Illegal penalty clauses in agreements in India

Author’s note

Penalty clauses are legal in agreements in India. But, certain penalty clauses which are not in relation to breach of contract are not legal.

You can not charge a penalty for omission or comission which does not breach the agreement. Penalty can only be charged for liquidated damages which occur due to a breach of the agreement.

Table of Contents

1. What are penalty clauses?
2. The difference between penalties and liquidated damages.
3. Are penalty clauses enforceable in India?
4. Position in the United Kingdom.
5. Conclusion.

What are penalty clauses?

A penalty clause ensures that the defaulting party to a contract provides damages in the event that the contract is breached.^[1]

Penalty clauses are legally enforceable if they are based on the doctrine of reasonable compensation. This means that the compensation must be proportional to the act that caused the breach of the contract. Damages are mostly rewarded based on what a reasonable man could have foreseen.

For example, A has leased property to B worth 10 crores and the lease deed states that B cannot use the pond in the property. If there is a penalty clause for the same and B does so, A may ask B for reasonable compensation, say 10 lakhs.

Penalty clauses are generally added to a contract to avoid taking a case of breach of contract to the court of law to minimize time and cost. It also serves as a deterrent from breaching the contract. Take the same examples as mentioned above, when B knows that he must pay 10 Lakhs if he touches the pond on the property, he will avoid doing so thus avoiding a breach of contract.

Difference between penalties and liquidated damages

Before answering the question of the legality of penalty clauses, we must first study the difference between compensation, liquidated damages, and penalties.

Are penalty clauses enforceable in India?

The legislature has not made any distinction between the two in India and believes that reasonable compensation must be given in all cases of breach of contract not exceeding the sum mentioned in the contract or in the penalty clause.^[4]

As per Section 74,^[5] In case of Compensation for breach of contract where the penalty is stipulated for, the court always awards reasonable compensation. This section is pro liquidated damages and is against penalty clauses. For the reason being that penalty generally exceeds the damages that have been or may have been sustained by the contracting parties. Another reason is that it is seen as opposed to public policy as no party must profit from a breach of contract.^[6]

The rationale behind awarding damages for breach is to ensure that the disadvantaged party is put in the same position as if there were no breach. Therefore, unjust enrichment is to be avoided by courts. However, in certain circumstances, it is difficult to decide upon a ‘reasonable compensation’ because it is hard to assess the actual loss or damage.^[7]

In the case of ONGC v. Saw Pipes,^[8] the Supreme Court held that courts must consider the terms of the contract before compensation is given. Compensation must be given according to Section 73 of the Contract Act if the terms regarding liquidated damages are:

1. Clear and unambiguous;
2. Not in the nature of a penalty;
3. Reasonable.

It was held in the case of Fateh Chand v. Balkishan Das, that the court may also award compensation for the breach even if there is no proof of actual damage.^[9] It was also held that

“In case of breach of some contracts, it may be impossible for the court to assess compensation arising from the breach, while in other cases compensation can be calculated in accordance with established Rules. Where the court is unable to assess the compensation, the sum named by the parties if it is regarded as a genuine pre-estimate may be taken into consideration as the measure of reasonable compensation, but not if the sum named is in the nature of a penalty.”

Therefore, as long as the penalty is not more than the amount stipulated by the contract, the clause is enforceable. For example, if A must give B 500 kgs of rice at rupees 1000 in two installments and A fails to give the second installment, A owes B rupees 500 for breach of contract (liquidated damages) and if the penalty clause in the contract states any amount more than rupees 500, it is unenforceable.

The duty not to enforce a penalty clause but to the only award, a reasonable compensation has been statutorily imposed by Section 74 upon the courts.^[10] The terms “stipulation by way of penalty” in section 74 refers to cases where a sum named as a penalty is to be paid in the future in case of a breach and not cases where a sum is already paid prior to entering into the contract.^[11]

For example, if the total amount to be paid to buy a house is 8 lakhs and the earnest money is 1lakh, forfeiture of a reasonable portion of earnest money will not amount to a penalty clause, however, in cases where the forfeiture is in the nature of a penalty, section 74 will apply.^[12] This is because ultimately, the earnest money is a part of the purchase price and will have to be forfeited if there is a breach of contract.

Position in the United Kingdom

Since the law on the same is not very clear in India, we may follow the judgments from the UK as it is a common law nation and our laws have their roots in this system.

In a landmark judgment in 2014, the Supreme Court of UK issued a joint judgment in the cases of Cavendish Square Holding BV v. Talal El Makdessi and ParkingEye Ltd v. Beavis^[13] and laid down a test for stating that –

“The correct test for a penalty is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract.”

Further, the penalty need not be a genuine pre-estimate of loss and does not have to be a specified amount, for example, the party relying on this clause can withhold deferred consideration or ask for property in return.

The court also laid down the following principles:

1. The penalty clause must be reasonable in nature
2. It acts as a deterrent to breach of contract
3. The party does not have to suffer an actual loss

However, these rules only apply when there is a breach of primary obligations.^[14] This refers to the obligations between the parties to an agreement only such as between a lender or a borrower, independent of any third party.^[15] A secondary obligation includes a third party and is contingent on the default of the primary obligation such as an agreement between a lender and a guarantor.^[16]

For example, Blends A money, and A is supposed to pay him back within a stipulated period of time and A fails to do so (primary obligation). A’s guarantor, C will have to pay B that money (secondary obligation). Therefore, the penalty clause cannot be enforceable against C.

Conclusion

Therefore, it can be concluded that according to Indian courts, liquidated damages must be reasonable in nature while penalties need not be as they have to be proved eventually. No compensation is awarded if the court concludes that no loss is likely to occur due to the breach of contract.

The position is still vague as a distinction between the two has still not been drawn by the courts or legislature which is why following English precedents is a plausible solution.

1. Dunlop Pneumatic Tyre Co Ltd v. New Garage & Motor Co Ltd [1914] UKHL 1. ↑
2. Black’s Law Dictionary, 2nd edition, The Lawbook Exchange. Ltd., (October 12, 1995). ↑
3. Compensatory Damages: General Damages, Consequential Damages, Punitive Damages, Nominal Damages, Liquidated Damages, https://law.jrank.org/pages/22525/Damages.html. ↑
4. Natesa Aiyar v. Appavu Padayachi (1915) ILR 38 Mad 178. ↑
5. Indian Contract Act, 1872, Section 74. ↑
6. Sakshi Agarwal, Liquidated Damages and Penalty, November 6, 2018, http://lawtimesjournal.in/liquidated-damages-and-penalty/. ↑
7. Maula bux v. Union of India, 1970 AIR 1955. ↑
8. ONGC v. Saw Pipes, 2003(5) SCC 705. ↑
9. Fateh Chand v. Balkishan Das, AIR 1963 SCC 1405. ↑
10. Id. ↑
11. Abdul Gani & Co. v. Trustees of the Port of Bombay I.L.R. 1952 Bom. 747. ↑
12. Kunwar Chiranjit Singh v. Har Swarup A.I.R. 1926 P.C. 1 ↑
13. [2015] UKSC 67. ↑
14. Id. ↑
15. Earl C. Arnold, Primary and Secondary Obligations, University of Pennsylvania Law Review 36, Vol. 74 (1925), https://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=8066&context=penn_law_review. ↑
16. Id. ↑