Applicability of the Penalty Doctrine to Primary Obligations – an Indian Perspective

[By Tvishi Pant and Alefiyah Shipchandler]

Tvishi is a student at ILS Law College, Pune and Alefiyah is an associate at Keystone Partners, Mumbai.

Introduction

Contract law allows parties to stipulate a certain sum payable upon breach of a contract. Section 74 (“S. 74”) of the Indian Contract Act, 1872 (the “Act”) provides for the payment of liquidated damages by a defaulting party upon breach of contract. Although the law surrounding the parameters of S. 74 is largely settled, there remain slight uncertainties in the scope of its applicability to scenarios where there has been no breach of contract.

Background – The Penalty Doctrine

The ‘penalty doctrine’ has its origin in equity. Broadly stated, it suggests that a clause providing for payment of a sum of money upon breach of contract may be unenforceable if it goes so far beyond the measure of compensation that it appears to be a penalty. The basic understanding of this doctrine has its roots in the case of Dunlop Pneumatic. This judgment laid down that if a particular sum is payable upon the breach of a contract, it would be regarded as a penalty if it “exceeds what can be regarded as a genuine pre-estimate of the damage likely to be caused by the breach”.

The penalty doctrine, thus, resulted in the formulation of a fundamental distinction between a ‘penalty’ and a ‘genuine and reasonable pre-estimate of damages’. Where an amount is named in a contract as liquidated damages, the party complaining of a breach will be entitled to receive a liquidated amount of reasonable compensation,      provided it is a genuine pre-estimate of damages. In other cases, only reasonable compensation will become payable which will not exceed the liquidated amount so stated.

The Supreme Court of India has time and again interpreted S. 74 of the Act in line with the aforementioned formulation of the penalty doctrine, and hence has allowed liquidated sums to be taken into consideration as the measure of reasonable compensation, where it is not in the nature of a penalty.

Application of S. 74 in Non- Breaches

A pertinent question which has time and again arisen, and largely remains unanswered, is whether such relief against unreasonable penalty clauses will be available to parties even where the event triggering the penalty is not a breach of contract.

Contractual clauses contemplating both scenarios, by way of illustration, are as under:

Clause A – Occurrence of a breach

“We agree to pay for ABC Ltd. a sum of Rs. 100/-. for each and every product, good or item sold or offered in breach of this agreement, as and by way of liquidated damages and not as a penalty.”

Clause B – Occurrence of an event other than a breach

“If you request a withdrawal or payment from your account which would overdraw your account, XYZ Bank may allow the withdrawal or payment to be made on the condition that  Rs. 50,000/- may be charged for XYZ Bank agreeing to honor the transaction which resulted in the overdrawn amount. This amount will be debited to your account.” As is evident from the heading of S. 74, it is certainly attracted to Clause A, which contemplates a breach. It is, thus, necessary to assess the viability of extending its scope to deal with events other than breaches as well, such as Clause B.

Application of the Doctrine in Foreign Jurisdictions

Australia

Up until 2015, Australian Courts had held that the penalty doctrine was limited to stipulations that were triggered on breaches of contract. However, in 2015, the  Andrews case marked a significant departure from this law.

The Court reasoned that historically, the “conditions” that triggered payment of a sum were not always breaches of existing contractual obligations. It was essentially held that the penalty doctrine was not limited in application to stipulations involving breaches of contract and that the event that triggered payment need not be restricted to a breach, in order to assess its position under the penalty doctrine. This judgment was affirmed by the Australian High Court in 2016, in Paciocco.

It is arguable that such an approach opens doors to an uncontrollably wide jurisdiction over contractual freedom and autonomy, by which simple matters of commercial prudence (or even lack thereof) fall within the purview of judicial inspection.

United Kingdom

The position in the United Kingdom has largely remained unchanged. One of the first few cases dealing with this question was Export Credits, where it was held that it has never been for the Court to relieve a party from the consequences of what may prove to be an onerous or commercially imprudent bargain.

