent a standard which could defeat that purpose. 27In
the beginning of the century, in numerous authoritative decisions of the House of
Lords and judicial committee, the law has been reiterated for today. In 1915, it has
been preserved in Dunlop Pneumatic Tyre Co.‟s case, 28 where Lord Dunedin
reframed in a series of “rules” the principles for ascertaining whether a stipulated sum
is liquidated damages or penalty. Moreover, a brief discussion is required here on
Ford Motor Co. Case.29 In this case, a manufacturer of cars supplies the quantity of
cars and spares parts of the cars to a dealer on the condition that they would not be
sold below the list prices. Sum of $ 50 was payable for every breach as “agreed
damages”. The dealer committed the breach. It was held that the sum fixed was a
penalty. The modern law rests upon this type of cases and rules. 30More importantly,
Kemble‟s case is also relevant here, as in this case the defendant agreed to perform at
the Covent garden theatre for four seasons at $ 3 6s 8d a night. The contract provided
that if either party refused to fulfil the agreement or any part thereof, such party
should pay to the other the sum of $ 1000 as „liquidated damages‟. The defendant
refused to perform during the second season. It was held that the stipulation was
penal. The following statement of Colman J has been treated as a useful modern
summary of what underpins the approach in the Dunlop case. It was as follows:
“whether a provision is to be treated as penalty is a matter of construction to be

25
In re Newman (1876) 4 Ch.D. 724. C.A; see also, Supra note 9.
26
Supra note 3. Also see, Supra note 14.
27
Alfred McAlpine Capital Projects Ltd. v. Tilebox Ltd., (2005) EWHC 281 (TCC), (2005) BLR 271,
at (48).
28
Supra note 3. See also, Clydebank Engineering Co. v. Don Jose RamosYzquierdoy Castaneda, (1905)
AC. 6; Public Works Commissioner v.Hills, (I906) 1 A.C. 368; P.C.; Webster v. Bosanquest,
(1912) A.C. 394P.C.; De Soysa v. De Pless Pol, (1912) A.C. 194. P.C.
29
Ford Motor Co. v. Armstrong, (1915) 31TLR 267 CA.
30
Supra note 4.

249
resolved by asking whether, at the time of entering into contract, the predominant
contractual function of the provision was to deter a party from breaking the contract
or to compensate the innocent party for breach. The contractual function is deterrent
rather than the compensatory can be reduced by comparing the amount that would be
payable on breach with the loss that might be sustained if breach occurred.31

Later on, at the end of this century, the judicial committee in Philips‟ case 32 also
endorsed their approach, while stressing the need for that approach to be realistic. The
House of Lords held that the sum fixed by the parties was a genuine pre-estimate of
the damage, which might ensue and not a penalty.In this case, using a formula based
on estimates, of the loss of return on the capital at a daily rate, the effect of the delay
on related contracts, and increased costs, was said to be sensible. 33The important part
of the speech of Lord Dunedin is worth mentioning here. He pointed out a few
important rules in this respect, which can be mentioned as follows34: -

 It will be held to be a penalty if the sum stipulated for it is extravagant and

unconscionable in amount in comparison with the greatest loss that could
conceivably be proved to have followed from the breach.

 It will be held to be a penalty if the breach consists only in not paying a sum of
money, and the sum stipulated is a sum greater than the sum which ought to
have been paid.

 There is a presumption (but no more) that it is a penalty when a single lump

sum is payable by way of compensation, on the occurrence of one or more of
all of several events, some of which may occasion serious and others trifling
charge than it is presumed that sum is in the nature of penalty.35

 There is no obstacle to the sum stipulated being a genuine pre-estimate of

damage, that the consequences of breach are such as to make precise pre-
estimation almost impossibility.36

Although all these rules are considered as no more than presumptions as to the
intention of the parties; they may be rebutted by evidence of a contrary intention,

31
Murray v. Leisureplayplc (2005), EWCA Civ.963, (2005) IRLR.
32
Supra note 3.
33
Ibid.
34
Anson‟s “Law of Contract”, ed. 29th, (2010), at.p.567.
35
Ibid at.p.568.
36
Ibid at.p.569.

250
appearing from a consideration of the contract as a whole,37 but still these rules have
their own significance, so far as the difference between liquidated damages and
penalty is concerned.

CONCEPT OF LIQUIDATED DAMAGES AND PENALTY UNDER

ENGLISH LAW

There has been an everlastingcontroversy as to whether a provision in a contract that

in the event of one party committing a breach of the covenant he shall be fined in a
certain amount is to be treated as penalty not recoverable in full in equity or as
liquidateddamages literally exercisable. It is a matter of regularincidents that parties to
a contract fix sum of money asbeing payable on a breach thereof, which according to
theirtrue intention, expresses only the maximum amount ofdamages. In such cases
such sum of money is penal in itsnature and intent and at Common law the parties
were notentitled to recover anything more than the actual damagessustained. Whereas
on the other hand, owing to the difficulty inforeseeing the extent of the injury and in
setting a moneyvalue thereon parties may agree upon a certain sum ofmoney as a
fixed measure of damages to be payable incase of a breach of the contract. In this type
of cases, courts oflaw have always treated such a sum as the ascertainedamount of
damages and allowed it to the aggrieved party. Inthe former case, it is called a
“penalty” merely stipulated interrorem against a possible breach of the obligation and
inthe latter “liquidated damages” which can be regarded as agenuine pre-estimate of
the creditor‟s interest in the dueperformance of the obligation.38

There are all the probabilities that the parties to contract may enter into a contract that
a particular sum is payable on the default of one of the parties and if the agreement is
not unbearable as a “penalty”, such a sum should be considered as “liquidated
damages” and is payable by the party in default. In all the other cases where the court
has to assess or quantify the damages or the loss, whether pecuniary or non-pecuniary,
the damages are considered to be “unliquidated”.39

37
Pye v. British Automobile Commercial Syndicate Ltd., (1906) 1 K.B. 425.
38
Clydebank Engineering and Shipbuilding Co. v. Yzquierdoy, (1905) A.C.6.
39
Halsbury‟s Laws of England, ed.4th, (1980) Vol. 12, at.p.415.

251
CONCEPT OF LEQUIDATED DAMAGES AND PENALTY UNDER LAW OF
CONTRACT IN INDIA

Liquidated damages are the active sum named in the contract, which the parties have
themselves calculated, would be a fair compensation for the breach of the contract. It
is a sum which represents a genuine pre-estimate of the loss caused by the breach, that
is, of what is needed to put the plaintiff into as good a position as if the contract had
been performed. “Liquidated damages means that it shall be taken as the sum which
the parties have by contract assessed as that is to be paid, whatever maybe the actual
damages.”40

Before adverting to the principle on which the damages can be granted, it would be
important to go through the provisions of Section 4 and 5 of Indian Contract Act,
1872, which deal with the formation of bilateral contract. The offer may be withdrawn
by a person who had made an offer but it has to be withdrawn before the acceptance
or even if it is accepted before it was communicated to him. It is cardinal principle
that the acceptance should be unconditional and absolute if there is no binding, the
contract between the parties or if the acceptance is neither absolute nor unconditional,
a party would not be entitled to damages. The next aspect, which has to be looked into
for granting of damages, is that the consideration should not be unlawful. The law not
only requires consideration but insist on lawful consideration. The object must also be
lawful. Sec. 23 of the Act, makes it very clear that a crime, which has unlawful
consideration, is void (illegal). This is also seen that at times, damages have to be
asserted if on the basis of terms of contract and if on time, term is essential
ingredient.Sec. 74 of the Indian Contract Act, 1872, lays down a slightly different
rule.

Section 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.”

40
Wallis v. Smith, (1882) 21 Ch D 243, 267, as per Cotten L.J.

252
Explanation: - A stipulation for increased interest from the date of default may be a
stipulation by way of penalty.41

Exception: - When any person enters into any bail-bond, recognizance or other
Instrument of the same nature, or under the provisions of any law, or under the orders
of the (Central Government)42 or of any (State)43 Government, gives any bond for the
performance of any public duty or act in which the public are interested, he shall be
liable, upon breach of the condition of any such instrument, to pay the whole sum
mentioned therein.

Explanation: - A person who enters into a contract with Government does not
necessarily thereby undertake any public duty, or promise to do an act in which the
public are interested.

PURPOSE OF SECTION 74

The purpose of law in framing the original section was to ignore court away with the
distinction between penalty and liquidated damages and two relieve the courts of the
difficult question to which it gives rise. Basically, the purpose of liquidated damages
is to compensate the injured party for the loss suffered. A breach of contract can never
be source of profit. The party who has suffered losses by breach is compensated for
the loss of his bargain, so that his expectations arising out of or created by the contract
can be protected. There are clauses in which contract reduces to writing a sum of
money to be paid as liquidated damages, it means that the purpose behind writing
such a clause is to exclude the right to claim an uncertain sum of money as damages.
The right to claim liquidated damages is enforceable under Sec. 74 of the Indian
Contract Act, 1872 and where right is found to exist, no question of ascertaining that
damages really arises under Section 73 of the Contract Act. It seems that if the parties
have deliberately specified the amount of liquidated damages, then there can be no
presumption that they at the same time intended to allow the party who has suffered
by the breach to give a coup by to the sum specified and claim instead a sum of

41
Substituted for first paragraph of s.74 by s.4, the Indian Contract (Amendment) Act 1899 (6 of
1899). The first paragraph of the section stood as follows before the amendment: “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,
the party complaining of the breach is entitled, whether or not actual damages or loss is proved to
have been caused thereby, to receive from the party who has broken the contract reasonable
compensation nor exceeding the amount so named.”
42
These words were substituted for „Government of India‟ by the A.O. 1937.
43
These words were substituted for „Provincial‟ by the A.O. 1950.

