Earnest Money Forfeiture under Indian Contract Law: A Reassessment

Earnest Money Forfeiture under Indian Contract Law: A Reassessment

Introduction

Indian contract jurisprudence has long grappled with the treatment of earnest money. Although traditional dicta equate earnest money with a binding pledge liable to forfeiture on a purchaser’s default, recent constitutional and statutory approaches have imposed substantial restraints. This article critically re-examines whether, and in what circumstances, earnest money can lawfully be forfeited, with particular focus on the Supreme Court’s decision in Kailash Nath Associates v. Delhi Development Authority and the doctrinal interplay between Section 74 of the Indian Contract Act, 1872 (“ICA”) and Article 14 of the Constitution.

Conceptual Foundations of Earnest Money

Classical common-law texts regard earnest as “a pledge for due performance”[1]. Indian courts have historically adopted five features articulated in Shree Hanuman Cotton Mills[2]: (i) contemporaneous payment, (ii) guarantee of performance, (iii) part-payment when the contract proceeds, (iv) forfeiture on purchaser’s default, and (v) automatic entitlement to forfeiture absent contrary stipulation. Yet, these features operate within the statutory confines of the ICA, especially Sections 73–75, and cannot override constitutional mandates applicable to State entities.

Statutory Framework

Section 74, Indian Contract Act, 1872

Section 74 caps “reasonable compensation” at the amount stipulated for breach, irrespective of proof of actual loss, but disallows sums that are penal. Where earnest money is stipulated to be forfeitable, the provision triggers judicial scrutiny on (a) existence of breach, (b) proof of loss, or (c) whether the sum constitutes a genuine pre-estimate of loss[3].

Ancillary Legislation

  • Transfer of Property Act, 1882 – Section 55(6)(b) confers on a buyer a statutory charge for refund of advance money on vendor’s default.
  • Special statutes (e.g., SARFAESI Rules 2002, Rule 9(5)) create enabling, not mandatory, powers to forfeit deposit, thereby retaining judicial discretion[4].

Evolution of Judicial Doctrine

A. Early Acceptance of Forfeiture

Pre-1963 precedents (e.g., Chiranjit Singh, Shree Hanuman Cotton Mills) permitted automatic forfeiture, emphasising freedom of contract. The Supreme Court in Shree Hanuman Cotton Mills upheld forfeiture of the entire Rs. 2,50,000, treating it wholly as earnest money and excluding Section 74 review because no portion was characterised as “part payment”. This formulation, while still cited, rests on twin assumptions: an admitted breach by the purchaser and a private contract setting.

B. Section 74 Revisited – Fateh Chand to Maula Bux

Fateh Chand v. Balkishan Dass marked a decisive shift, holding that only the sum expressly denominated as earnest (Rs. 1,000) could be forfeited, whereas the balance Rs. 24,000—being part payment—was refundable[5]. The Court declared Section 74 “comprehensive”, covering every stipulation in terrorem, including forfeiture of deposits. In Maula Bux v. Union of India, the Court allowed forfeiture of security deposits only where the sums represented a genuine pre-estimate and proof of actual loss was difficult[6].

C. Constitutional Overlay – Kailash Nath

In Kailash Nath Associates v. DDA the Supreme Court refused forfeiture of Rs. 78 lakhs earnest money because (i) there was no contractual breach by the bidder, and (ii) the public authority suffered no loss, having resold the property at a higher price[7]. Crucially, the Court invoked Article 14: a State instrumentality cannot enforce a disproportionately harsh clause that fails the test of reasonableness. Thus, forfeiture by public bodies must satisfy both Section 74 and constitutional scrutiny.

D. Liquidated Damages Interface – ONGC v. Saw Pipes

ONGC v. Saw Pipes broadened judicial intervention in arbitration awards, reiterating that stipulated sums function as liquidated damages only if they are a genuine pre-estimate; otherwise, they are penal. Although not an earnest-money case, its restatement of Section 74 principles fortifies the argument against automatic forfeiture absent loss[8].

Critical Analysis: Why Earnest Money Cannot Be Automatically Forfeited

1. Necessity of Breach by Depositor

Forfeiture presupposes default. If time is waived or extended (Section 63, ICA), the purchaser cannot be said to have breached, as in Kailash Nath. Absent breach, forfeiture is ultra vires the contract and Article 14.

