Beyond Compensation and a New Dawn for Section 74: Supreme Court and Agreed Sum for Breach of Contract
Introduction
Section 74 jurisprudence has come to mirror the liquidated damages-penalty distinction under English Law, which the drafters of the Indian Contracts Act had specifically intended to avoid (Shivprasad Swaminathan, De-inventing the Wheel, (2018)). However, considerations beyond the drafting history appear to have influenced the judges to revive the distinction. It is the role of ‘compensation’ in contractual damages.
The distinction operates in the following way. Liquidated damages are meant to serve the ‘compensatory’ function of the law of damages. The compensation principle laid down in Robinson v. Harman (1848), which Lord Sumption refers to as the fundamental principle of the law on damages, is to place the innocent party in a position, as far as possible, as if the contract is performed. It involves a counterfactual comparison between the ‘breach position’ and the ‘non-breach position’ to determine what the innocent party has ‘lost’. This ‘loss’ or ‘damage’ is to be compensated through award of ‘damages’. Then, an agreed sum in the contract to be paid upon breach will be enforced if it is a ‘liquidated damages clause’ – meaning it provides for a ‘genuine pre-estimate of loss or damage’ suffered.
A Liquidated damages clause is distinguished from a penalty clauses, which are ‘substantially in excess’ of loss or do not constitute a ‘genuine pre-estimate’, or “in terrorem”. Moreover, logically, if there is no ‘loss or damage’ caused due to breach, the agreed sum could not be provided as it would amount to ‘windfall’ or ‘unjust enrichment’. For the reasons that follow, this concern is misplaced. However, the Indian Supreme Court (‘SC’) had along adopted the above line of reasoning in a now-familiar line of cases beginning from Fateh Chand v. Balkishan Das (1964), Maula Baux v. UOI (1970), ONGC Ltd. v. Saw Pipes Ltd (2003), and mostly recently in Kailash Nath v. DDA (2015).
The English position has itself moved away from the liquidated damages-penalty distinction. A stipulated sum (intentionally referred to here as an ‘agreed sum’ and not as ‘liquidated damages’) payable upon breach of contract can be neither a penalty clause or a pre-estimate of loss i.e. a liquidated damages clause, and still enforceable when there was ‘commercial justification’ or there was a proportionate ‘legitimate interest’ in its enforcement. As held in Cavendish Square Holding BV (Appellant) v Talal El Makdessi (2015), the true test whether the clause amounts to a penalty and engages public policy concern against its enforcement is when the clause imposes burden upon a contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligations.
Importantly, it was recognised that, first, legitimate interest is not limited to compensation for ‘loss’ caused due to the breach of contract. Resultingly, second, the ‘genuine pre-estimate of loss’ is not the controlling test and can be overridden. The ‘justifiable commercial interest’ or the ‘legitimate interest’ in contractual performance sought to be protected by the agreed sum has been held to be a question of parties’ contractual bargain.
In a judgment delivered on 4 December 2025, the SC in BPL Ltd v Morgan Securities and Credit (Pvt) Ltd (2025) (‘Morgan Securities’) endorsed the Cavendish position in commercial contracts, marking a significant doctrinal shift in the treatment of agreed sums under Section 74. Part I shows how the Court adopts Cavendish by upholding enhanced interest on grounds of commercial justification approach rather than a ‘compensation for loss’ rationale. Part II argues that Morgan Securities departs from orthodox position reiterated in Kailash Nath by rejecting the ‘genuine pre-estimate of loss’ test. Part III offers normative justifications for decoupling agreed sums from compensatory damages, and argues that concerns of windfall or unjust enrichment misconceive the character of agreed sums and overlook their function as the parties’ bargain and allocation of post-breach risk. The article concludes that the statutory test of ‘reasonableness’ in Section 74 is sufficient to accommodate this shift.
BPL v. Morgan Securities and Enhanced Interest Rates
Here, the buyer (BPL Ltd) and seller (BDDL Ltd) approached the respondent (Morgan Securities) for a bill-discounting facility against unpaid invoices at a concessional interest rate, with a contractual clause providing that upon default, the concessional rate would be withdrawn and a higher rate would apply from the due date. This stipulation may amount to a penalty under Explanation 1 to Section 74 read with Illustration (d).
In upholding this arrangement, the Court emphasised the commercial rationale of bill discounting (para 47). Unlike a conventional loan, it provides immediate liquidity while transferring payment risk to the financier, with higher interest reflecting the elevated risk of non-payment, the unsecured and short-term nature of the facility, and the commercial value of immediate cash.
