Formulaic Claims, Arbitral Awards and the Credibility of Arbitration

Richard Feynman made this statement criticising relying on formulas to study physics and instead focus on the underlying reality. He was of the view that one could not get anywhere merely based on the formulas. This criticism holds good for construction law too.

Indian courts have criticised claims by construction contractors based on formulae such as Hudson, Emden, etc, and have required evidence of losses. So many arbitral awards have been set aside on this ground. Some awards could escape courts’ attention.

Arbitral awards awarding claims based on formulae when there is no or inadequate evidence justify the Department of Expenditure’s Office Memorandum 03.06.2024 that discourages arbitration. One such case is SBI v. KR Anand, 2026:DHC:7793.

The Construction Contract

• Work: Construction of seventy-six flats for officers at Sector-62, Noida
• Letter of Award: 22.12.2012
• Agreement: 16.01.2013
• Contract Value: 19.81 crores
• Scheduled Contract Completion Date: 15.01.2015 (25 months)
• Extensions: 3
• Actual completion date: 23.08.2016

Arbitration and Challenge

Contractor, KR Anand, invoked arbitration and made several claims. There were a total of 17 claims. Arbitrator awarded Rs. 1.43 crores to the contractor. SBI challenged the award in the Delhi High Court on 3 claims.

Decision of the Delhi High Court on Award on Claim 1

Claim 1 was for loss of overhead expenditure of Rs. 65.81 lakhs. Rs. 20.27 lakhs was awarded. There were two main problems with this part of the award. The arbitrator attributed 205 days of delay to the contractor and 175 days to SBI but chose to decide the claim in favour of the contractor. Another problem was that there was no evidence of losses. The contractor chose do defend the award on the basis of the Emden formula. We are concerned in this post about the second limb of the arbitrator's reasoning: reliance on Emden formula.

Proof of actual loss is essential. The Delhi High Court reiterated the settled law that proof of losses is required through evidence and formulae cannot substitute evidence. The court cited the Unibros decision and held: “The Supreme Court in Unibros v. All India Radio (supra) held that reliance on a formula is not a substitute for establishing the loss actually suffered… 13. In the case in hand the damages awarded relying upon the Emden Formula in the absence of evidence to prove the actual loss suffered is contrary to the settled position of law”.

The court considered the award on this claim to have been given in disregard of the Contract Act, which required proof of losses (Para 11). The court gave another dimension to the matter: An award that relies on formula as a substitute for proof of actual losses suffers from lack of reasoning and violates Section 31(3) of the Arbitration and Conciliation Act, 1996:

“However, even on a fair reading of the award as a whole no reason emanates for the arbitrator accepting the calculation based on the Emden formula without there being evidence to prove the loss suffered or that it was difficult or impossible to prove the actual loss suffered. The award of claim no.1 falls within the teeth of Section 31(3) of the Act.”

Credibility of Arbitration

There are so many judgments that dealt with the proposition that the Delhi High Court was relying on. See, for instance, here and here. Despite this, the arbitrator chose to award this claim in favour of the Contractor. Such arbitral awards justify DOE’s OM of 03.06.2024.

No Injunction/ Interim Measure Against Infrastructure Projects: Calcutta HC Decides

Golden Edge Engineering Private Limited vs. Bharat Heavy Electricals Limited (18.06.2020 - CALHC) : MANU/WB/0558/2020 is an important decision under the Specific Relief (Amendment) Act, 2018. Petitioner was the contractor of the Owner, BHEL in respect of an Infrastructure Project as defined in Explanation to Section 21A r/w Schedule to the Specific Relief Act, 1963 (as amended) (SRA).

The Petitioner (Contractor), in an agreement entered into in 2017, contended that BHEL had delayed in providing the frontage for the work and in making payments. The Contractor also relied on the lockdown due to Covid19 to argue that delay in performance was beyond the control of the Contractor. The Contractor argued that despite assurances of completion, BHEL had gone ahead with floating a tender for performance of the remaining works that the Contractor was yet to complete. Consequently, the Contractor prayed for an injunction restraining BHEL from withdrawing the work from the Contractor and awarding it through a new tender to some other person.

The court rejected the said contentions on several grounds, some of which are provided below:

• BHEL allowed time to the Contractor to complete the work after the lockdown period but the after the lifting of restrictions, it cannot be said that there has been uncertainty as the availability of manpower. In reality, there has been no migration of workers from the State of Jharkhand, which is the state where the project is located.
• The Contractor could not adhere to the schedule even before the Covid19 pandemic. 
• The prayer granted in the petition was barred by the SRA, as amended. in terms of Sections 41(ha) and 20A. 
• There is no provision in the Tender/ Contract specifically restricting BHEL from proceeding on risk and cost.
• Even if there is a legal injury to the Contractor, the same can be adequately compensated in terms of money. 
• Balance of convenience is in favour of BHEL. As a PSU, if it is prevented from engaging a new contractor in case the existing Contractor is unable to perform, it will lead to a situation where BHEL will be stuck with the non-performing Contractor and substantial time will be wasted and project will come to a standstill in the event BHEL is unable to go ahead with the new tender. 

Comments

Para 42 of the judgment is interesting and important, for it seeks to examine the issues at stake if an injunction is passed. It deserves noting, as it is, in the judgment:

"42. So, the balance of convenience is entirely in favour of the Respondent as a Public Sector Undertaking engaged in power generation ought not to be prevented from engaging a new contractor if the existing contractor is unable to provide the requisite standard of work as the documents on record clearly show that ample opportunities have been provided and are being provided by the respondent to the petitioner to complete their outstanding work as per requisite standards but instead of utilising the same the petitioner intends to secure a monopoly and ensure the Respondent is stuck with the Petitioner in whatever performance and/or quality of work they offer. It is stated and submitted that the entire project has been severely lagging behind the requisite standards and the Respondent's employer i.e. the National Thermal Power Corporation has been constantly reprimanding the Respondent because of the cascading effect the Petitioner's under performance has been having on the entire project. A lot of time will be wasted and the project will come to a standstill in the event the Respondent is unable to go ahead with the New Tender and have a candidate ready to replace the Petitioner in the event of the failure to complete the work as such new tender would have to be conducted post the Petitioners failure."

There are three interesting points in the decision:

• In respect of infrastructure projects, courts will not grant stay in view of the statutory mandate pursuant to the amendments to the SRA.
• Covid19 cannot be used as an excuse in respect of infrastructure projects especially where the Contractor is unable to perform the contract expeditiously;
• Tendering processes in respect of risk and cost contracting can be commenced even before termination, and would not be a ground for granting injunction.  

All the three points made above are significant in the current context. The court, rightly, analysed the importance of not passing stay orders on infrastructure projects. The judgment seems to be in line with the recent legislative mandate and seeks to balance competing interests and further the general principle of specific relief: injunctions will not be passed when damages would be adequate remedy.