2. Requirement of Proof of Loss or Reasonable Pre-Estimate

Post-Fateh Chand, courts demand either evidence of loss or justification that the forfeited sum was a bona fide pre-estimate. High courts have echoed this stance, limiting forfeiture to 10 % of sale price in consumer disputes[9], or disallowing forfeiture where no diminution in property value is shown[10].

3. Distinction between Earnest Money and Part Payment

A payment towards consideration, made after the contract or not expressly labelled as earnest, is refundable notwithstanding purchaser’s breach (Madan Mohan v. Jawala Parshad)[11]. The burden lies on the vendor to establish that the sum was intended as earnest.

4. Public-Law Constraints on State Entities

Governmental bodies wield public power; their contractual discretion is subject to Article 14. Unreasonable or punitive forfeiture clauses, even if contractually agreed, are unenforceable (Kailash Nath; UMC Technologies v. FCI)[12].

5. Enabling v. Mandatory Forfeiture Clauses

Statutory or contractual provisions often state earnest money “shall” be forfeited on default (e.g., Rule 9(5), SARFAESI Rules). The Karnataka High Court has interpreted such language as discretionary, not compulsory, preserving equitable relief[13].

Contrasting Lines of Authority

Certain Supreme Court authorities (e.g., V. Lakshmanan v. B.R. Mangalgiri; H.U.D.A v. Kewal Krishan Goel) uphold full forfeiture where the contract expressly permits it[14]. Nevertheless, these cases typically involve an undisputed default and no allegation of arbitrariness or disproportionality. Post-Kailash Nath, such precedents must be read subject to Section 74 reasonableness and constitutional proportionality.

Policy Considerations

  • Encouraging genuine bids in public auctions does not necessitate oppressive forfeiture; calibrated deposits coupled with eligibility screening achieve the objective without infringing Article 14.
  • Over-zealous forfeiture deters commerce and induces litigation, undermining transactional certainty.
  • International best practices (e.g., English Law Reform Committee, 1966) advocate judicial control over penalty clauses, resonating with Indian developments.

Conclusion

Earnest money serves a legitimate commercial purpose, yet its forfeiture is not an unfettered right. The combined force of Section 74 of the ICA and the equality principle of Article 14 circumscribes forfeiture to scenarios involving: (i) proven breach by the depositor, and (ii) either demonstrated loss or a reasonable pre-estimate thereof. In public contracts, additional constitutional scrutiny requires the forfeiture to be just, fair, and non-arbitrary. Consequently, the categorical proposition that “earnest money can be forfeited” has yielded to a more nuanced doctrine: earnest money cannot be forfeited unless the forfeiting party discharges the burden of establishing breach, loss, and proportionality.

Footnotes

  1. Kunwar Chiranjit Singh v. Har Swarup, AIR 1926 PC 1.
  2. Shree Hanuman Cotton Mills v. Tata Air Craft Ltd., (1969) 3 SCC 522.
  3. Indian Contract Act, 1872, s. 74; see Fateh Chand v. Balkishan Dass, AIR 1963 SC 1405.
  4. The Authorised Officer v. S N Mahadeva, 2021 SCC OnLine Kar 666.
  5. Fateh Chand v. Balkishan Dass, AIR 1963 SC 1405.
  6. Maula Bux v. Union of India, (1969) 2 SCC 554.
  7. Kailash Nath Associates v. Delhi Development Authority, (2015) 4 SCC 136.
  8. Oil & Natural Gas Corporation Ltd. v. Saw Pipes Ltd., (2003) 5 SCC 705.
  9. DLF Ltd. v. Bhagwanti Narula, 2015 SCC OnLine NCDRC 1613.
  10. M/s Kusal Construction Co. v. MCD, 2011 SCC OnLine Del 1187.
  11. Madan Mohan v. Jawala Parshad, AIR 1950 P&H 110.
  12. UMC Technologies Pvt. Ltd. v. Food Corporation of India, (2021) 2 SCC 551.
  13. The Authorised Officer v. S N Mahadeva, 2021 SCC OnLine Kar 666.
  14. V. Lakshmanan v. B.R. Mangalgiri, 1995 Supp (2) SCC 33; H.U.D.A v. Kewal Krishan Goel, (1996) 4 SCC 249.