Adv. Saji Koduvath 

In law of contracts, earnest-money is the amount paid as advance in sale of a property and forms part of the purchase price when the transaction goes forward; and liable to be forfeited by the seller, in case the sale is failed owing to the fault of the purchaser.[1]  Section 74 of the Indian Contract Act holds the field.

Section 74 of the Indian Contract Act

A genuine pre-estimate of damages had been accepted in law of contracts, under the English Common Law. But, a penalty had not been enforced by common law courts, as it was a stipulation in terrorem.

Section 74 of the Indian Contract Act reads as under:

• S. 74: “Compensation for breach of contract where penalty stipulated for: When a contract has been broken, if a sum is named in the contract as the amount to be paid in case of such breach, or if the contract contains any other stipulation by way of penalty, the party complaining of the breach is entitled, whether or not actual damage or loss is proved to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named or, as the case may be, the penalty stipulated for.”

Section 74 discusses two classes of cases:

• a sum is named (or fixed) as the amount to be paid in case of breach; and,
• any other stipulation by way of penalty.

Section 74 further says that, in both classes, a reasonable compensation alone will be entitled to by the party complaining of the breach.

Implication of ‘Reasonable Compensation’ in Section 74

Even if the parties to the contract have pre-estimated the damages to be paid by the defaulter on breach, the injured party cannot appropriate the pre-estimated damages, of his own; for, Sec. 74 stipulates that the party complaining of the breach is entitled, a ‘reasonable’ compensation alone. The implication of the word ‘reasonable’ is that the compensation is a matter always left to be determined by the appropriate court of law or other legal forum. It is found in Kailash Nath Vs. DD Authority (2015)^[2] that the party complaining of a breach could receive as reasonable compensation such liquidated amount only if it is a genuine pre-estimate of damages fixed by both parties and found to be such by the Court.

‘Whether or Not Actual Damage or Loss is Proved’

Section 74 deals with matters ‘whether or not actual damage or loss is proved to have been caused’ by the breach. Divergent views prevail on this matter.

First: Reasonable earnest money does not fall within the ambit of Section 74.

Adopting the English Common Law principle as to pre-estimated damages (forfeiture of a reasonable/nominal earnest money, not amounting to penalty),it was held by the Supreme Court of India in Maula Bux Vs. Union of India (1970)[3] (1970) that ‘forfeiture of earnest money under a contract for sale of property, if the amount is reasonable, does not fall within Section 74’. That is, when the forfeiture clause in a contract refers to a nominal (thereby reasonable) sum alone, as earnest money, it does not provide for an ‘amount to be paid in case of such breach’, or amount to imposing a penalty.  In such cases of forfeiture of reasonable (nominal) earnest money, it is immaterial ‘whether or not actual damage or loss is proved’.

This view is not followed in subsequent decisions including Satish Batra Vs. Sudhir Rawal (2013)[4] and Kailash Nath Vs. DD Authority (2015).^[5]

It is found in Kailash Nath that the observation in Maula Bux that forfeiture of earnest money, ‘if reasonable or nominal did not fall under Section 74’, was not on a matter that directly arose for decision in that case.It was so observed in Shree Hanuman Cotton Mills Vs. Tata Aircraft Limited[6]also that the decision in MaulaBux’s had no occasion to consider the question of reasonableness or otherwise of the earnest deposit being forfeited.

Nevertheless, it is a matter of common knowledge that, prior to a formal contract when parties join their mind to enter a contract, a token sum is paid to ensure that they would execute a contract. It is only legitimate to state that such a nominal ‘earnest’, prior to formal agreement, will not come under Sec. 74.

Second: where it is possible to prove damage, it must be proved.

The expression “whether or not actual damage or loss is proved to have been caused thereby” means that where it is possible to prove actual damage or loss in terms of money, such proof is not dispensed with; and it must be proved. Section 74, by this enabling clause, permits to award compensation in cases where it is difficult or impossible to prove damage or loss. In such cases the liquidated amount named in the contract, if a genuine pre-estimate of damage or loss, will be awarded.

This view is accepted in Kailash Nath Vs. DD Authority (2015).

Third: The Indian law brings-in a uniform principle.[7]  Section 74 applies to stipulations naming amounts to be paid in case of breach, and stipulations by way of penalty.  The court would award to the party aggrieved only reasonable compensation not exceeding the amount named or penalty stipulated. In Fateh Chand Vs. Balkishan Dass (1963)[8] it was observed that the ‘Legislature has sought to cut across the web of rules and presumptions under the English common law’ and the uniform principle is adopted. This proposition as to ‘reasonable’ compensation, and thereby the intervention of court to fix the reasonable amount, laid down in Section 74, is a deliberate deviation from the English Common Law which allows forfeiture of genuine pre-estimated damages, by the affected party.

