In general, one party pays the amount of compensation for the loss incurred to the other party when there is a failure in the performance of the contract. So, sometimes, parties mutually decide the amount to be payable as compensation. If the amount so specified indicates a fair and genuine pre-estimate of the damages, that may take place because of the breach, it is liquidated damages.
However, if the amount is not proportionate to the damages. Then, the court treats it as a penalty.
Basic Concept
When the parties to the contract decide in advance, at the time of entering into the contract, the amount of compensation that would be paid to the aggrieved party, in case any party defaults in the performance of the contract. In such a case, the most important question that pops up is whether the court will consider this figure as a measure for the loss or damage incurred.
As per English Law, the amount so pre-determined can be regarded as liquidated damages or penalty.
As per Indian Law, there is no distinction between liquidated damages and penalty. Further, the court only awards reasonable compensation to the injured party which is not more than the amount mentioned in the contract.
Content: Liquidated Damages Vs Penalty
Comparison Chart
| Basis for Comparison | Liquidated Damages | Penalty |
|---|---|---|
| Meaning | Liquidated Damage is an amount that the contracting parties fix during the formation of a contract, which is a fair prior estimate of the probable loss that would occur as a result of the breach. | Penalty refers to the sum determined in the contract to be paid in case of a breach, but the amount is not proportionate to the damage likely to occur. |
| Estimation of Loss | Estimation of loss that may arise due to the breach of contract. | No such estimation |
| Objective | To determine the maximum amount of compensation or loss. | To discourage parties to break the contract. |
| Imposed | For compensation | For punishment |
| Order | Pay the actual amount of loss but within the limited pre-specified. | Pay the actual amount of loss. |
What are Liquidated Damages?
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.
Objective
- To determine the amount of loss to remove uncertainty. This is done to ensure that no amount should be spent in future, to ascertain the amount of loss incurred, after going to court.
Note: Whatever amount the parties fix or estimate for payment in case of breach of contract. It is not certain that the same amount will be given to the aggrieved party as compensation for the damages. This implies that liquidated damages are the maximum limit.
Hence, the court has the power to fix any amount for compensation to be provided to the aggrieved party. But within the limits of the pre-fixed amount, i.e. liquidated damages.
Example
Disha borrowed ₹ 1,00,000 from Aishwarya and agreed to pay ₹ 1,20,000 as damages if she fails to pay the entire sum on the due date. Disha defaults in the payment of the money. In this case, Aishwarya is entitled to recover from Disha such compensation, as the court may decide as reasonable. But that would not be more than ₹1,20,000.
Also Read: Difference Between Agreement and Contract
What is the Penalty?
To penalize is to punish. The penalty has nothing to do with estimation. When the sum decided by the contracting parties for the breach of contract is not reasonable, i.e. it is double or triple the amount of loss. Also, it is used to compel the other party to perform the contract, then it is a penalty.
Any such clause is not regarded in a court of law. Also, the aggrieved party cannot recover the amount more than the actual loss incurred to him/her.
If it is observed that the contracting parties did not make any conscious effort to determine the damage or loss that may cause if there is a breach by any one of them. However, they decided a sum to be payable if there is any breach just to secure the performance of the contract, then that sum will be a penalty. So, we could say that penalty is an unfair, and unreasonable estimation of loss.
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.
Example
Suppose Vishal agrees to pay ₹ 20,000 to Amit on or before January 18, 2022. However, he fails to make payment of the sum at the stipulated time. And he agrees to pay ₹ 30,000 as liquidated damages. So, the additional ₹ 10,000 is a penalty because it is extravagant.
Objective
- To discourage parties to break the contract.
Note: In India, there is no difference between liquidated damages and penalties. And, the courts allow only reasonable compensation for the loss incurred to the aggrieved party. But this does not exceed the specified sum.
However, if we talk about English Law, liquidated damages are enforceable and not penalty.
Also Read: Difference Between Fine and Penalty
Key Differences Between Liquidated Damages and Penalty
While both liquidated damages and penalty are payable when there is a default in the performance of a contract. There are a number of differences between these two:
- When the amount payable on the breach is so large that it is far more than the probable loss/damage, it is a penalty. On the other hand, when there is just and equitable estimation of the amount payable for the probable damages suffered by the injured party, it is liquidated damages.
- As you have seen in the case of electricity bills, there is always a due date, on or before which we have to pay the amount of bill. If we fail to pay that on the due date, then we are bound to pay a further sum to keep the services. In such a case, the further sum that we pay is a kind of punishment for late payment which is ultimately a penalty.
- No matter what expression the parties have used in the contract, it is not considered final. That is to say, the court must identify whether the amount so pre-determined in the contract is actually a penalty or liquidated damages. If the amount decided is huge, the court will treat it as a penalty, irrespective of the term used by the parties in the contract.
- The point of whether the amount specified is either a penalty or liquidated damages is a question of construction, which is determined on the basis of the contractual terms and circumstances of the case, determined at the time of formation of the contract and not at the time of its breach.
The bottom line
The crux of a penalty is the payment of the specified money as fear or intimidation of the party that is in default of the terms of this contract, i.e. the offending party. Basically, the penalty is imposed to force a party to perform the contract. While the crux of liquidated damages is the reasonable prior estimation of the damage which is likely to occur to the injured party.
Example
Liquidated Damages
Vivek sold laptops to Javed, who contracted that he would not resell them or offer them for sale, at a price that is below the list price offered by Vivek. Javed agreed to pay a sum of ₹ 10,000 as liquidated damages if there is any breach of contract. Javed sold the tyre to Girish at a price less than the list price of Vivek, for which Vivek filed a suit against Javed for damages for breach.
The court held that the sum decided by the parties concerned was a fair pre-estimate of the damage. So, it is liquidated damage.
Penalty
Vishwa contracted with Shubam for repainting his house within a period of 10 days and charged a sum of ₹ 10,000. Further, Vishwa also agreed that if he fails to perform the contract within the stipulated time, he will pay ₹ 50,000 as damages. Apparently, the sum is not reasonable. So, it is a penalty.
Point to Note
No matter if the stipulated sum as compensation by the contracting parties if there is any breach, is liquidated damage or penalty. It is going to be decided on the basis of terms and conditions or intent of the parties.
Conclusion
By and large, the difference between liquidated damages and penalty is as per English law only. However, there is no such distinction considered in India.
Indian courts are required to determine the amount of actual loss. Further, this amount is awarded to the aggrieved party. However, this amount must not be more than the amount pre-fixed by the parties in their contract. Hence, the courts don’t bother about their difference. But they focus on awarding just and equitable compensation to the injured party. The compensation should not be more than the sum which the parties have decided beforehand.
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