However, the ultimate conclusion that: "I am of the opinion that the petitioner would be left with a claim for equitable compensation as there would be no significant prejudice to the petitioner in the event of refusal to grant interim injunction at this stage." is not entirely clear. Was the court indicating that the Petitioner/ Contractor could pursue the remedy of seeking compensation but that no prejudice would be caused to the Contractor if its prayer was refused.

[full disclosure: Till early last year, this blawgger was an employee of BHEL. However, this blawgger was in no way connected to the case or the subject-contract.]

Retrospective Operation of the Specific Relief (Amendment) Act, 2018

As stated in several previous posts in this blog, the Specific Relief (Amendment) Act, 2018 (“2018 Act”) brings several substantive changes in the Specific Relief Act, 1963 (“1963 Act”) thereby drastically altering contract remedies. Given that these amendments were brought into force from 01.10.2018, questions are likely to arise as to the retrospective operation of various provisions.

Bengaluru City Civil Court Decides

One of the first decisions on this issue is from the XII Additional City Civil Court, Bengaluru in OS No. 5395/2011 (Somashekar v. Lt. Col. Appu Ramanand Sharma (Retd.). The suit is for specific performance of an agreement to sell an immovable property and has been pending from 2011. When the matter was at the stage of arguments, the Plaintiff argued that the amendments to the 1963 Act have done away with the discretion of courts to order specific performance and that if the agreement is proved, the court is obligated to order specific performance.

The court rejected the contention of the plaintiff on this issue and held that the 2018 Amendment was not retrospective. The court relied on Section 1(2) of the 2018 Amendment, which provided:

"It shall come into force on such date as the Central Government may, by notification in the Official Gazette, appoint and different dates may be appointed for different provisions of this Act and any reference in any such provision to the commencement of this Act shall be construed as a reference to the coming into force of that provision."

On the basis of the above provision, the court concluded that the amendment was given a prospective effect. While the reasoning is not completely in accord with the legal provisions, the court was correct in rejecting the contentions of the Plaintiff on retrospectivity because the cause of action arose prior to the suit in 2011.

While the decision does not have any precedential value, this is perhaps one of the earliest decisions on the issue.

Whether the 2018 Act is Retrospective?

On the question of retrospectivity of the 2018 Act, readers would do well to have a look at this blog post on the subject. This post puts forth the following points:

• The 2018 Act does not contain any savings clause or a transitory provision.
• The 2018 Act is in the nature of substantive law since it provides for substantive changes in the law of remedies.
• Remedial statutes are prospective.
• In view of Section 6 of the General Clauses Act, 1897, the rights and obligations accrued prior to the bringing into force of 2018 Act (01.10.2018) would stand undisturbed by the 2018 Act.
• The 2018 Act would be applicable to all breaches and disputes subsequent to bringing into its force.
• This is irrespective of whether the contract was concluded before the 2018 Act came into force.

Thus, any breach (or cause of action) that arose on or after 01.10.2018 would be governed by the 2018 Act. This is even if the contract was signed before 01.10.2018.

Whether Absence of a Savings Provision or Transitory Clause is a Lacuna?

It is suggested in the aforesaid post that there is no savings provision or transitory clause and a similar absence has caused several problems in the context of the Arbitration and Conciliation (Amendment) Act, 2015. The analogy of the problems regarding retrospectivity, a subject well-discussed in this blog, with that of the 2018 Act is misconceived. While the arbitration amendments were both procedural and non-procedural, the amendments in the 2018 Act are substantive in nature, as the above blog states. Therefore, there is no reason why such a provision should be there. Such savings provisions are not common when an amending statute amends substantive law (as it is known), unless specific reasons warrant otherwise.

Specific Relief (Amendment) Act, 2018 Brought into Force from 1 October

We had done several posts on the Specific Relief (Amendment) Bill, 2018 and later Act.  See this post for a compilation of the past posts. On 19.09.2018, the Government of India has appointed 1 October 2018 as the date from when the new provisions would come into force. The Gazette Notification is available here.

Interesting times ahead. We'll keep readers posted on the developments. 

Guest Post: Mid-Year Arbitration Review- Part I

(In this guest post, Ms. Juhi Gupta reviews significant developments that took place in the first half of 2018 in India on arbitration. Ms. Gupta is an LL.M. graduate from Harvard Law School and is deeply interested in dispute resolution, particularly alternative dispute resolution.)

MID-YEAR ARBITRATION REVIEW - I

In a series of posts, I will endeavour to review several decisions of the Supreme Court and High Courts of India on arbitration this year. The cases I will be reviewing have been selected because they reiterate the prevailing law, or because they demonstrate the increasing pro-arbitration judicial attitude, or because they raise interesting questions to be examined in the months to come.

Seat (or place) versus venue – SC refers issue to larger bench

Union of India v Hardy Exploration andProduction (India) Inc. (Supreme Court, 01 May 2018)

Brief facts: Petition filed by Union of India (appellant) against Hardy Exploration (respondent) under section 34 of the Arbitration Act, 1996 (hereinafter “the Act”) challenging the legality, validity and correctness of the arbitral award made in favour of respondent in an international commercial arbitration proceeding between the parties. The arbitration agreement designated Kuala Lumpur as the venue and did not expressly specify the seat/place of arbitration. The UNCITRAL Model Law on International Commercial Arbitration of 1985 governed the arbitration proceedings and Indian law was the substantive law of contract. The Delhi High Court decided the section 34 petition in favour of the respondent, against which the Union of India appealed to the Supreme Court under section 37 of the Act.

Issue: Maintainability of the section 34 petition and the related issue as to whether or not Kuala Lumpur was the seat/place of arbitration, which in turn would determine whether Indian courts had supervisory jurisdiction over the arbitral award (note: in a foreign-seated arbitration, the supervisory jurisdiction of Indian courts under Part 1 of the Act is excluded as per Balco).

Arguments: Union of India, on the basis of prior Supreme Court and English Courts decisions, contended that when the arbitration agreement specifies the venue for holding arbitration proceedings but does not specify the seat, then the supervisory jurisdiction of Indian courts cannot be excluded. Hardy Exploration argued that Indian courts do not have jurisdiction to entertain the section 34 petition challenging the legality and correctness of the award as the arbitration was foreign-seated. Neither party went into detailed arguments before the Supreme Court.

It is useful to briefly examine the parties’ arguments before the Delhi High Court: Union of India argued that (i) as per Balco, in the absence of any specific choice of the law of the arbitration agreement, the same would be determined by the substantive law of the contract. Since Indian law is the substantive law, it would also be the proper law of the arbitration agreement; (ii) as per the UNCITRAL model law, it is for the arbitral tribunal to decide the seat, which it did not and Kuala Lumpur does not become the seat just because the award was made and signed there; (iii) since the UNCITRAL Model Law was adopted by enacting the Arbitration Act, the parties’ intention behind designating the Model Law as the curial law was to incorporate Article 34 of the Model Law which is analogous to section 34 of the Act i.e. apply Part 1; and (iv) the parent contract containing the arbitration was entered into prior to Balco and was therefore governed by Bhatia International.

