Liquidated damages (LD) are a pre-agreed sum specified in a contract as payable upon breach, representing the parties' genuine pre-estimate of the loss likely to result from that breach. They are distinguished from penalty clauses, which are unenforceable in common law jurisdictions as they impose a payment disproportionate to the legitimate interest in performance.
Section 74 of the Indian Contract Act 1872 is unique — it treats liquidated damages and penalty clauses the same way. Courts award 'reasonable compensation not exceeding the sum named' regardless of whether actual loss is proved or not (Fateh Chand v Balkishan Das [1963] SCR). This departs from English law.
Under UK law (Cavendish Square Holding v Makdessi [2015] UKSC), a clause is unenforceable as a penalty only if it is 'out of all proportion to any legitimate business interest of the innocent party'. The distinction between LD and penalty requires careful drafting.
Under the UCC and common law, LD clauses are enforceable if the amount was reasonable at the time of contracting and actual damages were difficult to estimate. Penalties are unenforceable.
Unless the contract explicitly states that LD are the 'sole remedy', the courts in many jurisdictions (including India) allow the innocent party to claim additional losses exceeding the LD sum. However, the contract can expressly cap liability at the LD amount.
In India (Section 74 ICA), both LD and penalty clauses are treated as stipulations of a 'reasonable sum'. Courts will award actual proven loss or the stipulated sum as reasonable compensation — whichever is lower. Pure penalties are not struck out but are limited to reasonable compensation.
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