"Hope for the best and draft for the worst" is a principle on which any contract should be drafted.
The Indian Contract Act, 1872 allows the parties to divide the risk and anticipate remedies for breach. Among the instruments at hand, liquidated damages act as a contractual estimate of probable loss and serve a purpose of avoiding litigation and promoting commercial certainty. The idea behind pre-estimating damages at the time of contracting is to help parties manage risk, reduce ambiguity in assigning accountability thus reducing evidentiary burdens, and mitigate the chances of under-compensation for losses that may be indirect or difficult to quantify. The enforceability of liquidated damages need not await the entire frustration of the contract. Even breach of specific terms can be anticipated and adequately addressed through such clauses, without undermining the remainder of the contract. Such clauses aim to provide a degree of commercial assurance, while also allowing parties to earmark specific breaches for fixed remedies, without disturbing the broader framework of unliquidated damages. This clause also helps parties' price performance risk, particularly in high-stakes infrastructure and service-delivery contracts where delays or failures carry consequences.
Still, in India this simple contractual tool causes a legal conundrum. Although Section 74 of the Indian Contract Act, 1872 stipulates that courts may award reasonable compensation "whether or not actual damage or loss is proved," Indian jurisprudence has followed a more nuanced path. Except in cases where such proof is either impractical or impossible, courts have regularly mandated some evidence of loss, so importing evidentiary thresholds even into contracts naming particular amounts.
I. Liquidated vs. Unliquidated Damages
A. Conceptual Framework
The distinction between liquidated and unliquidated damages in the Indian context hinges on whether the compensation for a breach is a pre-agreed "genuine estimate" or an amount to be judicially determined based on proven "actual loss." This distinction is not merely academic it holds significance for both drafting and interpretation of commercial contracts and directly affects the remedies available when a breach occurs.
B. Comparative Table
| Feature | Liquidated Damages | Unliquidated Damages |
| Governing Section | Section 74 of the Indian Contract Act, 1872 | Section 73 of the Indian Contract Act, 1872 |
| Determination | Pre-determined and specified in the contract | Ascertained by the court/tribunal after the breach |
| Basis of Calculation | A genuine pre-estimate of the likely loss | Actual loss or injury proved by the aggrieved party |
| Proof of Loss | Generally, no strict proof of actual loss required, but the amount must be a reasonable compensation. | The aggrieved party must prove the actual loss suffered. |
| Purpose | To ensure certainty, avoid litigation complexities, and act as a deterrent. | To compensate the aggrieved party for the actual loss sustained. |
| Judicial Discretion | The court can reduce the amount if it is deemed to be a penalty. The stipulated amount is the maximum limit. | The court has complete discretion in assessing the quantum of damages based on evidence. |
II.Historical and Comparative Context
A. International Background
The development of liquidated damages can be traced to English common law, in which one of the seminal case is Dunlop Pneumatic Tyre Co. Ltd. v. New Garage & Motor Co. Ltd[1]. The test laid out in the judgement is that the enforceability is subject to the determination of whether the amount charged is a real pre-estimate of the loss or a penalty. Liquidated damages clause will be regarded as being a penalty when the amount is not fair, is too high and extremely excessive. The clause however may be valid and will be enforceable otherwise, in case it is to secure the real interest of the other party, and that the penalty is reasonable in comparison to the effect of non-observance of such obligation.
It was through this dichotomy that the judgment of UK Supreme Court in Cavendish Square Holding BV v. Makdessi [2] that opened a more pragmatic era. Now, the court dismissed its approach regarding pre-estimate and replaced it with proportionality through the focused question of whether the clause formed a legitimate commercial interest without it being manifestly excessive. In case when a liquidated damages clause places an inequitable burden on the party breaching the contract, significantly beyond what is necessary to safeguard the true interests of the other contracting party, it will not be enforced. In making this decision English courts also consider whether both of the parties were free to negotiate the terms and whether they took legal advice before committing to them. In conclusion, this ruling of the UK Supreme Court shifted the focus from “How much money is lost?” to “What is the clause trying to protect?”.
B. Indian Legal Trajectory
Meanwhile, in the legal landscape of India, the law surrounding liquidated damages is enshrined in Section 74 of the Indian Contract Act, 1872 (“Contract Act”). It is prescribed in Section 74 of the Contract Act that before drafting the contract, parties can pre estimate the impact of breach and stipulate the amount of compensation to be paid in case of breach of the contract.
The provision of the Contract Act relating to liquidated damages is a legislative effort to avoid the complex methodology and hypothesis contained in the English law. It removes the strict line that used to exist between penalty and liquidated damages, preferring to tie the enforceability to the notion of reasonable compensation that never goes higher than the one whose amount is stated.
