Source: http://courtingthelaw.com/2019/03/22/commentary/liquidated-damages-performance-guarantees-a-complex-relationship/
Timestamp: 2019-04-19 16:28:27+00:00

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I recently read an article on Courting The Law titled Law of Liquidated Damages in Contracts – Under Contract Act 1872 And Case Law which summarized the jurisprudence of Section 55 of the Contract Act 1872, based on which, according to the article, a claim of liquidated damages (in the common law perspective) should be allowed in Pakistan.
Towards the end of the article, the fellow columnist made two observations.
Secondly, she criticized Pakistani judges and lawyers on the basis that “liquidated damages are demanded to be proven and are not granted otherwise in case of a delayed delivery of goods” and that “the legal provisions about liquidated damages are clear at this point, however, the encashment of performance bonds/guarantees becomes debatable despite the law and relevant jurisprudence being unambiguous about them once the conditions to have them enchased have been met”.
I respectfully disagree with the fellow columnist for the following reasons.
Section 55 of the Contract Act simply adopts the doctrine of ‘time being of the essence’. This is a product of common law and is widely seen in various enactments of commonwealth jurisdictions. The first part of Section 55 states that, subject to the intentions of the contracting parties, if time is of the essence and is breached by a promisor, the contract becomes voidable at the option of the promisee. The first part of Section 55 does not state that the promisor, being in breach of the stipulated time, is required to pay any damages or penalty.
The second part of Section 55 of the Contract Act states that if the parties did not intend for time to be of the essence, then on expiry of the stipulated time, the contract does not become voidable. Instead, “the promisee is entitled to compensation from the promisor for any loss occasioned to him by such failure.” Thus, the second part of Section 55 entitles a promisee to compensation “for any loss occasioned” (emphasizing past-tense, meaning that the loss must be ascertainable and not a pre-estimated assessment – see below for further explanation). The third part of Section 55 is not relevant to the present context and will not be deliberated upon for now.
Muhammad Iqbal versus Mehmood Ali (2015 SCMR 21).
With respect to other contracts (such as service contracts or contracts for the sale of goods), parties may agree on time to be of the essence, as stated in paragraph 18 of the judgment in Sandoz Limited, supra. However, if the promisor does not comply with the stipulated time, Section 55 only states that the contract may become voidable at the option of the promisee. If the promisee, nevertheless, seeks compensation due to the promisor’s breach of the stipulated time, then it is not Section 55 but Sections 73 and 74 of the Contract Act which will govern the promisee’s claim of compensation against the promisor.
According to Section 73 of the Contract Act, in case of a breach of contract, a party which suffers such breach is entitled to compensation for loss or damage that naturally arose in the usual course of things. Such compensation must be actual and not indirect or remote. In other words, in Pakistan, a party would only be entitled to actual losses which it must prove in court (see case-law below).
The language of Section 74 of the Contract Act is relatively tricky and often misleads law students and legal professionals to believe that this provision conveniently adopts the common law concept of liquidated damages in Pakistan. This is an incorrect interpretation (or understanding) as Section 74 of the Contract Act and has little to do with the common law concept of liquidated damages – it instead offers the concept of reasonable penalty in terrorem. In other words, Section 74 does not support the awarding of pre-estimated damages in full and without proof or rationale. Instead, Section 74 compels a promisor (with the threat of penal consequences i.e. terrorem) to comply with the contract in letter and spirit, failing which will entitle the promisee to reasonable compensation from the pre-determined amount (and not exceeding thereof) or penalty in the contract (if there is one – failing which would award compensation under Section 73, as provided above).
(b) the firm shall lift the goods within three (3) months of the date of acceptance – in case of failure to lift the goods, the guarantee would be encashed and the remaining goods would be disposed of.
Section 74 of the Contract Act does not recognise the difference that exists in the English law between liquidated damages and penalty. Under the Common Law a genuine pre‑estimate of damages agreed upon by the parties is regarded as liquidated damages. But a stipulation in a contract in terrorem is penalty. In the case of liquidated damages the contract is binding upon the parties. In the case of penalty, however, the Court refuses to enforce it and awards to the aggrieved party reasonable compensation.
The argument that section 74 of the Contract Act deals only with the right to receive from the party who has broken a contract reasonable compensation and not the right to forfeit what has already been received by the aggrieved party cannot be accepted in view of the terms of the section. The cases in which such a view has been taken appear to have ignored the expression “the contract contains any other stipulation by way of penalty” in the section. This expression is comprehensive enough to include cases of forfeiture of money or any property already delivered as well as cases of recovery of money or any, property on the basis of a promise to pay.
