LIQUIDATED DAMAGES AND PENALTY-ALL YOU NEED TO KNOW
In the event of a breach of contract, the party at default must pay liquidated damages and penalties to the aggrieved party. Liquidated damages and penalty clauses are not synonymous and there is a difference between the two. These terms are often used interchangeably and sometimes create confusion even in the court of law..
Whenever there is a breach of contract the aggrieved party asks the other party to compensate the damages or loss caused to it. Here at this moment, there comes a picture of the penalty and damages given by the party committing the breach to the aggrieved party.
Liquidated Damages are an appropriate pre-estimation by the contracting parties, of the loss that may occur in future due to the breach of contract. The breach of contract can be due to the failure of one party to perform the contract. So, it is the maximum limit of loss. This limit is pre-determined which is to be paid as compensation by the party responsible for the breach to the aggrieved party.
It is an approximate calculation of the amount which the parties assume, will compensate for the breach of contract. This clause is not just effective, but the amount so fixed is recoverable.
In other words, liquidated damages are a covenanted, fair, honest and reasonable approximation of loss.
LIQUIDATED DAMAGES
- Liquidated damages: If the amount fixed by all parties is a genuine estimate of the loss by a future breach of contract, then it is liquidated damages. Thus, all parties to the contract agree that the amount is fair compensation for the breach.
It is an approximate calculation of the amount which the parties assume, will compensate for the breach of contract. This clause is not just effective, but the amount so fixed is recoverable.
In other words, liquidated damages are a covenanted, fair, honest and reasonable approximation of loss.
PENALTY
To penalize is to punish. The penalty has nothing to do with estimation. A penalty obliges the breaching party to pay a pre-agreed amount of money to the innocent party. The amount of money must be excessive and disproportionate to the actual expected loss of the innocent party. Instead of simply find a remedy to the innocent party, the penalty clause punishes the breaching party.
Further, it indicates that a subsidiary contract which aims to attract more severe consequences, when there is non-performance of the original contract.
The sum specified by the parties is regarded as a penalty if:
- it is huge or unreasonable in amount when compared to the maximum loss that could have proved to have accrued from the breach of contract.
- the breach of contract comprises non-payment of a sum within the stipulated time and the sum specified is more than the sum to be paid.
Some principles to help you distinguish between a penalty and liquidated damages:
- If the sum payable is far in excess of the probable damage on breach of the contract, then it is a penalty.
- If a contract mentions an amount payable at a certain date and an additional amount if a default happens, then the additional sum is a penalty. This is because a mere delay in payment is unlikely to cause damage.
- Even if the contract specifies a sum as ‘penalty’ or ‘damages’, the Court needs to discern from the facts of the case if the amount mentioned therein is, in fact, a penalty or liquidated damages.
- The crux of the penalty is the payment of moneyas a terrorem of the defaulting party. Liquidated damages, on the other hand, are the true pre-estimate of the damage.
- While the English law distinguishes between a penalty and liquidated damages, in India, there is no such distinction. The Indian Courts focus on awarding a reasonable compensation to the suffering party which does not exceed the amount fixed in the contract.