In 2015, the Supreme Court’s judgment in Cavendish made a very important distinction between ‘primary obligations’ and ‘secondary/ accessory obligations’ for the purposes of determining whether the penalty doctrine applied where there has been no breach of contract.

The Court held that, “The penalty rule regulates only the remedies available for breach of a party’s primary obligations, not the primary obligations themselves.”[i]

While the Court did not categorically lay down the difference between such ‘primary’ and ‘secondary’ obligations, it appears to have proceeded on the assumption that a ‘primary’ obligation is one which is fundamental to the performance of a contract, and that the breach of such ‘primary’ obligation will give rise to a ‘secondary’ obligation to pay a certain amount to the innocent party as and by way of relief. The Court thus held that,

This means that in some cases the application of the penalty rule may depend on how the relevant obligation is framed in the instrument, i.e., whether it is mentioned as a conditional primary obligation or a secondary obligation providing a contractual alternative to damages at law. Thus, where a contract contains an obligation on one party to perform an act, and also provides that, if he does not perform it, he will pay the other party a specified sum of money, the obligation to pay the specified sum is a secondary obligation which is capable of being a penalty; but if the contract does not impose (expressly or impliedly) an obligation to perform the act, but simply provides that, if one party does not perform, he will pay the other party a specified sum, the obligation to pay the specified sum is a conditional primary obligation and cannot be a penalty.

Another pertinent observation made by the Court was that merely because a contractual clause is not a genuine pre-estimate of damages, does not mean that it is ipso facto penal. Such a deterrent provision is simply one species of provisions designed to influence the conduct of the potentially affected party.

The Court criticized the decision in Andrews, stating that it had incorrectly sought to treat as a clause which was in the nature of a “security” for the satisfaction of a primary obligation as a potential penalty. Drawing on the principles of contractual freedom, Cavendish held that the assimilation by courts of such contingent obligations into penal remedies would not be in line with the freedom to contract.

Analysis of the Indian Position

As on date, the position in India remains ambiguous. However, as aforementioned, the language of S. 74 of the Act presupposes the existence of a breach, and thus would fall neatly in line with the Cavendish approach.

In B.S.N.L. vs Reliance, B.S.N.L. raised an argument to the effect that the clause in question simply gave them an option to terminate the contract or to choose prolongation of the contract on payment of a certain sum. Thus, the clause merely prescribed payment of an amount on the happening of an event that is not a breach of contract, and so the question of assessment under Section 74 of the Act did not arise. However, the Supreme Court did not dwell on this aspect and directly proceeded to ascertain whether the clause was a genuine pre-estimate of reasonable compensation.

Even the Bombay High Court’s decision in Indiabulls is fairly aligned with the ruling in Cavendish. The Court adjudicated upon a leave and license agreement that provided for the payment of liquidated damages by the licensee, on premature termination. Indiabulls argued that the clause merely created a liability or a debt contingent and was in no manner a clause for damages. The Court held in favor of Indiabulls, and in stating that the claim was not one for damages at all, made some pertinent observations –

“Every claim for license fee for the remainder of a lock-in period in a leave and license agreement is not per se a claim for damages…In a given case…it may simply be a component of the contractual consideration and therefore, a debt properly so-called when the contingency in contemplation comes to pass.”

As such, it can be argued that Indiabulls seemed to follow the Cavendish distinction between a primary obligation and secondary obligation. The Court clearly held that a clause which simply creates a contingent debt would not qualify as a damages clause, irrespective of the terminology used in such clause.

The Cavendish rationale was also noted and followed in this regard by the CESTAT Mumbai in August 2019.

Conclusion

While there has been no precise judicial exposition on this, the Indian trend appears to align with the United Kingdom, as seen in Indiabulls. It is important for Indian Courts to take a categorical stance on this position, given the divergence that has now emerged within common law jurisdictions, especially given the language of S. 74. However, in adopting this position, courts must also caution against parties that attempt to evade the penalty doctrine by using clever drafting to cloak the clauses as primary conditional obligations.  The approach must take into account the substance of a clause over its form, to ensure detection of ‘disguised’ penalty clauses.

 Endnotes:

[i] Paragraph 13.

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