The cases reported in AIR 1942 Cal. 382 and P L D 1961 Kar. 623 have proceeded on the view that section 74 of the Contract Act has no application to a case of forfeiture of earnest money or of a deposit which is in the nature of earnest money as the section deals only with a class of cases where the contract names a sum to be paid in case of breach. In our view the learned Judges who decided these cases did not, with due respect, we may point out, take into account another class of cases which come under the expression “the contract contains any other stipulation by way of penalty”. It is difficult to see why a contract which contains a covenant for forfeiture of deposit actually made or an amount which is recoverable on failure to perform the contract will not come within the expres­sion “if the contract contains any other stipulation by way of penalty”. The award of compensation by the Court under section 74 of the Contract Act will depend upon its finding as to what in the facts and circumstances of the case is reasonable compensation subject to the limit of the amount mentioned in the contract. 1t is true that the aggrieved party is entitled to recover compensation from the party who is guilty of breach of the contract whether or not actual damage or loss is proved to have been caused thereby.
In the present case we are, therefore, to see whether the Province of West Pakistan can claim the whole or any part of the amount which the firm was to deposit by way of earnest money. It will be wrong to argue that since the firm had agreed to deposit a sum as earnest money and in lieu thereof furnished Bank Guarantee for the said amount the Government would be entitled to claim the whole of this amount simply because there was a breach of the contract by the firm. Such a contention does not even receive support from the cases where the view taken was that the forfeiture clause of a deposit in a contract does not come within the purview of section 74 of the Contract Act. In these cases also forfeiture was held to be justified if the amounts were found to be reasonable.
The law which settles the matter from the top is that a party in Pakistan, under Section 74 of the Contract Act, is entitled to receive reasonable compensation of the amount so named in the contract or penalty, subject to concrete proof. Thus, even though the Government was contractually entitled to forfeit five percent (5%) of the contract price in case the firm did not lift the goods within the stipulated time period (emphasizing that time is of the essence), the larger bench of the Supreme Court denied any compensation to the Government because it had incurred profit (and not any loss) on the sale of the remaining goods and it would have been unreasonable for the Government to forfeit the amount (submitted through guarantee by the firm) so mentioned in the contract by way of penalty. For the sake of argument, if the Government had incurred a loss on the sale of remaining goods, the Supreme Court would have awarded reasonable compensation to the Government under Section 74 of the Contract Act.
Thus, even if liquidated damages are taken interchangeably with a penalty in terrorem, under the present legal regime i.e. Section 74 of the Contract Act, a party is only entitled to reasonable compensation of the amount so named in the contract and not the full amount.
There are obviously numerous judgments of the High Courts in respect of liquidated damages (and many others which differentiate liquidated damages and a penalty in terrorem), but as a practising lawyer, it would be difficult to embellish their importance in light of the above judgments of the Supreme Court of Pakistan. In passing, and for better understanding, it is worth noting that Pakistani courts have disregarded late payment clauses or penalty clauses (without the element of reasonable compensation) for being unconscionable against the law and the system of Islamic finance. Interestingly, in another judgment, a claimant was denied any compensation due to absence of substantial proof even though the claimant had relied on the doctrine of “unjust enrichment”.
“28…A perusal of the above‑quoted section 73 shows that it deals with the consequences of breach of a contract and the basis on which compensation for any loss or damage is to be. assessed by providing that when a contract has been broken, the party who suffers by such breach is entitled to receive from the party who has broken the contract, compensation for any loss or damage caused to him thereby, which naturally arose in the usual course of things from such, breach, or which the parties knew, when they made the contract, to be likely to result from the breach of it. It further provides that such compensation was not to be given for any remote and indirect loss or damage sustained by reason of such breach.
It may also be noticed that second part of the above section deals with a case when an obligation resembling those created by contract has been incurred and has not been discharged. In such a case the compensation is to be assessed on the same basis if there was a breach of contract.
It may further be pointed out that explanation to above section 73 provides guideline to the Court by laying down that in estimating the loss or damage arising from a breach of contract, the means which existed of remedying the inconvenience caused by the non‑performance of the contract must be taken into account.
On the basis of the above, both law-lords (in their own respective legal opinions) assessed the actual loss (under Section 73 of the Contract Act) incurred by Sandoz and its agent and awarded the same while disregarding any losses which did not naturally arise or were indirect or remote. As far as Government’s claim is concerned, it is important to emphatically note that the Supreme Court did not award any liquidated damages to it under Clause 19 of the tender documents, which stipulated payment of liquidated damages at the rate of two percent (2%) per month or part thereof on the value of undelivered quantity. Instead, the Supreme Court dismissed the Government’s suit on the basis that it was not able to establish, through evidence, any basis for reasonable compensation. This is indeed the established jurisprudence under Section 74 of the Contract Act and therefore, the fellow columnist appears to have misinterpreted the settled principles of law in the judgments of the superior courts of Pakistan and to some extent, may have inadvertently incorporated common law principles into Pakistan’s jurisprudence on the subject.
