Understanding 'Damages' and 'Compensation' under Contract Law

This Article is written by Nidhi Singh, 3rd Year Law student from Lloyd Law College, Greater Noida.

“Damages” are often confused with “damage”. However, it should be known that these two terms are significantly distinct, and different from each other. While “damages” refer to the compensation awarded or sought for, “damage” refers to the injury or loss which such compensation is claimed for or being awarded. ‘Damage’ could be monetary or nonmonetary (which could in cases where there is loss of reputation, physical or mental pain or suffering) while ‘damages’ refer to pecuniary compensation.

In context of the Indian Contract Act, 1872 damages are referred in context to breach of contract i.e. a party’s failure to perform some contracted-for or agreed upon act, or his failure to comply with a duty imposed by law which is owed to another or to society. Breach of contract is a legal concept in which a binding agreement or negotiated for exchange is not respected by one or more of the parties to the contract by non-performance or interference with the other party’s performance.

A mere study of sections could give anyone an idea as to in what is the meaning of damages and penalty in the context in which it has been used in the said sections. But the fact as to what is the exact meaning and what all it would included in the said section and how these words have to be interpreted and construed is a matter of understanding and interpretation in different cases where in the mean and the sense may differ.

Damages[1] are compensation for the losses suffered by one person due to the non-performance of the other. It is normally in material i.e. monetary. It is either a part of contract if it could be computed while entering into (liquidated damages) but if it cannot be computed than the damages are claimed by the parties or ordered by the court in the event of breach. Damages are in actually a way to make good the loss that the plaintiff or aggrieved person suffers due to the failure of another person who willingly or unwillingly has failed to perform his part of contract. Damages are the basic remedy available for a breach of contract. It is a common law remedy that can be claimed as of right by the innocent party. The object of damages is usually to put the injured party into the same financial position he would have been in had the contract been properly performed.

Distinction between Section 73 And Section 74

Section 73 provides as under:

“When a contract has been broken, the party who suffers by such breach is entitled to receive, from the party who has broken the contract, compensation for any loss or damage caused to him thereby, which naturally arose in the usual course of things from such breach, or which the parties knew, when they made the contract, to be likely to result from the breach of it”.

The Indian Contract Act, 1872 uses the words loss or damage under section 73 as:

Compensation for loss or damage caused by breach of contract. –

When a contract has been broken, the party who suffers by such breach is entitled to receive, form the party who has broken the contract, compensation for any loss or damage caused to him thereby, which naturally arose in the usual course of things from such breach, or which the parties knew, when they made the contract, to be likely to result from the breach of it. Such compensation is not to be given for any remote and indirect loss of damage sustained by reason of the breach.

Section 74 of the Contract Act reads as under:

“When a contract has been broken, if a sum is named in the contract as the amount to be paid in case of such breach, or if the contract contains any other stipulation by way of penalty, the party complaining of the breach is entitled, whether or not actual damage or loss is provided to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named, or the case may be, the penalty stipulated for.”

The Indian Contract Act, 1872 uses the words Penalty under section 74 as:

“Compensation of breach of contract where penalty stipulated for :-When a contract has been broken, if a sum is named in the contract as the amount be paid in case of such breach, or if the contract contains any other stipulation by way of penalty, the party complaining of the breach is entitled, whether or not actual damage or loss or proved to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named or, as the case may be, the penalty stipulated for.”

In section 74 the words that have to be emphasized upon are sum is named,
The term sum is named gives out the meaning clearly that the amount that becomes payable in the event of any breach is pre estimated and is provided for in the contract. It is determined in the form of either damages or a stipulated penalty. Further, the sum that is so specified is the reasonable compensation for the breach and in no case the amount can be exceeded from what has been specified in the contract.
Thus, in short section 74 talks about liquidated damages and not other kind of damages.

Difference[2] between LD and a Penalty

A question frequently asked is ‘what is the difference between LD and a Penalty’. While the LD is a pre-assessed loss agreed to between the parties at the time of making a contract, as likely to arise from the breach. On the other hand, a Penalty is a stipulation in the contract in the nature of terroram. A Penalty, generally speaking is a stipulation to award an imposition which is so disproportionate or excessive that no prudent person would consider the same as a reasonable assessment of damages arising out of the breach. For example, a stipulation in the contract providing that the party in breach would be liable to pay ten times of the contract price to the aggrieved party in case of a breach is in the nature of Penalty. Therefore, while both the LD as well as a Penalty are based on the stipulations mentioned in the contract itself, there is a stark distinction between the two terms. LD represents reasonable stipulation of likely losses, a Penalty is far from being reasonable and is intended to secure performance of the contract.