253
money which was not ascertained or ascertainable at the date of breach. 44 “Most
probably, the intention of Legislature in amending the section was to be within its
scope all the cases in which persons ought to be relieved from the strict letter of their
bond on the ground that the stipulation is of a penal nature. While retaining the
language of the original section, the Legislature practically restored the English Law
for any cases not covered by it. Contracts falling within that section are inferentially
declared to be of a panel character, but otherwise the law regarding them is not
affected by the amendment.”45

ORIGIN OF SECTION 74

The basic idea of stipulating a fixed sum as liquidated damages originates from
common law doctrine of damages. Liquidated damages are generally payable in case
of contracts of uncertain value, where it is not easy to assess the damages and decide
the amount of compensation in advance. Here arises a question i.e. why, the courts
allow a plaintiff to recover liquidated damages, thereby ousting the judicial
assessment and awarding damages? In the answer to this question, it can be said that
liquidated damages have a number of advantages such as:

 Liquidated damages make it less likely that there will be serious dispute
between the parties;

 Liquidated damages help the defendant to know in advance what exactly his
liability will be in case of breach of contract;

 In view of administration of justice, liquidated damages save judicial time and

expenses in deciding what damages should be granted to the plaintiff;

 From the plaintiff‟s point of view, liquidated damages avoid the costs of
litigation and the risk of inaccurate assessment by the courts. And moreover,
if liquidated damages are there in the agreement, the party need not to prove
his loss according to the judicially imposed standard, and probably restrictions
such as remoteness and the known recoverability of certain types of losses.

 In addition to the above-mentioned advantages, the courts are not hostile to

liquidated damages because they reflect the compensatory aim of judicially

44
ChuniLal Mehta & Sons v. Cs & M. Co. Ltd., AIR 1974 SC 1265, at.p.1273.
45
Cunningham &Shephard‟s “Contract Act”, ed.11th. (2009), at.p.303.

254
 assessed damages i.e. they are a genuine pre-estimate of the sum needed to
put the plaintiff into as good a position as if the contract had been performed.

The above discussion makes it very clear that the concept of liquidated damages has
emerged due to its advantages to both the parties as well as to the judicial agencies
also.

ANALYSIS OF SECTION 74

 Legislative Changes46

This section was amended in 1899, by Act IV of 1899. The amendment to the share of
addition of the words “or if the contract contains any other stipulation by way of
penalty” after the words “in case of such breach” and the addition of the words “for as
the case may be, the penalty stipulated for” at the end of the first paragraph. The other
additions made were the Explanation and the Illustrations, (d), (e), (f) and (g).47

In the exception to the section, the word “State” it substituted for the word
“Provincial” by A.O., 1950.48

The explanation has been added to Sec.74 by the Amending Act VI of 1899. It does
not purport to make a new change in the law as enunciated in the section, as it stood
in 1872, but only explains and illustrates it. 49 Therefore, the connection that the
explanation does not apply to the present case, in as much as the Kabuliyat in question
is dated much interior to the Amending Act of 1899, has no force in it.50

 The Underlying principle in Section 74

The underlying principle in section 74 is that where a sum is named in a contract as

the amount to be paid in case of breach, regardless whether it is a penalty or not, the
party suffering from breach is entitled to receive reasonable compensation not
exceeding the amount so named. 51 It means that the named sum constitutes the
maximum limit of liability and the court is bound to follow the same. More precisely,
it can be said that the court cannot go beyond that limit while awarding damages.

46
Sanjiva Row‟s, Commentary on The Indian Contract Act, 1872 and Tenders”, revised by
P.N.Kumar, ed.12th, (2013), at.p.1127.
47
Ibid.
48
Ibid.
49
Ibid.
50
DevendraNathGhosh v. SambhuNathPandey, AIR 1925 Pat.64, at.pp.65-66, PLT 440.
51
Dr.Avtar Singh, “Law of Contract Act: (A Study of Contract Act, 1872) and Specific Relief”, ed.11th,
(2013), at.p.520.

255
Moreover, the difference between liquidated damages and penalty has been abolished
in India. The court can grant reasonable compensation, but it should not exceed the
stipulated amount. The liberty which the court has in this regard is that it can knock
down only those agreements which are unconscionable and extravagant.52 And the
court has the latitude to reduce the amount to what appears to be reasonable
inparticular circumstances.53 Whether or not, the party has proved to have suffered
actual loss, is immaterial.54

Advantages of the above-mentioned principle:-

Basically, the above mentioned principle has certain advantages over the English
system. These are as follows:-

 This principle dispenses with the necessity of laying down rules for
distinguishing liquidated damages from penalty.

 As per the English law, the court must either accept the amount as a whole or
reject it in its entirety, whereas in India, the courts need not to reject the
amount.

 The courts in India may either accept the amount or reduce it to what appears
reasonable.

The leading authority of Fateh Chand is worth mentioning here. It was observed by
the Supreme Court in this case as follows: 55 “Section 74 is clearly an attempt to
eliminate the somewhat elaborate refinement made under the English common law in
distinguishing between stipulations providing for payment of liquidated damages and
the stipulations in the nature of penalty. The Indian legislature sought to cut across the
web of the rules and presumptions under the English common law by enacting a

52
PushpendraMotiLal Singh v. Commercial Automobiles, (1999) 2 MPLJ 319 at.p.324. Carl Estate
(P) Ltd. v. Jagadish J.N. Counte, (2005), 4 Bom CR 630.
53
Hence, the right is the right to sue for the breach and not for the amount reserved because the court
has to ascertain its reasonableness. State of Gujarat v. M.K. Patel & Co., AIR 1985 Guj 179;
M.M.T.C. Ltd. v. Sineximco (P) Ltd., (2006) 135 DLT 629, the buyer's failure. In an international
contract to accept delivery of goods because of a fall in prices was held to be not justified. The
seller was not entitled to recover the whole amount specified in the liquidated damages clause. He is
entitled only to be suitably compensated within the limits specified in the contract.
54
This section is not attracted by a panel provision in a consent decree. Jagson international Ltd. v.
Oil & Natural Gas Corpn Ltd.,(2003) 4 Mah LJ 733: (2004) 2 Bom CR 272, the amount fixed in the
contract as liquidated damages was allowed to be recovered, it seemed to have been fixed with due
calculations and was also reasonable. The claimant had not to show any loss. Only the defendant to
show that the claimant had suffered no loss but that was not the case of the defendant here.
55
Fateh Chand v. BalkishanDass, AIR 1963 SC 1405: (1964) 1 SCR 515.

256
uniform principle applicable to all the stipulations naming the amount to be paid in
case of breach and stipulation is by way of penalty.”

 The amount stipulated in the contract is not excessive, but it is a good attempt
to avoid litigation.

 A difficult task of assessment of compensation with precision can be easy now

by applying this principle.

 Another advantage of this principle is that the figures were provided by the
parties gives a good start to overcome the difficulty of proof. Vijay Engineers‟
case56 is a very good example of this. Because the court in this case, had to
reduce the amount stipulated because neither that much loss was proved nor it
was in the neighbourhood of probable loss.57

 One party not to have the judgment power

A party to the agreement cannot be an arbiter in his own cause, because the power to
assess damages is subsidiary and consequential power and not the primary power. 58 In
the interest of justice and equity requirement is that where a party to a contract
disputes breach, adjudication should be by an independent person or body and not by
the other party to the contract. This kind of position will be different in those
circumstances where there is no dispute or there is consensus between the parties
regarding the breach of conditions. In such a case, the officer of the state even though
a party to the contract will be within his rights, in assessing the damages occasioned
by the breach. 59 Even the State could not be a judge in its own cause or its own
arbiter. 60 Thus, the collective effect of the decisions is that when breaches not

56
Vijay Engineers& Developers v. Suryadarshan Coop Housing Society Ltd., (2011) 5 Mah LJ 610
(Bom). Similar statement are to be seen in BSNL v. Reliance Communication Ltd., (2011) 1
SCC394, the court emphasised the desirability of providing in commercial contracts, compensatory
clauses particularly where commercial activities are subjected to regulatory regimes as in the case
of Telecom industry.
57
Ibid.
58
State of Karnataka v. Shree Rameshwara Rice Mills, (1987) 2 SCC 160: AIR 1987 SC 1359.
59
Anchor Lines (P) Ltd. v. Cement Corpn Of India Ltd., (2000) 4 Kant LJ 485, a party to the contract
cannot be arbiter in his own cause; adjudication of disputed question of breach of contract should be
by some independent person or body of persons. The party holding bank guarantee first encashed it
and then gave notice to the other of the alleged breach of contract and adjustment of the guarantee
amount against self-assessed damages. All this was held to be wrong.
60
JG Engineers (P) Ltd. v. Union of India,(2011) 5 SCC 758: AIR 2011 SC 2477, breach of contract
and termination of contract based on exclusion clauses and excepted matters involving the question
as to which party committed breach of delay and whether the contract was validly terminated, could
be decided only by the adjudicatory forum, i.e. court or arbitral tribunal, and not by a party to the
contract.