Hardy Exploration argued that (i) since it was a foreign company, the arbitration was an international commercial arbitration under section 2(1)(f) of the Act; (ii) Article 31(3) of the UNCITRAL Model Law stipulates that the award shall state its date and place of arbitration. Therefore, Kuala Lumpur was the place of arbitration; and (iii) post Balco, Part 1 is excluded when the seat is outside India.

Decision: The Supreme Court did not really engage in a detailed analysis of the issue. It noted that the question regarding the seat and venue needs to primarily be decided on the basis of the terms of the arbitration agreement itself; however, the court decided to refer the case to a larger bench taking into consideration the law laid down by different benches of variable strengths of the Supreme Court, submissions of the parties, and the fact that the issues involved in the case frequently arose in international commercial arbitration matters.

Comment: It will be interesting to see how the larger bench decides the issue that has come up repeatedly. Although the Law Commission recommended clarifying the place versus venue distinction in its 246^th Report, this suggestion was not incorporated in the 2015 Amendment Act and has also been left out of the 2018 Amendment Bill. In Roger Shashoua v Mukesh Sharma (2017 (14) SCC 722), where the parties designated Singapore as the venue and did not specify the seat, the Supreme Court concluded that Singapore was the seat of arbitration, despite the contract being a pre-2012 contract (i.e., prior to Balco). However, the circumstances in that case were unique as the Court relied on a prior English High Court ruling on the same issue between the same parties.

Public policy – judicial interference with arbitral award only permissible in instances of fraud or bias

Indian Oil Corporation Ltd. v Moni MadhavDutta (Gauhati High Court, 14 May 2018)

Brief facts: A contract between the appellant and respondent for the latter to transport gas cylinders excluded toll and ferry charges; however, the appellant reimbursed the respondent for these charges in the initial period of the contract. Subsequently, the appellant stopped reimbursing these charges. The respondent challenged the same via arbitration. The arbitrator issued an award in favour of the respondent, holding that it was entitled to reimbursement for toll and ferry charges. The appellant’s section 34 application was dismissed by the lower court, following which it appealed to the High Court under section 37.

Issue: Whether there is any patent illegality in the arbitral award on account of the arbitrator exceeding the scope of his reference?

Arguments: The appellant argued that the arbitrator did not confine himself to the contract between the parties while issuing his award and was therefore hit by section 34. The contract laid out an all-inclusive charge of transportation and contained no mention of toll and ferry charges. The reimbursements in the initial period of the contract were given by mistake and the fact that such reimbursements were issued by the appellant in the past to other transporters was insufficient grounds to claim reimbursements under the present contract.

The respondent argued that although the original tender document did not mention toll and ferry charges, the appellant agreed to this during the finalisation of the tender process as evidenced by the appellant’s written statements. The arbitrator took into account that the appellant reimbursed these charges historically and in the initial period of the contract at issue. Although the arbitrator did not stick to the four corners of the contract, his award on every issue was based on evidence and was not perverse under section 34.

Decision: The High Court upheld the arbitral award and lower court judgment, reiterating the minimal judicial supervision in arbitration proceedings wherein courts should only intervene in situations of fraud or bias. Agreeing with the respondent’s arguments, the Court determined that the arbitrator passed his award well within the prescribed law of the country and terms of contract, keeping in view the safety guidelines prescribed by the appellant for transportation of gas cylinders. The Court relied on McDermott International Inc v Burn Standard Co., where the Supreme Court held:

“the 1996 Act makes provision for the supervisory role of courts, for the review of the arbitral award only to ensure fairness. Intervention of the court is envisaged in few circumstances only, like, in case of fraud or bias by the arbitrators, violation of natural justice, etc. The court cannot correct errors of the arbitrators. It can only quash the award leaving the parties free to begin the arbitration again if it is desired. So, scheme of the provision aims at keeping the supervisory role of the court at minimum level” (paragraph 18) [emphasis supplied].

Public policy – fundamental policy of Indian law violated if damages for breach of contract claim automatically awarded without evidence being offered

Anila Gautam Jain v Hindustan PetroleumCorporation Limited (Bombay High Court, 03 May 2018)

Brief facts: Anila Gautam Jain (appellant) challenged an arbitral award under section 34 of the Act on grounds of patent illegality (section 34(2A)). The arbitration proceedings involved a breach of contract claim by Hindustan Petroleum (respondent) against the appellant. In response to the alleged breach of contract, the respondent made a counterclaim seeking penalty and other claims, and did not provide any corroborating evidence. The arbitrator issued an award in favour of the appellant, awarding it damages. The appellant’s section 34 petition challenging the award to the extent of the counter claim was dismissed, following which the appellant appealed to the High Court under section 37 of the Act.

Issue: Whether the counter claim as raised by the respondent could be allowed by the arbitrator?

Arguments: The appellant’s essential argument was that the respondent did not provide any evidence in support of its counterclaim. The arbitral award lacked reasons and was based solely on surmises and conjectures when instead the arbitrator was required to decide the issues on the basis of the evidence on record. On the other hand, the respondent argued that the arbitrator took into account the entire material placed on record, which was sufficient to award the respondent damages and did not require the respondent to lead oral evidence.

Decision: The High Court agreed with the appellant’s submissions. It held that while an arbitrator has the power to decide the question of liability for damages, the arbitrator in the instant proceedings gravely faltered in overlooking the fundamental provisions under section 73 of the Contract Act, which require a party to prove the damages it alleges to have suffered on account of breach of contract. If a party fails to furnish such proof, then it is not entitled to any damages or compensation. In the context of the contractual clauses, the respondent’s counter claims had to be proved on evidence and in any event, even if the parties were to agree on a quantum of liquidated damages, the party claiming such damages was required to prove the actual damages suffered by it. Further, the counter claims were clearly disputed by the appellant.

“…there is no discussion [in the award] whatsoever on the counter claims which are monetary claims as made by the respondent. The record does not indicate any cogent and acceptable evidence documentary which can be said to prove any of the counter claims of the respondent. The learned arbitrator completely discarded and dispensed with the obligation and burden on the respondent to prove the claim and straight way proceed to award the counter claims as per the operative part of the award. This approach of the learned Arbitrator was perverse to say the least” (paragraph 21).

Accordingly, the Court concluded that the arbitrator and lower court erred in holding that once there is a breach of contract, then damages are automatically required to be awarded without proof: “such a proposition certainly cannot be accepted in law. Thus, the impugned award was in conflict with the fundamental policy of Indian law and being contrary to the fundamental principles of law” (paragraph 25).

