What is the measure of compensation for breach of contract where penalty is stipulated......Explain with illustrations.

Question: What is the measure of compensation for breach of contract where penalty is stipulated for, in the contract? Explain with illustrations. [MPJS 2021]

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Answer

Under the Indian Contract Act, 1872, the measure of compensation for breach of contract where a penalty is stipulated is primarily governed by Sections 73 and 74. Section 73 outlines that a party suffering from a breach is entitled to compensation for losses caused by the breach, but this compensation must not cover any remote or indirect losses.

Section 74 specifically addresses stipulations for penalties in contracts. It states that if a contract specifies a sum to be paid in case of a breach, the aggrieved party can recover reasonable compensation, not exceeding the stipulated amount. This section differentiates between liquidated damages (which are enforceable) and penalties (which may not be).

Distinction Between Liquidated Damages and Penalties

Liquidated Damages: These are amounts set in advance by the parties, intended to represent a genuine pre-estimate of the losses that might occur due to a breach. For example, if a construction contract states that the contractor must pay ₹2,000 for each day of delay, this serves as a pre-estimated damage amount.

Penalty: This is an amount intended to deter a breach rather than to compensate the aggrieved party. For instance, if a contract specifies a payment of ₹1,00,000 in case of any breach, irrespective of actual damages, this would likely be classified as a penalty.

Illustrations

Liquidated Damages Example:

A supplier agrees to deliver goods by June 1st. The contract specifies ₹5,000 for each day of delay. If the delivery is made on June 10th, the buyer can claim ₹5,000 × 9 days = ₹45,000 as liquidated damages. This amount is enforceable as it represents a genuine estimate of loss.

Penalty Example:

A contractor has a deadline of March 31st to complete a project, with a stipulated penalty of ₹1,00,000 for late completion. If the actual loss incurred due to delay is only ₹20,000, the court may enforce only the ₹20,000 as compensation, viewing the ₹1,00,000 as an unenforceable penalty.

The measure of compensation for breach of contract with a penalty clause under the Indian Contract Act, 1872 is determined by the nature of the stipulation. Only reasonable damages reflecting actual losses are recoverable, with penalties deemed unenforceable.