It is equally important to emphasize that the judges cannot, on their own, adopt common law principles (such as awarding of liquidated damages in full and without proof) by adding or substituting words to the legislature because judges are expected to remain within the four corners of the law. The Contract Act 1872 is a sub-colonial law and requires major upgradation allowing contracting parties – as well the courts – to adopt contemporary principles and remedies. However, until such amendments (or fresh enactments) are made, the legal position set out above is likely to prevail, through no fault of the judiciary. In claiming the above, I need not review the position under Indian law and judicial precedents as they are, to this extent, different and only persuasive in a limited manner.
The law of guarantees in Pakistan requires a detailed analysis, however, in the present context, there are only two types of performance guarantees or bonds namely, “unconditional” and “conditional”.
In case of unconditional performance guarantees, a Pakistani court would not grant injunction against the encashment if the wording of the guarantee clearly envisages the creditor to be the “sole judge” of default of the principal debtor’s obligations, which is deemed to be the conclusive evidence, and if the surety is required to honor the creditor’s call of encashment at the first written demand and without further proof. For the present purpose, the judgment in Shipyard K. Damen International versus Karachi Shipyard and Engineering Works Limited (PLD 2003 SC 191) is the best judicial precedent in which the Supreme Court of Pakistan outlined nine (9) principles related to unconditional performance guarantees (in paragraph 7) on the basis of which an injunction should not be granted against the encashment of an unconditional performance guarantee. Similarly, in Standard Construction Company Limited versus Federation of Pakistan (2010 SCMR 524), the Supreme Court of Pakistan reiterated it view (in paragraph 5), that if the creditor is worded to be the “sole judge” of encashment of the performance guarantee, then the creditor’s demand of encashment to the surety would be sufficient and not require any further proof.
If the guaranteed amount in the performance guarantee is referred to as the ‘penal sum’.
In Standard Construction Company, supra, the Supreme Court of Pakistan adjudicated upon several performance guarantees and most efficaciously deciphered the unconditional and conditional nature of each relevant guarantee with the result that the unconditional performance guarantees were allowed to be encashed, whereas conditional performance guarantees were restrained from encashment, pending resolution of the dispute in arbitration. There are, yet again, numerous Pakistani judgments on the subject, but for now, the best precedent in Pakistan on the subject comes from Atlas Cables (Private) Limited versus Islamabad Electric Supply Company Limited and another (2016 CLD 1833) in which Justice Hassan Aurangzeb of the Islamabad High Court has very eminently adjudged (in paragraphs 48 to 58) the nature of the performance guarantee in question and restrained the creditor from encashing the same without establishing that the conditions prescribed in the said guarantee had been fulfilled.
Section 55 of the Contract Act only adopts the principle of ‘time being of the essence’. In case of breach of the stipulated time, the promisee must establish a claim under Sections 73 (actual losses) or 74 (reasonable compensation of the amount so named or penalty) of the Contract Act.
The common law concept of liquidated damages (award of pre-estimated amounts in full and without proof) has not been envisaged under Pakistan’s current legal regime. Courts would only award reasonable compensation of the pre-determined amount under Section 74 of the Contract Act.
Unconditional performance guarantees, where the creditor is the ‘sole judge’ of the principal debtor’s default, will not be restrained by Pakistani courts and may be encashed, whereas conditional performance guarantees will only be encashed once the creditor has established that the conditions mentioned in the guarantees have been fulfilled.
If the parent-contract (or the conditional performance guarantee) has a clause relating to liquidated damages, Pakistani courts are likely to apply the doctrine of ‘reading-in’ to Section 74 of the Contract Act and the law of conditional performance guarantees. In this context, the judgment of the Supreme Court of Pakistan in Saudi-Pak International, supra, is important – it declined to award liquidated damages arising out of encashment of the guarantee without establishing losses through evidence. Likewise, the judgment of the Islamabad High Court in Atlas Cables, supra, (in paragraphs 60 to 73) is equally important – it declined to accept the argument that through the encashment of performance bonds, the creditor would recover the liquidated damages due and payable under the parent-contract because, in that case, the creditor had not alleged, claimed and proven any losses in the dispute for the court to award reasonable compensation under Section 74 of the Contract Act. Thus, in Pakistan, only reasonable compensation of the amount so named will be awarded to promisees on establishing their claim, irrespective of whether the contract stipulates payment of pre-determined liquidated damages.