Comment: These two public policy decisions reiterate the increasingly pronounced non-interventionist judicial attitude to arbitral awards. The Bombay High Court decision serves as a useful illustration of the few instances when courts would intervene to set aside an award on grounds of patent illegality.

Reasoned award

Surajmal Yadav v Delhi State IndustrialInfrastructure Development Corporation Ltd. (Delhi High Court, 24 May 2018)

Brief facts: Surajmal Yadav (petitioner) filed a section 34 application on the limited ground that the arbitrator did not consider the petitioner’s entire prayer in his statement of claim while passing the arbitral award, namely the prayer to direct the DSIIDC (respondent) to refund stamp duty and interest on EMD and the bid amount paid by the petitioner under a lease deed which the respondent ultimately failed to execute. The arbitrator issued an award in favour of the petitioner as regards the payment of stamp duty, however he did not discuss or rule on the payment of interest.

Issue: Can a relief requested by a party be presumed to have been rejected by arbitrator if not discussed or ruled upon in the final award?

Arguments: The petitioner argued that the arbitrator did not consider the effect of the respondent’s failure to execute the lease deed as far as the EMD and bid amount deposited by the petitioner was concerned. The respondent argued that given the arbitrator passed a direction with respect to the stamp duty, it should be presumed that he rejected the prayer with respect to the interest.

Decision: The Court ruled that under section 31(3) of the Act, an arbitral tribunal has to state the reasons upon which the award is predicated. The petitioner’s prayer for refund and payment of interest could not be deemed to have been rejected by the arbitrator just because it was not granted in the final award. The arbitrator is required to give reasons for rejecting a prayer – “one cannot assume rejection of the prayer made by the petitioner and further assume reasons for rejection of such prayer” (paragraph 8). Although the Court noted that the arbitrator had clearly not considered this part of the petitioner’s claim given there was no discussion about it in the entire award, since neither party had challenged the award as passed, the court disposed the petition and granted leave to the petitioner to reagitate his claim. (Note: the Court clarified that the petitioner shall be entitled to claim the benefit of limitation in terms of section 43(4) of the Act in any such subsequent proceedings).

Comment: This decision reflects the well-established legal and judicial position that an arbitral award must set out the reasons on which it is based unless the parties have expressly agreed to the contrary.

 (More to follow in another post)

Specific Performance v Substituted Performance: Critique of the Proposed Amendments to Specific Relief Act

So far, we've had about five posts on the Specific Relief (Amendment) Bill, 2018 (pdf) providing a virtually unbridled right to specific performance:

Download the Expert Committee Report on Amendments to the Specific Relief Act

Why Should Specific Performance not be the Default Remedy: A Critique of the Recently Proposed Amendments

Efficient Breach as a Justification for Specific Performance as an Exception

Specific Performance as the Default Remedy in India? The Specific Relief (Amendment) Bill, 2018

Comments on the Specific Relief (Amendment) Bill, 2018

In this last post on the subject, we discuss why the amendment goes much beyond the Expert Committee's Report (pdf) on Specific Performance and is likely to lead to draconian results, especially for innocent promisors.

Whether the Bill Prioritises Specific Performance over Damages?

The Bill seeks to amend Section 10 such that the court's discretion is removed and specific performance is mandatorily ordered except in certain limited exceptions. Section 14. The heading of Section 10 is also sought to be changed from "Contracts which can be specifically enforced" to "Specific performance in respect of contracts". The Expert Committee also recommended the heading to be changed but the Committee's recommendation was to change it to "Specific performance and injunctions in respect of contracts". (See para 18.9).

As stated in an earlier post, the proposed amendment does not make specific performance as the first remedy but provides an option to the victim of the breach to either seek specific performance, or claim damages, or even claim the costs and expenses of substituted performance. In other words, the victim of the breach is empowered to decide the remedy of her choice. 

Why does the Bill not Balance the Interests of the Victim with that of the Promisor?

In the previous post, we had argued that Contract law does a fine balancing act between the interests of the victim whose contract was broken and at the same time ensures that the promisor who broke the contract is not made to pay the price and suffer as a consequence of the breach: contract law's focus is not to punish the breaching party but to satisfy the expectations of the promisee. We request readers to access the previous post for the discussion on this fine balancing act, which was discussed with an example.

It is true, as was acknowledged in the previous post, that Indian contract law does a bad job of compensating the victim and within reasonable time. Hence, the recommendation of the Expert Committee to provide for specific performance is fine. Recognising the fine balancing act that we're talking about, the Committee has also sought to protect this equilibrium: A perusal of Para 18.13 of the Committee's Report would reveal that the second ground that is sought to be a ground for refusing specific performance is where the party seeking specific performance could reasonably obtain substituted performance from another source on comparable terms, including price and time. Please recollect the lengthy example we discussed in the previous post where it was possible for Gowri to obtain substituted performance from Shyamu but even so Gowri sought to obtain specific performance from the original promisor Ramu, which would have resulted in disastrous consequence (and possibly loss of life) for the promisor, and which the law could not have intended.

The Committee's recommendation is in line with international practice. For instance, Article 7.2.2(c) of the UNIDROIT Principles of International Commercial Contracts provides that specific performance cannot be sought where the promisee "may reasonably obtain performance from another source". A similar provision can be found in Article 9:102(d) of the Principles of European Contract Law. (See, Para 12.2.2. of the Committee Report.

Why is the New Section 14 beyond the Committee's Recommendations and Erroneous?

Despite the recommendations by the Committee, the Government has sought to exclude this requirement and provide instead that specific performance cannot be claimed where a party to the contract "has obtained substituted performance". The difference between the clause recommended by the Committee and the one in the proposed Section 14(a) is that the proposed one excludes only those contracts for which substituted performance has been obtained while the one recommended by the Committee excluded cases where substituted performance "could be reasonably" obtained. Courts would have had the leeway to eliminate the injustice likely to be caused by an order for specific performance had the recommendation of the Committee been accepted. Instead, the Government chose to adopt a draconian provision that could result in substantial injustice, as in the case of Gowri discussed in the previous post.

There is absolutely no reason or justification why the Government did what it did: disregard the fine balancing act sought to be maintained by the Expert Committee and replace with a provision is draconian and is likely to cause substantial injustice. This is especially true especially in cases involving poor, uneducated or illiterate litigants. Considering the corruption in the legal system, it would do well to provide such safeguards as recommended by the Committee. Also, the recommendation by the Committee would only further genuine cases of efficient breach theory (see this post) where transaction costs of obtaining substituted performance are reckoned in the calculation.

There is also another problem with Section 14 of the 2018 Bill. It states that the "following contracts cannot be specifically enforced" but Section 14(a) does not strictly speak of a contract but of a situation "where a party to the contract has obtained substituted performance..."  

How to Remedy this Defective Provision?