257
admitted, one of the contracting parties cannot assume to itself the power to claim
compensation for the breach from the other party without their being any adjudication
by an outside agency as to whether there was any breach of contract.

 Both the breach and the right to compensation must be founded

To invoke section 74, the injured party has to prove that there has been a breach of
contract on the part of the other party. And, therefore, this remedy system provided in
the contract should be exercised. In a very famous authority,61 the action against the
defendant was not allowed and it was held by the court that the plaintiff could not take
shelter of the clause, when there was no breach on the part of the defendant. In this
case, the clause was that he would be liable to compensate the plaintiff, if his goods
were rejected by the foreign buyer, but it was found that the goods were rejected, not
because of any inherent effect, but because of the mis-functioning of the containers in
which the goods were shipped to. The plaintiff had filed a suit against the shipping
agent, but did not pursue it. Hence, the action against the defendant was not allowed.
In another case62 also the clause is to the liquidated damages, was not applied by the
court because in this case, the agreement specified damages for certain types of
breach of contract, whereas the breaches alleged were of different nature. Moreover, it
was held by the court in another judgement that the court has to make its own
assessment of the amount of loss caused by the breach and the court is not supposed
to blindly follow the contract clause in awarding damages without any adjudication.63,
Chennai Metropolitan Water Supply & Sewerage Board‟s case 64 is another good
example, in which the contract clauses clearly provided a formula for pre-estimation
of damages in the event of breach. The first extension was granted to the contract and
the second extension was granted subject to the levy of liquidated damages as
provided in the contract. Arbitrator did not proceed accordingly, and the award was
set aside by the court.

NATURE AND EFFECT OF LIQUIDATED DAMAGES

A perusal of this section makes it very clear that even though the parties may, by an
agreement, settle a fixed sum as damages for the breach of contract; the court is not

61
M.M.T.C Ltd. v. Mohamed Gani, AIR 2002 Mad 378.
62
SAIL v. Gupta Brothers Steel Tubes Ltd., (2009) 10 SCC 63.
63
Uma Minerals v. Malabar Cement Ltd., AIR 2003 Ker 146.
64
Chennai Metropolitan Water Supply & Sewerage Board v. Aban constructions (P) Ltd., (2006), 3
CTC 794 (Mad).

258
incapable to grant relief to the party committing default, if it is held that the amount of
damages fixed by the parties is unconscionable or penal. Once it is decided by the
court, it is open to it, to grant such reasonable compensation as the court may deem fit
in those circumstances. The scope and the effect of Sec.74 are very beautifully
considered and observed by the privy Council in BhaiPanna Singh‟s case. 65 The
observation made by Privy Council in this case was as follows:

“The effect of Sec. 74, of Indian contract act of 1872, is that it entitled the plaintiffs to
recover simpliciter the sum of Rs. 10,000 whether as penalty or liquidated damages.
The plaintiffs must prove that damages they have suffered.”66

Actually, the proof of actual damage is considered essential to seek damages. It is

necessary on the part of the innocent party to prove the actual amount of damages
suffered so that, to that extent the amount already paid may be allowed to be
retained. 67 Moreover, it was held by the court in another case that the agreed
liquidated damages in order to be enforced must be the result of a genuine pre-
estimate of damages.68

It appears that the courts should normally carry out the terms of the contract and those
damages as agreed to between the parties, where the clause relating to the award of
damages is consequence of breach of the contract, is an integral part of the contract,
and has been added as a guarantee for the performance of the contract, and the sum
fixed pre-estimate of damages, agreed to by the parties. And the question as to
whether or not the amount fixed in the contract is pre-estimate of damages or is a
penalty is generally determined according to the facts and circumstances of each case.

To understand the effect of Sec.74 more concretely, it is mandatory here to mention

Badhava Singh‟s case,69 where the true effect of Sec. 74 was summarised to some
extent as follows:-

 Merely because a sum is mentioned in the agreement to be so payable on the

breach thereof, the plaintiff cannot be entitled to the entire sum so named
„simpliciter’.

65
BhaiPanna Singh v. Arjun Singh, AIR 1929 PC 179: 1929 ALJ 191.
66
Ibid.
67
MarimuthuGounder v. RamaswamyGounder, AIR 1979 Mad 189, at.p.191.
68
Michel Habib v. Sulaiman E. Taji, AIR 1941 PC 101: 1941 AWR (PC) 63.
69
Badhava Singh v. Charan Singh, AIR 1955 Raj. 87: ILR (1954) 4 Raj. 755.

259
  The plaintiff would be entitled to only “reasonable compensation” which is
also subject to the amount named in the agreement, the maximum.

 The question of „reasonable compensation‟ would depend upon and must be

determined by the facts and the circumstances of each case.

 The effect of the Indian law as mentioned in Sec. 74 is to do away with the
distinction between „penalty‟ and „liquidated damages‟, which has sometimes
given rise to a little confusion under the English law.

 To invoke Sec. 74, it is necessary for the plaintiff to prove the damage
suffered by him, but a liberty is given to the plaintiff in this regard i.e. such
prove may be direct of circumstantial, and need not possess the quality of
arithmetical accuracy.

 The court may grant the entire sum named in the agreement as compensation
if the plaintiff becomes successful in establishing that the sum named in the
agreement is a genuine pre-estimate of the damages, or would otherwise be
reasonable compensation for the breach. Whereas on the other hand, if the
court comes to the conclusion that the amount as fixed in terrorem, or
unconscionable and extravagant, it would be open to the court to award as it
deems fit and reasonable.

 The question whether the amount is a genuine pre-estimate of the

compensation or not, the factor, which the court would consider is „whether
the sum named in the agreement is not disproportionate to the injury caused
and whether the burden evenly and equitably was on both the parties to the
contract‟.

Now, it is more clear that if the court is unable to assess the compensation, sum
named by the parties (if it be regarded as a genuine pre-estimate), may be taken into
consideration as the measure of reasonable compensation, but it cannot be taken into
consideration, if a sum named in the nature of a penalty. Moreover, this section will
be applicable only when a contract has been broken.

However, it may be noted that there are two kinds of the obligation on the part of the
parties to the contract i.e. primary obligation, and secondary obligation. If the primary
obligation under a contract is secured by a secondary covenant to pay a penalty or
liquidated damages, the obligee obtains no option of breaking his primary

260
obligation.Sec. 74 categorically provides that if the obligee sues for recovery of
damage, he cannot recover compensation in excess of the amount of penalty, or
liquidated damages. The obligee may, however, enforce any other remedy open to
him. Thus, he may, if he can sue for specific performance or injunction, and he may
enforce an alternative relief such as a right of re-entry or forfeiture.70 More precisely,
it can be said that Sec. 74 provides for compensation for breach of contract in two
types of cases:-

1. Where the contract names a sum to be paid in case of breach; and

2. Where the contract contains any other stipulation by way of penalty.

Thus, the plaintiff does not get the benefit of this provision, if he fails to make out that
there was legal injury resulting due to the breach attributed to the defendant.

DISTINCTION BETWEEN “PENALTY” AND “LIQUIDATED DAMAGES”

UNDER SECTION 74

The difference between penalties and liquidated damages depends upon the intention
of the parties to be gathered from the languages of the contract. If the intention is to
secure the performance of the contract by the imposition of a fine or penalty, then the
specified sum is a penalty. The essence of penalty is a payment of money as in
terrorem.71Whereas on the other hand, if the intention is to assess the damages for
breach of the contract, it is considered to be liquidated damages. 72 The Courts refuse
to be bound by the mere use of the word “liquidated damages” or “penalty” and will
look to what must be considered, in reason, to have been intended by the parties in
relation to the subject -matter.73

Penalty or liquidated damages cannot be taken as such on merely being so described.

A penalty is a sum of money so stipulated in terrorem, and liquidated damages are a
genuine pre-estimate of damages. They are to be so judged depending upon the facts
of each case. To determine the question whether a particular stipulation in a contract
is in the nature of penalty or liquidated damages, the court must have taken into
account various relevant factors, such as:-

70
Mulluck Chand Mollan v. SurendraNathMajumdar, AIR 1957 Cal.217, at.p.219.
71
KanakKumari v. ChandanLal, AIR 1955 Pat.215, at.p.222; Badhava Singh v. Charan Singh, AIR
1955 Raj.87, at.p.89; Union of India v. VasudeoAggarwal, AIR 1960 Pat.87, at.p.91.
72
Law v. Redditch Local Board, (1892) 1 G.B. 127: 61 L.J.G.B. 172.
73
Magee v. Lavell, (1874) L.R 9 C.P. 107: 43 L.J.C.P. 131.

261
  The character of the transaction;

 The special nature of the transaction, if any;

 The relative situation of the parties;

 The rights and obligations accruing from such a transaction under the general
law;

 The intention of the parties incorporated in the contract; and

 Thatstipulation which is challengedin the court to be penal in nature.

If after such a comprehensive consideration, the court finds that the real purpose for
which the stipulation was included in the contract was that by reason of its oppressive
or harsh character, it may operate in terrorem over the promisor so as to compel him
to fulfil the contract, then the provision will be held to be one by way of penalty. 74
Thus:

 An amount will be considered as penalty if the sum named is excessive and

unconscionable;75

 The amount stipulated will be considered as penalty if the breach consists in

paying of money and the sum stipulated is greater than the sum which ought to
have been paid;76

 The sum named will be considered as a penalty in those circumstances where

a single lump sum is payable as compensation on the happening of one or
more events some of which cause serious damage and other trivial,77 but this is
a mere presumption (nothing more than that). In such cases, one thing is very
sure that separate amounts must be fixed for each possible event.

