Liquidated Damages, French Civil Code and a March Towards Equity?

Anirud Raghav S U |

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Introduction

Damages is one of the most extensively discussed remedies for breach of contract. Within damages, liquidated damages (“LD”) has long troubled courts and scholars alike. In simple terms, liquidated damages are simply damages that are pre-fixed by parties to a contract. The purpose is simple - to avoid litigation and to bypass the arduous and expensive task of proving loss. Should a party seek damages without an LD clause, they will need to take recourse to s.73 of the Indian Contract Act (“ICA”). Section 73 represents a simple codification of Hadley v. Baxendale limbs, whereby actual loss must be demonstrated as a cause of the breach of contract. Usually, loss is demonstrated by juxtaposing the non-breach position with the position the innocent party would have been in but for the breach. Significant time and resources are expended in discharging this burden, and sometimes with little to no success. There lies the commercial viability of an LD clause, where parties can stipulate damages in advance, should a breach (or a specific type of breach) occur.

However, things are hardly ever that simple. Imagine a contract for supply of yarn worth Rs.500, where A is the supplier and B the purchaser. As per the contract, A must supply it within a week, failing which, a stipulated sum of Rs. 10 million would have to be paid by A. The breach occurs and B demands the payment. Should the LD clause be enforced? Equity would advise against it. Common law courts have categorized such disproportionate terms as penalties, which will not be enforced tout court.[1] To quote Lord Dunedin’s decision in Dunlop Tyres v. New Garage Co.:

“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.”

Thus, to decide whether a clause is a penalty (which will not be enforced at all) or an LD clause (which will be enforced), common law courts have come up with the genuine pre-estimate test: if the clause was a genuine forecast of loss, it would be enforceable as an LD clause; else, it would be an unenforceable penalty. Indian law, by abolishing the distinction between LD and penalty under s.74 of the Contract Act, had purportedly “cut across the web of presumptions” attaching to the LD-penalty dichotomy. However, as judicial decisions would have it, these very presumptions sought to be abolished now stand insuperably etched in the fineprint of the Indian law on LD.[2] To understand why, let us examine the considerations guiding LD adjudication in India.

What do Courts consider in evaluating LD?

Courts seem to principally concern themselves with 3 considerations. First, party autonomy and the freedom of contract. This would advocate that the LD must be enforced as is, since the LD is a voluntarily bargained-for exchange, which is the fundamental tenet of the “will theory” of Contract law. Second, commercial certainty and viability. As noted above, commercially minded parties employ LD clauses so they can escape the rigamaroles of litigation. Requiring parties to do the very thing–go to court–which they sought to avoid, would be to render s.74 pointless, and effectively reduce it to s.73. Consider the Supreme Court’s decision in BSNL v. Reliance, which holds:

“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.”

A similar holding is visible in a decision of the Bombay High Court, where the objective of LD clauses is recognized as being to “avoid litigation and introduce certainty in computation of difficult questions of assessment of damages”. A third consideration–which seems to trump the other two–is to prevent a windfall from accruing to the judgment creditor. While some courts have called it a “windfall”, and others call it “unjust enrichment”, the idea is that the purpose of damages is only to compensate for loss. Where there is no loss, there is no compensation even if the LD clause stipulates so. Nowhere is this more apparent than claimants being required to prove loss “where it is possible to prove loss” (Fateh Chand v. Balkishan Dass, Maula Bux v. Union of India, ONGC v. Saw Pipes, Kailash Nath v. DDA all reaffirm this). Notice that s.74 of the ICA says that the innocent party is entitled to the stipulated sum “whether or not actual damage or loss is shown to be caused thereby”. That the terms of the statute are sought to be effectively bypassed by a creative construction of this sort only shows the overriding importance of this third consideration. One could say it is as much about ensuring that the breaching party is not required to pay more than the losses he has caused, as it is about the innocent party being compensated. I say this because of the choice of words: unjust enrichment and windfalls. This, at the end of the day, is reducible to an equitable principle–you ought not be made to pay any more than the loss you have caused.

The French Story: From Party Autonomy to Greater Judicial Discretion

The French Civil Code provides an interesting vantage point for analysing the treatment of LD. In what constitutes a somewhat sharp departure from common law, the French Civil Code adopts an approach that heavily tilts in favour of party autonomy. This approach is understandable, given the creation of the Code in a post-revolutionary context where individual rights and liberties were urged as paramount. However, over the years, amendments to the original text of the Civil Code have diluted its party autonomy-favouring policy. Consider the relevant provision:

Art.1152 of the French Civil Code provides:

Where an agreement provides that he who fails to perform it will pay a certain sum as damages, the other party may not be awarded a greater or lesser sum.

(Act no 75-597 of 9 July 1975) Nevertheless, the judge may, "even of his own motion" (Act no 85-1097 of 11 Oct. 1985) moderate or increase the agreed penalty, where it is obviously excessive or ridiculously low. Any stipulation to the contrary shall be deemed unwritten.

The principal portion of the provision is of interest. It suggests that an LD clause may be enforced as it is; the innocent party may not receive a greater or a lesser sum than that stipulated. From the traveaux preparatories, we see that an amendment was suggested whereby the judge is given discretion to modify the sum awarded if the stated sum was obviously disproportionate to loss. Yet, this amendment was rejected in favour of the parties’ agreement. This naturally does away with the question of a proof of loss,[3] since the innocent party will simply be awarded the agreed sum. Courts have constantly held that parties need not prove loss.[4] Thus, in the pre-amendment phase of the French Civil Code, party autonomy reigned supreme and judicial adjustment of penalties was prohibited. French Courts have been “remarkably faithful”[5] to their sanctity of contract approach, disregarding equity-based pleas to judicially adjust the sum.

