Liquidated Damages vs. Penalty: Are Causation and Loss Required?

Topics: Contract, Contract law, Liquidated damages Pages: 8 (2728 words) Published: April 11, 2011
Liquidated Damages v. Penalty
Are Causation and Loss Really Required?,

Pooja Sharma*
In a contract, the parties may name a sum to be payable in the event of breach. If such sum is a genuine pre estimate of loss it is termed liquidated damages, and if it bears no reflection on the loss suffered, it is termed a penalty. Courts are reluctant to enforce penalty clauses and in such cases the sum stipulated is normally reduced. It has been perceptively observed by Fansworth that in comparison to the bargaining power which parties enjoy in negotiating their substantive contractual rights and duties, their power to bargain over their remedial rights is surprisingly limited. They are not at liberty to name an extravagant sum having no relation to the breach, for fear of it being construed as a penalty. It is interesting to contrast this with the law relating to consideration. A man may sell his car for a handful of marbles, and the law cares not, as long as he is satisfied. Yet the law would give no peace to a man who claims ten thousand rupees for failure to deliver a handful of marbles, branding such a clause penal. The Position in England

It is stated in a standard work that the specification of damages by the parties does not exclude the rule that damages for loss are expected to compensate for actual loss suffered. The major distinction between English and Indian law upon the point is that under English law, penalties are irrecoverable. In case of a penal clause, damages will be assessed in the usual way, and the plaintiff may even recover a sum greater than the stipulated amount. In discerning the true nature of the contract and the compensation payable, the court must have regard to the terms and inherent circumstances at the time of the making of the contract and not at the time the breach occurred. The terms used by the parties are not conclusive and the court is not bound by their phraseology. If a term is stated to be a penalty but turns out to be a genuine pre-estimate of loss, it will be treated as liquidated damages. Some rules for determining the true nature of the sum stipulated were laid down by Lord Dunedin in Dunlop Pneumatic Tyre Co. Ltd. v. New Garage and Motor Co. Ltd. : (i) The sum will be a penalty if it is extravagant and unconscionable compared to greatest loss that could conceivably be proved to have followed from the breach; (ii) The clause will be penal if the breach entails not paying a sum of money and the amount to be paid as damages exceeds the sum which ought to have been paid; (iii) There is a presumption that the sum named is a penalty, when a single lump sum is made payable in cases of all breaches, irrespective of their nature or magnitude; and (iv) It is no obstacle to a sum being treated as liquidated damages that the consequences of the breach are such as to make precise pre-estimation an impossibility. However, even under English law, a liquidated damages clause will result in the plaintiff recovering the stipulated sum without being required to prove damage and irrespective of any actual damage, even when actual damage is demonstrably smaller than the stipulated sum. It is stated in the Chitty that the purpose of fixing a sum is to facilitate recovery of damage without the difficulty and expense of proving actual damage; or to avoid the risk of under compensation, where the rules on remoteness of damage might not cover consequential, indirect or idiosyncratic loss; or to give the promisee an assurance that he may safely rely on the fulfillment of the promise. A distinction is drawn between contracts which accelerate an existing liability to pay and those which create or increase liability to pay. The latter are penal, the former are not. In this context, it is also relevant to consider contracts which provide for forfeiture of amounts already paid. If the sum paid is penal and it is unconscionable for the payee to retain the money, equitable relief may be available. However, the...
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