The Constitution Bench of the Supreme Court, in Fateh Chand Vs. Balkishan Dass, further pointed out that an award of compensation would not be justified if no legal injury at all had been resulted in consequence of the breach.

These views are followed in Kailash Nath Vs. DD Authority (2015).

Important findings:

Fateh Chand Vs. Balkishan Dass (1963):

• The Indian Legislature has sought to cut across the web of rules and presumptions under the English common law, by enacting a uniform principle applicable to all stipulations naming amounts to be paid in case of breach, and stipulations by way of penalty.
• It does not justify the award of compensation when in consequence of the breach no legal injury at all has resulted, because compensation for breach of contract can be awarded to make good loss or damage which naturally arose in the usual course of things, or which the parties knew when they made the contract, to be likely to result from the breach.
• The court has to adjudge in every case reasonable compensation to which the plaintiff is entitled from the defendant on breach of the contract. Such compensation has to be ascertained having regard to the conditions existing on the date of the breach.

The Attorney-General appearing on behalf of the defendant has not challenged the plaintiff’s right to forfeit Rs. 1,000/- which were expressly named and paid as earnest money.

Moula Bux Vs. Union of India (1970)^[9]

1. Forfeiture of earnest money under a contract for sale of property- movable or immovable-if the amount is reasonable, does not fall within Section 74.
2. But if forfeiture is of the nature of penalty, Section 74 applies.
3. The expression “whether or not actual damage or loss is proved to have been caused thereby” is intended to cover different classes of contracts which come before the Courts.
4. In case of breach of some contracts it may be impossible for the Court to assess compensation arising from breach, while in other cases compensation can be calculated in accordance with established rules. Where the Court is unable to assess the compensation, the sum named by the parties if it be regarded as a genuine pre-estimate may be taken into consideration as the measure of reasonable compensation, but not if the sum named is in the nature of a penalty.
5. Where loss in terms of money can be determined, the party claiming compensation must prove the loss suffered by him.

Two Extreme Divergent Views on ‘Pre-estimated’ Earnest Money

In Satish Batra Vs. Sudhir Rawal (2013)[10]our Apex Court had taken the view that entire earnest money could be forfeited by the seller if the contract was failed by the default of the purchaser. It is clear that their lordships proceeded substantially on the theory of ‘genuine pre-estimate of damages’ recognised under the English Common Law.

But, in a subsequent decision, Kailash Nath Associates Vs. Delhi Development Authority (2015)^[11], Supreme Court accepted the law laid down in Fateh Chand’s case[12] that all pre-estimated stipulations fixing damages, including the earnest money, were covered by Section 74; and upheld the view that the pre-estimated damages, fixed by the parties, should be ‘found to be such by the Court’. That is, one party to the contract cannot enforce the forfeiture clause unilaterally, without recourse to court.

Kailash Nath Vs. DDA &  Section 74

In Kailash Nath (2015),^[13] the Supreme Court categorically held in para 43 as under:

• Where a sum is named in a contract as a liquidated amount payable by way of damages, the party complaining of a breach can receive as reasonable compensation such liquidated amount only if it is a genuine pre-estimate of damages fixed by both parties and found to be such by the Court.
• In other cases where a sum is named in a contract as a liquidated amount payable by way of damages, only reasonable compensation can be awarded not exceeding the amount so stated.
• Similarly, in cases where the amount fixed is in the nature of penalty, only reasonable compensation can be awarded not exceeding the penalty so stated.
• Reasonable compensation will be fixed on well-known principles that are applicable to the law of contract, which are to be found inter alia in Section 73 of the Contract Act.
• Since Section 74 awards reasonable compensation for damage or loss caused by a breach of contract, damage or loss caused is a sine qua non for the applicability of the Section.
• The Section applies whether a person is a plaintiff or a defendant in a suit.
• The sum spoken of may already be paid or be payable in future.
• The expression “whether or not actual damage or loss is proved to have been caused thereby” means that where it is possible to prove actual damage or loss, such proof is not dispensed with. It is only in cases where damage or loss is difficult or impossible to prove that the liquidated amount named in the contract, if a genuine pre-estimate of damage or loss, can be awarded.

