Breach of Contract: Damages, Liquidated Damages and Penalty Clauses

Almost every commercial dispute eventually asks the same question: what is the loss worth in money? Under the Indian Contract Act, 1872, the answer comes from two provisions, Sections 73 and 74. Section 73 deals with ordinary compensation for breach. Section 74 deals with contracts that fix the amount payable in advance, which is where disputes over liquidated damages and penalty clauses arise.

What Compensation Can Be Claimed Under Section 73?

Under Section 73, a party who suffers from a breach is entitled to receive from the party who broke the contract compensation for any loss or damage caused to them which naturally arose in the usual course of things from the breach, or which the parties knew, when they made the contract, to be likely to result from it. Compensation is not given for any remote and indirect loss or damage.

In practice, this means a claimant must prove three things:

• That the contract was breached
• That a specific loss was suffered because of that breach
• That the loss was foreseeable when the contract was made, or arose naturally from the breach

Lost profits can be recovered if they were a foreseeable result and can be proved with reasonable certainty. Speculative claims are rejected. Evidence such as accounts, comparable contracts, invoices and expert reports carries more weight than assertions. The explanation to Section 73 also says that the party who claims must have taken reasonable steps to reduce the loss, so a buyer who fails to buy substitute goods in a rising market, or a seller who does not resell goods, may see the claim reduced.

What Is a Liquidated Damages Clause?

Many commercial contracts fix in advance the sum payable on breach, for example a percentage of the contract value for each week of delay. Such a clause is called a liquidated damages clause. Where the amount represents a genuine pre-estimate of the likely loss, it is useful for both sides: the claimant avoids proving loss in detail and the breaching party knows its exposure.

How Does Section 74 Treat These Clauses?

Section 74 provides that when a contract names a sum to be paid on breach, or 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 receive from the party who broke the contract reasonable compensation not exceeding the amount named. Indian law does not draw the sharp line between liquidated damages and penalties that English law does. Instead, the named sum acts as a ceiling, and the court awards reasonable compensation up to that sum.

The leading cases set the approach:

• Fateh Chand v. Balkishan Dass (1963): forfeiture of a large sum as earnest money was limited to a reasonable amount
• ONGC v. Saw Pipes (2003): where the sum is a genuine pre-estimate of loss, proof of actual loss is not required
• Kailash Nath Associates v. DDA (2015): reasonable compensation up to the named sum; some loss must be shown

The practical result is that courts will often enforce a liquidated damages clause where loss is difficult to prove and the sum is not extravagant. They will scale it down, where it is disproportionate, to what is reasonable. They may refuse to award anything if there is no loss of any kind and none could be shown.

What About Forfeiture of Advance or Earnest Money?

The same reasoning applies to advances. A seller who retains an advance after a buyer defaults is, in effect, relying on a penalty clause, and can keep only what is reasonable, unless the amount is truly earnest money in a form that courts accept. A buyer who wants the advance back should therefore examine the clause and the evidence of the seller's actual loss. The conduct of the parties and the pre-contract negotiations also matter.

What Other Remedies Exist Besides Damages?

Damages are not the only option. Since the Specific Relief Act was amended in 2018, specific performance of a contract is no longer a purely discretionary remedy and is the general rule, subject to statutory exceptions. An injunction can restrain breach of a negative covenant. Where a contract has been performed in part, a claim for the value of the work done can be made. And where the other side's breach is serious, a party may also be entitled to terminate and claim damages. Our note on specific performance of sale agreements explains the position for property contracts.

How Should Businesses Draft and Handle These Clauses?

Draft a liquidated damages clause with a rational link to the likely loss, for example a per-day rate tied to the cost of delay, with a cap. Avoid a single punitive figure unrelated to the contract value. Keep contemporaneous records of loss, since even a liquidated sum may require some proof. On breach, send a written notice, preserve evidence, and take steps to reduce the loss. Limitation for a claim of breach is generally three years from the date of breach, as we explain in our note on limitation for recovery of money.

Valuing a contract claim, or defending one, depends on the clause and the evidence. Our Contract & Arbitration practice advises on breach claims and liquidated damages, and you can request a consultation.