There are two options to remedy this situation: the first option is for the Government to introduce amendments Clause 14(a) and incorporate the recommendations of the Expert Committee. The Bill is not yet an enactment; it has only been passed by Lok Sabha. The second option is to be exercised by the courts; in case the Bill in its current form is passed, the courts should construe Section 14(a) such that "has obtained substituted performance" would be read as "has or could reasonably obtain substituted performance." 

"Court May Refuse Specific Performance"

In Section 14, the Committee recommended: "(1) The Court may refuse to grant specific performance or injunction in the following cases, and in no others..." Note that the term used is "may". This means that even if the grounds in Section 14(1) for refusing specific performance, the court could still enforce specific performance. However, this is not found in the Bill. Section 14 of the Bill simply starts off with the expression: "The following contracts cannot be specifically enforced..." Thus, it appears that the Government avoided the phrase used by the Committee. But does it mean that the Government chose to reject the Committee's recommendation on the issue? We are not too sure.  

Committee's Report and the Bill does not go the Whole Way

In Para 11.9, the Committee recommended that Section 14 should have limited grounds on which specific performance could be refused. The Committee stated: "Such change will cast the burden of proving the grounds of refusal on the party against whom such relief is sought.." However, the Committee did not clearly cast the burden on the promisor while making its recommendations on the text of the amendments. Section 10 merely proposed that the victim would be entitled to specific performance, "unless relief can be refused under sections 14, 16 or 41..." (see Para 18.10). However, even this Section does not clarify who has to prove the availability of a reasonable source for substitute performance. Similarly Section 14 of the Bill also does not clearly cast the burden. 

Of course, owing to Section 103 of the Indian Evidence Act, 1872, it could be argued that the the burden of proof of the availability of reasonable substitute would  be on the person who would wish to be believe in its existence. It could also be argued that the plaintiff/ victim cannot be expected to prove the negative: that no reasonable substituted performance is available. On the other hand, the facts regarding substituted performance could very well be especially within the knowledge of the victim/ plaintiff, who then has to establish that no reasonable substitute was available as per the mandate of Section 106 of the Indian Evidence Act, 1872.

We are not very sure if the Expert Committee sought to leave it for courts to come up with the onus: going by the recommendations of the Committee in para 11.9, it appears that the burden was supposed to be cast on the defendant. We are also not altogether sure if the Government consciously had a view to leave it to the courts to construe the provision and cast the onus accordingly. 

We therefore suggest that Section 14 of the Bill be modified to state: The following contracts cannot be specifically enforced "All contracts can be specifically enforced unless the promisor in breach of the contract establishes that...  Note that it is sufficient if the party breaching contract establishes one ground in Section 14.  

Why Should Specific Performance not be the Default Remedy: A Critique of the Recently Proposed Amendments

Edward Fry in his epochal work on Specific Performance prophesied:

"It may be suggested that [] a perfect system of jurisprudence ought to enforce the actual performance of contracts of every kind and class, except only when there are circumstances which render such enforcement unnecessary or inexpedient, and that it ought to be assumed that every contract is specifically enforceable until the contrary be shown. But so broad a proposition has never, it is believed, been asserted by any of the judges of the court of chancery, or their successors in the high court of justice, though, if prophecy were the function of a law writer, it might be suggested that they will more and more approximate to such a rule."

This prophecy did not become true in English law but might in India.

Readers may recollect the three recent posts in this blog (here, here, and here) on the proposed amendments to the Specific Relief Act, 1963. In this post, we critically evaluate the proposed amendment making specific performance as the default remedy. As a prelude to this discussion, we draw readers' attention to a previous post in this blog where we stated that the proposed amendments sought to do away with the general rule in contract law that damages would be the default remedy and specific performance would be the exception. 

The amendment Bill seeks to alter the legal position which has been in vogue for more than 200 years (see, for instance, Harnett v Yielding (1805)). Although Scots law and certain civil law jurisdictions have specific performance as a default remedy, damages as the default remedy is the near universal rule in common law jurisdictions. The present amendments seek to alter this approach in India.

We argue in this post that the said proposal should be re-thought. We supply reasons in this post for this. Before this, we wish to give two disclaimers: One, most of the members of the Expert Committee who proposed the amendment have tremendous experience in the subject. Yet, with a lot of deference, we state that the approach might not be altogether correct. The second, and the most important disclaimer is that we have not yet read the report as it is not in the public domain, and therefore, we are not in a position to completely fathom why the report so suggests. Anyway, we can only hazard a guess: India has a dismal rate of contract enforcement, and the report intends to correct this state of affairs by making such contracts specifically enforceable. We also think that this paper (by one of the members of the Committee) might throw some light on why the Committee so proposed.

Before Critiquing the Proposal, let us briefly see what the amendment proposes.

Proposed Amendments on Specific Relief

Section 10 of the existing 1963, which enumerates cases where, and conditions in which, specific performance of contract is enforceable, is sought to be replaced with the following provision: “10. The specific performance of a contract shall be enforced by the court subject to the provisions contained in sub-section (2) of section 11, section 14 and section 16.”

Note that the newly proposed Section 10 refers to Section 14. The existing Section 14, which enumerates grounds that are not specifically enforceable, is sought to be replaced with the following:

“14. The following contracts cannot be specifically enforced, namely:— 

(a) where a party to the contract has obtained substituted performance of contract in accordance with the provisions of section 20; 

(b) a contract, the performance of which involves the performance of a continuous duty which the court cannot supervise; 

(c) a contract which is so dependent on the personal qualifications of the parties that the court cannot enforce specific performance of its material terms; and 

(d) a contract which is in its nature determinable."

Except for ground 14(a) above, the rest of the grounds are available in the existing Section 14. The new Section 14 proposed does away with few of the existing grounds and the one which we are concerned about is where where compensation for breach is an adequate remedy. The proposed Section 14 replaces this ground with where the victim of breach has obtained substituted performance.

Note that the existing sub-heading for Sections 20 to 24 of the 1963 Act, "Discretion and Powers of Court" is sought to be replaced with the sub-heading “Substituted performance of contracts, etc.”. The existing Section 20 titled "Discretion as to decreeing specific performance" is sought to be replaced with a section on Substituted Performance.The new Section 20 provides the victim of breach "the option of substituted performance through a third party or by his own agency." 

Therefore, a victim of breach under the new regime would have the following options:

• seek substituted performance under the new S. 20,
• seek specific performance under the new S. 10, if he has not sought substituted performance under the new S. 14, or
• claim damages or liquidated damages [the new S 20(1) on substituted performance starts off with the phrase "without prejudice to the generality of the provisions contained in the Indian Contract Act, 1872...".]

Thus, the victim of breach can claim any of these things. The law as it stands now provides that specific performance cannot be ordered when compensation for non-performance is an adequate relief [S. 14(1)(a)].

Strictly speaking, it is not that specific performance is proposed to be made as the default remedy; rather, all three (or four, if you include liquidated damages) are the default remedies.