Whereas on the other hand:

 where it is impracticable to make a precise pre-estimate of damage a sum

stipulated as damages is considered as a true bargain between the parties;78

74
Supra note 55.
75
Supra note 38.
76
Supra note 22, (1824- 34) All ER Rep 641.
77
Elphinstone v. Monkland Iron and Coal Co. Ltd., (1886) II App CAS 332, at.p.342.
78
Imperial Tobacco Co. (of Great Britain and Ireland) Ltd. v. Parsley, (1936) 2 All ER 515, at.p.519.

262
  Even if a precise pre-estimate of the damage is possible, the parties may fix a
sum in the contract to avoid the difficulty and expenses in the assessment of
damages.79

Whether a stipulated sum is penalty or liquidated damages is a question of

construction to be decided upon the terms and inherent circumstances, as they existed
at the time of the contract, and not at the time of its breach.80

Whether a stipulated sum should be considered as „penalty‟ or „liquidated damages‟,

is a question of construction and of law81 and that is why, it should be determined by
the court,82 as per the literal language of the contract. Even though a sum is clearly
stipulated in the agreement, still it can be disregarded if it does not signify the real
nature of the transaction.83 The distinction between the two had been very beautifully
explained by Lord Dunedin in his words as follows84:

1. The court must find out whether the sum stipulated in the contract is a penalty
or liquidated damages in real sense or not, although the terminology used by
the parties to a contract may prima facie be supposed to mean what they say,
yet the expression used in the agreement is not considered as conclusive.

2. The fact, which the court must take into account while determining whether
the sum stipulated is a „penalty‟ or „liquidated damages‟ is that the essence of
both the concepts is totally different. In case of penalty, it is a payment of
money stipulated as in terrorem of the defaulting party, whereas the essence of
liquidated damages is a pre-estimate of damage.

3. As the question whether a sum liquidated his the penalty or liquidated

damages is always question of construction which is decided by taking into
account the terms and inherent circumstances of each particular contract, so it
must be judged on the basis of the time of making of the contract, not at the
time of breach of contract.

79
Distal v. Stevenson ,(1906) 2 KB 345, at.p.350.
80
Public Works Commissioner v. Hills, (1906) AC 368: (1904-07) All ER Rep 919; Fateh Chand v
Balkishan Das (1964) 1 SCR 515, at.p.526: AIR 1963 SC 1405, at.p.1411; Phonographic
Equipment (1958) Ltd. v. Muslu (1961)3 All ER 626.
81
Supra note 24:(1895-99) All ER Rep 325(CA), as per Lord Esher MR.
82
Supra note 3;Robophone Facilities Ltd. v. Blank (1966) 3 All ER 128.
83
Bridge v. Campbell Discount Co. Ltd. (1962) AC 600: (1962) 1 AJI ER 385, at.p.395; as per Lord
Radcliffe, (1962) 2 WLR 439 (HL);Supra note 79.
84
Supra note 3.

263
 4. To support this task of construction, various tests have been suggested, which,
if taken into account, may prove helpful or even conclusive. Such as:-

 If the sum stipulated in the agreement is found to be extra vigilant and

unconscionable in amount in comparison with the greatest loss, which could
conceivably be proved to have followed from the breach, then it will be
considered as a penalty.

 The sum stipulated is a sum greater than the sum, which ought to have been
paid and moreover if the breach consists only in not paying a sum of money,
then it will be considered as a penalty.

 When a single lump sum is made payable by way of compensation, on the

occurrence of one or more or all of several events, and some of which may
occasion, serious and others trifling damage, then it is presumed to be a
penalty. But it is nothing more than a presumption.

Whereas on the other hand:-

 It is no obstacle to the sum stipulated being a genuine pre-estimate of damage,

that the consequences of the breach are such as to make precise pre-estimation
almost impossibility. On the contrary, that is just the situation when it is
probable that the pre-estimated damage was the true bargain between the
parties.

Analysis of the above-mentioned rules proves itself that these rules are nothing but
presumptions regarding the intention of the parties and these may be rebutted by
giving evidence of the contrary intention.85 The payment will be held to be a penalty
if the breach consists only in not paying a sum of money, and the sum stipulated is a
sum greater than the sum which ought to have been paid, but it may not be a penalty
where it is agreed to charge a certain rate of interest with a condition that if the
payment is made, a lesser rate will be accepted; nor where the whole sum becomes
payable in a contract for payment by instalments, in the event of any Instalment
falling in arrears. Where the stipulation is not a stipulation by way of liquidated
damages, as it is in the nature of a penalty, it would not preclude a claim for
unliquidated damages. 86 In case, the stipulation is in the nature of penalty, the

85
Supra note 37.
86
GopaldasJethmal v. Municipality Hyderabad, AIR 1949 Sind 1.

264
aggrieved party is still entitled to invoke the usual remedy of unliquidated damages,
but if the stipulation is one of liquidated damages, the provision excludes the claim of
unliquidated damages for that breach. There may, again, be a conventional sum which
is neither damages nor penalty, but, as it has been called a „liquidated satisfaction‟87
the agreed price of liberty to do or omit something. In such a case there is merely a
conditional or alternative promise which, if not open to any other objection, will take
effect according to its terms.

From the above discussion, it can be concluded that in some cases, the parties are
bound by the true letters of their agreement which should be given effect to, whereas
in other cases, it is inferred that they themselves do not contemplate being bound by
it, and that they do not mean what they have said.It is very categorically pointed out
by Pollock and Mulla as follows88:-

“The nearest approximation to a general test yet arrived at is that so-called liquidated
damages will not be recoverable in full when the court considers that this would be
extravagant or unreasonable having regard to circumstances of the particular case.”

However, in India, the distinction between “penalty” and “liquidated damages” has
been fortunately done away with by a bold stroke of the Legislature, which relieved
the courts in this country of solving the many complex questions which the distinction
has given rise to. 89 Section 74 of the Indian Contract Act makes provision for
payment of compensation in all cases in which the parties named a sum in the contract
amount to be paid in case of a breach thereof, irrespective of the question whether the
sum named is treated as a penalty or liquidated damages.

Four distinguishing features of Sec. 74

This section has four unique features, which have to be borne in mind:

1. Section 74 covers every stipulation contained in a contract whether it be in the

form of payment of a sum named or compensation in any other form which is
to come into operation upon the breach and it would be treated as a penalty;

87
Supra note 77.
88
Pollock and Mulla, “Indian Contract Act”, ed.6th, Reprint (2004), at.p.435.
89
Mackintosh v. Crow, I.L.R. 9 Cal. 692; Brahmaputra Tea Co. v. Scarth, I.L.R. 11 Cal. 550;
DenoNath v. Nibaran, I.L.R. 27 Cal. 423; VengideswaraPuttar v. Chatu Ache:1, I.L.R. 3 Mad. 224;
Nait Ram v. ShibDat, I.L.R. 5 All 238; Union of India v. VasudeoAgarwal, A.I.R. 1960 Pat. 87,
at.p.92.

265
 2. The party complaining of the breach is not entitled to full compensation
stipulated to be paid but he or she can recover only a reasonable
compensation;

3. Such reasonable compensation should not exceed the original expectations of

the parties in any case; and

4. Even though the actual loss or damage has not been sustained from the breach
still such reasonable compensation can be recovered.

In view of the above discussion, precisely, it can be said that where the court after
taking into account all the circumstances of the case finds that the terms, which were
intended to come into operation on a breach of the contract, are in the nature of a
penalty within the meaning of this section or in other words they are harsh, unjust and
unreasonable, it must refuse to enforce them and proceed to assess the damages at a
sum which is reasonable under those circumstances. The court is not bound to allow
the maximum limit stipulated by the parties, it may allow much less than that which is
afforded by the parties.

ANALYSIS OF EXPLANATION

This section has done away with all is difficult questions, and has laid down the rule
of awarding a reasonable compensation, not exceeding the sum so named, for the
penalty named, in a contract. There are certain stipulations like:-

 Stipulation for interest;

 Stipulations for forfeiture of earnest money;
 Stipulations for security deposit; and
 Stipulations for withdrawal of concession;
which are needed to be discussed separately for the better understanding of Section
74.

1. Stipulation for Interest

Considerably the largest numbers of cases decided under this section are
related to stipulation providing for interest. Those stipulations may be divided
into the following five classes90:-

90
Sir DinshahFardunjiMulla‟s, “Indian Contract Act”, edited by AnirudhWadhwa, ed.13 th, (2011),
at.p.233.

266
 I. Stipulations for payment of interest at a higher rate on default on the part of
the debtor to pay the principle or part thereof for interest on the due date, and
these may again be subdivided into:

a.) Stipulations for payment of enhanced interest from the date of the bond, and

b.) Those for payment of such interest from the date of default.

II. Stipulations for payment on default of compound interest, which may be

divided into:

a.) Stipulations for payment of compound interest at the same rate as simple
interest, and

b.) Those for payment of compound interest at a rate higher than simple interest,
or for payment of an increased rate of interest and compound interest at that
rate.

III. Stipulations for payment of interest at a specified rate, if the principal for a
part thereof is not paid on the due date.

