Monday, December 6, 2010

The Supreme Court in BSNL v Reliance: Penalty and Liquidated Damages

The complexity of the distinction between penalties and liquidated damages in English law is amply borne out by the fact that even McGregor’s remarkably concise and insightful account is forced to begin with a seventeenth century statute (18th edition, ¶¶13.001 onwards). For an elaborate account of the law, interested readers may refer to Chitty on Contracts (30th edition, ¶ 26-010 onwards), McGregor on Damages (18th edition, Chapter 13), and the leading decisions in Astley v Weldon, Dunlop Pneumatic Tyre v New Garage (especially Lord Dunedin) and Phillips v AG of Hong Kong, (1993) 61 BLR 41. It suffices to note here that in traditional English law, a claimant generally could not recover in excess of actual loss if the sum stipulated in the contract for breach was not a “genuine pre-estimate” of loss and was therefore a “penalty”. This did not bar any action for actual loss, even in the rare circumstances where actual loss exceeded the penalty sum. He was, on the other hand, entitled to liquidated damages without proving actual loss, although in the rare circumstances where actual loss rarely exceeded that sum, he was confined to that sum. Naturally, this made the exercise of distinguishing between a penalty and liquidated damages a crucial one in English law.

The Indian legislature, to quote the Constitution Bench in Fateh Chand, cut across this “web of presumptions” in English law, and enacted a simple rule in s. 74 that a claimant, in the event of breach of contract, is entitled to “reasonable compensation” not exceeding the sum named as penalty or as the sum payable in case of breach. The word “penalty”, which did not originally exist in the section, was added by way of an amendment in 1899, and Sankaran Nair J. explained in 1910 that the object was to make abundantly clear that the provision applied to any stipulation intended to compel the performance of a contract, and not just to the payment of a sum of money in the event of breach. However, Sankaran Nair J. was dealing with the forfeiture of a deposit upon non-completion, which is close in substance to a penalty, and it is not clear whether s. 74 applies to a provision requiring the payment of a sum of money or other performance upon the happening of a certain event that is arguably inconsistent with the putative payer’s primary obligations under the contract, and yet may not constitute a “breach”.

The Supreme Court had an opportunity to clarify whether this is so recently, in BSNL v Reliance. Unfortunately, it has not done so. BSNL v Reliance arose out of the 1997 BSO Interconnect Agreement [“BIA”] and its subsequent amendment that the two companies had entered into, concerning, in layman terms, the sharing of networks. In 2003, the BSO regime was itself replaced in India by the “Unified Access Service Provider” regime, and the BIA was consequently amended in 2006 with retrospective effect from 2003. It provided for charges to be levied by BSNL on Reliance for calls on its network, depending on the nature of the call (local, international etc.). Of importance to this dispute was the “Caller Line Identification” [“CLI”] device, which was not only used by the parties as a means of identifying the caller, but for deciding for billing purposes at what rate a call was to be charged.

In September 2004, BSNL, pursuant to enquiries, discovered that certain CLI numbers were occurring in data more frequently than normal, suggesting either that the CLIs had been tampered with, or, more seriously, that international calls were being “masked” as domestic calls by the manipulation of the CLI. Invoking clause 6.4.6 of the BIA and BIA 2003, which allowed it to invoke a certain method of computing charges and the use of the highest applicable rate for a period of two months before the calls, BSNL levied a charge of about Rs. 9.89 crores on Reliance.

In the Supreme Court, BSNL argued that the court need not even determine whether clause 6.4.6 represents a penalty, because such characterisation is irrelevant to a “sum payable on the happening of an event other than breach.” There is support for this contention in English law. In Export Credits Guarantee Department ([1983] 1 WLR 399), the locus classicus on the point, where the House of Lords rejected an attempt to portray a sum stipulated in the contract as a penalty upon the sole ground that it was payable not in the event of breach of that contract, but on the breach of a contractual obligation the defendant owed to third parties. Whether this is true in India in light of the wide statutory formulation and the Constitution Bench decision in Fateh Chand is an important question of law. Had the Court considered it, it would have been a close point on the facts as well, since clause 6.4.6 was titled “Wrongly Routed Calls” and ostensibly only provided for a different mechanism for computing the charges payable on the happening of a certain event (detection of unauthorised calls).