Why is Specific Performance not the Default Remedy?

Specific Performance is not the default remedy but damages is, in India. The law allows the promisor to 'efficiently' breach the contract, which under circumstances, is socially optimal (see this post).(this ground is not without counter-arguments). In many cases, specific performance is unduly harsh on the promisor (more on this later).

What is the Problem with Damages being the Default Remedy?

Damages is difficult to prove. Even then at times parties suffer special damages but for reasons do not foresee (although they should) at the time of contracting. Owing to the difficulty of proof, damages are, most of the times, undercompensatory. In many cases in India, the road to recovering the money is a long drawn process and results in substantial injustice to the victim of the breach. In pursuing the legal remedies, the victim is often not even compensated for the costs incurred. The victim has better information than the courts as to the adequacy of damages, and the courts/ legislature should not forcibly impose such a standard on the victim.

Alan Schwartz wrote an important paper titled "The Case for Specific Performance" 89 Yale L. J. 271 (1979) where he argued that the victim has to be provided the option of deciding to go for damages or specific relief depending on which of those two will properly compensate her. Schwartz argued:

"The compensation goal of contract law can be achieved by requiring the promisor to pay damages or by requiring the promisor to render the promised performance. Under current law, a promisee is entitled to a damage award as of right but the court retains discretion to decide whether specific performance should be granted. Because specific performance is a superior method for achieving the compensation goal, promisees should be able to obtain specific performance on request."

[The compensation goal that Schwartz was referring to was to put the victim in the position as if the contract was performed.]

This is what the Bill proposed to do: provide the victim the option to either choose, without limit, specific performance or damages (substituted performance can by assumed to be a type of damages)

Which of these Two, then?

Thus, the Bill seeks to make out a strong case for specific performance. But this should not be so. The reason is the fine balancing act played by contract law between the victim of the breach and the promisor who broke the contract. What is this fine balancing act about?

For a movie-maker, a conflict between characters is good because that gives scope to develop a character and take the movie forward. But conflict is not good in real life. Law should ensure that conflict is either resolved, or at the least, avoided. When specific performance is the default remedy, the conflict is neither avoided nor resolved but the promisor and the victim are put in a conflict zone, ripe for the deepening of conflict and even for sabotage of one's interests by the other. To take an analogy, specific performance as the default remedy is like death penalty in criminal law; it calls for the blood of the guilty. We quote Lord Hoffmann extensively in this part of the post; he puts it so aptly: "[The order for specific performance] yokes the parties together in a continuing hostile relationship. [It] prolongs the battle." (Co-operative Insurance Society Ltd v. Argyll Stores [1997] UKHL 17).

So, by awarding damages, law seeks to provide the equivalent to the promisee's expectation out of the contract. Damages put an end to the warring parties and protects the expectation interests of the victim. Lord Hoffmann says: "A remedy which enables [the victim] to secure, in money terms, more than the performance due to him is unjust... An award of damages [] brings the litigation to an end. The defendant pays damages, the forensic link between them is severed, they go their separate ways and the wounds of conflict can heal."

That law does a miserable job out of protecting the expectation interest of the victim, especially in the Indian context, is no excuse for putting the parties in the hostile zone by making specific performance the default remedy or providing a chance to the victim to get more out of the breach than what warrants. We always look for shortcuts instead of reforming what is to be reformed: the judicial system and the delays. We bye-pass it by 'reforming' only the contract law enforcement parts of it, and do a bad job with it.

Consider this example: There is a village Sitapur where Ramu, a mango retailer, promises to deliver 100 kg of mangoes to Gowri for Rs. 1000 (Rs. 10/ kg) on a particular date. Ramu thinks he will invest Rs. 800 that he has with him for buying mangoes from the wholesale market, sell it to Gowri, and get Rs. 200 as profit (at Rs. 2/kg). On the date when he is supposed to go to the wholesale market, his child falls sick and is to be admitted in the hospital. Ramu expects that he will have to spend about Rs. 700 for the hospital. So he tells Gowri that he will not be able to perform the contract. Gowri is angry at Ramu and shouts at Ramu that he is no man as he cannot even keep his promise! So she threatens to teach Ramu a lesson. Gowri enquires with another retailer Shyamu who agrees to sell the mangoes at Rs. 1100 (at Rs. 11/ kg). Still angry at Ramu, she gives a complaint to the village Panchayat. The elders of the Panchayat summons both Ramu and Gowri and a sitting is held on a sunny Sunday. Ramu, whose daughter's surgery is scheduled to be held the next day attends the sitting. After hearing both the parties, the Panchayat says that even the Parliament of India in its infinite wisdom has amended the Specific Relief Act, 1963 to give the option to the victim of breach to decide on whether the victim wants specific performance or damages. So the elders ask Gowri. Gowri says she wants specific performance. Ramu's implores with Gowri to forgive him and his cries that unless he pays up Rs. 700 to the hospital, his daughter will not be operated on and might die fails to move Gowri. Suddenly Shyamu jumps up and says he'll provide a solution. He says that if Gowri buys Shyamu's mangoes at Rs. 11/ kg and if Ramu pays to Gowri that Rs. 1/ kg extra that Gowri has to shell out to Shyamu, Gowri will get the mangoes, Shyamu will make a profit (at Rs. 3/kg) and Ramu will have to shell out Rs. 1/ kg (Rs. 100), which he will be able to do even after paying up for his daughter's surgery. Shyamu says if the solution he proposed is adopted, Shyamu, Gowri and Ramu will all get what they want. What should the Panchayat do?

We'll leave the readers to answer the question in the way they wish to but we'll conclude with the words of Lord Hoffmann: "[T]he purpose of the law of contract is not to punish wrongdoing but to satisfy the expectations of the party entitled to performance... From a wider perspective, it cannot be in the public interest for the courts to require someone to carry on business at a loss if there is any plausible alternative by which the other party can be given compensation."

[Note: In understanding and writing several on concepts of Contract Law Theory, this blawgger has substantially used Mindy Chen-Wishart's superb text book on Contract Law. The specialty of the book is it presents theoretical aspects of contract law in a simple manner.]

Reliance Interest in Contract Damages and Expectation Damages

In the past few weeks, we have been discussing the recently proposed amendments to the Specific Relief Act, 1963 (this, this and this). In this post we discuss one of the most monumental contributions to contract law, Fuller & Perdue's paper, "The Reliance Interest in Contract Damages", which was published in two parts (Part 1 & Part 2). One of the main ideas in the paper was the popular (or notorious, depending on your view) three-fold classification of contract damages. We also discuss the reason why expectation damages are awarded in contract law.