IV. Stipulations for payment of interest at a lower rate, if interest paid on due
dates.

V. Stipulations for payment of interest from the date of the bond, but at an
exorbitant rate.

The above mentioned classes of stipulations are needed to be discussed in detail.

Thus, these can be considered as below:-

I. Stipulations for enhanced rate of interest:-

Such a stipulation taking place in a contract may be of a dual character91:-

 It may either provide for payment of interest at an increased rate from the date
of the contract on failure of the debtor to pay on the due date, the interest or
principal or an instalment of principal, or

 It may provide for the payment at a higher rate from the date of default, only.

In the first situation, it has been held that stipulation always 92 amounts to a penalty
and the provision of section 74 applies, so that the court may relieve the debtor,

91
Ibid.

267
andaward only such compensation to the creditor as it deems fit and reasonable in
those circumstances.93 Whereas in the second situation, where the increased interest
stipulated to have operation only from the date of default, the provision has not
generally been regarded as a penalty.94 But in certain cases, a stipulation may be held
to be penal. It will be held to be penal if the enhanced rate is unconscionable or if it is
such as to lead to the conclusion that it could not have been intended to be part of the
primary contract between the parties.95 Consequently, it can be said that the law as to
such stipulation may be mentioned as follows:-

 A stipulation which is for increased interest from the date of the contract is
always in the nature of penalty, and relief will be granted against it.

 Stipulation which is for increased interest from the date of default may be a
stipulation by way of penalty, and whenever it is so, the relief will be granted
under this section.Such a stipulation is panel or not, is clearly a question of
construction depending upon the facts and circumstances of each particular
contract, and it is for the court to decide on such facts.

II. Stipulations for compound interest96

A stipulation in a contract for the payment of compound interest on failure to pay

simple interest at the same way as for payable upon the principal is not a penalty
within the meaning of this section.97 Sunder Koer‟s case98 is the leading authority on
this point, in which it was observed in the words of Lord Davey, as follows:
“compound interest is in itself perfectly legal, but compound interest at a rate
exceeding the rate of interest on the principal money, being in excess of and outside
the ordinary and usual stipulation, may well be regarded as in the nature of penalty.”99

92
Supra note 89.
93
Rameshwar Prasad Singh v. Rai Sham Kishen, (1901) 29 Cal 43, 50; Trimback v. Bhagchand,
(1902) 27 Bom 21.
94
Abdul Gani v. Nandlal, (1902) 30 Cal 15; Jyoti Cold Stores v. Punjab. Financial Corporation, AIR
1973 P&H 38.
95
Umarkhan v. Salekhan, (1892) 17 Bom 106, 113.
96
“The courts do not lean towards compound interest, they do not awarded in the absence of
stipulation; but where there is a clear agreement for its payment it is, in the absence of disentitling
circumstances, allowed”; HariLahuPatil v. RamjiValadPandu, (1904) 28 Bom 371, 377.
97
Ganga Dayal v. BacchuLal, (1902) 25 All 26; Surya Narain v. JagendraNarain, (1892) 20 Cal 360.
98
Sunder Koer v. Rai Sham Kishen, (1906) 34 Cal 150, at.p.158: LR 34 IA 9; MangatRai v. Babu
Singh, (1927) 8 Lah 721: 103 IC 437: AIR 1927 Lah 415.
99
Ibid.

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In such a case, the court may allow compound interest at the same rate as simple
interest.100This is by no means a rule of law and the rate of interest to be allowed as
compensation is still in the discretion of the court.101 The Supreme Court in a very
fine judgement makes it very clear that the stipulation for payment of compound
interest in case of default, interest at the rate of 7 ½% compound was changed to 7%
simple up to the expiry of the period of redemption.102

An agreement to pay compound interest at a rate by no means uncommon cannot be

said to be by way of penalty, and in such a case law does not cast an onus on the
mortgagee to justify.103Moreover, compound interest cannot be refused on the ground
of security field sufficient.104 Similarly mere fact that the rate of interest charged was
high, although the security was good is not sufficient by itself, to raise a presumption
of undue influence. 105 Conversely, the case will be different when the compound
interest is charged on the entire mortgage money while the mortgagee is in possession
of the bulk of the property.106

According to section 74 of the Indian Contract Act, when a contract has been broken,
and if a sum named in the contract as the amount to be paid in the case of such breach,
is avoided on the ground that it is penalty, the party who has broken the contract
should be made to pay reasonable compensation not exceeding the amount so named,
or as the case may be, the penalty stipulated for.107 Thus, it is clear that even if it is
found that the charging of compound interest is penal per se, even in the mortgagee
has to be compensated for the deprivation of compound interest, and such
compensation can extend up to the amount which would be payable if compound
interest is charged. In case, if it is held that the charging of compound interest, in case
of default, at the same rate, is penal, even then, the mortgagee has to be compensated
as contemplated under section 74, and such compensation in the circumstances should
extend up to the full amount payable in case compound interest charged is
stipulated.108

100
Supra note 93.
101
Ram Krishnayya v. VenkataSomayajulu, 146 IC 467 : AIR 1934 Mad.31 (F.B.).
102
Nageshwara Swami v. VishwasundraRao, AIR 1966 SC 370, at.p.373:1966 SCJ 539.
103
Ambalavana v. GowriAmmal, AIR 1936 Mad.871: 170 IC 749:44 M.L.W. 467:1936 M.W.N. 1274
104
KarupasandhuNath v. Panchu, 1933 M.W.N. 408.
105
Sitaram v. Ram Rao, AIR 1951 Nag.91, at.p.92:130 IC 870:30 N.L.J. 213.
106
Jwaya v. Mulraj, AIR 1932 Lah. 252, at.p.253: I.L.R. 13 Lah. 542: 33 Punj.L.R. 172: 136 IC 556.
107
Supra note 46, at.p.1185.
108
M.S.Murthy v. B.S.Raju, AIR 1982, A.P. 313, at.p.315.

269
 III. Stipulations for payment of interest if principal not paid on due date

As the amendment of the present section by Act VI of 1899, no room is left for any
doubt, and now, the law is well settled that where no interest is payable until default,
but there is a stipulation to pay interest at an excessive rate on default, whether from
the date of contract or from the date of default, the stipulation will be considered as
penal in its character and the courts are competent to grant relief. 109In certain cases,
court can come to the conclusion that the stipulation to pay that rate is by way of
penalty, that will only affect the question as to the rate upon which interest would be
payable by the debtor, and it never mean that the debt did not bear any interest.110
Moreover, in some cases a distinction has been drawn between forms of stipulations
to pay interest in case of default to pay the principal. But it has been held that if
interest is to be charged from the date of default, at the ordinary rate, the stipulation is
not in the nature of penalty, but where it is charged from the date of the bond, it is
always penal. If the rate of interest is excessive, again, it can be said that the
stipulation is penal in nature.

IV. Stipulations for payment of interest at reduced rate

Where a bond provides for payment of interest that 24% per annum, with the proviso
that, if the debtor pays interest punctually at the end of every year, the creditor would
accept interest at the rate of 18% per annum, the creditor is entitled on the failure of
payment of interest on the due date to the interest at the higher rate of 24% per
annum. Such a clause is not considered as penal in nature.111

It cannot be said that the reduction in the rate of interest contemplated on actual
payment of instalments amounts to a penalty under section 74 of the Indian contract
act.112 In order to avoid the consequences of the present section all that the mortgagee
need is to reserve the higher rate as payable under the mortgage and to provide for its
reduction in case of punctual payment.113 Merely because the mortgagee is generous

109
Mutthu Krishna v. Shankaralingam, ILR 36 Mad. 229 (F.B.); Subramania v.Subramania, 22 IC.411:
1914 M.W.N. 154; Bishan Chand v. Narain, AIR 1928 Lah. 857, at.p.858:110 IC 311.
110
Ajodhya ParsadBhagat v. GovindMissir, AIR 1946 Pat. 404, at.p.405: 224 IC 65: 27 P.L.T.
464:1946 P.W.N. 349.
111
Kutub-Ud-Din v. Bashir-Ud-Din, (1910) 32 All 448.
112
Administrator General Burma v. M.E.Moola, ILR 5 Rang.573:105 IC 592: AIR 1928 Rang.19.
113
Fitz-Holmes v. Bank of Upper India, AIR 1923, Lah.548, at.p. 551: ILR 4 Lah. 258:77 IC 523:5
L.L.J. 438.

270
enough to offer a concession in certain circumstances, and on certain conditions, it
cannot be said that the contractual rate is penal.

V. Stipulation for payment of interest and exorbitant rate

Whether a stipulation for payment of interest can be deemed as a “stipulation by way

of penalty” within the meaning of this section, if the bond provides for the payment of
interest at one rate from the date of the bond, and that rate is high and exorbitant? This
is the question that comes for consideration under this head. Different courts have
different approaches while deciding this question. It has been held by the High Court
of Calcutta that whether the stipulation to pay interest at the rate of 75% per annum is
a “stipulation by way of penalty”, is a question of fact depending on the
circumstances of each case, and if the court finds that the rate of interest is penal in
nature, the court has power to grant relief under this section.114 In another way, the
proposition which the authorities found in these cases was that the present section can
have no application to the cases like the above, for the simple reason that there cannot
be a stipulation by way of penalty, unless there is another antecedent promise.

