In the construction industry, many contracts are made between homeowners and contractors. Sometimes, these contracts are breached, causing significant losses to one of the parties. To prevent or address such situations, two common remedies are used: penalty clauses and liquidated damages.
Read on to understand their importance and the key differences between penalty and liquidated damages.
What Is a Penalty Clause in the Construction Industry?
A penalty clause in a construction contract is a term that requires the breaching party (usually the contractor) to pay a higher amount than the actual damages suffered, in case they fail to meet the terms of the agreement. The main goal of this clause is to punish or discourage delays or poor performance and not to compensate the other party fairly for actual losses. However, under many legal systems, including India, such clauses are not automatically enforceable if the stipulated amount is considered excessive or disproportionate to the actual harm caused. In India, Section 74 of the Indian Contract Act, 1872, governs such provisions and allows courts to award reasonable compensation not exceeding the amount mentioned in the contract, regardless of whether actual damage is proved.
Major Characteristics of Penalty
- The penalty does not calculate the actual losses, but it’s meant to inhibit the breaching party from non-performance or delay.
- In the penalty clause, the breaching party has to pay a higher amount, which is disproportionate to the actual loss.
- Indian courts approach penalty clauses with caution. If a penalty is found to be excessive or unreasonable, courts can reduce the amount to a reasonable level.
Example of Penalty
If the contractor fails to complete the project work within the stipulated 12-month period, a penalty of ₹50,000 per week of delay shall be imposed, up to a maximum of ₹5,00,000. The penalty amount, ₹50,000 per week, is not linked to the actual damages suffered by the client. Such clauses are designed to deter breaches rather than to reflect genuine losses.
Risks of Including Penalty Clauses in Contracts
If you are including penalty clauses in your contracts, think twice. You may face the following conflicts:
- Courts often refuse to execute penalty clauses if they are considered excessive, arbitrary, or punitive rather than compensatory. Section 74 of the Indian Contract Act, 1872, supports courts in granting only reasonable compensation, not beyond the amount specified, irrespective of the actual loss or damage proven. This means parties relying on hefty penalty clauses may recover far less than expected, damaging the intended deterrent effect.
- Excessive penalties can strain business relationships and increase the likelihood of disputes, as courts may intervene to reduce or disregard such clauses.
What Are Liquidated Damages in Construction Contracts?
Liquidated damages in construction contracts are predetermined amounts of money specified in the contract, agreed upon by the contractor and the project owner before work begins. For example, if the contractor fails to complete the project by the agreed-upon completion date, they must pay this amount for each day of delay. This payment will cover the losses the owner might face because of the delay, such as extra rent, interest, or missed business opportunities.
These liquidated damages are usually deducted from the contractor’s final payment, which can reduce their overall profit. This encourages the contractor to complete the work on time. In India, such clauses are governed by Section 74 of the Indian Contract Act, 1872
Crucial Conditions of Liquidated Damages
For a liquidated damages in contract clause to be legally valid and enforceable, it must meet three main conditions:
Uncertainty of damages: When the contract is made, the actual loss that might happen due to a breach is difficult to estimate in advance.
Clear intention: Both parties must clearly indicate in the contract that they agree to pay a specific amount as compensation in the case of a breach.
Reasonable amount: The amount mentioned as liquidated damages must be fair and related to the expected loss. It should not be too high or act like a penalty.
If any of these conditions are not fulfilled, the liquidated damages clause may not be accepted in court and can be considered unenforceable.
Example of Liquidated Damages
If the contractor does not complete the construction within the time mentioned in the contract, they must pay the project owner (employer) liquidated damages of ₹20,000 for each day of delay, which reflects the estimated loss and administrative costs. This penalty applies for a maximum of 40 days, ₹8,00,000.
If the delay continues beyond 40 days, the owner has the right to terminate the contract. The owner can also seek additional remedies as specified in the agreement, such as hiring another contractor to finish the work or recovering extra costs caused by the delay.
Best Practices During Implementation and Administration
For liquidated damages clauses to be enforceable in India, certain conditions must be met:
- The amount specified in the contract must be a genuine pre-estimate of the loss likely to be caused by the breach, not a penalty intended to punish the defaulting party.
- If the amount of liquidated damages varies, the contract should include a clear and concise formula or method for calculation, ensuring both parties know how the amount is determined.
- Indian courts will examine such clauses to ensure they are meant to cover loss rather than a punishment. Courts may reduce the amount to a reasonable level if the amount seems too high.
- The clause must be agreed upon at the time of contract formation and should be reasonable in light of the anticipated harm.
Section 74 of the Indian Contract Act 1872 allows the aggrieved party to claim reasonable compensation not exceeding the amount specified, even if actual loss is not proven, but courts will not enforce amounts that are clearly punitive.
Penalty vs Liquidated Damages: Key Differences
The following are the major differences between penalty and liquidated damages:
| Aspect | Liquidated Damages | Penalty |
| Purpose | Compensatory: Intended to estimate and compensate for actual or anticipated loss. | Punitive/Deterrent: Designed to punish or deter breach, not to compensate for real loss. |
| Enforceability | Enforceable if the amount is a genuine pre-estimate and reasonable. | Often reduced or struck down by courts if found excessive or unconscionable. |
| Basis of Calculation | Based on a genuine pre-estimate of loss likely to be suffered due to breach. | Arbitrary or excessive amount, often disproportionate to the actual loss. |
| Legal Treatment | Upheld under Section 74 of the Indian Contract Act if reasonable and not punitive. | Scrutinised and adjusted by courts under Section 74; only reasonable compensation awarded. |
On a final note, both liquidated damages and penalty clauses cope with breach of contract, but their functions differ. By setting clear penalties for breaches of contract, they encourage contractors to meet deadlines while also protecting the owners from financial losses. Liquidated damages are similar to a safety net for construction contracts; they ensure projects stay on track even if things go wayward. The penalty is charged in addition to the liquidated damages. In construction contracts, clarity and fairness in these clauses are essential. They not only hold contractors accountable but also keep the project timeline in check. Hence, for peace of mind and timely project delivery, trust Brick & Bolt—India’s leading construction company known for transparent contracts and timely completion. Their expert team ensures your construction journey is smooth, with fair and enforceable contract terms that protect your investment.
Hemali Patel