Liquidated Damages – Does Section 74 of the Indian Contract Act Require Proof of Actual Loss?

In a landmark decision, the Supreme Court’s interpretation in Kailash Nath Associates v. Delhi Development Authority has redefined how liquidated damages clauses are enforced under Indian law. Here’s what you need to know:

Understanding Section 74 of the Contract Act

Section 74 of the Indian Contract Act, 1872, allows parties to pre-set a compensation amount in contracts to be paid in case of breach. But a critical question arises: Is proof of actual loss necessary for claiming these damages?

Key Insights from the Kailash Nath Case
 

• Case Background: Kailash Nath Associates defaulted on a payment deadline to the Delhi Development Authority (DDA) for an auctioned plot. DDA canceled the allotment and forfeited the earnest money.
• Supreme Court Ruling: The Apex Court held that since DDA suffered no loss (as they sold the plot at a higher price), forfeiting the earnest money was arbitrary. Compensation under Section 74 requires actual loss proof, except when determining such loss is impractical. Feature Article: Liquidated Damages – Does Section 74 of the Indian Contract Act Require Proof of Actual Loss?
• The Kailash Nath decision contrasts with the earlier ONGC v. Saw Pipes ruling, which allowed liquidated damages without proving actual loss. Kailash Nath has provided a clearer framework: liquidated damages are valid if they represent a "genuine pre-estimate" of loss, and only actual loss must be compensated where it can be shown.

1. Requirement of Actual Loss: Proving actual loss or damage is generally essential for awarding compensation. Section 74 is not intended to unjustly enrich the aggrieved party.
2. Penalty Clauses: If a penalty clause specifies an amount disproportionate to the loss, the court will cap compensation at a reasonable amount.
3. When Proof of Loss Isn’t Required: In cases where calculating loss is highly challenging, the pre-agreed liquidated sum may be accepted as reasonable.

• The Apex court outlined that a fixed sum in a contract for damages should reflect a genuine pre-estimate of damage.
• When the amount is punitive, compensation is limited to a reasonable amount, not exceeding the penalty.
• Actual loss, if provable, should be demonstrated. Only in cases where loss calculation is impractical can the pre-set amount be upheld.