Thus, from the above discussion, now it is very clear that the decisions are not
uniform with regard to the fair rate of interest, simple or compound that is to be
followed, notwithstanding the parties‟ agreement.115 But in view of the recent Debt
Relief Acts in the various states and in view of the recent Supreme Court decision in
Nageshwara case,116 it can be submitted that 5% or 6% simple or compound may be
regarded as reasonable and allowable interest in modern days. Now, the courts are
empowered to relieve against excessive interest where:

 The interest is excessive, and

 The transaction is substantially unfair.

2. Stipulations for forfeiture of “earnest money”

So far as the stipulation for forfeiture of earnest money is concerned,it is necessary

here to understand the meaning of earnest money first, only then the forfeiture of the
same can be understood.

114
Krishna Chandra v. Sanat Kumar, ILR 44 Cal. 162; see also Gopeshwara v. Jadao Chandra, ILR 43
Cal. 631.
115
Supra note 46, at.p.1186.
116
Supra note 102.

271
Meaning of Earnest Money

“Earnest money is part of the purchase price when the transaction goes forward.”117 In
some cases, when the parties enter into the contract, they intentionally use the word
“advance” but mere misdescriptionalnomenclature will not conclude the matter. What
may be called “advance” may be “deposit” and what may be termed as “deposit” may
ultimately be proved to be “advance”. In either case, the cardinal rule of interpretation
of the contract is to find out whether the actual intention of the parties will be
applicable. And such an intention can be gathered by the express terms of the contract
or from the conduct and by the surrounding circumstances incidental to such a
contract. But this is not considered as the sole guide for the purposes of determination
of the fact whether the amount should be treated as “earnest money”, or it is just a
“deposit”. If by pleadings or proof, it is established that the amount given by the
depositor as earnest money for the due performance of the contract only then it can be
forfeited by the deposit notwithstanding the breach of the contract by the depositor:
this proposition, however, is subject to the doctrine of reasonableness. 118 For the
clarity on this point, it is necessary here to discuss the basic features of “Earnest
money”.

Basic features of “Earnest Money”

The basic principles regarding “earnest money” can be explained as follows119:-

 It must be given at the moment when the contract is concluded.

 It must be the part of the purchase price when the transaction is carried out.

 It must be present as a guarantee that the contract will be fulfilled or, in other
words, it can be said that it must be given to bind the contract.

 It is only forfeited when the transaction falls through by reason of the fault or
failure of the purchaser.

 Moreover, on default omitted by the purchaser, the seller is entitled to forfeit

the earnest money, 120 unless there is anything contrary in the terms of the
contract.

117
Supra note 46, at.p.1157.
118
Ibid.
119
Supra note 46, at.p.1159.

272
Thus, in a given contract if a sum is paid under the heading “deposit” or “earnest
money” or has to be interpreted as such, according to the intention of the parties, and
is made forfeitable in case of breach, even the courts have to adjudge the reasonable
compensation to which the party would be entitled to, in such circumstances. The
above mentioned features were laid down by the Supreme Court in the case of
Hanuman Cotton Mills121 after reviewing various decisions noted in the judgement,
which includes that of the Privy Council rendered in Chiranjit Singh‟s case. 122
Precisely, it can be said that features of “earnest money” serves basically two
purposes:

 Firstly, it moves in part payment of the purchase money for which it is

deposited; and

 Secondly, but primarily, it is the security for the performance of the

contract.123

Forfeiture of Earnest Money or Deposit

The Supreme Court has drawn distinction between “earnest money” and “security
deposit”, for the application of section 74 to the forfeiture clauses. The distinction was
set to work in Fateh Chand v. Balkishan Das.124 It is very important to discuss the
facts of this case, as considered one of the leading authorities on this point. The facts
of this case are as follows125:-

“There was an agreement between the parties for the sale of certain land and
bungalow for Rs. 1, 12,500. It was provided in the agreement that the buyer had to
pay Rs. 1000 as earnest money and rest of the Rs. 24,000 had to be paid on delivery
of possession. It was further, provided in the agreement that if the buyer failed to pay
the balance price and get the sale deed registered by certain day, the sum of Rs.

120
Shree Hanuman Cotton Mills v. Tata Air Craft Ltd., AIR 1970 SC 1986, at.p.1994 : (1970) 2 S.C.J.
420 : (1970) 2 S.C.A. 482.
121
Ibid.
122
Chiranjit Singh v. HarSwarup, AIR 1926, PC 1.
123
Narendra Kumar Nakhat v. M/s Nandi Hasbi Textile Mills Ltd., AIR 1997, Kant. 185, at.p.187:
1997 (1) Kant. L.J.755.
124
Supra note 55. Happy Home Builders (P) Ltd. v. Delite Enterprises, (1995) 2 AIHC 1320.
Forfeiture of licence fee does not take place automatically on violation of the condition of the
licence. The Commissioner may order forfeiture, either in full or in part, but before that he must
hear the licensee and pass a judgement in accordance with the loss to the Government. Automatic
forfeiture would amount to a penalty, G. Shankar Reddy v. Prohibition and Excise Superintendent,
(1997) 5 ANLT 177.
125
Supra note 51, at.p.525.

273
25,000 would stand forfeited, the agreement would be considered as cancelled and the
buyer shall return possession to the seller. The seller forfeited the above sum because
the buyer defaulted. Moreover, the seller brought an action to recover the possession
and compensation for occupation and use.”

In this case, the seller was allowed to forfeit Rs. 1000 being earnest money and to
retain the sum of Rs. 24,000 also not by virtue of his right to forfeit, but as
representing use value. The defendant did not object to the plaintiff‟s right to forfeit
Rs. 1000 paid as earnest money under the agreement, but contended that Rs. 24,000
was expressly paid out of sale price and the stipulation was in the nature of penalty.
The Supreme Court made it very clear that Rs. 24,000 was not paid as an earnest
money, and it was expressly referred to in the agreement as paid “out of sale price”.
Moreover, no evidence was found regarding the fact that Rs. 24,000 was paid as a
security for the performance of the contract. Thus, in these circumstances, it could not
be assumed that because there was a stipulation for forfeiture of the amount paid must
bear the character of deposit for the performance of the contract. Hence, the plaintiff
was only entitled to retain Rs. 1000 received by him as earnest money. If in any
contract there is no forfeiture clause, then the vendor cannot forfeit earnest money,
and he would be entitled to reasonable compensation only.126

Therefore, in all cases, where there is a stipulation in the nature of penalty for
forfeiture of an amount deposited pursuant to the terms of the contract, the court has
jurisdiction to award such sum only as it considers reasonable, but not exceeding the
amount specified in the contract as liable to forfeiture. 127 There are certain rules

126
Mohammad Sultan v. Naina Mohammad, AIR 1973, Mad. 233.
127
The provision is applicable to every kind of deposit by whatever name it may be called. The words
“any other stipulation by way of penalty” are wide enough to cover all kinds of forfeiture
provisions. Union of India v. ShyamSundarLal, 1963 All LJ 251. Bombay Scrap Traders v. Port of
Bombay, (1994) 1 Bom CR 266, failure on the part of the tenderer to comply with the work order,
forfeiture of earnest money, Held justified. State of Karnataka v. Stellar Construction Co., AIR
2002 Kant.6: (2002) 5 Kant. LJ 474, the road building contract was not paid extra charges because
the claim in respect of thereof, was not found by the Department to be justified. He had received
payment as per contractual terms. He stopped working, and did not resume it in spite of clear notice.
The court said that this amounted to breach. He was not entitled to claim refund of the forfeited
security deposit. New Media Broadcasting (P) Ltd. v. Union of India, AIR 2008 NOC 967 (Del),
contract envisaged specifications of further details, by government, some changes or representation
of bidders were within tender terms, bidder those bead bars excepted refused to sign, right to forfeit
earnest money and claim damages arose. Winmaxx Management Service (P) Ltd. v. UCO Bank,
AIR 2011 Gau 217, buyer failed to pay the whole of the earnest money. Forfeiture of money
actually paid by him held to be justified. Haryana Financial Corporation v. Rajesh Gupta, AIR 2010
SC 338, auction sale of unit, earnest money deposited on assurance that independent approach road
to unit would be provided, but not actually done, the purchaser did not make further payment,
forfeiture of his earnest held to be not proper.

274
regarding the forfeiture of earnest money which the courts must keep in mind while
deciding whether the earnest money should be forfeited or not. These are as follows:-

 Neither the earnest money nor any other kind of deposit, which is liable to be
forfeited, can be subjected to forfeiture if the underlying contract is void.
Moreover, it is refundable under section 65, if the contract is found to be
void.128

 There can be no forfeiture or encashment of bank guarantee where no contract

arises due to the revocation of acceptance or due to any other reason.129

 Forfeiture of earnest money is permissible by way of liquidated damages.130

 There is no absolute right to forfeit the entire amount without the proof of total
extent of loss, when the material on record showed that the extent of loss was
less than the amount held as earnest, forfeiture could not go beyond that.