Defendant Can Resist Without Counter Claim

Going by various decisions referred to above, it is clear that a defendant in a suit for recovery of earnest money can resist the prayer for realisation of advance amount, without a counter claim (even if it is needed, otherwise), because this Section applies ‘whether a person is a plaintiff or a defendant’.[14] Sec. 74 governs and controls the entire domain and gamut relating to these matters; and the Sec. 74 speaks: “party complaining of breach is entitled, reasonable compensation”.

Therefore, a defendant can adduce evidence to prove that he suffered loss and damages by the breach of the plaintiff and can support forfeiture, and resist the recovery of earnest money. 

Facts of Satish Batra Vs. Sudhir Rawal (2013)[15] and Kailash Nath Associates Vs. Delhi Development Authority (2015)^[16] are good examples to show that a counter claim is not needed to resist the claim of recovery of advance. In both cases purchasers, as plaintiff, instituted the suits for recovery of money paid by them to the seller-defendant.  It was earnest money under the termsand conditions. Defendants in both the suits contested claiming right of forfeiture in its Written Statement (without a counter claim).

Contractual Terms to Subserve Sec. 74

Sec. 74 mandates that the contractual terms as to damages, should subserve the edicts under this Section.

When Advance can be Forfeited by the Seller?

In the matter of forfeiture of earnest, the main enquiry will be – who breached the contract, seller or buyer. If it is the seller who breached, the seller cannot forfeit the earnest, under the provisions of Sec. 74.

Even if the purchaser breached the contract and there is no breach on the part of seller, then a further question arises for consideration, by virtue of Sec. 74 – whether seller suffered any loss or damage. If no loss or damage, then the seller has to return the entire amount (because, under Sec. 73, ‘reasonable compensation’ alone is ‘entitled’ by him and it alone could be ‘received’).

Sec. 74 mandates that where loss in terms of money can be determined, the party claiming compensation must prove the loss suffered by him (Kailash Nath Associates Vs. DDA).  If reasonable damage is proved, then the court can allow to forfeit that much amount as ‘reasonable compensation’.

Measure of  Damages Under S. 73

Sec, 73 Reads as under:

• “73. Compensation for loss or damage caused by breach of contract.- When a contract has been broken, the party who suffers by such breach is entitled to receive, from the party who has broken the contract, compensation for any loss or damage caused to him thereby, which naturally arose in the usual course of things from such breach, or which the parties knew, when they made the contract, to be likely to result from the breach of it.
• Such compensation is not to be given for any remote and indirect loss or damage sustained by reason of the breach.”

In Murlidhar Chiranjilal Vs. Harishchandra Dwarkadas (1962)[17]  it is held as under:

“In these circumstances this is not a case where it can be said that the parties when they made the contract knew that the likely result of breach would be that the buyer would not be able to make profit in Calcutta. This is a simple case of purchase of goods for re-sale anywhere and therefore the measure of damages has to be calculated as they would naturally arise in the usual course of things from such breach. That means that the respondent had to prove the market rate at Kanpur on the date of breach for similar goods and that would fix the amount of damages, in case that rate had gone above the contract rate on the date of breach.

We are therefore of opinion that this is not a case of the special type to which the words “which the parties knew, when they made the contract, to be likely to result from the breach of it” appearing in s. 73 of the Contract Act apply. This is an ordinary case of contract between traders which is covered by the words “which naturally arose in the usual course of things from such breach” appearing in s. 73. As the respondent had failed to prove the rate for similar canvas in Kanpur on the date of breach it is not entitled to any damages in the circumstances.”[18]

The measure of damage in the usual course of things may be the amount of profit lost to the contractor by the breach. This can be stated as the loss which the parties knew when they made the contract, as likely to result from the breach of it, also.[19]

Principles Emerge As To Awarding Damages

On the whole, the following principles emerge as to awarding damages:

1. Sec. 74 governs both the two classes; first, the sum named as compensation in the contract, and the second, penalty. 
2. Both classes are treated equally under Sec. 74.
3. Damages or compensation is awarded by the courts according to the settled principles. The quantum thereof will be that naturally arises in the usual course of things;or which the parties knew, when they made the contract, to be likely to result, special damage or loss, from the breach.
4. Such compensation is not to be given for any remote and indirect loss or damage sustained by reason of the breach. The party claiming damages cannot rely on any impediment caused to him by a third party which he himself could have thwarted by resorting to necessary legal action. (Karsandas Vs. Saran Engineering Co.)
5. The compensation is to be fixed, ‘reasonably’, with the aid of S. 73. The court has to adjudge, in every case, ‘reasonable compensation’. (Fateh Chand). (It is a deviation from the English Common Law which permits pre-estimated damages.)
6. If the party at default knew about special damages to be suffered by the other, when they made the contract, to be likely to result from the breach, under Sec. 74, it may also be awarded (Fateh Chand).
7. When awarding compensation by the court there should not be ‘unjust enrichment’ – to both buyer [Indian Oil Corporation Vs.  Lloyds Steel Industries (2007)[20]] or seller [Kailash Nath Vs. DDA]
8. The court has to adjudge reasonable compensation having regard to the conditions existing on the date of the breach (Fateh Chand).
9. The party suffered breach can realise penalty also ‘as the case may be’ at a reasonable quantum, fixed by the court.
10. The words “whether or not actual damage or loss is proved” denotes that in all cases where damages can be proved, it must be proved (Moula Bux and Kailash Nath). It does not justify the award of compensation when no legal injury at all has been resulted (Fateh Chand).
11. S.74 can be invoked by both plaintiff and defendant.  The defendant resisting a suit for return of earnest money can prove that he suffered loss and damages by the breach and default of the plaintiff; that too, without a counter claim; because, Sec. 74 governs and controls the entire domain and gamut relating to these matters and the Sec. 74 enables “party complaining of breach is enabled, reasonable compensation”.
12. If a seller is at breach, purchaser can realise damages on its proof.
13. By virtue of the very wordings in Section 74, the quantum of damages that can be awarded by a court will not exceed the penalty stipulated for, or the sum named as compensation, by the parties to the contract.
14. There should be no fault on such person for not remedying the inconvenience caused by the breach, and he had not neglected to avail himself of them. A party who is entitled to damages is required by law to take steps in mitigation of damages.

Conclusion

In Satish Batra Vs. Sudhir Rawal (2013)[21] our Apex Court had taken an extreme-view that entire earnest money could be forfeited by seller, of his own, in case the buyer breaches the contract.  On the other hand, subsequently, in Kailash Nath Associates Vs. Delhi Development Authority (2015)[22] the Supreme Court took the opposite extreme-view to the effect that no amount, even a nominal sum, could not be forfeited as earnest money by the seller; and that reasonable compensation or damages was always subject to or depended upon the judicial determination.

Though it may appear that the acceptable legal position lies midway between the two differing views; that is, where a nominal or token sum is paid as earnest money, it can be forfeited, as observed in Maula Bux Vs. Union of India (1970),[23] applying the English Common Law principles, holding that the forfeiture of a reasonable/nominal (i.e. not amounting to penalty) earnest money does not fall within the ambit of Section 74, since the ‘Legislature has sought to cut across the web of rules and presumptions under the English common law’ as observed in Fateh Chand Vs. Balkishan Dass (1963),[24] we are bound by the provisions in Sec.74 alone.We have also to accept that the law is correctly laid down in Kailash Nath Associates Vs. Delhi Development Authority.

[1] Shree Hanuman Cotton MillsVs. Tata Aircraft Limited, 1970 (3) SCR 127 

[2] (2015) 4 SCC 136

[3] (1970)1 SCR 928:  AIR 1970 SC 1955

[4] (2013) 1 SCC 345

[5] (2015) 4 SCC 136

[6]1970 (3) SCR 127  

[7] Union of India v. Raman Iron Foundry: AIR 1974 SC 1265

[8]1964 SCR (1) 515: AIR 1963 SC 1405

[9] (1970)1 SCR 928:  AIR 1970 SC 1955

[10]  (2013) 1 SCC 345

[11] (2015) 4 SCC 136

[12]Fateh Chand Vs. Balkishan Dass: 1964 SCR (1) 515: AIR 1963 SC 1405

[13] (2015) 4 SCC 136

[14]Kailash Nath Vs. DDA:  (2015) 4 SCC 136

[15]  (2013) 1 SCC 345

[16] (2015) 4 SCC 136

[17]  (1962) 1 SCR 653

[18]Quoted in Anglo American Metallurgical Coal Pty Ltd.  Vs. MMTC Ltd., 2020 Supreme(SC) 719

[19]State of Kerala Vs. Bhaskaran:  AIR 1985 Ker 49

[20]2007 4 Arb LR 84; 2007 144 DLT 659 (Delhi High Court, AK Sikri, J.)

[21] (2013) 1 SCC 345

[22] (2015) 4 SCC 136

[23] (1970)1 SCR 928:  AIR 1970 SC 1955

[24]1964 SCR (1) 515: AIR 1963 SC 1405