Liquidated damages (LDs) are the pre-estimated sum to be paid by way of compensation in the event of breach of a stipulated term of the contract. Share purchase Agreements (SPAs) frequently provide for LDs in the event of certain breaches. Such provisions, where valid, are applied to fix the measure of damages, replacing the elements that would otherwise go into the court's determination of the amount of recovery.
Section 74 of the Indian Contract Act, 1872 stipulates that in cases of breach of contract, where a pre-agreed sum is stipulated, the party complaining of breach is entitled to the stipulated amount provided it is proven that loss has been caused to the complaining party. However, the complaining party need not prove the exact quantum of loss if the stipulated amount is reasonable and not unconscionable.
The rationale behind any damages clause is to enable restoration of the economic position in which the plaintiff would have been had the breach not taken place. It is thus, that the damages must be a bona fide and reasonable estimate of the damages arising from the breach and not an amount intended to penalize the other party or coerce performance of the contract. The courts have wide discretion in determining reasonability of the compensation, however, the same may not exceed the amount stipulated in the contract. If the stipulated sum agreed upon in a contract is a genuine pre-estimate of loss likely to flow from a breach, they qualify as LDs. Any amount which is extravagantly and excessively high, greater than the possible amount of LDs that could be foreseen at the time of drafting of the contract, is taken to be a penalty clause.While there is no precise formula to distinguish penalty from LDs, the court upon taking into consideration the terms of the contract and the reasonability of the stipulated sum claimed as damages may make subjective awards.
Though the requirement of the section is that the pre-agreed quantum of damages have to be paid, the court stresses that certain legal injury or damage has to be shown before making such a claim. When such computation or proof of the precise damage is impossible for the court, the amount stipulated in the contract, if it is not unreasonable or penal in nature can be awarded by the court .
In India, there is no provision for a pecuniary liability to automatically arise in the event of complaint of breach of a contractual term where LDs are provided for, until determination of entitlement to the same by the court.The position, therefore, would be that on the breach, only a right to sue for damages may accrue. However, LD clauses, if carefully drawn, can be extremely useful to either or both of the parties to a SPA.
LD clauses provide for an assurance of compensation upon agreement of a reasonable amount, while, limiting the risks of the party causing the breach as the damages are already stipulated for. These serve the useful purpose of avoiding unnecessary litigation and promoting commercial certainty, especially where the quantum of damages are impossible or difficult to ascertain. LD clauses enable the parties to provide for LDs for specific breaches, while allowing other types of breaches to be dealt with by unliquidated damages.These provisions not only facilitate the calculation of risks, but also alleviates the difficulty and expense of proving the quantum of actual damages.
For the aforementioned reasons, frequently provision for LDs is made in SPAs in connection with buyer’s as well as seller’s obligations such as non-compete or non-solicitation clauses, confidentiality clauses, anti-corruption clauses and any ancillary aspects or intangible losses such as damage to reputation, loss of business opportunity that cannot be stipulated using a straight jacket formula. In most cases where the calculation of the anticipated or actual damages suffered by the non-breaching party is difficult or time consuming, a calculation method to ascertain the LDs can be provided in the SPA. This pre-agreed arrangement between the parties on the amount or method of calculation cannot be undermined in case of actual default as it saves not only time but also substantial uncertainty. When the nature of transaction is such that assessment of damages is not possible, the court, if satisfied that the LDs are a fair and reasonable pre-estimate of damages agreed between the parties, is empowered to grant the full amount provided as LDs.
In SPAs, it is common for LD provisions to apply in case of breach of contractual provisions by a party for failing to complete the transaction as agreed in the SPA or breach of the representation and warranties by a party after the completion of the transaction pursuant to which the other party has suffered actual damage. The amount of the buyer's deposit or on rare occasions, the seller’s initial instalments of shares, is adopted as the amount of LDs in case of failure to complete a transaction. Such forfeiture of money held by an escrow company or assets delivered makes recovery convenient for the seller, or alternatively, the buyer as applicable. Typically, such forfeiture of a reasonable amount paid as earnest money or advance deposit as part payment does not amount to imposition of penalty, however, in cases where the forfeiture is penal in nature, Section 74 of the Indian Contract Act, 1872 applies.
LD provisions, therefore, act as a sort of limited insurance for the parties to a SPA. If either party breaches the contract, the other knows the exact sum that can be anticipated to cover the damages from the said breach, effectively, mitigating the party’s risk upon breach of terms of the said contract and also avoiding needless litigations or disputes.