Liquidated Damages Clause in Lease Deed Invalidated by Delhi High Court

A summary of the judgment of the Delhi High Court on the interpretation and application of liquidated damages and breach of contract under the Indian Contract Act, 1872

Introduction of Liquidated damages

Liquidated damages are a fixed amount of money that the parties agree to pay in case of a breach of contract. They are meant to be a reasonable estimate of the actual loss that the party would suffer due to the breach. They are used in contracts to avoid disputes over the quantum of damages, and to provide certainty and security to both parties.

In this case, the landlord had leased out his premises to the tenant for a period of five years, with a lock-in period of three years, under a lease deed dated 01.04.2019. The lease deed contained an arbitration clause for resolution of disputes arising out of the agreement. The tenant terminated the lease deed on 31.03.2020, before the expiry of the lock-in period, on the ground that the premises were not suitable for its business and that it had suffered losses due to the COVID-19 pandemic and the lockdown imposed by the government. The landlord invoked the arbitration clause and claimed liquidated damages from the tenant for the remaining period of the lock-in period, as per Clause 3.3 of the lease deed, which stated that “the Tenant shall be liable to pay to the Landlord, the rent for the unexpired period of the lock-in period and/or the Lease Period, as the case may be, as liquidated damages, whether or not actual loss is proved”. The tenant filed a counter-claim for refund of security deposit and other amounts paid by it to the landlord.

The arbitrator appointed by the court partly allowed the tenant’s counter-claim and dismissed the landlord’s claim for liquidated damages. The arbitrator held that there was no breach of contract by the tenant, as it had terminated the lease deed on valid grounds, such as unsuitability of premises, losses due to COVID-19 pandemic, force majeure event, frustration of contract, and waiver and acquiescence by the landlord. The arbitrator also held that Clause 3.3 of the lease deed was not a valid liquidated damages clause, as it did not stipulate any pre-estimate of loss or damage, but was a penalty for breach of contract. The arbitrator also held that the landlord had failed to prove any actual loss or damage suffered by him due to the termination of the lease deed by the tenant. The arbitrator also applied the principle of mitigation of loss to the landlord, and found that he did not make any genuine efforts to find a new tenant for the premises, and had instead demanded an exorbitant rent from prospective tenants.

The landlord challenged the arbitral award in the high court under Section 34 of the Arbitration and Conciliation Act, 1996 (the Act), on the grounds that it was in violation of public policy of India and patently illegal. The landlord contended that the arbitrator had erred in law and jurisdiction by holding that there was no breach of contract by the tenant, by interpreting Clause 3.3 of the lease deed wrongly, by ignoring the settled law on liquidated damages, by applying the principle of mitigation of loss wrongly, and by allowing the tenant’s counter-claim contrary to the terms of the lease deed.

The high court dismissed the landlord’s petition and upheld the arbitral award in favour of the tenant. The high court held that there was no violation of public policy or patent illegality in the arbitral award, as it was based on sound principles of law relating to liquidated damages and breach of contract under Sections 73 and 74 of the Indian Contract Act, 1872 (the Contract Act). The high court also held that the arbitrator had considered the evidence and circumstances of the case, and had not committed any error of law or jurisdiction. The high court also held that the arbitral award was based on sound reasoning and logic, and did not suffer from any infirmity or perversity.

Legal Issues Involved

The main legal issues involved in this case were:

•  Whether the arbitral award was in violation of public policy of India under Section 34(2)(b)(ii) of the Act?
• Whether the arbitral award was patently illegal under Section 34(2A) of the Act?
• Whether the arbitrator had correctly applied the principles of law relating to liquidated damages and breach of contract under Sections 73 and 74 of the Contract Act?
• Whether the clause for payment of rent for the unexpired period of the lock-in period and/or the lease period was a valid liquidated damages clause under the Contract Act?
• Whether the landlord had proved any actual loss or damage due to the termination of the lease deed by the tenant?
• Whether the principle of mitigation of loss was applicable to the landlord?

Analysis of the Judgment

The high court analysed the legal issues involved in this case as follows:

• The high court reiterated that interference with an arbitral award is permissible only on limited grounds under Section 34 of the Act. However, if an award is found to be contrary to public policy or patently illegal, then interference is warranted. The high court also referred to the judgments of the Supreme Court and various High Courts, which had defined and explained the meaning and scope of public policy and patent illegality under the Act.
• The high court found that there was no conflict between the arbitral award and the public policy of India, as it was not against the fundamental policy of Indian law, the interest of India, justice or morality. The high court also found that there was no patent illegality in the arbitral award, as it was not contrary to the substantive law of India, and did not affect the rights of the parties.
• The high court interpreted and applied Section 74 of the Contract Act, which deals with the compensation for breach of contract where penalty is stipulated for. The high court held that this section does not mean that proof of loss is dispensed with altogether, but only that proof of exact amount of loss is not required, if there is a pre-estimate of loss in the contract. However, if there is no pre-estimate of loss in the contract, then proof of existence of loss is still required, even if the exact amount of loss is not required. The high court also held that this section does not validate any clause for payment of a fixed sum in case of breach of contract, but only limits the compensation to a reasonable amount not exceeding the sum named or the penalty stipulated.
• The high court found that Clause 3.3 of the lease deed was not a valid liquidated damages clause, as it did not stipulate any pre-estimate of loss or damage that would be caused to the landlord in case of breach of contract by the tenant. The high court found that this clause was in the nature of a penalty, and not liquidated damages. The high court also found that this clause was unreasonable and unconscionable, as it required the tenant to pay rent for the unexpired period of the lock-in period and/or the lease period, irrespective of whether the landlord suffered any actual loss or damage or not.
• The high court considered the evidence and circumstances of the case, and found that the landlord had failed to prove any actual loss or damage suffered by him due to the termination of the lease deed by the tenant. The high court found that the landlord had received rent from the tenant till March 2020, and had also retained the security deposit and other amounts paid by the tenant. The high court also found that the landlord had not suffered any loss of income or profit, as he had not shown any evidence of having a new tenant for the premises, or having any prospective tenants who were willing to pay the same or higher rent as the tenant.
• The high court applied the principle of mitigation of loss to the landlord, and found that he did not make any genuine efforts to find a new tenant for the premises, and had instead demanded an exorbitant rent from prospective tenants. The high court held that this principle requires the party who suffers a breach of contract to take reasonable steps to minimize its loss. The high court also held that this principle is applicable to liquidated damages, as well as direct and consequential damages.

Conclusion

The high court concluded that the petition filed by the landlord for setting aside the arbitral award was devoid of merit, and dismissed the same with costs. The high court also upheld the arbitral award in favour of the tenant, and directed the landlord to comply with the same within four weeks. The high court also imposed a cost of Rs. 50,000 on the landlord for filing a frivolous petition.

The high court’s judgment has implications and consequences for future cases involving liquidated damages clauses in contracts. It clarifies and reaffirms the principles and conditions for granting liquidated damages under Section 74 of the Contract Act. It also emphasizes the need for proof of actual loss or damage, and the application of mitigation of loss principle, in cases where liquidated damages are claimed. It also invalidates any clause for payment of a fixed sum in case of breach of contract, which is unreasonable and unconscionable, and amounts to a penalty. It also cautions against filing petitions for setting aside arbitral awards on frivolous grounds, and imposes costs on such petitioners.