Where are my engines? (Penalty Clauses Explained)

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TL;DR: Hindustan Aeronautics Ltd. used the penalty clause in its agreement with GE Aerospace because the aircraft engines were not delivered on time. A penalty clause acts as a deterrent in a contract and allows one party to claim a pre-agreed amount if the other party fails to perform its obligations on time. Enforcing such clauses remains difficult as Indian courts have set strict requirements.

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Table of Contents

• What Happened?

• What was the Transaction?

• What is a ‘Penalty Clause’?

• Is a ‘Penalty Clause’ Valid under Indian Law?

• Practical Tips

Source: Tenor

What Happened?

Hindustan Aeronautics Ltd. (HAL) has invoked the ‘penalty clause’ against General Electric Aerospace (GE Aerospace) under a purchase agreement for aircraft engines. This is because GE Aerospace has failed to deliver the aircraft engines on time.

What was the Transaction?

HAL (Indian state-owned entity) and GE Aerospace entered into a purchase agreement for the supply of aircraft engines (to be specific, 99 F-404 aircraft engines).

HAL is a lead manufacturer of ‘LCA Mk1A’, which is an advanced light combat aircraft for the Indian Air Force. In 2021, HAL and the Indian Defence Ministry entered into a ₹ 48,000 crore deal for these aircrafts. HAL required the engines from GE Aerospace for this aircraft.

What is a ‘Penalty Clause’?

Generally, a penalty clause requires one party to pay a certain amount to the other party if they fail to perform their obligation on time. The can either be a specific amount or a percentage of the total price.

This clause is used as a deterrent against the other party (to avoid non-performance or delayed performance), particularly in high-stakes deals or projects, where timely performance is important.

Example:

If the Seller fails to deliver the goods within the delivery period specified in Article 7 (Delivery Schedule) due to reasons attributable to the Seller, the Seller shall pay a penalty of 0.5% of the total contract price for each week of delay, up to a maximum of 5% of the total contract price. The penalty will be deducted from any amounts due to the Seller under this Agreement.

Is a ‘Penalty Clause’ Valid under Indian Law?

While a ‘penalty clause’ is valid under Indian law, courts have put the following conditions:

• The amount mentioned must be a “genuine pre-estimate of damages” fixed by the parties; the amount cannot be exorbitant.

• The party requesting the penalty amount must prove the actual loss that has been suffered.

• Only a “reasonable compensation” will be awarded by the court (with the amount mentioned in the clause as the upper limit).

As it can be seen, Indian courts have made enforcement of penalty clauses difficult. This has affected the manner in which parties are using such clauses in their contracts.

To take an example from HAL itself, one of its standard contractual requirements mentions the following clause:

To recover from the Contractor as per liquidated damages, and not by way of penalty, a sum of 0.5% of the price (on basic cost only excluding taxes & duties, if such details are furnished separately in the bid submitted) of any stores which the contractor has failed to deliver as aforesaid, for each week or part thereof during which the delivery or such stores may be in arrears subject to a maximum of 10% of the price of the stores in default. (emphasis added)

It seems that this is done to make the amount seem like a “genuine pre-estimate”.

Practical Tips

It is difficult to enforce ‘penalty clauses’ with the strict requirements set by Indian courts. While drafting such clauses, the parties’ reasoning behind the mentioned amount can be briefly mentioned. This can be as simple as:

Failure of the Seller to deliver the goods within the stipulated period shall cause the Buyer to incur substantial losses.

Cautious parties can even go a step further and add the following wording to their contract:

This amount only represents damages estimated by both the parties and is not intended to be a penalty.