This article is written by M.Sujithra, graduated from Sri Kengal Hanumanthaiya Law college LLB doing an internship at Ledroit India.
ABSTRACT:
Liquidated damages and penalty clauses are contractual provisions used to establish pre-determined compensation for breaches. These clauses differ in its legal functions, Liquidated damages are genuine and enforceable if they are reasonable. Whereas penalty clauses unenforceable as they are seen as punitive and deterrent rather than compensatory. The abstract examines the main difference between liquidated damages and penalty clause, analysing their enforceability, purpose, practical implications in contract law. It explores legal precedents focusing how court differentiate between these clauses, as well as parties drafting the contract.
KEYWORDS
- Liquidated damages
- Penalty clauses
- Enforceability
- Reasonableness
- Courts’ scrutiny
- Legal implifications
INTRODUCTION
Liquidated damages are a pre -agreed amount specified in a contract to compensate for losses caused by a breach. Its for that reason the amount must estimate the actual harm and its applicable if its reasonable. On the other hand, penalty causes impose an excessive amount calculated to punish the breaching party in lieu of loss. courts generally find penalty clauses ineffectual when they are disproportionate to the actual damage.
In contacts especially those involving construction, service agreements, and long-term business agreements, clauses related to breaches and their consequences are commonplace. The main difference between liquidated damages is very compensatory and reasonable, while
DEFINITION
- LIQUIDATED DAMAGES
This is pre-determined money, which is agreed during a contract, where one party will pay another party when they breach the contract. This amount will calculate actual loss or damage that would result from the breach, and it is applicable as long as it is reasonable and not excessive. liquidated damages are meant to provide a direct remedy for failure to perform contractual obligations, which avoids the need for further litigation to determine the actual damages.
Example: If the contractor fails to complete the contract on time mentioned in the agreement, then the contractor should pay the employer liquidated damages of rupees 25,000 per day of delay up to the maximum of 45 days then the employer have the right to terminate the contract and ask for various remedies which are mentioned in the agreement.
- PENALTY CLAUSE
It is one of the actions in the contract for providing amount of money and other consequences on a party which breaches the contract, usually in an amount that exceeds the actual damages suffered. Penalty clauses are generally inapplicable in many legal systems if the amount is deemed excessive or disproportionate to the actual harm caused by the breach.
Example: A contract might stipulate that if the party is late in performing its duty, then it must pay a fixed penalty that bears no direct responsibility to the loss because of the delay but instead it serves as a punishment
Key characteristics of liquidated damages :
Pre-estimated loss: The amount is calculated based on the foreknown damages [anticipated damages] so the other party would incur due to the breach.
- Reasonable and proportionate: To punish the breaching party, it compensates in sum of reasonable amount and not excessive.
- Applicable to delays or non-performance: Liquidated damages are commonly used in construction contracts, service agreements, and delivery contracts where timelines are critical.
Key characteristics of Penalty
Causes
- Punitive in nature: The penalty does not calculate the actual losses, but it’s meant to inhibit the breaching party from non-performance or delay.
- Excessive amount: In penalty clause breaching party must pay large sum of amount, which is disproportionate to actual loss.
- Generally unenforceable: penalty clauses are unenforceable because the provision is excessive in nature, so the law system strikes those provisions.
KEY DIFFERENCE BETWEEN LIQUIDATED DAMAGES AND PENALTY CLAUSES:
- Purpose
- Enforceability
- Amount
- Nature
PURPOSE:
- Liquidated damages are meant to calculate the loss suffered by breaching party and serve compensation accordingly.
- Penalty clauses punish the breaching party and impediment against non-performance.
Enforceability:
- Liquidated damages are generally enforceable when the amount is not unreasonable.
- Penalty clauses are because it is punitive rather than compensatory, so the jurisdiction strikes those provisions.
Amount:
- Liquidated damages reflect a reasonable estimation of loss in previously mentioned contract.
- Penalty clause is always likely exceeding the actual loss amount which is disproportionate.
Nature:
- Liquidated damages are based on the actual loss the non breaching party is expected to incur due to the breach.
- Penalty clause main aim is to punish a breaching party when they fail to perform according to the contract.
CASE LAW:
K.K. Verma V. Union of India [1954]
In this Indian case the suprme court applied the principles established in Dunlop. The court held that if the sum stipulated for breach of contract is extravagant or unconsiouable in comparison to the actual damage, it will be considered a penalty, and therefore unenforceable. Liquidated damages , on the other hand,are enforceable if they represent a genuine Pre-estimate the loss.
Wallis V. Pratt [1900]
This case clarified that a sum agreed upon as liquidated damages should be reasonable estimate of the actual loss that may be suffered from a breach. The judgment reinforced the idea that the function of liquidated damages is compensatory, not punitive.
CONCLUSION:
In summary, while both liquidated damages and penalty clauses which deals with breaches of contract but their functions are different. Where, liquidated damages provides fair compensation for the loss estimated , while penalty clauses are punitive ,which aims to punish the breaching party. It is important to carefully draft the contract by distinguishing between these two and ensure the clause related to breach is reasonable, and make sure it is in the legal principle. When it comes to these principle it is crucial understand that the contract sounds legally enforceable.