The Three-Fold Classification of Damages

F&P classified the reasons for the award of damages into protection of three kinds of interests:

• Restitution interests: The restitution interest consists of any benefit the promisee has provided the breaching party. For example, if a seller agrees to make monthly deliveries of a commodity in return for fixed payments due 60 days after each delivery and the buyer repudiates the contract after receiving and retaining two deliveries but making no payments, restitutionary damages would restore to the seller the value of the delivered goods.
• Reliance interests: The reliance interest is measured by the promisee’s wealth in the pre-contractual position. Reliance damages provide compensation both for any benefit conferred on the breaching party and for any other reliance investments made by the promisee in anticipation of performance to the extent such investments cannot be recovered.
• Expectation interests: The expectation interest is measured by the net benefit the promisee would receive should performance occur.

After making the three-fold classification, F&P observed:

• In most instances, the restitution measure will provide the lowest amount of recovery and the expectation measure the highest recovery. 
• However, the restitution measure will provide the strongest claim while the expectation measure will provide the weakest. The restitution measure seeks to correct unjust impoverishment of the breacher and the unjust enrichment of the non-breacher. In case of reliance interest, it seeks to correct the unjust loss suffered by the non-breacher but does not undo any corresponding gain of the breacher. 

The three-fold classification has attained a lot of prominence. Two papers could be referred to for a critique of the classification: Friedmann, The Performance Interest in Contract Damages (1995) 111 LQR 628 and Richard Craswell, Against Fuller & Perdue, 67 Uni Chi L Rev (2000). The two articles criticise F&P on numerous grounds. We do not need to go into these criticisms for the purpose of the present article but the classification presents a simple and a powerful analysis of the interests sought to be protected by contract law. F&P's contribution is regarded as influential so much that it has been regarded as the most famous contract article ever written (see Friedmann). Like many influential works, it appears that F&P's article went unnoticed for a long time. Later, it was dusted off from the graveyard of law review articles, taught, analysed and criticised.

The interesting trivia around the F&P article is that Perdue was a third year research assistant of Lon Fuller. The theoretical parts of the paper were written by Fuller himself and the case laws were researched by William Perdue Jr. Another interesting trivia is that Richard M Nixon, the former American president (the only President of the US to have resigned- notorious for the Watergate scandal) would have "almost served as Fuller's research assistant" for the article (see, William M. Wiecek, The History of the Supreme Court of the United States, p. 449, foot note 39). Fuller should be credited for the ethical decision to let Perdue be the co-author for the work. This is an important lesson for academicians in India. In an age where research supervisors hijack the work of research scholars and at times sexually abuse them, Fuller's action of acknowledging Perdue as the co-author should be the lesson that academicians should learn.

Why Expectation Damages?

The concept of "expectation damages" was further brought to the mainstream by the law and economics scholars, who argued that so long as performance is not inefficient (notice the double negative), expectation damages provide the incentive for the promisor to perform the contract. If there is no expectation damages, the promisee would be left with non-performance, which was not desirable from the social welfare point of view.

[Note: The next part of this post cannot be understood unless the previous post is read]

Now read the hypothetical case discussed in the previous post (read carefully). The profit of Dintel in the transaction between Dintel and Denovo was Rs. 2,000 (Rs. 10,000- Rs. 8,000). The benefits out of the transaction for Denovo was Rs. 2,000.  But the profit of Dintel in the transaction between Dintel and Yechee was Rs. 5,000 (Rs. 13,000- Rs. 8,000). If Dintel was allowed to breach after compensating Denovo for Rs. 2,000, Dintel would still earn Rs. 3,000 (Rs. 5000-Rs 2000), which was provided as the justification for the efficient breach theory. It was a win-win situation for all the three parties (under the assumption that Denovo could make alternative arrangements). 

Now what would have happened if Yechee offered only Rs.11,000? After compensating Denovo (of Rs. 2000), Dintel would have earned a profit of only Rs. 1000, which was Rs. 1000 less than what it would've earned had it performed the contract with Denovo. Consider a scenario where Yechee offers only Rs. 11000 to Dintel, and if Dintel breaches the contract with Denovo, Denovo would have to pay Rs. 2000 for alternative procurement for another company CMD. In a case where expectation damages does not exist (and Dintel did not incur costs), Dintel would simply breach the contract with Denovo, leaving Denovo in the lurch, and go for Yechee's contract, thus earning a cool profit of Rs. 3,000. Denovo would then have to spend Rs. 2,000 extra and its profits from the sale of the laptop would be eroded, leaving Denovo worse off. Only if expectation damages existed would Dintel be prevented from breaching the contract with Denovo as it would earn a profit only of Rs. 1000 giving no incentive for Dintel to breach the contract with Denovo. 

This is the justification for expectation damages. More on the relevance of this discussion in the next post.

Efficient Breach as a Justification for Specific Performance as an Exception

Readers may recollect the two recent posts in this blog (here and here) on the proposed amendments to the Specific Relief Act, 1963. Taking the topic forward, we discuss why damages and not specific performance is the default remedy. We discuss the efficient breach theory as popularised by Richard Posner and others. 

The Efficient Breach Theory

Efficicent breach theory was first introduced by Robert Birmingham in a 1970 article Breach of Contract, Damage Measures and Economic Efficiency, 24 Rutgers L Rev 273 (1970) and was subsequently developed by Richard Posner’s 1972 book titled, Economic Analysis of Law.

One of the most powerful theoretical justifications to the principle that damages should be the default remedy in case of contractual breaches and specific performance should be the exception is the efficient breach theory. As early as in 1897, OW Holmes famously stated: "The duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it- nothing else." This is the battle cry of the proponents of the efficient breach theory.

The theory of efficient breach argues that damages as awarded by courts gives the promisor an incentive to perform the contract except when the result would be an inefficient use of resources. In such a case, the theory prescribes, promisor should be allowed to breach the contract so long as the victim is adequately compensated. The theory seems to be morally repugnant on the face of it but its appeal can be explained through a hypothetical example. 

What does the Theory Say? A hypothetical Case: 

Let us take a hypothetical case of laptop and processors business. The hypothetical case is slightly complicated and hence readers may pay close attention to each word in the case.

On 01.01.2018, manufacturers of processors, Dintel enters into contract to sell processors to Denovo Computers, a manufacturer of laptops. As per the contract, Dintel is supposed to deliver 100 units to Denovo on or before 01.07.2018. If Dintel breaches the contract, Denovo can procure the equivalent processors from another manufacturer, CMD at, say, around the same rate and without much delay. But Dintel's maximum capacity is only, say, 100 units in seven months.

Under the contract, Denovo is to pay Rs. 10000 per Processor or Rs. 10,00,000 by 01.08.2018 for delivery thereof. Dintel has to spend Rs. 8000 on manufacture, shipment and overheads. Denovo has to use the processors to manufacture laptops. On top of the cost it would incur for the processor, Denovo has to spend an extra Rs. 6000 per laptop (for other parts) and will sell the laptop at Rs. 18,000.