The Supreme Court in Fateh Chand v. Balkishan Das [3] set the tone and made it clear that though parties might come to an agreement on a certain amount payable upon breach, courts will only enforce what is reasonable. In the following judgement the Supreme Court pointed out that Section 74 of Contract Act governs the determination of compensation in breach of the contract which may be of two types, (i) a pre decided sum is agreed to be payable in case of breach of contract and (ii) the contract provides penalty.
This principle was reaffirmed in Maula Bux v. Union of India[4], where the Supreme Court observed that:
“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 case 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 compensation, the sum named by the parties if it be regarded as genuine estimate may be taken into consideration as the measure of reasonable compensation but not if the sum named is in the nature of penalty. Where loss in terms of money can be determined, the party claiming compensation must prove the loss suffered by him. In the present case, the Government could have proved the rates at which they had to be purchased and also other incidental charge incurred by them in procuring the goods contracted for. But no such attempt was made.”
The observation of the Court clarifies the fact that although Section 74 authorizes the compensation without requiring some actual loss, this does not apply universally. The claimant must show real harm, especially where damages are quantifiable. Unless the amount is a genuine pre-estimate, then liquidated damages clauses cannot supersede evidence in those matters. The decision supports the evidentiary threshold when enforcement is conducted and cautions against relying solely on contractual stipulations where loss can be established.
However, the jurisprudential shift came with Oil and Natural Gas Corporation Ltd. v. Saw Pipes Ltd.[5], which expanded the scope of enforceability of liquidated damages clauses. The Supreme Court held that:
“(1) Terms of the contract are required to be taken into consideration before arriving at the conclusion whether the party claiming damages is entitled to the same;
(2) If the terms are clear and unambiguous stipulating the liquidated damages in case of the breach of the contract unless it is held that such estimate of damages/compensation is unreasonable or is by way of penalty, party who has committed the breach is required to pay such compensation and that is what is provided in Section 73 of the Contract Act.
(3) Section 74 is to be read along with Section 73 and, therefore, 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. The Court is competent to award reasonable compensation in case of breach even if no actual damage is proved to have been suffered in consequences of the breach of a contract.
(4) In some contracts, it would be impossible for the Court to assess the compensation arising from breach and if the compensation contemplated is not by way of penalty or unreasonable, Court can award the same if it is genuine pre-estimate by the parties as the measure of reasonable compensation.”
This divergence acts as a catalyst in expanding the enforceability of the liquidated damages clause as it was held that where the loss is difficult to quantify, a clause representing a genuine pre-estimate need not be backed by actual proof of damage.
III. Enforceability of Liquidated Damages: Judicial Analysis
Indian courts however no longer view liquidated damages clauses with scepticism, but scrutiny is multiple layered and context specific. The current jurisprudence has the following essential pillars:
A. Breach as a Prerequisite
One of the most important preconditions for a liquidated damages clause to be enforceable is the establishment of breach. This opinion was even refined in the case of Kailash Nath Associates v. DDA[6] , whereby, Kailash Nath had won a public auction carried out by Delhi Development Authority (“DDA”) and had proceeded to deposit an earnest money. DDA without any formal breach notice cancelled the allotment and forfeited the earnest money. The Supreme Court was of the view that there had been no violation by Kailash Nath and held that DDA had failed to establish any breach. Additionally, the Supreme Court held that the forfeiture of earnest money was irrational and unjust. The Supreme Court entrenched the rule of proportionality and how there must be discernible loss in some form, even if not precisely quantified.
B. Decoding Contractual Terms
Indian courts interpret liquidated damages clauses by examining both the wording of the clause and the overall context in which the contract was entered into. The pertinent question is whether the clause was intended to provide a penalty or an adequate guesstimate of settlement in case of breach. It is determined by the terms and inherent circumstances as they existed at the time of the contract, and not at the time of its breach.
The Supreme Court in the case of Bharat Sanchar Nigam Limited v Reliance Communications Ltd[7] has made it clear that the question as to the clause being penal or it being actual pre-estimate of loss is dependent on its construction and the whole circumstances that prevailed at the time of signing the contract. Courts do not stop with the label that is given in the agreement to refer to something as a penalty or liquidated damages. The crux lies in whether the question cuts to the heart of what the clause was designed to achieve.
C. Evidence of Actual Damage or Loss
When attempting to enforce a liquidated damages clause in India under Section 74 of the Contract Act, it is essential to prove that some loss or damage has occurred due to the breach of the clause. In case the party bringing the claim was reasonably in a position to prove actual loss as a result of the breach but does not do so then there is a possibility that the claim may be dismissed, or any arbitral award so rendered may be set aside.
But in cases where damages are difficult or almost impossible to quantify, like the delays in infrastructure projects mainly being construction of roads or bridges, the courts may grant liquidated damages even without detailed proof of actual loss. In such situations, the delay itself is seen as causing loss, and the pre-agreed amount is treated as a fair estimate of damages.
