Psychology Of Breach: How Misreading Liquidated Damages Skews Contractual Behavior

The main cause of this confusion is an inaccurate reading of legal cases, revolving around the Supreme Court's ruling in Kailash Nath Associates v. DDA. Although the case affirmed the validity of the LD clauses in the absence of stringent evidence of real loss, it has been reduced to a very popular headnote that implies the opposite. This legal expediency has influenced legal opinion, agreement settlement, lawsuits, and even the logic used by lower-level courts. The result is a perverse shift in behavior in which parties, under the seeming right and requirement to establish a loss, regard LD clauses as acts of paper tigers rather than commitments to act on them. This misperception comes at a high cost to the company. Employers are hesitant to rely on the LD clause for fear of potential hurdles, and breaching parties become confident in defaulting because there is a chance that enforcement will fail.

Section 74 and the Forgotten Simplicity

Section 74 has statutory language that is misleading. According to it, if a contract specifies a specific sum to be paid in breach, the aggrieved party is entitled to reasonable compensation not exceeding the amount specified, even if actual harm is not demonstrated. This argument is self-explanatory: when the parties agree on a reasonable estimate of the damage, the court can apply it even if there was no real loss. The law serves two purposes: to reduce the burden of demonstrating loss in difficult-to-value breaches and to prohibit imposing ill-conceived sanctions on the violating party.

This reasoning was confirmed in landmark decisions such as Fateh Chand v. Balkishan Dass and ONGC Saw Pipes. In such cases, the Supreme Court has made it clear that courts are free to give compensation under Section 74 without requiring comprehensive evidence of loss, especially when the damages are extremely difficult to quantify. These decisions established a jurisprudential presumption: that an LD provision is an actual estimate of reasonably anticipated harm and will be effective unless it is shown that it has become punitive or unsupportable. The burden of disproving the clause falls on the breaching party rather than the injured party.

However, over time, the fundamental meaning of Section 74 has been diluted by editorial cuts rather than legislative changes or judicial decisions. Case digests, headnotes, and, most importantly, summaries have become the accepted format for legal reading. This is clearly demonstrated in the Kailash Nath Associates case, which holds that a fair LD clause can be enforced without causing actual loss. However, its headnote appears to say the contrary. The reliance on these summaries, at the expense of considering the reasons behind them, has fostered a fallacy among legal experts that Section 74 makes proof of loss an exception rather than the rule.

The Behavioural Fallout of Misinterpretation

The real-world consequences of this disparity between what Section 74 states and what many people believe it says can be seen. Business conduct has not remained consistent with the actual legislation, but has been misinterpreted. The most visible shift is in the behavior of contractors and suppliers, particularly in time-sensitive industries like infrastructure, EPC, and government procurements. These parties have begun to read LD clauses as non-binding, hoping that the courts will impose unrealistic standards of loss quantification on employers. Consequently, the deterrence LD is undermined.

Consider the following two case studies:

Case Study 1: Delhi Metro Rail Corporation v. Simplex Infrastructures Ltd. (2017, Arbitration Matter)

In an arbitration dispute involving delays or projects and based on LD, the contractor claimed that LD was imposed on the grounds that actual financial loss was not quantified. Even though the delay was admitted and the LD provision was contractually agreed upon, the contractor contended that no money could be claimed unless the delay resulted in a definite financial loss, citing legal advice indicating that a similar case had attracted Kailash Nath. This resulted in several years of hearings during which each side spent a significant amount of time gathering expert opinion and cost modelling, despite the fact that the contract itself contained a clearly worded LD clause. Due to the fear of an adverse award, the employer accepted a lesser amount of money.

Case Study 2: National Highways Authority of India v. Gammon Engineers & Contractors (2020, NCLT Observation)

In another case involving delays in the road-building contract, the contractor again contested LD, claiming that the delays resulted in no income loss for the government. The panel explained that the LD provision was created as a national bidding guideline and appears to be a reasonable estimate of costs incurred as a result of a time overrun. However, the problem has escalated into full-fledged litigation, which is a waste of taxpayer time and money because the contractor wielded the 18th-century sword of reporting the actual loss. The tribunal upheld the clause, albeit with significant delay and cost to the government as a result of legal misinterpretation.

All of these examples demonstrate a common trend: the parties no longer regard LD clauses as viable risk allocations, but rather as contestable approximations that can be exploited after the breach. The LD clause has emerged in legal society as a procedural strategy designed to promote procedural justice rather than substantive justice. Attorneys representing side-breaking parties frequently advise them to file an LD provisions challenge--not because they have discovered anything wrong with the provisions, but because they know the other party may struggle to meet a level that is not even required by law. The LD clauses are now so damaged in contract drafting that even drafters are afraid to use them literally. This is not what Section 74 was intended to do, and it certainly contradicts what Indian commercial law is supposed to do.

Relearning Section 74

Reverting to the fundamentals is necessary to correct this distortion; a new law is not necessary. Section 74 was intended to ease rather than complicate the routine of breach enforcement. The key question is not whether there was a loss, but whether the LD clause was a reasonable anticipation of harm when the contracting parties entered into the agreement. Such is the premise that was established in Fateh Chand, reiterated in Saw Pipes, and continued in Kailash Nath. Courts have the jurisdiction to determine and reduce LD payments if they are judged to be excessive or punitive. However, they do not have to ignore LD entirely because it is difficult. Certain recent verdicts appear to be shifting the tide against the myth. The case of Dhiraj Lakhamashi Shah v. Madhav Hari Karmarkar and Devichand Construction. According to the Union of India and the High Courts, the existence of an LD clause, where the sum is predetermined and reasonable, is sufficient evidence of pre-estimation. Such verdicts are long required judicial rectification, reminding the parties involved that LD clauses are deemed genuine unless proven otherwise.

Section 74 was remedial in nature, with the goal of enhancing certainty, justice, and efficiency in the enforcement of commercial contracts. It was intended to avoid protracted litigation over damages expenses for breaching a contract by allowing them to pre-agree on the costs of breach. However, the aim is currently being undermined, not by a failure of the law, but by a lack of comprehension. The premise that real loss must always be demonstrated has reduced LD clauses to devices of uncertainty rather than assurance.

The credibility of the contract is at stake in this case, not just its enforcement. When one party loses faith that the other will keep its pre-contractual promises, the very nature of biizzard predictability begins to wane. This dimming of trust is neither inherent in statute 74 nor is it caused by a misunderstanding of the statute or its deceptive implementation.

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