Sometimes, parties to a contract stipulate at the time of its formation (i.e., in advance) that in case of breach of its performance by either of the parties, a certain specified sum will be payable as damages. Such a sum is known as:-
(i) Liquidated Damages, or
(i) Liquidated damages:
It is a sum fixed or ascertained by the parties to the contract, which is a fair and genuine per-estimate of the probable loss that might occur as a result of breach of contract. Thus, liquidated damages are an assessment of loss which in the opinion of the parties will occur due to breach. Such damages are effective and recoverable by the aggrieved party from the other.
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On the other hand, penalty is the sum mentioned in the contract at the time of its formation which is disproportionate to the damages likely to occur as a result of the breach of the contract. Penalty is fixed with a view to getting the contract performed, but it has no concern with the probable loss likely to occur to the parties due to the breach of the contract.
Indian Contract Act recognizes both ‘liquidated damages’ and ‘penalty’, while the English Law gives effect to ‘liquidated damages’ only. The courts in India allow only a reasonable compensation which may include both ‘liquidated damages’ and ‘penalty’. Section 74 is very clear in this regard, which reads as under:-
“When a contract has been broken, if a sum is named in the contract as the amount to be paid in case of such breach, or if the contract contains any other stipulation by way of penalty, the party complaining breach, is entitled, whether or not actual damage or is proved to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named or, as the case may be, the penalty stipulated for.”
X agrees with A to pay Y Rs. 400, if he fails to pay Rs. 200 on a given day, X fails to pay Y Rs. 200 on that day. Y is entitled to recover from X such compensation not exceeding Rs. 400 as the court considers reasonable.
Thus, the essence of liquidated damages is a genuine per-estimate of damages for breach, while essence of a penalty is the payment as in terrorism of the offending party. However, the courts in India allow only reasonable compensation.
Rules determining Liquidated Damages or Penalty:
Rules for determining, whether a stipulation is by way of ‘liquidated damages’ or by way of ‘penalty’ are as under :-
(1) The parties to a contract may use the words ‘liquidated damages’ or ‘penalty’ inter- exchangeable, but the court will not be bound by it, e.g., if the parties have stated the sum as ‘liquidated damages’, while the court considers it as ‘penalty’, it can relieve the parties from payment of such penalty.
Contrary to it, if the parties call the sum fixed ‘penalty’, but it may turn out to be pre-estimate of loss, in such a case, it will be treated as ‘ Liquidated Damages’ and the aggrieved party will be entitled to it.
(2) The essence of penalty is to compel the performance of the contract by providing something by way of punishment, if the contract is not performed. On the other hand, the essence of liquidated damages is the per-estimation of loss likely to be caused by non-performance of the contract.
(3) The question whether the sum decided is ‘liquidated damages’ or ‘penalty’ is decided on the basis of the terms and circumstances of the contract at the time of its formation, and not at the time of breach.
(4) Even when a single sum is paid, a part of it may be by way of ‘liquidated damages’, while the other by way of ‘penalty’.
(5) Penalty may be in case when the sum is more than the actual loss.
(6) Penalty may also be if the breach is for not paying on the day or time fixed.