These “commercial justifications” enabled the Court to conclude that the increased interest on default was not a penalty under Section 74 (para 114). The court relied on Lordsvale Finance Plc v Bank of Zambia (1996) QB 752, where a higher default interest clause was upheld as ‘commercially justifiable’ despite not being a ‘genuine pre-estimate of loss’. Morgan Securities endorsed this restrained approach on the ground that judicial evaluation of commercial bargains would risk bringing about inconsistency and uncertainty in commercial contracts. This aligns with the original intent of Section 74, which was not to interfere with genuine commercial bargains, but only those that are unreasonable or unconscionable (Swaminathan (2018), p.107).
Presumption in favour of enforcement of parties bargain
The court reasoned that the facility agreement in issue was between commercial parties on an equal-footing. These commercial parties would be the best judge of what would be reasonable consequences in the event of a breach of the agreement (emphasis, para 94). The court also invoked what is commonly referred to as the ‘validation’ principle’ (see, Enka v. Chubb (2020) [75], Union of India v. D.N. Revri (1976)) – meaning “the [commercial] contract should be interpreted so that it is valid rather than ineffective” – and not render Clause 4 invalid (para 117). Morgan Securities now provides for a presumption in favour of enforceability of the agreed sum in commercial contracts, and places a high burden on the other party to displace it as an unenforceable penalty clause.
Therefore, the main thrust of the Court’s reasoning lay in its insistence that the mutual bargain of commercial parties be respected. It eschews any discussion on ‘genuine pre-estimate of loss’ requirement or compensation. It acknowledged the inherent difficulty of applying the “genuine pre-estimate of loss” test in complex commercial contracts (para 88). The assessment is unavoidably subjective and is, in principle, a matter for the parties’ bargain and their own allocation of risk. In adopting this view, the Court embraced the Cavendish approach, which, it is argued, affords commercial parties greater latitude to structure and define their contractual relationship (para 86).
Beyond Compensation: Cavendish and the end of Kailash Nath
The word ‘compensation’ in Section 74 hides more than it reveals. T.T. Arvind shows that nineteenth-century English law treated the penalty rule as concerned with confining recovery to compensation for loss, with liquidated damages functioning as a narrow “evidentiary exception” where loss was difficult to prove, thereby giving rise to the requirement of a genuine pre-estimate. By contrast, Swaminathan argues that reading “compensation” in Section 74 as confined to compensation for loss is unwarranted as a matter of drafting history.
Section 74 itself clearly mentions that ‘whether or not actual damage or loss is proved to have been caused’ upon breach of contract, an agreed sum can be enforced. However, the judicial treatment of this has been what Swaminathan calls it ‘de-inventing the wheel’ and bringing back the pre-Cavendish English position. Fateh Chand and Maula Baux held that this phrase merely dispenses with “proof of actual loss or damages”, and it does not justify the award of ‘compensation’ when as consequence of the breach “no legal injury” is suffered. It was correctly stated that ‘compensatory damages’ was to ‘make good loss or damage’ caused. However, its further reasoning that section 74 can only be invoked as compensation for loss misses the point about stipulation of an agreed sum because it need not be intended as merely providing for ‘compensation’.
Nevertheless, this position was reiterated over time and endorsed in Kailash Nath (para 43.6), which has since assumed canonical status on agreed sums under Section 74. Saw Pipes and Kailash Nath further held that proof of loss is dispensed with only where loss is ‘difficult or impossible to prove’. Nevertheless, for all practical purposes, courts enforce an agreed sum only if it qualifies as a ‘genuine pre-estimate’ of loss or damage in fact suffered. Otherwise, it is treated as a penalty and the court awards reasonable compensation under Section 73, disregarding the contractual sum.
This added complexity undermines a core purpose of agreed sums i.e. certainty, simplicity and efficiency in quantification. Fundamentally, Indian courts have superimposed a rigid ‘compensation’ requirement. As Lord Neuberger and Lord Sumption observe in Cavendish, remedies for breach of contract are not confined to providing a financial substitute for performance as compensation (para 29).
This is evident from the availability of specific performance where damages are inadequate or suitable. The recognition of specific performance as a primary remedy in Indian law post-2018 strongly supports the proposition that the law protects values and performance interests beyond compensation. In other circumstances, the law does not allow for the innocent party without ‘sufficient legitimate interest’ in continued performance to keep the contract alive after repudiatory breach of contract by another party, and sue in debt rather than claiming damages (White & Carter (Councils) Ltd. v McGregor, (1962) AC 413). For these reasons, Cavendish held that an agreed sum on breach may be enforceable for reasons beyond compensating financial loss caused by breach.