Penalty is the sanction for the breach of the parties imposed in the form of punishment
whereas damages are an agreed sum of money that the parties consent to pay in the event of breach.
Damages are reasonable compensation where as penalties are not.
Penalty is for enforcement of the obligation of performance on the said party
whereas damages are to compensate the party which suffers a loss due to non performance of the said party.

CASE LAWS:

Dunlop Pneumatic Tyre Co Ltd v. New

Garage & Motor Co Ltd [1914] UKHL 1[3]

For an understanding of what amounts to “penalty”, the court held that: “It will be held to be penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach… It will be held to be a penalty if the breach consists only in not paying a sum of money, and the sum stipulated is a sum greater than the sum which ought to have been paid… There is a presumption (but no more) that it is penalty when ‘a single lump sum is made payable by way of compensation, on the occurrence of one or more or all of several events, some of which may occasion serious and others but trifling damage’. On the other hand: It is no obstacle to the sum stipulated being a genuine pre-estimate of damage, that the consequences of the breach are such as to make precise pre-estimation almost an impossibility …”

Bharat Sanchar Nigam Ltd. v. Motorola

India Ltd[4]. 2009 (2) SCC 337

“…the question of holding a person liable for Liquidated Damages and the question of quantifying the amount to be paid by way of Liquidated Damages are entirely different. Fixing of liability is primary, while the quantification, which is provided for … is secondary to it.”

Hadley v. Baxendale[5] (1854) 9 EX 341

Subsequent to a contractual breach, an injured party can claim which should “reasonably be considered… [as]arising naturally, i.e., according to the usual course of things” from the breach or might “reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, as the probable result of the breach.”

In ONGC Ltd. v. SAW Pipes Ltd.[6]

It has been held with regards to damages and penalty as under:

The stipulation providing for damages is by way of penalty, it can grant reasonable Compensation upon proof of damages.
In case of penalty damages need to be proven.
Damages are a reasonable compensation whereas penalties are not.

In these sections their are three things to analyse;

Whether there is breach of contract or not ?
If there is breach of contract ;what damage or loss caused to a party by it?
What can be compensated to fulfill the loss or to make the loss good ?

Let’s understand these points to analyse

Breach of contract

“Breach of contract” constitutes the pre-condition for a claim of damages, be it liquidated, un-liquidated or otherwise.

A contract is said to be breached in case of contravention with the terms of the contract or when the promise made is broken. It may so happen that the terms are not complied in a manner which had been contemplated in the contract. For example, if a party contracts with another for repairing the other’s house in a certain manner, and the repair was not done in the manner which was decided, then the aggrieved party in entitled to damages to the extent of costs of making repairs in conformity with the contract.

A Party’s failure to perform some contracted-for or agreed upon act, or his failure to comply with a duty imposed by law which is owed to another or to society. Breach of contract is a legal concept in which a binding agreement or negotiated for exchange is not respected by one or more of the parties to the contract by non-performance or interference with the other party’s performance.

Example-“A delivers to B, a courier company, a machine to be delivered overnight to A’s factory. B does not deliver the machine on time, and A, in consequence, loses a profitable contract with the Government. A is entitled to receive from B, by way of compensation, the average amount of profit which would have been made by the working of the factory during the time that delivery of it was delayed, but not the loss sustained through the loss of the Government contract.”

Meaning of Damage or Loss according to Section 73 of ICA, 1872

According to Oxford dictionary the term ‘damages’ are defined as ‘financial compensation for loss or injury’.

In law, damages are money claimed by, or ordered to be paid to, a person as compensation for loss or injury Black’s Law Dictionary.

In context of the Indian Contract Act, 1872 damages are

referred in context to breach of contract i.e. a party’s failure to perform some contracted-for or agreed upon act, or his failure to comply with a duty imposed by law which is owed to another or to society.

A contract is not a property. It is only a promise supported by some consideration upon which either the remedy of specific performance or that of damage is available.
The party who is injured by the breach of a contract may bring an action for the damages. The term
‘Damages´ means compensation in terms of money for the loss suffered by the injured party. Burden lies on the injured party to prove his loss.
Every action for damages raises two problems. The first is the problem for remoteness of damage and the second that of measure of damages´.

Remoteness of Damage

Every Breach of contract upsets many a settled expectations of the injured party. He may feel the consequences for a long time and in variety of ways. A person contracts to supply to a shopkeeper pure mustard oil, but he sends impure stuff, which is a breach. The oil is seized by an inspector and destroyed. The shopkeeper is arrested, prosecuted and convicted. He suffers the loss of oil, the loss of profits to be gained on selling it, the loss of social prestige and of business reputation, not to speak of the time and money and energy wasted on defence and mental agony and torture of prosecution. Thus theoretically the consequences of a breach may be endless, but there must be an end to liability. The defendant cannot be held liable for all that follows from his breach. There must be a limit to liability and beyond that limit the damage is said to be too remote and, therefore, irrecoverable.

