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 earnest money of Rs. 20 Lakhs deposited by the buyer to the seller because of the loss suffered to him.

The buyer contended that the earnest money cannot be forfeited as it formed part of the sale consideration payment.

The trial court dismissed the Appellant's plea, following which an appeal was filed before the High Court, which also resulted in the same fate.

Aggrieved by the impugned findings, the Appellant approached the Supreme Court.

Decision

Affirming the impugned findings, the judgment authored by Justice Pardiwala observed:

“it becomes amply clear that the amount of Rs.20,00,000/- termed as “advance money” in the ATS, was essentially “earnest money”. In other words, it was in the nature of a guarantee for the due performance of the contract. In a fashion akin to earnest money, the said amount was paid at the very execution of the ATS. It was meant to be adjusted against the total sale consideration of Rs.55,50,000/- if the transaction was carried out, which is evident from the ATS clause that states the balance sale consideration to be as Rs.35,50,000/-. Further, it was liable to be forfeited in the event that the transaction fell through by reason of the default on part of the purchaser. Consequently, when the appellantpurchaser failed to comply with the contractual stipulation of paying the balance sale consideration within a period of four months from the date of the agreement, the respondent nos. 1-4 (vendors) were justified in forfeiting the advance money.”, the court said.

“Having regard to the aforesaid authorities, the intention of the parties and the surrounding circumstances in the present case, it can be sufficiently inferred that the inclusion of the forfeiture clause in the ATS was intended to bind the contracting parties and ensure the due performance of the contract. This is particularly significant given the stipulated four-month period for completing the sale transaction and the primary object of executing the ATS, being the urgency of the respondent nos. 1–4 regarding the OTS, which was known to the appellant, as recorded by the Trial Court. The findings of the Trial Court, along with the impugned judgment affirming that time was of the essence, further substantiate the said intent.”, the court added.

In terms of the aforesaid, the court dismissed the appeal.

Case Title: K.R. SURESH VERSUS R. POORNIMA & ORS.

Citation : 2025 LiveLaw (SC) 522

Click here to read/download the judgment

Appearance:

For Petitioner(s) :Mr. Anand Sanjay M Nuli, Sr. Adv. M/S. Nuli & Nuli, AOR Mr. Suraj Kaushik, Adv. Mr. Firoz Gandhi, Adv. Mr. Nahar Singh Yadav, Adv.

For Respondent(s) :Ms. Supreeta Sharanagouda, AOR Mr. Sharanagouda Patil, Adv. Mrs. Supreeta Sharanagouda (aor), Adv. Mr. Jyotish Pandey, Adv. Mr. Vinod Kumar Srivastava, Adv. Mr. Saket Gogia, Adv. Ms. Gauri Pande, Adv. Ms. Sheetal Maggon, Adv. Mr. Mansingh, Adv. Mr. Dhawesh Pahuja, AOR