Section 74 of the Indian Contracts Act, 1872 (‘Contracts Act’) deals with enforcement of a Liquidated Damages (‘LD’) clause. However, there is a stark contrast between the actual usage and the proposed legislative intent behind LD. The same is largely rooted in inconsistencies arising out of misinterpretation of case laws through headnotes instead of reading the entire judgment.
A classic case on point is Kailash Nath Associates v. DDA [(2015) 4 SCC 136], more precisely paragraph 43 and in particular paragraphs 43.1, 43.2 and 43.6. The Headnotes of this case are frequently interpreted to mean that LD must withstand the rigours of Section 73 of the Contract Act by proving actual loss, leading to a misconception that proving actual loss is a sine qua non for claiming LD. This article critiques the boiling misrepresentations arising particularly from over-reliance on Headnotes and distorting the interpretation of Section 74, thereby frustrating the commercial purpose of LD clauses.
Section 74 entitles the injured party to receive a pre-determined genuine estimate of losses as compensation upon breach of contract, whether or not actual damage or loss is proven. The legislative intent/ rationale was to simplify contractual enforcement: in a pre-decided event of a breach e.g., delay etc., the injured party may be compensated without having to prove the full extent of the financial damage with precision, i.e., actual loss.
The purpose was to streamline protracted adjudication over loss assessment in the event of a particular type of breach, by quantifying losses upfront and anchoring them in the contract to enable fair and timely compensation. It also works in favour of the breaching party, by protecting them from disproportionate penal consequences and allowing them to factor in potential liability in their quoted bids.
The principle that though compensation presupposes existence of legal injury, Courts are empowered to compensate for losses even in the absence of actual loss finds affirmation in Fateh Chand v. Balkishan Dass [1963 SCC OnLine SC 49; 8, 10 & 15]. Similarly, in ONGC v. Saw Pipes Ltd. [(2003) 5 SCC 705; 64, 67 & 68] it was held that an injured party was not required to lead evidence to prove loss when the parties were aware of the likelihood of loss due to the breach. This places a rebuttable presumption that parties estimating their damages is in itself evidence on the quantum of such loss. Such presumption is good in law unless proved otherwise and such burden of proof is not upon the breacher.
Both judgments presumed LD clauses to be a genuine pre-estimate of loss, unless proven otherwise by the breaching party.
Kailash Nath affirmed that proof of actual loss is not mandatory under Section 74; where LD clause reflects a genuine and reasonable pre-estimate of loss, Courts can award reasonable compensation even without proof of loss, especially where such proof is inherently difficult or impractical. Essentially, when a breach is established and the LD stipulated reflects a reasonable pre-estimate, Courts must lean towards enforcement rather than create unnecessary hurdles. The burden of disproving the validity of LD clause lies upon the breaching party, i.e., the breaching party must establish that the compensation is not a genuine estimate or is not reasonable and that there is a possibility of showing actual loss.
However, the headnote of Kailash Nath as reported in legal data bases has led to widespread confusion and misinterpretation. The headnotes suggest that the requirement of proving actual loss is a mandatory prerequisite to claiming LD, even when LD is stipulated in contract – implying that Sections 73 and 74 require a conjunctive reading. Whereas, a careful reading of paragraph 43 of Kailash Nath reveals a more balanced and practical view: compensation may be granted under a genuine LD clause even in the absence of loss, provided the LD clause is a reasonable pre-estimate of damages. This renders the headnote’s framing potentially misleading and distorts the efficacy of LD clauses through excessive evidentiary requirements. A holistic reading of Kailash Nath reveals that it is also in tandem with Saw Pipes and does not deviate from the established jurisprudence of Fateh Chand.
To rectify the embedded misunderstanding, judgements have clarified that in fact paragraph 43 of Kailash Nath never intended to require proof of actual loss. In cases such as Dhiraj Lakhamashi Shah v. Madhav Hari Karmarkar [2022 SCC OnLine Bom 1712; 19 & 24] and Devichand Construction v. UoI [2022 SCC OnLine Ker 826; 7 & 10], Courts have rightly held that the assessment or quantification of damages at the time of contract formation in itself acts as evidence of a genuine pre-estimate. Moreover, the inclusion of a cap on stipulated LD sum is additional evidence of a genuine pre-estimate. There is no burden upon the injured party to show genuine pre-estimate or to establish actual loss until and unless the contrary is established by the party disputing LD clause. These decisions reaffirm the correct reading of Kailash Nath; otherwise, Section 74 would be rendered meaningless.
Understanding of legal jurisprudence in modern times, particularly in commercial adjudication, is often influenced more by what is reported summarily than what is decided. While headnotes are useful for navigation and to ascertain relevancy of judgment to one’s use, they lack contextual nuance/ accuracy and actual intention of the judgment. Overt reliance on headnotes has resulted in misinterpretation of judgments like Kailash Nath, where the headnote implies a rigid requirement of proving actual loss in ignorance of its actual holding.
Incorporation of an LD clause reflects the mutual consensus that certain types of breach, i.e., contractually defined breach, would trigger genuine losses. Section 74 reference to a “sum named in the contract,” implies that parties have pre-assessed and accepted this amount as a fair estimate.
Worst still, the contractors feel emboldened to now freely challenge LD clauses, eroding their deterrent value on timely contract performance, especially in EPC projects where delay risks are high. The original purpose of LD is undermined when parties are misguided that there is a stringent requirement of proof of actual loss. The unintended shift in judicial understanding, primarily due to headnote reading rather than delving into the judgment’s actual ratio, has significantly disrupted contractual enforcement and meaningful recourses.
Misinterpretation of Section 74, rooted in misread headnotes rather than reliance on judgment text, has led to confusion in law on LD, creating an additional burden which Section 74 does not mandate or imply. A genuine, pre-estimated LD clause is enforceable without the necessity for proving actual damage - the burden of rebutting the presumption of genuineness lies upon the breaching party. Reinforcing such understanding is critical and contractually fair and consistent with commercial certainty. Rectifying the misconception to reflect the true holding of law will restore confidence in contractual enforcement. Section 74 is a tool for certainty and not confusion. To rebuild clarity, the temptation to indulge in case notes or headnotes or summaries must be avoided. Section 74 was never about proving actual loss. Rather, it was about the need to avoid doing so to uphold commercial certainty.
About the authors: Amit Meharia is the Managing Partner of MCO Legals (Meharia & Company). Sambhav Choudhary is a Senior Associate at the firm.
Disclaimer: The opinions expressed in this article are those of the author(s). The opinions presented do not necessarily reflect the views of Bar & Bench.
If you would like your Deals, Columns, Press Releases to be published on Bar & Bench, please fill in the form available here.