Law of Liquidated Damages in Contracts: The Interplay of Section

73 and 74 of Contract Act 1872

 By: Waiza Rafique

LLB (Hons.), DBL, DIA, ILCC

 

The history of contracts and promises dates back to the ancient Greek and Roman era when people used to create rights and obligations by virtue of mutual agreements whether written or oral. With the passage of time grew the intricacies in laws and contracts which led to substantial evolution in jurisprudence of the contact law and countless new authorities and opinions were added in the pool of legal research over questions of law in transactional matters.

Every contract carries a tendency of breach and every breach carries with it a potential for dispute. In modern transactions, these breaches and disputes are quite complex and technical which end up in having various different views and authorities over the same points of law. One of such example is the law as to liquidated damages under the provisions of the Contract Act 1872.

To simply put, liquidated damages are pre-estimated or ascertained damages that are foreseen/envisaged by the parties and are stipulated within the agreement/ contract. As defined in the famous Dunlop Pneumatic Tyre Co. Ltd. vs. New Garage (1915), Liquidated Damages are the ‘genuine covenanted pre-estimate of damages’ which need not be proven and which need not to have occurred even. Thus, it can be inferred that for liquidated damages to be enforceable, no actual loss or suffering needs to be put on record or proved.   

It is important to note that for claiming damages, the concept of ‘time being of the essence’ and ‘not of the essence’ is also important. The relevant provision of the Contract Act for the determination of time being essential or not is Section 55.

For the thorough understanding of this concept, section 55 is reproduced below:

55. Effect of failure to perform at a fixed time, in contract in which time is essential.—When a party to a contract promises to do a certain thing at or before a specified time, or certain things at or before specified times, and fails to do any such thing at or before the specified time, the contract, or so much of it as has not been performed, becomes voidable at the option of the promisee, if the intention of the parties was that time should be of the essence of the contract. —

If it was not the intention of the parties that time should be of the essence of the contract, the contract does not become voidable by the failure to do such thing at or before the specified time; but the promisee is entitled to compensation from the promisor for any loss occasioned to him by such failure. —

If, in case of a contract voidable on account of the promisor’s failure to perform his promise at the time agreed, the promisee accepts performance of such promise at any time other than that agreed, the promisee cannot claim compensation for any loss occasioned by the non-performance of the promise at the time agreed, unless, at the time of such acceptance he gives notice to the promisor of his intention to do so.

 

The bare reading of section 55 suggests that the conduct of the Parties is of prime importance to see if time was of essence in the contract or not.

For instance, a party to a contract was to receive certain goods/material within a stipulated time. The other party fails to deliver such goods/material within the specified time and the first party accepts the late delivery of such goods/material. Here, the conduct of the first party shows that the time was not of the essence in this contract. Had the said party accepted delivery only within the specified time or would have either repudiated the Contract, in terms of sub clause 1 of Section 55, and sought damages or accepted late delivery subject to issuance a notice to the other party as warranted under sub clause 3 of Section 55, time would have been of essence. Thus, where Party ‘A’ agrees to deliver certain goods/material to Party ‘B’ and both the parties agree in the contract that ‘Delivery’ shall commence within 90 days and stipulate $200 per week in case of late delivery then this provision specifically grants to party B the right to recover the stipulated amount of $200 per week as damages in case of delay in delivery.

The leading judicial pronouncement which laid down factors to determine whether time is of the essence of the contract or not is Sandoz Limited Versus Federation of Pakistan cited as 1995 SCMR 1431 (Sandoz Case).  The facts in Sandoz Case were that in term of the supply contract awarded to Sandoz Limited by the Federal Directorate of Agriculture Supplies, Ministry of Food and Agriculture, Sandoz had to supply the material within a fixed date and in case of delay in supply Sandoz was liable to pay damages.

Having surveyed leading authorities, on the issue,  from American, British and  Pakistani jurisdictions, their Lordships while interpreting Section 55 of the Contract Act, 1872 in Sandoz Case,  arrived at the finding that the expression “time should be of essence of the contract”,  appearing at the bottom of the first part of the Section,  has been left undefined by the legislature “for whether time is or is not of the essence must inevitably depend upon the parties’ intention to be gathered from the terms of the contract as a whole, and the antecedent circumstances leading to the contract”.  Mr.  Justice (R)Fazal Karim, while agreeing with Ajmal Mian J. (as he then was), held at para 39, page 1475 of the Sandoz Case that:

“The test to determine whether time is or is not to be regarded as of the essence, therefore, is whether failure to perform the promise timeously will deprive the promise of the whole or substantially the whole benefit which it was intended that he should obtain for the contract”. It was further held at para 39-A that “Section 55 of the Contract Act makes the contract voidable at the option of the promisee if the specified time was intended to be of the essence and the contract is not performed within the specified time, but if the time was not intended to be of the essence, it entitles the promisee to compensation from the promisor for any loss occasioned to him.”