 No one can be allowed to enrich himself at the cost of the other by taking
advantage of forfeiture clause.131

 Forfeiture of earnest money under a contract of sale, if the amount is

reasonable does not fall within Sec. 74.132

 Forfeiture of earnest money should be allowed only when it is reasonable to

do so.133

 No forfeiture of earnest money should be allowed where extra cost otherwise

can be recovered.134

 No forfeiture of earnest money should be allowed where contract still has not
performed and the amount if forfeited is refundable.135

128
Tarsem Singh v. Sukhminder Singh, (1998) 3 SCC 471: AIR 1998 SC 1400; J.K. Enterprises v. State
of M.P., AIR 1997 MP 68, forfeiture of earnest money on failure of bidder to perform, justified.
129
Food Corporation of India v. Sujit Roy, AIR 2000 Gau. 61. The earnest money of a tenderer was
forfeited before acceptance of the tenderer and conclusion of the contract and the dispute between
the parties was also not related with the contract, a writ petition challenging the forfeiture was held
to be maintainable.
130
Amarjeet Singh v. Zonal manager, FCI, (2002) 4 ICC 47 (P&H), public authority has to exercise its
powers even under the contract fairly and reasonably. Even otherwise, namely, where government
is not a party, the terms relating to forfeiture must be strictly followed and the courts should also
strictly construe them.
131
GattaRattaiah v. Food Corpn. Of India, AIR 2011 AP 65.
132
Supra note 122.
133
Supra note 120. See alsoSupra note 122.
134
State of U.P. v. Chandra Gupta & Co., AIR 2004, Kant 155.

275
  To invoke Sec. 74 it is not necessary that a contract should be broken in its
entirety.

 Forfeiture of earnest money without issuance of a show cause notice is

considered as violation of the principle of natural Justice.136

3. Stipulations forforfeiture ofSecurity deposit

In ordinary course a security deposit is intended to be refunded and the amount in

question is kept in deposit only for the purpose of securing the due performance of the
contract. The said amount is forfeited only when a breach of contract occurs and
results in a legal injury.137 It is not necessary that all the breaches of contract result in
loss, damage or injury, and this would be more so, in cases of commercial contracts,
where for varieties of reasons, the breach may result in profit or in a situation where
there is neither any profit nor any loss.138When the question before the court is one of
the forfeiture of security deposit in case of breach of contract, such sum does not ipso
facto go to the respondent. Union of India v. Rampur Distillery and Chemical Co.
Ltd. 139 is considered to be the leading authority on this point. In this case, the
respondents supplied to the appellants a large quantity of rum. The rum was found not
to conform to the quality stipulated, and was, therefore, rejected by the appellants.
The appellants then cancelled the contract and forfeited the entire security deposit of
Rs. 18,332, which was kept by the respondents for the due performance of the
contract. The breach of contract caused no loss to the appellants. The stipulated
quantity of rum was subsequently supplied to the appellants by the respondents
themselves on the same rate. The High Court was right in rejecting the appellants‟
claim that they are entitled to forfeit the security deposit. The Supreme Court
observed that “the party to a contract taxing security deposit from the other party to
ensure due performance of the contract is not entitled to forfeit the deposit on the
ground of default, when no losses caused to him due to the consequence of such
default”. As stated by the court in this case that the respondents have not proved that
they have sustained any legal injury due to the breach committed by the appellants. If
135
Commr of HR & CE Deptt.v. S. Muthekrishnan, AIR 2012 Mad. 43, the court held that the absence
of any time prescribed for the acceptance could not give the authority and unlimited and
unreasonable period of time. The forfeiture was not proper. And, therefore, the amount forfeited
was refundable. JayantShantilalSanghvi v. Vadodara Municipal Corpn, AIR 2011 Guj 122 (DB).
136
S.R.S. Infra Projects (P) Ltd. v. Gwalior Development Authority, (2010) 2 MPLJ 142.
137
Supra note 46, at.p.1156.
138
Ibid.
139
AIR 1973 SC 1098, at.pp.1098-99.

276
the party complaining is in a position to adduce evidence whereby the court can assess
reasonable compensation, then even without proof of actual loss, damages will not be
awarded and the amount mentioned in the contract will be considered as penalty. In
such circumstances, the respondents are not entitled to forfeit the security deposit.140

4. Stipulation for withdrawal of concessional payments

In so many cases, 141 it was observed that an agreement may allow a debtor to
discharge his larger debt by payment of a lesser sum by instalments or within a
specified time with a stipulation that in default, the full amount of the debt shall be
payable and such a stipulation will not be considered as a penalty. Moreover, it will
be considered in the nature of the withdrawal of a concession.

Application of Section 74 to Consent Decree

Basically, the principle which is applicable to consent decree is that if a creditor

agrees to reduce the amount of its claim on certain conditions, but the agreement
provides that, on the failure of the debtor fulfil any of those conditions, the original
claim shall revive, it is clear that the revival of the original claim is not in the nature
of a penalty. But if, on the contrary, a debtor agrees to pay a sum of money over and
above his original liability, he is entitled to be relieved against what undoubtedly has
to be regarded as penalty.142 Only when a clause or condition of the decree entitled a
party to something, to which he would not have been at all entitled to, in the suit, can
be held to be penal in nature and not otherwise. Thus, Section 74 cannot be invoked to
such decree if that decree makes a provision by way of concession rather than by way
of penalty. For the application of section 74, the requirement is that there must be a
contract; it is immaterial whether the contract is outside the court, or inside the court.
A contract does not cease to be a contract merely by virtue of the fact that decree has
been obtained on that basis. Moreover, where a consent decree gives effect to an
agreement which embodies a right to forfeiture, the court while exercising its
equitable jurisdiction, is competent to grant such relief against forfeiture, as it might
have granted if there had been no consent decree and a suit had been instituted to
enforce the compromise. No distinction has been drawn between the regular court and

140
P.K. Abdulla v. State of Kerala, AIR 2002 Ker. 108 at.p.111: 2001 (3) Ker.L.J. 903.
141
Burjorji v. MadhavLal, (1934) 58 Bom 610: 36 Bom LR 798:152 IC 575: AIR 1934 Bom 379;
Waman v. Yeshwant, (1948) Bom 654: 50 Bom LR 688: AIR 1949, Bom 97; Popular Bank of India
v. CheranjiLal, (1947) All. 201: AIR 1947 All 136:231 IC 275.
142
Supra note 46, at.p.1134.

277
the executing court as regards the jurisdiction to examine the applicability of this
section. While recording a compromise and to pass decree on the basis, the scope of
scrutiny is very limited and all that court can examine is whether agreement is lawful
or not.143But if it is considered that once the compromise is recorded, the court would
be powerless in the matter, the policy of law would be reversed and the object would
be frustrated. Moreover, if it bare reading of Cl. (2) of Sec.2, C.P.C., is taken then it
will be clear that „decree‟ includes a compromise or a consent decree under this
section. It means certainly, such a decree embodies the agreement between the parties
with the courts, command added to it. In spite of the fact, that the decree based on a
compromise or agreement between the parties it does not invite the exercise of
adjudicatory powers and conclusively that reminds the rights of the parties with
regard to the matter in controversy. Such a consent decree, in terms of Sec. 2(2) of
CPC nonetheless remains a decree as a result of the adjudication by the court, and the
principle incorporated in section 74 of the contract act, can never be applied to such a
decree.144 In a case, the court has made it very clear that the executive court had no
jurisdiction to go into the question whether the rate of interest awarded was excessive
or unreasonable. 145 In another case, 146 the court observed that when the parties
submitted before the court and agreed to a decree in terms of the compromise
specifying the liquidated damages and if decree was passed in terms of the agreement,
the judgement debtor could not later on turn around and contended that damages
agreed to were panel in nature. Thus, the very idea of the decree being penal is found
to be foreign to the decree for the rights of the parties settled by the said decree.147

Ultimately, it can be said that the compromise decree is considered to be a creature of

the agreement on which it is based and it is subject to all the incidents of such
agreement that it is a contract with the command of a judge super added to it, and
while construing its provisions the fundamental principles governing the construction
of the contracts, will be applicable. The cardinal principle the construction of the
contract is that the entire contract must be taken as constituting an organic synthesis

143
Order XXIII, Rule 3, Civil Procedure Code, 1908.
144
Supra note 46, at.p.1135.
145
B.V.Basavraj v. N.R.Chandran, (2000) 3 Kant.LJ 195.
146
Sukumaran v. Anthony, (2005) 2 KLT 919.
147
Punjab Woollen Textile Firm v. Bank of India through its Branch Manager, 1991 (1) Punj.L.R. 626,
at.pp. 629, 630: AIR 1992 P&H 158, at.p.161.

278
embodying provisions which balance in the sum of reciprocal rights and
obligations.148

SCOPE AND APPLICABILITY OF SECTION 74

So far as the scope of Sec.74 is concerned, now categorically, it can be stated that this
section deals with the measure of damages in two classes of cases:-

1. Where the contract names a sum to be paid in case of breach (liquidated

damages); and

2. Where the contract contains any other stipulation by way of penalty (penalty).

The second category widens the amplitude of this section. This category would
comprise forfeiture of a right to money, or other property already delivered, such as a
forfeiture of earnest money, security deposit, etc.149 To invoke this section the proof
of actual loss or damage is not the essential condition for awarding reasonable
compensation, whereas under Sec.73 the actual loss or damage which naturally arose
in the course of things has to be proved. The section actually does not do away with
the proof of actual loss or damage, if this is proved; the court may take into account in
awarding “reasonable compensation”. 150 Although this section also deals with
compensation in respect of a breach of contract just like the provision under section
Sec.73, but the contracts dealt with this section are those containing a penalty or a
named sum to be paid in the event of a breach of contract. Whereas the scope of
Sec.73 extends to those contracts also where no named sum or penalty is stated. There
can be certain cases where it is possible that in the same contract, there is a provision
for liquidated damages for some type of breach, and these would therefore fall within
the ambit of Sec.74, while the other types of breach, which are not provided for would
be covered under Sec.73.151 Sec.74 can be invoked only when there is a contractual
breach. There the contract provides for liquidated damages and the arbitrator awards
the full amount named in the contract, the award cannot be said to be bad on the face
of it, as being opposed to Sec.73 and Sec.74 of the Indian Contract Act, because both
the section has provided for reasonable compensation andSec.74contemplates that the
maximum reasonable compensation may be the amount which may be named in the

148
HabibMian v. Mukhtar Ahmad, AIR 1969 All 296 (FB).
149
Supra note 124. See also Supra note 127.
150
MaulaBux v. Union of India, (1970) 1 SCR 928: AIR 1970 SC 1955.
151
Supra note 62.

