Thursday, June 25, 2015

The Supreme Court on Penalties and Liquidated Damages

In its recent judgment in Kailash Nath Associates v DDA, the Supreme Court has considered some important questions relating to section 74 of the Indian Contract Act 1872. As its conclusions appear to depart from some well-known principles of contract law, the case warrants close attention. Section 74, of course, provides that the claimant in a breach of contract case is entitled to ‘reasonable compensation’ not exceeding the sum named in the contract as payable in the event of breach. This was an (intentional) departure from the distinction traditionally drawn by the common law (or, to be more precise, equity) between penalties and liquidated damages. As this Blog has noted, section 74 has given rise to difficult questions in recent years.

The dispute in Kailash Nath arose out of an auction conducted by the Delhi Development Authority (‘DDA’). Kailash Nath Associates’ (‘KNA’) bid for one of the plots was accepted. It paid Rs. 78 lakhs as earnest money. The conditions of auction provided that DDA was entitled to forfeit this amount (which represented 25% of the sale price) ‘in case of any default, breach or non-compliance of any of the terms and conditions of the auction…’ One of these terms was that KNA had to pay the remaining 75% within three months. This KNA was unable to do, but DDA, at its request, extended the deadline on the understanding that KNA would pay 18% interest. Eventually, some six years after the bid was accepted, DDA decided to forfeit the earnest money and cancelled the allotment. It then re-auctioned the property and was able to sell it for around Rs. 11 crores, nearly three times the amount KNA had agreed to pay. KNA sought specific performance and, in the alternative, a refund of the earnest money. The specific performance claim failed but the single judge held that it was entitled to a refund. The Division Bench reversed the single judge and dismissed KNA’s claim.

In the Supreme Court, Nariman J gave two reasons for allowing KNA’s appeal. The first was that there was actually no breach of contract which entitled DDA to forfeit the earnest money. This is not a question of law: it turned on the effect of DDA granting extensions to KNA. Nariman J held that this effectively extended the three-month deadline set out in the conditions of auction; since KNA had not refused to perform before the expiry of the extended deadline, it was not in breach, and the DDA was not entitled to forfeit the earnest money. If the Court had stopped there, its conclusion would undoubtedly have been correct, though one might wonder why it had granted leave. However, Nariman J went on to say that DDA was not entitled to forfeit the earnest money even on the assumption that KNA was in breach of contract in failing to pay the 75%, on two grounds. First, article 14 of the Constitution prevents a public authority from simply appropriating Rs. 78 lakhs where it has suffered no loss (since it was able to re-sell at a higher price); and secondly, and more importantly for our purposes, the forfeiture is barred by section 74 of the Contract. One may respectfully doubt the cogency of the first point: even if article 14 applies, it is not easy to see why it is ‘arbitrary’ for a public authority to do what (on this hypothesis) the law of contract permits it to do. If the law of contract allows the claimant, in certain circumstances, to recover damages even though it suffered no loss—and sometimes it undoubtedly does—the fact that the claimant happens to be a public authority seems irrelevant. So it is the second ground that is the more significant.

Why would section 74 bar the forfeiture of earnest money? It is important to remember that it is being assumed for the purposes of this argument that forfeiture was permitted by the contract, ie, that KNA’s failure to pay within three months did constitute a breach of contract. In the common law, the courts have generally been reluctant to apply the penalty rules to forfeiture clauses of this kind: as Eder J pointed out recently, these clauses have usually been readily enforced. Early Indian cases, notably Abdul Gani, also took the same view, but the scope of section 74 was considerably expanded by an amendment introduced in 1899. The amendment was made to address a particular problem that had arisen at the time about the applicability of the provision to contractual stipulations requiring the borrower, in the event of default, to pay a higher rate of interest from the date of the original loan. The 1899 amendment inserted the words ‘or any other stipulation by way of penalty’; in Fateh Chand, a Constitution Bench held that it therefore also applied to forfeiture clauses and not merely to payments to be made on breach. In Kailash Nath, the Court has held unequivocally that all earnest money clauses are subject to section 74, if triggered by breach, clarifying that certain observations to the contrary in Maula Bux were not necessary for the purposes of deciding that case.

The only difficulty with the Court’s reasoning is the proposition that section 74 applies only in the event of breach. There is no doubt that this is true, so far as it goes: section 74 opens with the words ‘where a contract has been broken…’ However, the question is whether the Indian courts retain equitable jurisdiction to grant relief against penalty clauses even if section 74 does not apply in terms. There is some support in the early cases for this proposition, but the Supreme Court in Kailash Nath appears to have assumed that this jurisdiction does not exist. It was, of course, unnecessary to decide this point given the question before the court; and its observations can therefore be treated as obiter. But the point remains unresolved in India and it is one that warrants close consideration.

It may be of interest to note that the UK Supreme Court is scheduled to hear argument on 21 July in one of the most important penalty cases of recent times: Makdessi v Cavendish.

2 comments:

Badrinath Srinivasan said...

Sir, the critique that the public authority will be able to sell at a higher price is problematic for two reasons: (1) the obvious one that this is theretical; (2) when the lowest bidder backs out, there are two major problems associated with it: (a) the CVC guidelines and almost all govt. tendering procedures mandate re-tendering if the L1/H1 bidder as the case may be backs out. This means that the public authority has to expend costs towards man-hours, re-tendering and advertising (b) the second negative effect which follows from the first is that it inevitably leads to delay in completion of the project or in the present case, delay in receipt of the value of plot/ building. The function of LD is to typically address these aspects. The larger point is that a more nuanced perspective needs to be given to the LD issue.

Further, I also hypothesise that we should look beyond the LD Law of the economies UK and USA where the quantum of public works has always been relatively less (?) unlike in India. From this perspective, I think Kailash Nath is in the right direction.

Sourish Mohan Mitra said...

I had looking for this distinction in the context of liquidated damages and penalty. Very useful thoughts captured. Thank you for highlighting it in your article above.