 Muhammad Karimuddin v. Kanza Food Industries Ltd. (reported as 1989 MLD 3900); Industrial Development Bank of Pakistan v. Messrs Baloch Engineering Industry (Pvt.) Ltd. (reported as 2010 CLD 591); Messrs United Bank Limited v. Messrs M. Esmail and Company (Pvt.) Limited (2006 CLD 394); Allied Bank of Pakistan Limited, Faisalabad v. Messrs Asisha Garments (reported as 2001 MLD 1955); National Development Finance Corporation v. Moona Liza Fruit Juices Limited (reported as 1999 YLR 500); and Messrs HITEC Metal Plast (Pvt.) Ltd. v. Habib Bank Limited (reported as PLD 1997 Quetta 87).
 Muhammad Farooq Azam v. Bank Al-Falah Limited (DB judgment of the Lahore High Court reported as 2015 CLC 1439).
 Arbaian Sea Enterprises Limited versus Abid Amin Bhatti (reported as PLD 2013 Sindh 290).
(i) The parties to a contract may make time for the performance of their contract as the essence by expressly providing that “time is of the essence”‘ or by using any other words which may manifest that the intention of the parties is that the time shall be of essence of the contract.
(ii) That the intention of the parties as to the factum, whether the time for the performance of the contract is of the essence or not may be ascertained by the nature of the contract or the circumstances of the case. If the nature of the contract is such that non‑performance of the same within the stipulated period rendered the contract for the promisee useless or of no benefit, the time for the performance shall be construed as of the essence.
(iii) That if non‑performance of the contract within the stipulated period does not cause any loss or injury to the promisee, time is not regarded as of the essence of the contract even when a date for completion of the contract is specified.
(iv) The rule of the common law was that time for performance of a contract was always considered as the essence and non‑performance of the same within the agreed time used to render a promisor to be sued inter alia for damages, but with ‘the passage of time, the above rule stands modified/negated inter alia by statutory provisions, like section 10(2) of the English Sale of Goods Act, 1893, which provides that stipulations as to the time of payment are not deemed to be the essence of the contract of sale, subject to a contrary express I agreement.
(i) That in case of a contract involving sale of an immovable property, time is not the essence in the absence of an express provision making it so.
(ii) That in case of commercial contracts time is generally the essence of the contracts unless from the terms of the contracts and the conduct of the parties it can be inferred otherwise.
(iii) That in all, the contracts irrespective of the nature of the subject ­matter, the question, whether time for performance of the contract specified is the essence, will depend on the intention of the parties to be ascertained from the terms of the contract. In doing so, resort can be made to the conduct of the parties preceding and subsequent to the conclusion of the contract.
(iv) That even in a contract in which time for the performance is not the essence of the contract, it can be made as the essence of the contract if the promisor or promisee is guilty of an inordinate delay in performing his obligation by serving a notice specifying reasonable time for completion of the contract.
(i) ‘The performance of guarantee stands on the footing similar to as irrevocable letter of credit of Bank, which gives performance guarantee must honour that guarantee according to its terms. It is not concerned in the least with the relations between the supplier has performed his contracted obligation or not, nor with the question whether the supplier is in default or not. The Bank must pay according to its guarantee all demand if so stipulated without proof or conditions. Only exception is when there is a clear fraud of which Bank has notice.
(ii) There is an absolute obligation upon the banker to comply with the terms and conditions as enumerated in the guarantee and to pay the amount stipulated therein irrespective of any disputes there may be between buyer and seller as to whether goods are up to contract or not.
(iii) The bank guarantee should be enforced on its own terms and realization against the bank guarantee would not affect or prejudice the case of contractor, if ultimately the dispute is referred to arbitration for the reason, once the terms and conditions of the guarantee were fulfilled, the bank’s liability under the guarantee was absolute and it was wholly independent of the dispute proposed to be raised.
(iv) The contract of bank guarantee is an independent contract between the bank and the party concerned and is to be worked out independently of the dispute arising out of the work agreement between the parties concerned to such work agreement and, therefore, the extent of the dispute and claims or counter‑claims were matters extraneous to the consideration of the question of enforcement of the bank and were to be investigated by the arbitrator.
(v) Where the bank had undertaken to pay the stipulated sum to respondent, at any time, without demur, reservation, recourse, contest or protest, and without any reference to the contractor, no interim injunction restraining payment under the guarantee could be granted.
(vi) The Bank guarantee is an autonomous contract and imposes an absolute obligation on the bank to fulfil the terms and the payment on the bank guarantee becomes due on the happening of a contingency on the occurrence of which the guarantee becomes enforceable.
(vii) When once bank guarantee is discharged, the obligation of the bank ends and there is no question of going behind such discharge bank guarantee. Courts should refrain from probing into the nature of the transactions between the bank and customer, which led to the furnishing of the bank guarantee.
(viii) In the absence of any special equities and the absence of any clear fraud, the bank must pay on demand, if so stipulated and whether the terms are such must be have to found out from the performance l guarantee as such.
(ix) The unqualified terms of guarantee could not be interfered with by Courts irrespective of the existence of dispute.

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