• Total cost of producing the laptop = Rs. 8000 (cost of processor) + Rs. 6000 (other parts of the laptop) = Rs. 14,000.
• Overall value created out of the deal= Rs. 18,000 (selling price) – Rs. 14,000 (cost) = Rs. 4000
• Of the value of Rs. 4000, Rs. 2000 will go to Dintel (Rs. 10,000- 8000) and Rs. 2000 will go to Denovo [Rs. 18,000- (Rs. 10,000+6,000)]

Depending upon the relative bargaining power, either Dintel or Denovo may adjust the profit but would generally not make a loss-making deal, such as selling the processor at Rs. 6000 to Denovo (loss to Dintel) or at Rs. 13000 (loss to Denovo)

Although the above deal presents overall value to both parties, risks involved or new situations could make the deal unattractive to either one of them. One such situation is discussed below:

Consider a scenario where on 01.04.2018, YECHEE, a competitor to Denovo offers Rs. 13,000 per unit of 100 processors for delivery on 01.07.2018. YECHEE is offering so because it can produce the remaining parts in cheaper costs using its technology at just Rs. 3000. Please recollect that the overall value created in the transaction between Dintel and Denovo was Rs. 4000, that is, Rs. 18,000 (selling price) – Rs. 14,000 (production cost) = Rs. 4000. 

Whereas the overall value created in the transaction between Dintel and YECHEE would be [Rs. 18,000 (selling price) – (Rs. 8000 + Rs. 3000)] = Rs.  7000. [note that the production costs for YECHEE apart from the processor cost is just Rs. 3000.

Therefore, maximum social welfare (selling value minus production costs) would be achieved if the transaction between Dintel and YECHEE is allowed. In other words, if Dintel is allowed to breach the contract with Denovo, subject of course on payment of damages, both Dintel and Denovo will be well-off. This is, in simple, what the efficient breach theory prescribes: it would be socially optimal for Dintel to breach the contract and allow Dintel to enter into a deal with YECHEE provided Denovo is compensated. It will be a win-win situation for the victim of breach, for the promisor, and for the third party, YECHEE. Hence ,there will be no point in awarding specific performance, as specific performance will lead to a lesser overall societal value and will result in two disappointed parties (Dintel and YECHEE) of the three. This is the basis for the rule that specific performance will not be awarded where damages would adequately compensate the victim of breach. 

A Case for Specific Performance in the Above Scenario: Readers may recollect the assumption above that If Dintel breaches the contract, Denovo can procure the equivalent processors from another manufacturer, CMD at, say, around the same rate and without much delay. What if this assumption is not there? What if, owing to Dintel's breach, Denovo will not be able to supply laptops to its long-term customers, and which will lead to loss of reputation and a huge loss in market share such that the said losses would mean Denovo losing crores of rupees. Would breach still be allowed? In this situation, the breach would make Denovo seriously worse off, and would be a situation where damages would not adequately compensate Denovo. Therefore, specific performance would have to be ordered.

This is, in simple, the efficient breach theory.

Criticisms of the Efficient Breach Theory

So much was the theory’s influence that in 1983 Restatement (Second) of Contracts, the theory received a tentative endorsement” in the Introductory Note on Remedies with a caveat, which represents two broad strands of criticism- morally repugnant and reliance on false assumptions. In view of the criticisms, it appears that the theory was further refined but certain criticisms continued to be unsatisfactorily answered by the theory. 

Moral Repugnancy: This strand of criticism stems for the contract as a promise theory. 

• The efficient breach theory encourages parties to a conduct (breaching the contract) which laws should condemn.
• The theory allocates all gains from the wrong (breach) to the wrong-doer while affords no-loss-no-gain to the original buyer.
• Critiques ask what will happen to the market and the sanctity of bargains if the chain goes on?

False Assumptions: Critiques argue that the theory is based upon several false assumptions.

• It largely ignores transaction costs. It offers no account of how the breaching parties come to pay expectation damages- litigation will consumer lot of judicial and party resources which may even lead to huge costs making the transaction socially inefficient.
• What happens especially in a situation like in India where it takes several years to award damages and to recover it, especially where the promisor refuses to pay damages?
• The theory assumes perfect information. In actual world, damages measure and the calculations on profit/ overall welfare are complicated and unpredictable. Further, many meritorious cases fail due to lack of evidence or negligence of counsel/ parties.
• The theory wholly ignores market reputation and repeat play, especially in long-term scenarios. Parties may not be cold-blooded and self-interested in such cases.

Despite the serious criticisms that the theory faces, the theory presents a power justification for the rule that specific performance should be the exception and damages should be the default remedy.

More on this topic in another post. 

Breaking (!) Ban on Penalty Clauses Survives! UK SC in Cavendish Square Holding v Talal El Makdessi

Regular readers of this Blog would be aware of the recent post on the UK Supreme Court's case of Cavendish Square Holding BV v Talal El Makdessi (Earlier posts on case in this blog can be accessed from here and here.). The issues involved in this case are:

1. Whether the rule against penalties applies to commercial contracts between sophisticated parties.
2. If the rule does apply to such contracts, whether clauses 5.1 and 5.6 are within the scope of the rule.
3. If the clauses are within the scope of the rule against penalties, whether the Court of Appeal was wrong to conclude that they were penal and therefore unenforceable.

In this case, it was contended  by one of the parties that the rule against penalties should go as a whole irrespective of whether the contract was a commercial contract. The UK SC would be authoritatively ruling on the rule against penalties which, rudimentarily put, restricts damages to the actual losses suffered and has been established for more than two centuries.

The Supreme Court has decided the case today (04.11.2015). Following is a summary of conclusions of the court on the rule against penalties (as taken from the UK SC Press Release):

1) The penalty rule is an “ancient, haphazardly constructed edifice which has not weathered well” but has stood the test of time. Similar rules exists in all all other developed systems of law.

2) Therefore, it should not therefore be abolished. At the same time, it should not also be extended unnecessarily.

3) Penalty clauses not merely apply to clauses relating to money penalties but also to obligations to transfer assets, or clauses where one party forfeits a deposit following its’ breach of contract.

4) The concepts of ‘deterrence’ and “genuine pre-estimate of loss” in determining whether a clause is a penalty or not are not relevant.

5) The true test, according to Lord Mance, is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.

6) The method of applying this test is as follows:

a) The first step is to consider whether any (and if so what) legitimate business interest is served and protected by the clause, and if so,

b) whether the provision made for that interest is extravagant, exorbitant or unconscionable.

7) The test to determine penalty clauses, according to Lord Hodge, is whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract. A clause, according to Lord Hodge, fixing a level of damages payable on breach will be a penalty if there is an extravagant disproportion between the stipulated sum and the highest level of damages that could possibly arise from the breach.

The judgement can be accessed from here. The Press Summary of the UK Supreme Court can be accessed from here. More on this judgement and the Bunge SA judgement in the next few posts in this blog.