Commercial Law Monologues: Conditional Primary Obligations and Section 74 of the Indian Contract Act - Testing Cavendish v. Makdessi in India

Lord Diplock explained in Photo Production Ltd. v. Securicor Transport Ltd., reported at [1980] 2 WLR 283, that “Every failure to perform a primary obligation is a breach of contract. The secondary obligation on the part of the contract breaker to which it gives rise by implication of the common law is to pay monetary compensation to the other party for the loss sustained by him in consequence of the breach… …”

In English law, the enforceability of an obligation to pay a sum of money triggered on the breach of a contract has been generally tested based on whether the sum stipulated is a penalty or liquidated damages. [See Dunlop Pneumatic Tyre Co Ltd v. New Garage and Motor Co Ltd, reported at [1915] AC 79, at pages 86 and 87].

For example, in Scandinavian Trading Tanker Co Ab v. Flota Petrolera Ecuatoriana, reported at [1983] 2 AC 694, at page 702, Lord Diplock held that a “penalty clause is one which provides that upon breach of a primary obligation under the contract a secondary obligation shall arise on the part of the party in breach to pay to the other party a sum of money which does not represent a genuine pre-estimate of any loss likely to be sustained by him as the result of the breach of primary obligation but is substantially in excess of that sum.”

The principles underlying the penalty rule under English law were revisited in Cavendish Square Holdings BV v. Talal El Makdessi, reported at [2015] UKSC 67 (“Cavendish”). In Cavendish, the Supreme Court of the United Kingdom (“UKSC”) held that the test for determining whether a contractual provision is a penalty is “whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.”

More importantly, in Cavendish, the UKSC also held that a contractual stipulation may not impose an obligation to perform a specific act, but may provide that, if a specific act is not performed, the contracting party would have to pay a specified sum of money. The obligation to pay such a sum of money would be a “conditional primary obligation”. It was also held that a conditional primary obligation can sometimes be triggered on the breach of a primary obligation as well.

Whether a contractual obligation to pay a specified sum of money is a conditional primary obligation or a secondary obligation would be a matter of construction of the contract, based on the principles laid down in several English cases, some of which are reflected in Cavendish. For example, if there is an overwhelming commercial justification for prescribing such a conditional primary obligation, the objective of which is far beyond compensating the innocent party for the loss suffered from the breach, and its dominant purpose is not to penalize the contract-breaker. A price adjustment clause triggered upon the breach of a contract could be one such stipulation. Broadly speaking, a conditional primary obligation will resemble a contractual debt, while a secondary obligation will resemble a claim for damages.

Further, Cavendish recognizes (at least in the opinion of Lord Neuberger and Lord Sumption with whom Lord Carnwath agreed) that if a contractual obligation to pay a specified sum of money is found to be a conditional primary obligation, it cannot be subject to the penalty doctrine under English law.

Ordinarily, the principles laid down by the UKSC in Cavendish regarding conditional primary obligations should be equally applicable under Indian law. However, one could hear a potential argument that such an obligation to pay a specified sum of money upon the breach of a contract should be tested fully in terms of Section 74 of the Indian Contract Act, 1872, as amended (“Indian Contract Act”).

The dominant view is that Section 74 of the Indian Contract Act governs a sum named in the contract, or any other stipulation by way of penalty, with the objective of compensating the innocent party for the loss suffered by it on account of a breach of an obligation, to which that stipulation is tied. Therefore, Section 74 of the Indian Contract Act applies only to secondary obligations and not to primary obligations [See Ponnuswami Naicken v. Nadimuthu Chetty, reported at (1917) 6 LW 421, at page 425].

However, the enforceability of an obligation to pay a specified sum of money that is triggered upon the breach of a primary obligation under a contract should involve a more piercing analysis under Indian law, as it would perhaps be even under English law.

Examining the question as to the enforceability of a conditional primary obligation under Indian law will involve evaluation of primarily three different scenarios, i.e., (i) when a conditional primary obligation is unequivocally predicated upon a non-breach event; (ii) when a conditional primary obligation is occasioned on the breach of a primary obligation; and (iii) when a conditional primary obligation is predicated upon the occurrence several events, one or some of which may amount to a breach of a contract.

Scenario I:

When a conditional primary obligation is predicated upon a non-breach event, it is governed by Section 31 to Section 33 of the Indian Contract Act. Such a conditional primary obligation falls beyond the purview of Section 74, as illustrated in Indiabulls Properties Private Ltd. v. Treasure World Developers Private Ltd., reported at 2014 SCC Online Bom 4768, at paragraphs 53, 58, 59.

Scenario II:

When a conditional primary obligation is predicated upon the breach of a primary obligation, courts in India are more likely to construe an obligation triggered upon such breach as a secondary obligation, instead of a conditional primary obligation. As a matter of practice, the use of the expression “when a contract has been broken” in Section 74 of the Indian Contract Act blurs the distinction between a conditional primary obligation and a secondary obligation. Courts often apply the principles of Section 74 of the Indian Contract Act simply because the obligation is triggered upon the breach of a contract, without any further enquiry [See DAG Private Limited v. Ravi Shankar Institute for Music and Performing Arts, reported at 2023 SCC Online Del 3293, at paragraphs 117 to 120].

Nevertheless, some courts in India have started embarking upon the exercise of ascertaining the true nature of the obligation and have found that the stipulation to pay a specified sum of money triggered upon the breach of a contract to be a conditional primary obligation, integral to the contractual bargain, and have enforced such stipulations [See Indian Oil Corporation Ltd. v. Fiberfill Engineers, reported at (2025) 316 DLT 172, at paragraphs 37, 38, 51]. However, this is an ongoing process of development of Indian law on this subject. It is possible that in addition to the tests recognized in English law for ascertaining as to whether a stipulation of such a nature is a conditional primary obligation or a secondary obligation, courts in India will develop certain additional facets of these tests, specific to the Indian context.

Scenario III:

When a conditional primary obligation is predicated upon the occurrence of several events, one or some of which may amount to a breach of a contract, such an obligation would not always be governed by Section 74 of the Indian Contract Act. The enquiry in such a case would be to find the true nature of such an obligation even if it is occasioned on a breach. For example, it might be evident that a conditional primary obligation in a particular case is not intended to remedy the loss caused by breach, but forms part of the contractual consideration on the happening of several stipulated events, one or some of them being a breach of the contract [See Videocon Telecommunications Ltd. v. IBM India Private Ltd., reported at 2018 SCC Online Del 11606, at paragraphs 46, 47].

Having said that, there was a context unique to India in which Section 74 of the Indian Contract Act was enacted. It is, therefore, imperative that the exercise of ascertaining whether a stipulation to pay a specified sum of money on the breach of a contract is a conditional primary obligation or a secondary obligation, as a matter of construction of a contract, is undertaken by courts with caution. A true secondary obligation, which is merely couched as a conditional primary obligation by clever drafting, ought not to escape the scrutiny of courts under Indian law.

Gaurav Pachnanda is a Senior Advocate, based in New Delhi, whose practice includes a wide range of commercial litigation, international commercial arbitration and intellectual property litigation.

He is also a Barrister at Fountain Court Chambers, London.