Legitimate Interests in Performance is a function of contractual construction
Consequently, Cavendish test is not tied to compensation for loss, and an agreed sum need not be a genuine pre-estimate of damage. Instead, it is enforceable so long as it is not ‘out of proportion’ to the innocent party’s legitimate interest in performance of the primary obligations, assessed through contractual construction in its commercial context. This approach is consistent with K.P. Subbarama Sastri v K.S. Raghavan (1987), which held that the determination of a clause as penalty must be informed by party intent, contractual background and nature of the transaction, and has now been endorsed in Morgan Securities. Although not articulated in these terms, SC effectively applied this test by upholding Clause 4 on the basis of its commercial justification and the parties’ bargain, without engaging in an inquiry into genuine-pre-estimate of loss or compensation.
Morgan Securities, therefore, conflicts with both limbs of Kailash Nath, the requirement of proof of ‘loss or damage’ and the insistence that the agreed sum be “a genuine pre-estimate of damages”. Both limbs rest on the mistaken assumption, traceable to Fateh Chand and Maula Bux, that agreed sums serve only a compensatory function to remedy financial loss. While Cavendish accepts that in usual liquidated damages clauses the legitimate interest will not extend (if rarely) beyond compensation which protects expectation interest in performance. However, it makes clear that this is not determinative, and that compensation is not the only legitimate interest a commercial party may have in securing performance of primary contractual obligations.
This position is consistent with contract law theory. As Webb observes, compensatory interests does not exhaust the performance interests of the innocent party. A claimant may have suffered no loss and be no worse off by reason of the breach, yet still not have received the performance contracted for which requires a remedy. This shows that the right to compensatory damages gives effect to an interest distinct from the performance interests. Parties are free to bargain a sum payable on breach to protect their other performance interests.
The key insight is that an agreed sum protects a party’s legitimate interest in performance, not merely compensation. As Cavendish held, deterrence is not penal where it serves such a legitimate interest, including interest in influencing the other party’s conduct and ensuring performance. This reasoning applies to payment obligations, as recognised in Morgan Securities. Hence, Morgan Securities departs from the orthodox position since Fateh Chand by accepting that an agreed sum on breach may extend beyond compensatory damages.
Does Moving Beyond Compensation Cause Windfall or Unjust Enrichment?
The prominent concern is that an agreed sum not constituting a ‘genuine pre-estimate of loss’ or compensatory damages might put the claimant in a better position than if the contract had been performed (see, Batliboi Environmental Engineers v. Hindustan Petroleum(2023), para 16). However, recognising the agreed sum as a reflection of the parties’ commercial bargain and risk allocation considerably tempers this objection. Fateh Chand justified the requirement of loss or damage on the basis that the section “does not confer a special benefit upon any party,”. While Kailash Nath warned that awarding the sum without loss would create a ‘windfall’, the Delhi High Court in Indian Oil v Lloyds’ Steel (2007) described it as ‘unjust enrichment’. None of these concerns withstand scrutiny for the reasons explained in what follows.
Primary and Secondary Obligation
It is important to understand the nature of an obligation to pay an agreed sum upon breach. Lord Diplock’s distinction between primary and secondary obligations is well-known where the latter provides consequences for breach of the former (Photo Production Ltd. v. Securicor Transport Ltd (1980) UKHL 2). The secondary obligation, imposed by the law, to pay a monetary sum arises under the contract upon failure to perform the primary contractual obligation (UltraTech Cements v. Sunfield Resources (2016), para 28). The penalty rule is the law’s mechanism to regulate the remedies available for breach of a party’s primary obligations in the form of secondary obligations, not the fairness of the primary obligations themselves (see also, Cavendish, 13). These secondary obligations can be modified through parties’ agreement (emphasis).[1] Accordingly, when the contract itself stipulates the secondary obligation in the form of an agreed sum, the additional consideration of respect for parties contractual bargain is invoked.
‘Reasonableness’ under Section 74
Morgan Securities holds that “the freedom of the parties to define their relationship is the most fundamental principle.” The penalty rule obviously interferes with this freedom and undermines commercial certainty. Where sophisticated commercial parties have bargained for an agreed sum in their commercial background, imposing a legal requirement of ‘loss’ negates their bargain and risk allocation. Both Cavendish (para 35) and Morgan Securities (para 94) recognise that such parties are best placed to judge what is legitimate dealing with the consequences of breach. This presumption is subject to limits where bargaining power is unequal, or the contract is outside usual commercial context, or not negotiated, circumstances where the court’s jurisdiction of remedial discretion and the reasonableness test under Section 74 may apply with greater justification. Importantly, however, reasonableness under Section 74 does not confine compensation to proven loss or damage.
