Introduction
Post the Covid-19 pandemic, business organizations have reopened physical offices and employees are rushing back to cities to look for accommodation. This has led to an increase in the number of lease agreements being executed.
Typically, parties to a lease agreement insert a lock-in period to ensure that either party is unable to terminate the agreement before the stipulated period. The purpose of having a lock-in period clause in a lease agreement is to ensure that any party does not suffer any loss on account of hasty termination by the other party. While the lessor may be seeking to recover the amount incurred on restoration and beautification of the property to suit the lessee’s requirements, the lessee may be looking at ensuring a minimum rental period to suit its business requirements. Further, such agreements also incorporate a provision for liquidated damages in the form of rent for the remainder of the lock-in period.
Liquidated Damages – Indian Position
Liquidated damages are damages which are stipulated by the parties at the time of formation of a contract as compensation to be collected upon breach of a contract. The provision for liquidated damages is covered under Section 74 of the Indian Contract Act, 1872.
Section 74 of the Indian Contract Act, 1872 stipulates that in case of breach of a contract, the party complaining of the breach is entitled to either a sum named in the contract or the penalty which is stipulated under a contract. Further, it is not necessary to prove actual damage or loss, however, the complaining party is entitled to receive a reasonable amount only from the party who has broken the contract, subject to the maximum limit stipulated under the contract. Further, the complaining party needs to establish that it had taken adequate measure to mitigate the loss.
The terms ‘liquidated damages’ and ‘penalty’ are sometimes used interchangeably, though there is a vast difference between these two terms. While liquidated damages are pre-estimated losses which may occur due to breach of a contract, a penalty is punitive in nature and seeks to penalize the wrongdoer even if the other party has not incurred any actual loss.
The Supreme Court of India in its judgment in Oil & Natural Gas Corporation Ltd. v. Saw Pipes Ltd.[1] discussed the principles for determination of the quantum of compensation. The contract stipulated compensation in case of a breach of contract and stated that such amount was a genuine pre-estimate of damages and not a penalty. The claim for compensation was set aside by the arbitrator as the claimant was not able to prove the actual loss incurred by it. However, the Apex Court reversed the decision of the arbitrator and stated the following principles:
1. It is vital to examine the terms of the contract to determine the nature of compensation stipulated under the contract.
2. The complainant party is entitled to the amount stipulated in the contract as compensation unless it is manifestly unreasonable or in the form of penalty.
3. In certain circumstances where it is difficult to prove actual loss or damage, the court may award the stipulated amount as compensation provided it is a genuine pre-estimate of loss by parties.
In Kailash Nath Associates v. Delhi Development Authority & Anr.[2], the Apex Court also examined the principles of said Section 74 and set out a distinction between liquidated damages and penalty. It was noted that the threshold of evidence required to claim liquidated damages is lower than that of the penalty. If a contract stipulates penalty, then the innocent party is entitled to a reasonable amount, however, if a contract stipulates liquidated damages, the innocent party is entitled to such amount only if it is a genuine estimate of loss. In either case the complainant party must show that some form of loss has taken place even if it is impossible to prove the actual quantum of loss in certain circumstances.
Effect on lock-in period
Thus, if the parties to a contract seek to stipulate liquidated damages, adequate care must be taken to ensure that the contract only stipulates a genuine pre-estimate of losses, as amount of liquidated damages is based on sound determination factoring in the ability of the complaining party to mitigate such issues. The parties may have to spend a considerable amount of time on this exercise; however, this will lower the threshold of evidence in case of breach of contract.
A lock-in period clause is one of the critical clauses of a lease agreement and must be carefully drafted in light of the jurisprudence surrounding its enforceability. If either party seeks to build a right to claim an unreasonable amount as liquidated damages using its bargaining power, then enforceability of such claim could be delayed.
[The authors are Senior Associate and Associate, respectively, in Corporate and M&A practice at Lakshmikumaran & Sridharan Attorneys, New Delhi]
[1] (2003) 5 SCC 705
[2] Civil Appeal No. 193 of 2015