For instance, in GAIL v. Punj Lloyd [8] the Delhi High Court went ahead and enforced the clause where loss was not proved, observing the contractor ought to have anticipated possible weather disturbances. Equally, in Oil and Natural Gas Corporation Ltd. (supra) and Construction and Design Services v. Delhi Development Authority[9], the Supreme Court held that in public utility contracts where specific loss is hard to prove, the delay itself justifies compensation.
In a nutshell, Indian courts require proof of actual loss only when such proof is realistically possible. When it is not possible to prove such actual loss and the liquidated damages represent a genuine pre-estimate, courts may still award compensation without such proof.
D. Burden of Proof
Under Indian law, the burden of proof in disputes concerning liquidated damages clauses has been shaped significantly by the judicial interpretation of Section 74 of the Contract Act. The jurisprudence is aware of the fact that when the sum provided in the contract is a true pre-estimate of the loss, it may be enforced without strict proof of actual damage, but the non-breaching party must still establish breach of contract.
The critical precedent was laid by the Supreme Court in Oil and Natural Gas Corporation Ltd. (supra). The Court observed that where the parties have consciously agreed upon a reasonable pre-determined sum as compensation on breach of a contract and where the agreed sum is not of a penal nature then there is no necessity on the part of the non-breaching party to adduce evidence to prove actual loss or damage. Rather it is the duty of the breaching party to demonstrate that no loss was probable to have arisen or that the sum or amount specified was unreasonable.
This reasoning has been affirmed in Construction and Design Services (supra) where it was observed that when a clause has been proved to be fair and reasonably reflect the expectation of loss then the onus of proving the contrary must be shifted to the party defaulting. It was also opined, that denial of compensation in such cases, even after the existence of breach, and caused harm, would undermine the contractual spirit and the legislative mandate of Section 74 of Contract Act.
Accordingly, a liquidated damages clause that has been fairly drafted and that is unaccompanied by any penal nature and is coupled with a commercial rationale has a prescriptive effect that it will be enforceable. It does not just support contractual certainty but saves judicial resources since it lowers the evidentiary burden, thereby reducing the need for detailed litigation and trial-based evidence, which can often prolong proceedings and increase litigation costs. In such circumstances, it is naturally incumbent on the breaching party to displace the clause's presumption of reasonableness.
E. Liquidated Damages – When are parties not entitled to claim?
While a liquidated damages clause may be validly incorporated into a contract, a party's entitlement to claim compensation under such a clause is not absolute. The courts in India have identified specific circumstances where the right to recover liquidated damages may be defeated by principles of equity, contract law, and procedural fairness.
To begin with, when a party has accepted the terms of contract unconditionally including terms relating to liquidated damages, the party is not permitted to later question the enforceability of such terms. In Shyam Telelink Ltd. v. Union of India[10], the Supreme Court invoked the doctrine of estoppel, and held that once a party has agreed to and acted upon a contractual regime such as a migration package including liquidated damages it cannot later approbate and reprobate.
Secondly, no liquidated damages can be claimed by a party that is in whole or in part responsible in causing the breach or delay that has triggered the clause. This is based on a well-established "prevention principle" recognised in Indian law, whereby a party cannot benefit from its own default. As the Supreme Court held in the case of Welspun Specialty Solutions Ltd. v. ONGC Ltd.[11] , in instances where the claimant's own acts contributed to the breach, the liquidated damages clause would be rendered unenforceable.
Thirdly, the duty to mitigate losses remains an essential consideration. Though courts in some common law jurisdictions have carved out exceptions to the mitigation rule in the presence of a liquidated damages clause, Indian jurisprudence continues to treat mitigation as a relevant factor in assessing “reasonable compensation” under Section 74 of the Contract Act. Therefore, a claimant must demonstrate that reasonable efforts were made to reduce the impact of the breach.
The mere existence of a liquidated damages clause does not automatically entitle a party to recover the agreed-upon amount. Courts evaluate whether the fundamental conditions of the contract have been met, such as ensuring that performance of the contract is not obstructed, the terms of the contract have been accepted, and efforts to mitigate losses have been made. If any of these conditions are not fulfilled, the party may lose the right to claim damages, even if the clause itself is legally valid.
IV. Drafting Considerations: Refining the Liquidated Damages Clause
In the court of law, it is the quality of drafting of the Contract under consideration which usually decides the fate of a liquidated damages clause. According to the jurisprudential trends and the best practices in commerce, the following considerations are vital:
(i) Fair Pre-Estimates of Loss and Exclusion Clauses:
The clause should be a bona fide pre-estimate of probable loss as existed at the time when the contract was made to compensate the non-breaching party rather than to punish the defaulting party. This sense of equilibrium may be attained through objective evaluation of all the pertinent facts and the principle of fairness.
