Forfeiture Of 'Earnest Money' Is Not Penal In Ordinary Sense So As To Apply Section 74 Contract Act : Supreme Court

The Supreme Court today (May 2) upheld the forfeiture of earnest money deposited as part of the Advance Sale Agreement by the purchaser with the seller upon the purchaser's failure to pay the balance consideration amount. The Court rejected the purchaser's argument that there cannot be a forfeiture of the earnest money deposited with the seller. Instead, it said that Rs. 20 lakhs paid by the appellant under the Advance Sale Agreement (ATS) constituted "earnest money," intended as a security deposit to bind the contract.Section 74 of the Indian Contract Act 1872 will only apply where the forfeiture is in the nature of a penalty. Reference was made to the Fateh Chand vs . Balkishan Dass decision, which held that, insofar as forfeiture of earnest money is concerned, Section 74 of the 1872 Act will not apply. Section 74 says that on breach of contract, the affected party is entitled to "reasonable compensation" not exceeding the amount specified in the contract, or the penalty stipulated.A forfeiture clause, if found to be unfair and unreasonable, cannot be enforced by this Court, the judgment said, referring to the recent judgment in Godrej Projects Development Ltd. v. Anil Karlekar."It is evident that a clause for the forfeiture of earnest money is not penal in the ordinary sense, rendering Section 74 of the 1872 Act, inapplicable. In the present case, the stipulated amount under the ATS was in the nature of an earnest money deposit and thus, Section 74 of the 1872 Act cannot apply to the same. Further, the forfeiture clause was fair and equitable rather than one-sided and unconscionable, as it imposed liabilities on both the appellant purchaser and respondent-sellers, wherein the seller was obligated to pay twice the advance amount paid by the buyer in case of his default,” the Court observed.The Court also referred to the judgment in Kailash Nath Associates v. DDA which took the view that Section 74 will apply to forfeiture of earnest money and that that proof of actual damage or loss is a sine qua non for invoking the said section and thereby, only a reasonable amount will be permissible for forfeiture upon the breach of contract.Even if Section 74 of the Contract Act is assumed to apply, the forfeiture of the entire amount of advance money by the respondents would still be justified on the ground that there was breach of contract by the appellant, which led to financial losses for the respondents, the Court said. Such losses, as specifically pleaded and proved by the evidence led before the Trial Court, far exceeded the amount forfeited under the ATS, a position that was duly noted and accepted by the Trial Court.The Bench, relying on Satish Batra v. Sudhir Rawal (2013), said, “An amount which is in nature of an advance or serves as part-payment of the purchase price cannot be forfeited unless it is a guarantee for the due performance of the contract…despite the existence of an outright forfeiture clause, it shall not apply if the amount stipulated in the contract is found to be only in the nature of part-payment of the purchase price… the forfeiture of advance money as part of earnest money can only be justified if the terms of the contract are clear and explicit to that effect.”Difference between 'earnest money' and 'advance payment'Explaining the difference between the 'earnest money' and 'advance payment', the bench comprising Justices JB Pardiwala and R Mahadevan observed that earnest money is paid as a pledge for the due performance of the contract, that can be forfeited by the seller on account of the buyer's default.Whereas, an amount which is in nature of an “advance” or serves as part-payment of the purchase price cannot be forfeited unless it is a guarantee for the due performance of the contract. In other words, if the payment is made only towards part-payment of consideration and not intended as earnest money, then the forfeiture clause will not apply.More recently, the Court in Central Bank of India v. Shanmugavelu, (2024) 6 SCC 641 succinctly clarified the distinction in the following words: “Earnest is something given by the promisee to the promisor to mark the conclusiveness of the contract. This is quite apart from the price. It may also avail as a part-payment if the contract goes through. But even so it would not lose its character as earnest, if in fact and in truth it was intended as mere evidence of the bargain. An advance is a part to be adjusted at the time of the final payment. If the promisee defaults to carry out the contract, he loses the earnest but may recover the part-payment leaving untouched the promisor's right to recover damages.” Background This was the case where Rs. 20 lakhs were paid under the Advance Sale Agreement (ATS) to the seller as "earnest money," for the purpose of creating a security deposit to bind the contract. When the purchaser failed to deposit the balance sale consideration as part of payment within the given timeline, the seller forfeited the...

Forfeiture Of 'Earnest Money' Is Not Penal In Ordinary Sense So As To Apply Section 74 Contract Act : Supreme Court

Yash Mittal

Tags