Qualifying of the Compensatory Principle
While the compensatory principle is described as the ‘aim’ of damages, the law contains several instances of both under-compensation and over-compensation, meaning, departures from actual loss – effectuated through the parties’ contractual arrangements. [2] This is because the compensatory object of damages is qualified by general common law rules such as mitigation, remoteness, scope of duty etc. An agreed sum under Section 74 can likewise qualify the compensatory object upon breach. To understand why, it is necessary to examine the justifications for imposing a secondary obligation to pay damages in the first place.
Corrective Justice and Compensation
The law on damages in private law is influenced by ‘corrective justice’ rationale.[3] Upon breach of a primary obligation, the law imposes a secondary obligation to do the “next-best thing” to performance. It means, when specific performance is not possible, compensation is awarded. Drawing on John Gardner’s ‘continuity thesis’, this secondary obligation acts as a substitute for performance by conforming to the original reasons underlying the primary obligation. This is the ‘continuity’ between primary and secondary obligations.
Niranjan V argues that the law qualifies this pursuit of corrective justice made through an award of compensation. Consider the ‘reasonable contemplation’ based remoteness rule in Hadley v Baxendale (1854). While compensatory damages seek to place the claimant, so far as possible, in the position as if the contract were performed, remoteness limits recovery to losses within the parties’ reasonable contemplation at the time of contract was made. The modern approach, reflected in Lord Hoffmann’s assumption of responsibility approach, asks which losses the parties may reasonably be taken to have assumed responsibility for, assessed by reference to their contractual bargain in its commercial context.
In this sense, law’s pursuit of corrective justice is qualified by parties’ bargain. As Niranjan observes, “obligation to do the next-best thing, which is imposed by law, is qualified because the parties agreed that it would be qualified”.
Furthermore, in principle, Niranjan argues that limits on compensatory liability lacking a corrective justice rationale are best justified when they are derived from the parties’ agreement. An agreed sum payable on breach under Section 74 performs precisely this function by defining the contractual consequences of breach. As recognised in Cavendish and Morgan Securities, parties are best placed to determine the legitimate consequences of breach within their commercial context, and the fact that an agreed sum may be over- or under-compensatory is not, by itself, a basis to disregard their contractual bargain.
Therefore, there is justification in parties agreeing to allocate the consequences of breach that go beyond (or lesser than) compensation for loss caused due to the breach. It has never been the jurisdiction of the court to relieve the parties of their commercially imprudent bargain. It is in tune with the modern rule on contractual interpretation as restated in Arnold v. Britton (2015). This must be applicable equally to primary obligations and secondary obligations arising upon breach, though freedom of contract rationale is less limited in secondary obligations i.e. a matter of remedies.[4]
When the law regulates the remedies available for breach through the penalty rule, it is concerned about legitimate interest that the innocent party has in enforcing the agreed sum for breach. This is based upon a narrow general principle, as Lord Reid famously observed in White & Carter v McGregor, where a party has no legitimate interest in insisting on a particular remedy, they should not be permitted to do so, or to saddle the other party with an additional burden without any corresponding benefit to themselves.
As a matter of fundamental principle in the law of contract, an agreed sum payable upon breach represents the parties’ own allocation of risk for the post-breach period. The commercial justification or legitimate interest underpinning its enforcement may extend beyond mere compensation. It is ultimately a matter of their bargain. The court’s task in assessing the ‘reasonableness’ of such a stipulation is only to ensure that the agreed sum is not disproportionate to the parties’ legitimate performance interests and not merely compensatory interest. Therefore, the starting point, particularly with sophisticated commercial parties, is to hold them to the bargain they have made, even if it later appears imprudent.
The broad takeaway from the present discussion remains that law tolerates overcompensation and undercompensation – qualifications to the corrective justice aim of law – through parties’ agreement. In other instances, deviations from compensation principle are also justified for certainty and ease of assessment (which is also why commercial parties choose liquidated damage and/or agreed sums) as the following brief discussion demonstrates.
Windfall
Usually, application of remoteness rule of Hadley v Baxendale can lead to non-recovery of losses factually incurred but which was not within the reasonable contemplation., or outside of the assumed responsibility of the parties (undercompensation).