At the same time, the contract must clearly define any exclusion clauses that limit or cap the liability for certain events. These exclusion clauses should be worded precisely to address potential contingencies that could hinder or prevent the performance of the contract, and they must not undermine the primary purpose of the contract. By setting out clear exclusions or limitations on the amount and duration of damages that can be claimed, the contract ensures that liquidated damages clauses do not extend beyond what was originally intended by the parties. This dual consideration of fair pre-estimation and well-defined exclusions ensures that the liquidated damages clause is both legally enforceable and commercially reasonable
(ii) Methodology for Estimation:
Parties are not restricted to stipulating a single lump sum to liquidate damages. They may tailor their clauses by using a variety of estimation mechanisms suited to the nature and gravity of possible breaches. These may include:
- Fixed lump sum amounts for specific breaches;
- Time-linked rates, such as per-day or per-week damages for delay; or
- A Structured Liquidated Damages Mechanism, outlining different pre-determined sums or calculation formulas based on the seriousness or nature of breach (e.g., quality deviation, late delivery, data protection lapses).
Such matrices, when acknowledged as mutually agreed commercial terms, enhance enforceability by showing that parties applied their mind at the time of execution. The primary objective behind these methods is to avoid the expense and delay of post-breach assessments and litigation, while allowing parties to proceed with the performance of the contract confidently, knowing how damages will be settled should breach occur.
Courts have affirmed that liquidated damages need not await the entire frustration of the contract. Even breach of specific terms can be anticipated and adequately addressed through such clauses, without undermining the remainder of the contract.
(iii) Specific Performance and Time Frame:
Parties have to understand whether damages themselves would be satisfactory in terms of remedy. If not, then the clause must make it clear that it is without prejudice to the right to seek specific performance. In cases where damages are sufficient, then one should carry an estimated loss which is calculated on the scope of the different consequences of breach and also have a fixed time frame within which these damages will accrue.
(iv) Granularity:
The clause is supposed to disclose the actual events, or kind of breach that would cause liability. The amount payable can be expressed as a certain percentage of the price of the contract or specified by an objective formula, rather than a uniform fixed sum for all breaches.
(v) Timelines:
The liquidated damages must take into consideration the effect of different timelines on delay or breach. The clause should provide a clear way in which the extent of damages will correlate with the duration of non-performance.
V. Common Pitfalls in Drafting Liquidated Damages Clause
Even though they are commonly used, liquidated damages clauses do not usually stand up to judicial scrutiny due to certain recurring drafting mistakes. A common pitfall that is often committed is to use arbitrary or round figures like a flat sum of ₹1 crore for delay without correlating it with the anticipated loss.
Courts are wary of such amounts as they may indicate a penal intent rather than a genuine pre-estimate of damages as observed in various judicial precedents. Another frequent pitfall is the indiscriminate use of boilerplate clauses copied from unrelated agreements. Such provisions, lacking contextual relevance to the specific transaction, are unlikely to be enforced. Moreover, liquidated damages cannot be applied in areas where they exceed the triviality or immateriality of the breaches which are not directly concerned with the inability to meet primary obligations between the parties under the contract. Overreaching in this manner undermines the credibility of the clause.
Lastly, the fact that there was no recorded justification of the amount stipulated in the negotiation phase goes a long way in weakening its enforcement. Courts often look for evidence that the parties applied their minds to the estimation of loss at the time of contracting. Failure to demonstrate this may leave the clause being regarded as a penalty and not compensatory in nature.
The law of liquidated damages in India has evolved from a rigid, cosmetics over content approach to one rooted in reasonableness, commercial sensibility, and equitable enforcement. Though the Indian courts still guard against punitive clauses or disproportionately stringent clauses, by increasingly acknowledge and upholding the sanctity of well-negotiated contractual terms provided they reflect a genuine pre-estimate of loss and are not intended to operate in terrorem as held in Kailash Nath Associates (supra).
Therefore, it is important for the legal practitioners to move beyond boilerplate clauses. The drafting of the Liquidated Damage and allied clauses should be grounded in commercial reality, supported by evidence or genuine estimation, and framed with a view to proportionality. A liquidated damages clause is more than the conventional deterrence when drafted with great finesse. It becomes a contractual risk allocation tool, a mechanism for preserving certainty, a means of reducing litigation, and, in many transactions, a critical business safeguard. As such, it is not just a legal clause it is a strategic instrument that aligns legal enforceability with commercial reality.
Authors: Adv. Ravi Prakash (Associate Partner), Adv. Menali Jain (Associate), Adv. Sugyan Kumar Singh (Associate) At Corporate Professionals Advisers & Advocates. Views are personal.
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