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The damages are divided into two categories

General Damages: General damages are those which arise naturally in the usual course of things from the breach itself. Another mode of putting this is that the defendant is liable for all that which naturally follows in the usual course of things after the breach.

Special Damages: Special damages are those which arise on account of the unusual circumstances affecting the plaintiff. They are not recoverable unless the special circumstances were brought to the knowledge of the defendant; so that the possibility of the special loss was in contemplation of the parties

Liquidated and Unliquidated damages

In case of contracts, parties may agree to payment of a certain sum on breach of the contract. When such stipulations are made in the contract, they are known as liquidated damages. On the other hand, unliquidated damages are awarded by the courts on an assessment of the loss or injury caused to the party suffering such breach of contract. Under the Indian Contract Act 1872, unliquidated and liquidated damages are given under sections 73 and 74 respectively. The essence of liquidated damages is a pre-estimate of damage, which is compensatory in nature. The question whether a sum is a penalty or liquidated damages is to be determined or understood by the parties, at the time of entering into the contract, and not as at the time of the breach. If the sum stipulated is far excessive in relation with the greatest loss that can conceivably be proved, it will be held by the adjudicators to be a penalty

Indirect Damages (Loss of Profits)

The following is the best example for consideration. “A delivers to B, a courier company, a machine to be delivered overnight to A’s factory. B does not deliver the machine on time, and A, in consequence, loses a profitable contract with the Government. A is entitled to receive from B, by way of compensation, the average amount of profit which would have been made by the working of the factory during the time that delivery of it was delayed, but not the loss sustained through the loss of the Government contract.” The leading case on this subject is that of Hadley v. Baxendale[7] in which held that,

The damages available for breach of contract include:

Those which may fairly and reasonably be considered arising naturally from the breach of contract or
Such damages as may reasonably be supposed to have been in the contemplation of both the parties at the time the contract was made.

Calculation of damages and compensation in breach of contract to make the loss good[8]

The quantum of damages to be awarded is be distinguished from the measure of damages. The former deals with the amount of damages while the later involves considerations of law as well. With respect to assessment and calculation of damages, the determination of loss or damage resulting from such damage, especially in the context of unliquidated damages, gains immense significance. The damages awarded in case of breach of contract aim at restoration of the party against whom a breach has been committed to the position which would have existed if the breach would not have taken place. Thus, the damages awarded should not exceed the loss suffered or likely to be suffered.70 For understanding the relation between “damages” and “loss”, the Supreme Court has observed that:

“In the absence of any special circumstances the measure of damages cannot be the amount of the loss ultimately sustained by the injured party. It can only be the difference between the price which he paid and the price which he would have received if he had resold them in the market forthwith after the purchase provided of course that there was a fair market then.… In other words, the mode of dealing with damages in such a case is to see what it would have cost him to get out of the situation, i.e., how much worse off was his estate owing to the bargain in which he entered into.

With respect to calculation of damages subsequent to breach of contract, there are two important principles laid down by the Supreme Court, which are:

After proving the breach of contract, the party claiming for damages is to be placed so far as money can do it in as good a situation as if the contract had been performed, and
The plaintiff is duty-bound to take all reasonable steps to mitigate the loss resulting from the breach, and he would be prevented from claiming any part of the damage which is a consequence of his failure to mitigate such damage or loss

In the case of breach of contract, the party guilty of breach of contract is liable only for reasonably foreseeable losses — those that a normally prudent person, standing in his place possessing his information when contracting, would have had reason to foresee as probable consequences of future breach. In the case of breach of a works contract, the breach of contract prevents the gains of party wronged.

Regarding the time and place for assessment of damages, generally, the ‘the value of the goods at the time and place at which they ought to have been delivered, that is, the value of the goods to the purchaser of such goods at the time and place they ought to have been delivered’ is considered. If the goods were being purchased for self-use and not re-sale, then additional factors like the nature of the intended use may be considered. And for determining the market price or value, courts refer to the buying price at which the purchaser can obtain equivalent goods of like quantity at the time and place where the delivery should have been made. In the absence of an appropriate market for determining the market price, assessment can be made by referring to the closest market or the market to which the aggrieved promisee would resort to, on the breach of the contract.

In a case where a party contracts with another for supplying certain goods at price higher than the cost of procurement, and later the receiver refrains from accepting such goods, the supplier is entitled to damages to the extent of the difference between the supply price and the cost of procurement.