Conversely, imagine a scenario where A supplies defective goods to B, who had already sub-sold them to C, but incurs no liability under the sub-contract. Does the buyer’s recovery of substantial damages for defective goods provide a ‘windfall’ for the buyer? In a well-known case Slater & Co v Hoyle & Smith Ltd (1920) 2 KB 11, the court awarded substantial damages, measured by the market value of goods, even though the buyer has not suffered factual loss because he successfully managed to pass off the goods onto the sub-contract. The court’s reasons were based upon the sub-sale being outside the parties’ contemplation and independent/collateral to their bargain. Similar results of “overcompensation” occurred in Rodocanachi Sons & Co v Milburn Bros (1886) and Williams Brothers v Ed T Agius Ltd (1914). Such situations are also reflected in Illustration (o) to Section 73.
This resort to the market measure of loss (‘market rule’) – difference between the contractual value and the market value of the goods – is justified on grounds of commercial certainty, ease of calculation, and reduced litigation expenses (The Skyros v Hapag-Lloyd (2025) para 50). This is notwithstanding that it may lead to overcompensation, as in Slater, Rodocanachi and Williams Bros, or under-compensation when remoteness rule is applied, as in Transfield Shipping v Mercator Shipping (2008), where losses from a forward charter were held too remote (see generally Michael Bridge, ‘Market Damages or Compensation’ NUS Law Working Paper (2025/016)).
The primary relevance of this being that the compensation principle for ‘loss’, though fundamental, is qualified through various rules of contract law– drawing upon parties’ agreement. It is least arguable that it cannot be qualified through parties’ contractual bargain of an agreed sum (like liquidated damages clauses) in defining their secondary obligation.
Therefore, agreed sum to be payable on breach of contract cannot per se amount to a ‘windfall’ merely because it is not tied to compensation for loss, so long as it reflects parties contractual bargain and satisfies the ‘reasonableness’ requirement under Section 74 – interpreted with reference to legitimate interest test and/or commercial justification in line with Cavendish and Morgan Securities.
Unjust Enrichment
The similar reasoning applies to the supposed need to prevent unjust enrichment if agreed sum is awarded de hors relevant loss. The law of unjust enrichment is untheorized and underdeveloped in Indian case-law. For the present purpose, limited reference can be made to English law under which a claim for unjust enrichment requires ‘unjust factor’ as one of the four conditions. When there is a valid legal obligation arising under a contract or otherwise to pay an amount or confer a benefit, there cannot be an unjust factor. UKSC in Barton v. Morris (2023) reiterated that a claim in unjust enrichment must respect contractual bargain and the allocations of risk agreed between the parties. This is called the ‘obligation rule’ (Dargamo Holdings Ltd v Avonwick Holdings (2021). Hence, unjust enrichment does not offer a means of subverting parties’ agreement and risk-allocation. Therefore, a valid contractual stipulation (in terms of Section 74’s evaluation of reasonableness) defining the contours of a secondary obligations upon breach, though not compensating for any loss, cannot amount to unjust enrichment.
Concluding Remarks
The final question is whether moving beyond mere ‘compensation for loss’ fits within the framework of Section 74. It is argued that the statutory test of reasonableness, coupled with the phrase “whether or not actual damage or loss is proved”, is sufficient to accommodate this shift. By endorsing Cavendish, Morgan Securities rejected the ‘genuine pre-estimate of loss’ test, signalling a clear doctrinal break from the trajectory running from Fateh Chand to Kailash Nath. This shift, however, aligns with the original intent of Section 74 to replace the penalty-liquidated damages distinction with a single standard of reasonableness. Moreover, Morgan Securities’ emphasis on giving effect to the parties’ contractual bargain of agreed sum is in the right direction, as it reduces complexity in assessing reasonableness under section 74 and affirms party autonomy in defining the consequences of breach.
[1] David Foxton, ‘How Useful Is Lord Diplock’s Distinction between Primary and. Secondary Obligations in Contract?’ (2019) 135 LQR 249, 255.
[2] V Niranjan, “The Contract Remoteness Rule: Exclusion, Not Assumption of Responsibility” in A Dyson, J Goudkamp and F Wilmot-Smith, Defences in Contract (Oxford, 2017) 188, 189.
[3] Ibid. 192
[4] Fisher, “Rearticulating the Rule Against Penalty Clauses” [2016] L.M.C.L.Q. 171
*Chiranth Mukunda is a 3rd Year BA,.LLB student at the National Law School of India University, Bengaluru.