279
contract.152This section says that the compensation that can be awarded should not
exceed the penalty stipulated for, which will be treated as the ceiling, as it were. As
for the quantification of the compensation, it is a matter entirely for the discretion of
the court subject to the built-in guidance of reasonableness in the award of
compensation. The Supreme Court observed as follows:-

“The measure of damages in the case of breach of a stipulation by way of penalty

under Sec.74 is reasonable compensation not exceeding the penalty stipulated for. In
assessing damages the court has, subject to the limit of the penalty stipulated,
jurisdiction to award such compensation as it deems reasonable having regard to all
the circumstances of the case. Jurisdiction of the court to award compensation in case
of breach of contract is unqualified except as to the maximum stipulated: but
compensation has to be reasonable and which imposes upon the court duty to award
compensation according to settle principles. This section undoubtedly says that the
aggressive party is entitled to receive compensation from the party who has broken
the contract, whether or not actual damage or loss is proved to have been caused by
the breach. Thereby, it merely dispenses with proof of actual loss or damages; it does
not justify the award of compensation, when in consequence of the breach no legal
injury at all has resulted, because compensation for breach of contract can be awarded
to make good loss or damages, which naturally arose in the usual course of things, or
which the parties knew, when they made the contract, to be likely to result from the
breach”.153

The distinction between „liquidated damages‟ and „penalty‟ has been abolished by the
Indian Legislature and therefore, it is not necessary in India for the courts to decide
whether the amount fixed in the contract has been fixed as a penalty or, as liquidated
damages, because the result in either case, is that the courts must determine
reasonable compensation.154 The provision of Sec.74 of the Indian contract act would
not be applicable to the surety bonds executed in favour of the courts. 155 As
mentioned above also, there is nothing in section 74 to limit its application to any

152
Shiva Jute Bailing Ltd. v. Hindley & Co. Ltd., AIR 1959 SC 1357, at.p.1362.
153
Lakshmi Starch Factory Ltd v. Mohammad Ismail, 1968 Ker L.T. 713, at.p.715.
154
N. Hardip Singh v. M/s Hira Films, AIR 1960 Punj.637, at.pp.638,639 : 62 P.L.R. 650.
155
ArjanLal v. PrabashChandre, (1968) 70 Punj.L.R. 237, at.p.241.

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particular form of contract and a consent decree does not become less a contract
between the parties because it is impressed with the seal of the court.156

ANALYSIS OF EXCEPTION ATTACHED TO SECTION 74

Exception: - When any person enters into any bail-bond, recognizance or other
instrument of the same nature, or under the provisions of any law, or under the orders
of the (Central Government)157 or of any (State)158 Government, gives any bond for
the performance of any public duty or act in which the public are interested, he shall
be liable, upon breach of the condition of any such instrument, to pay the whole sum
mentioned therein.

Although this exception provides that the person entering into the bond shall be liable
upon breach of the bond to pay the whole sum mentioned therein, that in ordinary
legal language does not mean that the court, is bound to accept the whole of the
liability to the extent of the amount mentioned in the bond, and pass a decree for the
whole amount.159

Actually, it means that the sum of penalty is the total of the amount of liability beyond
which is liability cannot be stretched. It never means that all the discretion is taken out
of the hands of the courts, so that it cannot reduce the amount of the penalty,
according to the circumstances of the case. 160 To understand the meaning of this
exception more clearly Taluk Board‟s case 161 is very helpful. In this case, a bond
given by market contractor under the provisions of the Madras Local Boards Act has
been held not to be a bond “given under the provisions of any law” within the
meaning of this exception. Another example which is best suited here is the case of
Srinivasa v. Rathanasabapathy, 162 where it was held that a contract with the
municipality for the lighting up a town, whereby it is stipulated that the deposit made
by the creditor should be forfeited on any default made by him carrying out the terms
of the contract does not fall within the four corners of this exception.

156
Supra note 46, at.p.1142.
157
Supra note 42.
158
Supra note 43.
159
Supra note 46, at.p.1189.
160
Secretary of State v. DilsiziahFreres, AIR 1921 Bom. 447, at.p.448: 23 Bom.L.R. 495.
161
President, Taluk Board v. Lakshminarayana, I.L.R. 31 Mad.54.
162
I.L.R. 16 Mad. 474; cf I.L.R. 29 Mad. 118.

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In another case,163 the plaintiff had committed a breach of the contract, whereby Cl.8
of the contract, which gave the discretion to the union of India to forfeit the security
deposit, became operative. It was held that the totality of the circumstances of this
case, such forfeiture, however, would operate as a penalty. But the court in view of
the Exception to Sec.74 of the contract act, 1872, cannot directly relieve the plaintiff
of the hardship on that score.164

SOME COMMON FEATURES BETWEEN ENGLISH LAW AND INDIAN

LAW

Even though there is a difference between liquidated damages and penalty. But it is
not altogether irrelevant to this section. Its importance and relevance can be seen in
the following points:-

 Firstly, its relevance arises from the fact that the amount contemplated by the
parties will be reduced only if it appears to be by way of penalty. Otherwise
the whole of it is recoverable as liquidated damages.

 Secondly, the first explanation to section 74 uses the word “penalty” which
provides that “a stipulation for increased interest from the date of default may
be a stipulation by way of penalty”.

 The best example of the common feature of English common law and Indian
law is given in the decisions of the Supreme Court in ChuniLal‟s case, 165
which is mentioned earlier also, where it has been held that “by providing for
compensation in express terms the right to claim damages under the general
law is necessarily excluded”.

CONCLUSION

Commonly,it happens that while performing a contract, the party may breach the
contract (not necessary wilfully). In such cases, it is not possible to pay the whole of
the total damage as it might lead to the party getting insolvent and bankrupt. To
protect itself from such situations, the clause of „Limitation of Liability‟ is made.
Such clauses limit one‟s liability to a certain amount that has been pre-determined by
the parties which may be to the total cost of the contract or as agreed upon between

163
Union of India v. K.H.Rao, AIR 1976 SC 626, at.p.631.
164
Ibid.
165
Supra note 44.

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the parties. Indian Contract Act, 1872 expressly classifies liability arising by reason of
death or personal injury, fraud or gross negligence as unlimited liability.Whereas,
Section 74 of the Indian Contract Act, 1872 deals with “Limitation of Liability”. The
language of this section provides that when a contract has been broken, if a sum is
named in the contract as the amount 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.The general principle in the English Common Law is that “a genuine
pre-estimate of damages by mutual consent is considered as liquidated damages and
penalty is considered as an act of terrorizing.”Therefore, the English Courts refuse to
enforce it, while awarding the aggrieved party just the reasonable compensation. The
Indian courts on the contrary do not distinguish between liquidated damages and
penalty by just awarding a reasonable compensation to the aggrieved party which
shall not exceed the amount stipulated in the contract.

The Supreme Court of India in the landmark judgment of Oil and Natural Gas
Corporation Ltd. v. Saw Pipes Ltd. 166 laid down certain guidelines for deciding a
reasonable compensation in the event of breach of a contract, which hold as good
position as they had when they were laid down. These guidelines can be summarised
as follows:-

 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;

 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.

 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

166
AIR 2003 SC 2629.

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 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 consequences of the breach
of a contract.

 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, court can award the same if it is genuine
pre-estimate by the parties as the measure of reasonable compensation.

Moreover, in Steel Authority of India v. Gupta Brothers Steel Tubes Ltd. 167 , the
Supreme Court of India observed that“There is neither any hindrance nor we know of
any obstacle for the parties to a contract to make provision of liquidated damages for
specific breaches only leaving other types of breaches to be dealt with as unliquidated
damages. We are not aware of any principle that once the provision of liquidated
damages has been made in the contract, in the event of breach by one of the parties,
such clause has to be read covering all types of breaches although parties may not
have intended and provided for compensation in express terms for all types of
breaches.”168

To conclude this chapter in brief, it can be stated that the purpose of setting liquidated
damages clause in contracts is actually to ascertain a fixed and reasonable
compensation at the time of drafting of the contract and reduce the burden and
expense of assessment of actual damages. It also gives an assurance to the parties to
the contract that the obligations under the contract will be complied with. There are
many landmark judgments which are discussed above lay down rules and guidelines
for providing a reasonable compensation under Sections 73 and 74 of the Indian
Contract Act, 1872. Both the sections should be read together while awarding
damages under a contract. It should also be noted that as far as possible the aggrieved
party should be placed in the same position as it would have enjoyed if the contract
had been performed and reasonable steps should be taken to mitigate the losses.

167
(2009) 10 SCC 63: 2009 (14) SCR 253.
168
Ibid.

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