Similarly, if a contractor abandons the ongoing construction work, the measure of damages is the cost incurred in completing the work.

On a similar note, in case of a failure to deliver goods, the receiver/buyer may procure substitutes if considered reasonable to do so, and can later recover from the seller, any difference in the price at which the buyer has subsequently procured and the original contract price. The attempts made by the buyer to diminish losses shall also be taken into consideration.

In case of delayed delivery, damages can be calculated, proportionately, by considering the losses suffered and the attempts of Mitigation[9] by the plaintiff.

The House of Lords in England in Koufos v. C. Czarnikow Ltd.[10] (1969) 1 A.C. 350, has enunciated the following principles:

In case of breach of contract, the aggrieved party is only entitled to recover such part of the loss actually resulting as was at the time of the contract reasonably foreseeable as liable to result from the breach
What was at that time reasonably so foreseeable depends on the knowledge then possessed by the parties or at all events, by the party who later commits the breach

For this purpose, knowledge ‘possessed’ is of two kinds: one imputed, the other actual. Everyone ,as a reasonable person, is taken to know the ‘ordinary course of things and consequently what loss is liable to result from a breach of contract in that ordinary course.’ But to this knowledge which a contract breaker is assumed to possess whether he actually possesses it or not,

In the landmark case of Hadley v. Baxendale (“Hadley v.

Baxendale”), the principle governing remoteness of damages was elaborated. The rules enunciated in this case were that a party injured by a breach of contract can recover only those damages that either should “reasonably be considered…as arising naturally, i.e., according to the usual course of things” from the breach, or might “reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, as the probable result of the breach of it.”This forms the basis of the understanding of special damages. In this case, the Court recognized that the failure of the defendant to send the crankshaft for repairs was the only cause for the stoppage of the mill of the plaintiffs, which resulted in loss of profits.

However, it added that,“…in the great multitude of cases of millers sending off broken shafts to third persons by a carrier under ordinary circumstances, such consequences would not, in all probability, have occurred; and these special circumstances were here never communicated by the plaintiffs to the defendants.”

CASE LAWS:

Hajee Ismail Sait and Sons v. Wilson and

Co. AIR 1919 Mad 1053 (DB)[11]

“…natural and fair measure of damages is the value of the goods at the time and place at which they ought to have been delivered to the owner, which I read as meaning the value of the goods to the owner of such goods at the time and place they ought to have been delivered.” “…it is not the nearest market that always governs but the place where, having regard to all the facts of a particular case, the plaintiff would without any material inconvenience to himself procure the goods in a manner that would throw the least amount of hardship on the other party.”

Mcdermott International Inc v. Burn Standard

Co. Ltd. & Ors (2006) 11 SCC[12]

“We do not intend to delve deep into the matter as it is an accepted position that different formulas can be applied in different circumstances and the question as to whether damages should be computed by taking recourse to one or the other formula, having regard to the facts and circumstances of a particular case, would eminently fall within the domain of the Arbitrator.”

“…the aforementioned formula evolved over the years, is accepted internationally and, therefore, cannot be said to be wholly contrary to the provisions of the Indian law.”

CONCLUSION

Damages on breach of contracts have been considered to be advantageous than other remedies that may be available to parties suffering losses from breach of contracts. One of such advantages could be that a claim for damages could be made as a matter of right, contrasted with other reliefs like specific performance which are subject to and greatly influenced by judicial discretion and findings.

“Damages are reasonable compensation whereas penalties are not.”

Thus, an aggrieved party should claim for damages which can put them in a better position in order to get the amount even for the mental trauma etc. that has been suffer by the innocent party due to breach.The reason as to why damages and penalty are confused is mainly due to the liquidated damages which as per the Indian Contract Act have not been differentiated. But the damages in general are not the same as that of Penalty which is clear from the above analysis.

References:

[1] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1724542

[2]http://wahabohidlegalaid.blogspot.com/2012/04/difference-between-liquidated-damages.html

[3] https://www.casemine.com/judgement/uk/5a8ff8ca60d03e7f57ecd762

[4] https://indiankanoon.org/doc/1822986/

[5] https://www.lawteacher.net/cases/hadley-v-baxendale.php

[6] https://indiankanoon.org/doc/919241/

[7] https://www.isurv.com/directory_record/4065/hadley_v_baxendale

[8]https://www.toppr.com/guides/business-laws/indian-contract-act-1872-part-ii/suit-for-damages/

[9]https://www.mondaq.com/india/CorporateCommercial-Law/730250/Mitigation-Of-Damage

[10] https://www.trans-lex.org/302300/_/koufos-v-c-czarnikow-ltd-%5B1969%5D-1-ac-350/

[11] https://indiankanoon.org/doc/678534/