However, Kapadia C.J. held that the “regulatory regime” must be kept in mind, and that making unauthorised calls destroys the principle of “level playing field” in illegitimately allowing BSNL’s competitors to offer lower rates for international calls. The Court also held that the impossibility of tracing the unauthorised call makes the stipulated method a “reasonable pre-estimate of damage”. Citing Treitel and Chitty on the tests to distinguish between the two, the Court made the following observations:

The nature of the call, be it local or national or international, as indicated by corresponding CLI, is the basis for the levy of IUC (including ADC). If by wrong routing of calls or by masking the cost of providing services is reduced, the concerned operator gets an undue advantage not only in the Indian market over other competing operators but also in the international market. …These time lines is [sic] an indicia showing that clause 6.4.6 is not penal but a pre-estimate of reasonable compensation for the loss foreseen at the time of entering into the agreement. Lastly, it may be noted that liquidated damages serve the useful purpose of avoiding litigation and promoting commercial certainty and, therefore, the court should not be astute to categorize as penalties the clauses described as liquidated damages. This principle is relevant to regulatory regimes… Section 74 of the Contract Act is not violated. Thus, it is not necessary to discuss various judgments of this Court under Section 74 of the Contract Act [emphasis mine].

Two observations may be made. First, if, as BSNL contended, clause 6.4.6 was just one of the many obligations of the parties upon the happening of a certain event (in this case the detection of unauthorised calls), it is not relevant to even consider whether it is a penalty or a genuine pre-estimate of loss. While it was possible for the Court to reach the conclusion that the legal nature of the clause was consistent with a provision regulating the consequences of breach, it is submitted, with great respect, that it could not proceed to the second step without making this finding. Secondly, even assuming clause 6.4.6 engages s. 74, it is difficult to see why it is important to characterise it as a penalty or as a genuine pre-estimate of loss, since in either event the court is required to award “reasonable compensation” not exceeding that sum. The factors relevant to this analysis were discussed by the Constitution Bench in Fateh Chand, and while one could argue that the Court in BSNL v Reliance merely took the view that the named sum, if a genuine pre-estimate, was the best indicator of “reasonable compensation”, the judgment itself does not appear to so limit its use of clause 6.4.6. Thirdly, it is submitted, with respect, that it is in any event irrelevant to consider the “regulatory regime” or the possibility that BSNL’s competitors may offer lower rates, except as an indicator of the likely intention of the parties.

One hopes that the Supreme Court will clarify the true scope of s. 74 in this respect, and engage with the Indian case law on the subject, when the next opportunity arises.


Renganath said...

S.74 begins with the words "When a contract is broken...". I suppose therefore that it would be possible to forcefully contend that S.74 has no application to the mere happening of an event not being a breach. Of course, the moot point often is, as you have suggested, whether there is or is not a breach in a particular scenario. In the instant case, I would think that if the contract contained a specific covenant that Reliance shall not mask calls, in addition to the "Wrongly Routed Calls" provision, then it undoubtedly would be a breach. However, in the absence of the said covenant, the latter provision to me seems more of an event and less of a breach scenario inasmuch as such a wording would be an option to the party to operate the CLI and pay proportional rates or do away with the CLI and pay at the peak rate, possibly akin to (presumptive taxation) provisions in the Income Tax Act where certain industries may not maintain accounts and pay tax at the prescribed flat rate (or, to give another example where manufacturers using common inputs for the manufacture of excisable and exempt products may dispense with records and choose to pay a flat 8% on the value of the exempted products).

V. Niranjan said...

Exactly. In such contracts, the clause appears then to be a risk-allocation provision - that one party is entitled to pay at proportionate rates provided he can establish the facts necessary for invoking that rate. And if it is a risk-allocation provision, it appears inappropriate to consider it a breach.

This is likely to be a close point in most cases, since the contractual provision will invariably be atleast partly inconsistent with the primary obligation of the claimant. It is unfortunate that the Court did not consider this issue, especially since its conclusion that clause 6.4.6. is a "genuine pre-estimate" leaves room for the argument that it impliedly rejected the submission that the clause is an event, and not a breach.