The general rules of construction of contracts as stipulated in Chitty On Contracts are that the object of all construction of the terms of a written agreement is to discover the intention of the parties therein (Para 12-039), and that in order to resolve any ambiguity, while construing any document, the court may look at its commercial purpose and the factual background (Para 12-040). Furthermore, the rule of adoption of ordinary meaning of words (Para 12-044) envisages that the terms of contract are to be understood in their plain, ordinary, and popular sense.

Furthermore, in order for a party to demand the precise or correct amount, it has been required as a condition precedent to ‘Quantify” the amount of liquidated damages and thereafter serve a written notice to the other party and claim payment. It is only if a party fails to comply with the written demand notice that party that the other party becomes authorized to recover the demanded amount forthwith through calling upon the Performance/Warranty Bond Guarantee.

Another leading authority enunciating the same principle is ‘Oil and Natural Gas Corporation Ltd. versus SAW Pipes Ltd’ (the SAW Pipes Case AIR 2003 SC 2629). In this case, the supplier delayed delivery of casting pipes which caused delay in deployment of rigs and on that basis actual production of gas from a specified platform had to be changed. Since one of the witnesses on testified that the delay was one of the factors for the redeployment plan, therefore the arbitration tribunal held that the Petitioner Corporation was not entitled to retain compensation. After survey of leading authorities and provisions on the point the Indian Supreme Court held at Para 68 that:

“In our view, in such a contract, it would be difficult to prove exact loss or damage which the parties suffer because of the breach thereof. In such a situation, if the parties have pre-estimated such loss after clear understanding, it would be totally unjustified to arrive at the conclusion that party who has committed breach of the contract is not liable to pay compensation. It would be against the specific provisions of Ss. 73 and 74 of the Indian Contract Act.”

Another factor on the basic of which the Court found the judgment in favour of the Petitioner was that:

“there is nothing on the record that compensation contemplated by the parties was in any way unreasonable.” It was further held that “It was also mentioned that the liquidated damages are not by way of penalty. Finally, while setting aside the tribunals decision, the Court held that “There was no reason for the tribunal not to rely on upon the clear and unambiguous terms of agreement stipulating pre-estimate damages because of delay in supply of goods.”

The reasonableness or the genuineness of the pre-estimated loss also raises some very difficult and technical questions both in commercial as well as non-commercial contracts.

There was an argument raised by shipbuilders in ‘Clydebank Engineering Co. vs. Yzquierdo Y Castaneda’ (1905) where the contract was for building four warships and the penalty for late delivery was fixed at the rate of £500 per week. The Clydebank contended that there cannot be a genuine pre-estimation of loss as the warship does not earn money. However, Lord Halsbury refuted the argument and termed the stipulated rate of penalty as ‘liquidated damages’ establishing that a difficulty in ascertainment is no barrier to an estimate being made. This ruling has been followed by courts on various occasions and the courts have laid the dicta that ‘the very difficulty in ascertaining the damages for late completion is a good reason why such damages should be liquidated.’

In the above referred Dunlop Pneumatic Tyre case, Lord Dunedin agreed to Lord Halsbury stating the following:

“It is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility. On the contrary, that is just the situation when it is probable that pre-estimated damage was true bargain between the parties.”  

Apart from the Sandoz Case which clarified the position with regard to essence of time and the applicability of Section 55 of the Contract Act to the specified situations, the SAW Pipes Case aluminates the matter regarding eligibility of a party to liquidated damages in a sale of goods contract where the contract has envisaged grant of compensation due to breach of contract even when the proof of actual loss due to delay in delivery of goods have not been proven.

However, the perspective of Pakistani Judges and lawyers is quite different as to the interpretation of the abovementioned provisions of the Contract Act. In many instances, the liquidated damages are demanded to be proven and are not granted otherwise in case of delayed delivery of the goods. Although the legal provisions about liquidated damages are clear on this point. The encashment of Performance bonds also becomes debatable even though the law and jurisprudence is unambiguous about encashment of guarantees/performance bonds once the conditions to have them enchased are met.

The views expressed are of the author. This article is the intellectual property of Ms. Waiza Rafique who takes full responsibility to ensure the accuracy of the laws quoted and the content referred to in the article. No part of this publication shall be reproduced without prior written permission of the author.