However, come 1975, the Civil Code was amended to confer the judge a discretion to adjust the sum if it was “obviously excessive” or “ridiculously low”. It seems that the proposed amendment had seen the light of day. In 1985, the text was further amended so that the judge now enjoyed discretion even on his own motion to perform such an adjustment. This seemed to bring France in line with the common law’s proscription of penalty clauses. By inserting the words “obviously excessive” or “ridiculously low”, some amount of litigation would now be necessary. For one, the claimant is presumably required to show that the sum is the equivalent of a “genuine pre-estimate”, to borrow common law parlance. Today, then, it would appear that the French trajectory is simply a march from party autonomy towards equity and public policy. This is also redolent of the Indian story, from Brahmaputra Tea Estate to the more modern precedents like Kailash Nath.

The relevant lessons I want to draw are twofold. First, that the pre-amendment Civil Code represented a system where party autonomy occupied the top of the hierarchy. The fact that no proof of loss had to be shown to claim damages is the clearest testament to this the prioritization of party autonomy over equity-based overcompensation concerns. The point of illustrating this is to show contrasting state practice that adopts a different hierarchy, and particularly what the proof of loss standards are a window to deciphering the hierarchy. A second, yet unrelated lesson, is that a post-amendment French law seems to have adopted a system that is in substance close to common law, since there is now judicial imprimatur to adjust the stipulated amount. It has, in other words, been a slow march from party autonomy towards equity.

What about bad bargains?

Imagine two scenarios. One where a party agrees to a liquidated damages of Rs.10 million in a contract for which the consideration is only Rs.500. Now imagine another contract where a seller, knowing full well he has only 100 bats in his inventory and cannot secure any more, contracts to sell 1,000 bats to the purchaser within the week. Assume the seller breaches the Contract in the second case, and the purchaser seeks damages. Is it open to the seller to contend that he ought not pay the damages, all other things remaining equal? The answer is no. There has been a fundamental breach, so as to warrant termination and a claim for damages. It is not open to the seller to escape his bad bargain by citing some vague notion of public policy, or some vitiating factor like misrepresentation or duress. The seller, with full knowledge of the limited bats in his possession, voluntarily made a bad bargain to sell far beyond capacity when he knew he could. He would be held to his contract, or made liable to pay the monetary equivalent thereof.

Why should not a similar approach be adopted in the case of one the parties agreeing to a disproportionate LD clause? Why must it not be considered yet another instance of a bad bargain that should be enforced? Would this not reward laxity on the part of the purchaser? What is so fundamentally different about a disproportionate LD clause and an otherwise bad bargain? This has been criticized as an unwarranted interference with the autonomy of parties. To put it in the words of the learned Richard Posner, the ‘relief against penalties’ was ‘a major unexplained puzzle in the economic theory of the common law’.[6] Sir George Jessel MR saw relief against penalties as an ‘irrational aberration’ from the rule of party autonomy.[7] 

Unless the contract itself is fundamentally defective due to some vitiating factors, there is good reason to hold parties to their bad bargains. Consider the dictum of Rimer LJ of the Court of Appeals, in a case where a term of was highly commercially improbable:

“Perhaps the most that can be said is that … the contractual terms seem improbable ones for Persimmon to have signed up to. If so, the explanation is either (i) that it made a bad bargain, or (ii) that it may have made a sensible one but the written agreement recorded it wrongly. If the former, Persimmon is stuck with its bargain, and it is not the court’s function to reform it. If the latter, Persimmon may have a claim to have the agreement rectified.”

Perhaps one way to justify interference, and to sidestep the bad bargain argument, is to say that public policy requires that Courts provide a relief against penalties. But this would risk making ‘public policy’ the destroyer of the freedom of contract–there is little guidance, apart from starkly violative cases, as to what nebulous terrain public policy occupies. This would all but open the floodgates for parties to abuse the public policy exceptions and escape bad bargains.

As Schauer illustriously put it:

But law is more than simply doing the right thing in each individual case. At times law’s unwillingness to do just that will seem wrong, but what makes law what it is—usually for better but sometimes for worse—is that it takes larger institutional and systemic values as important, even if occasionally at the expense of justice or wise policy or efficiency in the individual case.

[1] Shivprasad Swaminathan, 'A Centennial Refurbishment of Dunlop's Emporium of Contractual Concepts: Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Limited v Beavis' (2016) 45 Comm L World Rev 248

[2] Shivprasad Swaminathan, ‘De-inventing the Wheel: Liquidated Damages, Penalties and the Indian Contract Act, 1972’ (2018) Chinese Journal of Comparative Law 1.

[3] See Nils Jansen & Reinhard Zimmermann, Commentaries on European Contract Laws (2018 OUP) 1548.

[4] See Peter Benjamin, 'Penalties, Liquidated Damages and Penal Clauses in Commerical Contracts: A Comparative Study of English and Continental Law' (1960) 9 Int'l & Comp LQ 600, 615, and the authorities cited there: Civ. 17 janvier 1906, D.1906.1.262; Req. 8 juillet 1873, D.P.1874.1.56. See also Mazeaud, op. cit., III, p. 765.

[5] Peter (n 4) 613.

[6] ‘Some Uses and Abuses of Economics in Law’ (1979) 46 U Chi LR 281, 290; 261.

[7] Wallis v Smith (1882) 21 Ch D 243.