Page 84 - DMGT102_MERCANTILE_LAWS_I

Mercantile Laws-I

Notes 6.2 Liquidated Damages and Penalty

Sometimes parties themselves at the time of entering into a contract agree that a particular sum
will be payable by a party in case of breach of the contract by him. Such a sum may either be by
way of ‘liquidated damages’ or it may be way of ‘penalty’. The essence of liquidated damages
is a genuine covenanted pre-estimate of the damages. Thus, the stipulated sum payable in case
of breach is to be regarded as liquidated damages if it be found that parties to the contract
conscientiously tried to make a pre-estimate of the loss which might happen to them in case the
contract was broken by any of them. On the other hand, the essence of a penalty is a payment
of money stipulated as “in terrorem” of the offending party. Thus, if it is found that the parties
made no attempt to estimate the loss that might happen to them on breach of the contract but still
stipulated a sum to be paid in case of a breach of it, with the object of coercing the offending party
to perform the contract it is a case of penalty.
It is obvious that a term in a contract amounts to a penalty where a sum of money, which is out of
all proportion to the loss, is stipulated as payable in case of its breach. Where the amount payable,
in case of its breach, is fi xed in advance whether by way of liquidated damages or penalty, the
party may claim only a reasonable compensation for the breach, not exceeding the amount so
named or, as the case may be, the penalty stipulated for. (s.74).

Example:
(i) A contracts with B to pay B ` 1,000 if he fails to pay B ` 500 on that day. A fails to pay ` 500
on that day. B is entitled to recover from A such compensation not exceeding ` 1,000, as the
court considers reasonable.
(ii) A contracts with B that if A practices as a surgeon within Calcutta, he will pay B ` 5,000. A
practices as a surgeon in Calcutta. B is entitled to such compensation not exceeding ` 5,000
as the court considers reasonable.
Whether payment of interest at a higher rate amounts to penalty? Whether an agreement to pay
interest at a higher rate in the case of breach of a contract amounts to penalty shall depend upon
the circumstances of each case. However, following rules may be helpful in understanding the
legal position in this regard.
(i) A stipulation for increased interest from the date of default shall be a stipulation by way
of penalty if the rate of interest is abnormally high. A gives B a bond for the repayment of
` 1,000 with interest at 12% p.a. at the end of six months with a stipulation that in case of
default interest shall be payable at the rate of 75 percent from the date of default. This is a
stipulation by way of penalty and B is only entitled to recover from A such compensation
as the court considers reasonable.
(ii) Where there is a stipulation to pay increased interest from the date of the bond and not
merely from the date of default; it is always to be considered as penalty.
(iii) As regards compound interest, it is not itself a penalty. But it is allowed only in cases where
the parties expressly agree to it. However, a stipulation to pay compound interest at a
higher rate on default is considered as a penalty.
(iv) An agreement to pay a particular rate of interest with stipulation that a reduced rate will
be acceptable if paid punctually is not a stipulation by way of penalty. Thus, where a bond
provided for payment of interest at 12% p.a. with a provision that if the debtor pays interest
punctually at the end of every year the creditor would accept interest at the rate of 9% p.a.
Such a clause is not in the nature of penalty and hence interest @ 12% shall be payable.

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