Penalty clause in an Arbitration agreement

Contributed by: P&A Law Offices


This note is divided into four parts (a) Part I provides a brief introduction of the concept of penalty; (b) Part II discusses whether a penalty clause in a contract can be struck down; (c) Part III discusses whether a party is entitled to penalty without proving any injury/ loss suffered and (d) Part IV sets out the conclusion.


I. BACKGROUND


A contract may specify the damages that a party is liable to pay at the time of breach of the contract. If such damages are a genuine pre-estimate of the loss flowing from a breach of the contract, such damages are called liquidated damages. On the other hand, if the damages are such that it forces one party to adhere to the conditions of the contract (i.e., in the nature of a paymentin terroram), then such damages are called penalty. Notably, a Court can determine that a sum stipulated in a contract amounts to liquidated damages or a penalty only after taking into account the facts and circumstances of each case.


Section 73 of the Indian Contract Act, 1872 (“the Act”) deals with liquidated damages while section 74 of the Act deals with penalty. Section 74 of the Act states as follows:


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 of the breach is entitled, whether or not actual damage or loss 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.


In light of the above, it is explicit that even if a penalty is stipulated in a contract, the party which has suffered the loss (i.e., the aggrieved party) is allowed to receive only a reasonable compensation which cannot exceed the penalty stipulated in the contract.


II. STRIKING DOWN OF THE PENALTY CLAUSE


In Central Inland Water Transport Corporation Limited and Ors. v. Brojo Nath Ganguly and Ors.[1], the Hon’ble Supreme Court of India held as follows:


“[...]
89. … Our judges are bound by their oath to ‘uphold the Constitution and the laws’. The Constitution was enacted to secure to all the citizens of this country social and economic justice. Article 14 of the Constitution guarantees to all persons - equality before the law and equal protection of the laws. This principle is that the courts will not enforce and will, when called upon to do so, strike down an unfair and unreasonable contract, or an unfair and unreasonable clause in a contract, entered into between parties who are not equal in bargaining power. [...]”

In view of the above, it is clear that where the penalty clause is proved to be unreasonable or unfair, the Court, in its judicial approach, may strike it down when: (a) called upon to do so; and (b) the bargaining power of the parties to the contract is unequal. The sequitur that follows is that even in commercial transactions, a Court is unlikely to strike down the penalty clause considering that such transactions are generally entered into between such parties who have equal or almost equal bargaining power.[2]


In my opinion, where the bargaining power of the parties is equal or almost equal at the time of entering to the contract, a Court is likely to only declare the penalty provision to be unenforceable and would not resort to striking it down.


Please note that striking down of any unenforceable/ unnecessary or redundant clause (including a penalty clause) in a contract is backed by blue pencil doctrine (concept in common law countries).[3] This is because the said doctrine allows a Court to sever that portion(s)/ clause(s) of the contract which is unenforceable/ void by running a blue pencil through it leaving the other portion(s)/ clause(s) as it is.[4]


Simply put, in a situation where a certain sum is stipulated as a penalty in a contract and the aggrieved party has claimed such sum as damages, following situations may occur:


Case A – The Court may grant reasonable compensation which cannot exceed the penalty amount;

Case B – The Court may declare the penalty clause as unenforceable for being unreasonable or unfair when the bargaining power of the parties to the contract is equal or almost equal; and

Case C – The Court may strike down the penalty clause for being unreasonable or unfair when the bargaining power of the parties to the contract is unequal.


Albeit, there appears to be no judicial precedent to prove striking down of the penalty clause by a Court, in my opinion, Courts may take a recourse to striking down the penalty clause in a contract only where the bargaining power of the parties to the contract is unequal.


III. PROVING OF INJURY/ LOSS FOR ENTITLEMENT TO PENALTY


Pertinently, section 74 of the Act awards reasonable compensation for the damage or loss caused by a breach of contract, therefore, damage or loss caused is a sine qua non for the applicability of the said section.[5]The rule regarding proving of loss for claiming penalty was laid down in Maula Bux v. Union of India.[6]In the said judgement, it was held as follows:


[...]
It is true that in every case of breach of contract, the person aggrieved by the breach is not required to prove actual loss or damage suffered by him before he can claim a decree and the Court is competent to award reasonable compensation in case of breach even if no actual damage is proved to have been suffered in consequence of the breach of contract. But the expression whether or not actual damage or loss is proved to have been caused thereby is intended to cover different classes of contracts which come before the Courts. In cases of breach of some contracts it may be impossible for the Court to assess compensation arising from breach, while in other cases compensation can be calculated in accordance with established rules. Where the Court is unable to assess the compensation, the sum named by the parties if it be regarded as a genuine pre-estimate may be taken into consideration as the measure of reasonable compensation, but not if the sum named is in the nature of a penalty. Where loss in terms of money can be determined, the party claiming compensation must prove the loss suffered by him[...].

From the aforesaid, it is abundantly clear that: (a) if the Court is unable to assess the compensation arising from the breach of a contract, it may grant full liquidated damages (if found to be reasonable) without having to prove any loss as it is difficult to prove loss in such cases; and (b) If the Court is able to assess the compensation arising from the breach of a contract, the aggrieved party is required to prove actual loss for entitlement to the same. That said, in any case, the Court will grant only reasonable compensation which cannot exceed the liquidated damages or the penalty, as stipulated in the contract.


Notably, the words in section 74 of the Act - “whether or not actual damage or loss is proved to have been caused thereby” should not be construed as proving of actual loss not being necessary. The said words under section 74 of the Act are confined to cases in which it is not possible to prove the monetary value loss.[7] Therefore, in such cases, reasonable compensation as fixed by the parties becomes the benchmark based on which a Court finally decides the compensation to be granted.


In a nutshell, where it is possible to prove actual damage or loss, such proof cannot be discounted. It is only in cases where damage or loss is difficult or impossible to prove that the amount (whether liquidated or penalty) named in the contract, if reasonable, can be awarded.


IV. CONCLUSION


A contractual penalty clause is typically that clause in a contract by which a party in breach of an obligation is required to pay an amount which is greater than the reasonable proportion of the loss caused due to such breach. Regarding striking down of the penalty clause, in my opinion, a Court may strike it down when such clause is unreasonable or unfair and the bargaining power of the parties is unequal. As far as proving of loss for claiming penalty is concerned, the necessity for proving loss does not arise in all kinds of contracts. The aggrieved party claiming penalty as damages is required to prove the loss only in those cases where loss in terms of money can be determined.



  1. [1] (1986) 3 SCC 156 [2] DTC v. Mazdoor Congress, 1991 Supp (1) SCC 600 [3] Cipla Ltd. v. Anant Ganpat Patil and Ors., 2008 (1) Bom CR 78 [4] P. Ramanatha Aiyar's Advanced Law Lexicon, 3rd Edn. 2005, Vol.1, p.553-554, Beed District Central Co-operative Bank Ltd. v. State of Maharashtra and Ors., (2006) 8 SCC 514 [5] Mahanagar Telephone Nigam Ltd. vs. Tata Communications Ltd., (2019) 5 SCC 341 [6] AIR 1970 SC 1955 [7] Kailash Nath Associates v DDA, (2015) 4 SCC 136


Contributed by: P&A Law Offices


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