In a valid and enforceable contract, it is the legal responsibility of the parties to fulfil all the obligations in accordance with the terms of the contract. Many a time, the parties fail to do so, and the non-fulfilment of this contractual obligation is known as a breach of contract. In the event of a breach, it becomes essential that the defaulting party pay some compensation to the aggrieved party to make good the losses.
Liquidated damages and Penalties are two forms of compensation, which are provided under the Indian Contract Act, 1872. Though these terms are used interchangeably, there are various differences between the two in legal parlance. In this article, we will explain the difference between liquidated damages and penalties.
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Difference Between Liquidated Damages and Penalty
| Parameters | Liquidated Damage | Penalty |
| Meaning | It refers to the pre-decided amount of damage that is mutually decided between the parties to be paid to the aggrieved party. | It refers to a sort of punishment that is imposed on the defaulting party for non-fulfilling the contractual obligation.
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| Object | The main objective of liquidated damage is to compensate the aggrieved party and put it in a condition as if no default has taken place. | The main objective of the penalty is to create fear in the mind of the defaulting party and prevent the future breach of such a contract. |
| Quantum of Compensation | The amount of liquidated damage is always determined in proportionate to the actual loss that occurred. | The penalty is an addition to the liquidated damage.
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| Reasonability of compensation | The liquidated damages are generally reasonable. | The amount of Penalty is often unreasonable and excess in comparison to the actual loss.
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| Discretionary power of the court | The discretionary power of the court is very limited. | The court enjoys a wide discretionary power while imposing penalties. |
| Example | Clause …. of the lease agreement states that if the lessee doesn’t maintain the property in a proper manner, he shall be liable to pay INR 1,00,000 to the owner.
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Clause …. of the loan agreement provides that if the borrower doesn’t pay the part-period interest on time, he will be liable to pay 10 times interest to the bank.
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What are liquidated damages?
It is one of the prime remedies against the non-performance or breach of a commercial contract. The term “liquidated damage” refers to that damages wherein the parties quantify and negotiate the amount of damage, which shall be paid in case of default. In simple words, in liquidated damages, the parties mutually decide the exact compensation amount and put the same in the contract.
Take an example – Clause X of the lease agreement states that if the lessee doesn’t maintain the property in a proper manner, he shall be liable to pay INR 1,00,000 to the owner.
This is a simple example of liquidated damages. Here, the parties have already determined the amount of compensation in case of default. The liquidated damages remove ambiguity and bring clarity to the default. Since the parties are already aware of the amount of compensation, the court intervention is limited only to the extent of ordering the other party to pay the default amount.
The liquidated damages are used when the parties are in a condition to foresee or anticipate the amount of loss in case of breach of contract by the other party. Practically, all the normal contracts do have a liquidated damage clause. It is important to note that the court cannot put an objection to a reasonable amount decided by the parties. The concept of liquidation damage is based on the principle of the party’s autonomy. With the increasing commercial transactions, the importance of liquidated damages has also increased as the aggrieved party can easily get the compensation amount. However, it is important to note that for claiming liquidated damages, the aggrieved party need to show the actual loss incurred. In case the default is proportional, the court may award a proportional amount as liquidated damages.
What is a Penalty?
The term penalty refers to a sort of punishment for the defaulting party. The main objective of imposing a penalty is to deter the other party from committing the same offense or breach again. In contractual jurisprudence, the term penalty is also used in a similar fashion. To better understand the concept of penalty, let’s take an example-
Clause X of the loan agreement provides that if the borrower doesn’t pay the part-period interest on time, he will be liable to pay 10 times interest to the bank.
Here, the interest would be multiplied by 10 times, if the obligation in the contract is not met. This is a penalty clause that is incorporated with an objective to ensure that the borrower doesn’t fail in making the payment of interest. Normally, the penalty clause is provided in the contract. However, in exceptional circumstances, the court may impose a penalty on the defaulting party.
From the above discussion, it can be inferred that if the amount of damage fixed by the party is not reasonable and laid down in the contract with the sole motive of creating fear in the mind of another party to follow the terms of the contract, it shall be understood as a penalty clause. It is normally an excessive amount in comparison to the actual loss that occurred. It is also important to note that the complete amount received from the penalty is not awarded to the aggrieved party, but is used for some other purpose.
The penalty can be understood as damages that are additional to the liquidated damages. Its purpose is not to provide compensation to the aggrieved party but to act as a deterrence from potential default.
In India, Section 74 of the Indian Contract Act deals with liquidated damages and penalties. The doctrine of ‘reasonable compensation is widely followed which states that the duty of the court is to award reasonable compensation to the aggrieved party. Thus, in India, the penalty clause is valid to the extent as it provides for reasonable compensation. Any unreasonable or excessive amount putting an unnecessary burden on the defaulting party will not pass the muster.
Key differences between liquidated damages and penalty
- The liquidated damage refers to the pre-decided amount of damage that is paid by the defaulting party to the aggrieved party whereas the term penalty refers to a sort of punishment that is imposed on the defaulting party.
- The amount of liquidated damage is always in proportionate to the actual loss that occurred whereas the penalty is an addition to the liquidated damage.
- The main objective of liquidated damage is to compensate the aggrieved party whereas the objective of penalty is to create fear in the mind of a defaulting party.
- The liquidated damages are generally reasonable, whereas the penalty is unreasonable and excessive in comparison to the actual loss.
- In the case of liquidated damages, the discretionary power of the court is very limited whereas the court enjoys a wide discretionary power while imposing a penalty on the defaulting party.
Conclusion
Liquidated damages and penalties are two important forms of compensation that are awarded to the aggrieved party. Liquidated damage is given with an objective to place the aggrieved party in a position where the breach didn’t take place. The penalty is provided with an intention to create fear in the mind of the defaulting party to not repeat the same offense again. In India, both of them are governed by Section 74 of the Indian Contract Act. The said section differentiates both of them with the doctrine of reasonable compensation.
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