Punitive v predetermined damages

By Vivek Vashi, Bharucha & Partners.
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Is a provision that imposes an obligation to pay up if a certain event takes place a penal provision or is it a pre-estimate of damages to be imposed?

Vivek Vashi Bharucha & Partners
Vivek Vashi
Bharucha & Partners

In BSNL v Reliance Communication Ltd the Supreme Court stated that if the predominant function of the provision was to deter a party from breaking a contract, it would be penal. However, if the provision had been included in an attempt to estimate losses resulting from a breach, it would amount to liquidated damages.

As such clause 6.4.6 in a contract between Bharat Sanchar Nigam Limited (BSNL) and Reliance was not a penal clause. Instead, it represented a pre-estimate of reasonable compensation for loss suffered by BSNL.

The facts of the case

BSNL and Reliance entered into a contract that allowed the latter to operate as a unified access service (UAS) provider. Subsequently, the Department of Telecommunications (DOT) issued a circular specifying that calling line identification (CLI) cannot be tampered with.

In 2004, BSNL received complaints from its subscribers in Gujarat who had received international long distance calls with local numbers. BSNL inquired into the matter and found the local numbers did not exist. They reported the matter to Reliance, which found numerous calls with a particular CLI had been made by one of their subscribers. So, in accordance with clause 6.4.6 of the contract, BSNL demanded Reliance pay ₹91,727,746 (US$2 million) with interest at 21% p.a. for illegal routing of calls.

Claiming that these calls were “grey market calls” and were neither wrongly routed nor had their CLIs been tampered with, Reliance filed a petition against BSNL’s demand to the Telecom Disputes Settlement and Appellate Tribunal (TDSAT). TDSAT held that clause 6.4.6 was penal in nature and ordered that BSNL should distinguish between unauthorized calls and calls without modified CLI. It also said that the demand was not commensurate with the actual damage suffered by BSNL.

Appeal to apex court

Appealing the TDSAT ruling in the Supreme Court, BSNL submitted that clause 6.4.6 merely prescribes a payment for when something other than a breach takes place and that it was meant to operate as an alternative mode of performance of the contract. BSNL also argued that although the sum payable may be more than the actual loss, the contract had been entered into by parties with equal bargaining power and as long as the sum is not exaggerated, it cannot be designated as a penalty.

Responding to BSNL’s arguments Reliance pointed out that grey market operations in telecom is a reality faced by all operators, so it should not be grounds for invoking clause 6.4.6. Reliance also argued that the clause can only be invoked in case of a breach. But as BSNL could not identify the wrongly routed or tampered calls, the breach could not be attributed to Reliance.

In addition, Reliance pointed out the payment demanded was not compensatory and would in fact be unconscionable, as all calls were charged at the highest rates. As a result, the demand would appear penal if imposed. Reliance told the court that such a penalty would be equivalent to punitive damages, which no party is entitled to recover under contract law. In the event of a breach, an aggrieved party should only be entitled to reasonable compensation, which was not what clause 6.4.6 envisaged.

Agreeing with BSNL the apex court held the contractual obligation of the UAS provider was to prevent misuse by determining the nature of the call and reflecting it in the billing records – failing which BSNL should be free to invoke clause 6.4.6. The court reasoned that if the billing records were inaccurate, the UAS provider would benefit by paying less access deficit charges, which would mean lower costs to them.

The court said that the actual damage may be more than what was demanded and the clause merely envisaged a “rough and ready measure”. In this manner, the court noted the general principle of encouraging liquidated damages as they serve the purpose of avoiding litigation and promoting commercial certainty.

On 29 November, a Supreme Court bench comprising chief justice SH Kapadia and justices KS Radhakrishnan and Swatanter Kumar set aside the TDSAT ruling and held that clause 6.4.6 of the contract represents a pre-estimate of reasonable compensation for the loss suffered by BSNL and is not a penalty provision.

Impact of the judgment

As a result of this judgment companies can insert contractual provisions to represent a predetermined and approximate estimate of compensation to be paid to them, without it being struck down as punitive.

The decision reveals that the Supreme Court sees “call masking” as a problem that results in telecom operators making immense profits at the expense of providers like BSNL. By making telecom operators responsible for identifying whether a call is local or international and allocating it accordingly, the court has placed the burden of averting “call masking” on the operators.

Vivek Vashi is the mainstay of the litigation department at Bharucha & Partners.

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