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'Earnest money or deposit' is some amount given at the execution of the contract, which serves two purposes- (a) it acts as a guarantee that the contract will be honoured by the person who gives it and is forfeited in case he defaults; (b) it also serves as part- payment if the contract goes through. The issue which needs consideration is whether section 74 of the Indian Contract Act, 1872(ICA) is applicable to forfeiture of earnest money or not?

Position of English law regarding forfeiture of earnest money

English common law provided a distinction between liquidated damages and penalty. It allowed the recovery of liquidated damages- which were a genuine attempt to estimate in advance the loss which the claimant would be likely to suffer from a breach of contract, but provided that if a clause is in the nature of penalty (which were termed as an exorbitant sum incorporated into a contract to deter a party from breaching the terms of contract), then it was unenforceable.

With that being stated, although there was a difference in how common law treated liquidated damages clause and a penalty clause, there is no doubt that position with regard to forfeiture of earnest money was clear, and it treated the forfeiture of earnest money differently from the other two. The common law allowed the forfeiture of earnest money in case of a breach of contract. It was also not necessary that the party had to prove that it has suffered some loss in order to forfeit it. Although it was in essence a type of penalty, but it was treated as an exception by common law. An earnest money which is not reasonable may be challenged as a penalty clause.

Indian law and the interpretation of Supreme Court

The law regarding stipulations contained in the contract or a penalty clause is incorporated under section 74 of ICA. The first judgment in line is Fateh Chand v. Balkishan Das 1963 INSC 1(Fateh Chand), which was a Constitutional Bench judgment. This case cannot be considered to lay down the law whether the earnest money clause comes within the ambit of section 74 of the ICA or not, for the simple reason that the argument against the forfeiture of earnest money was conceded by the attorney general and was accepted by the Supreme Court, so it cannot be termed the ratio decidendi of the case. [Page 525]. Then comes the case of Maula Bux v. Union of India 1969 INSC 189, this case also does not serve as a precedent for the issue formulated for the simple reason that it was not a case related to the earnest money on facts (Supreme court held that the forfeiture clause was not earnest money) so the observation regarding earnest money were not necessary to reach the conclusion in the facts of the case. [Page 931].

The three judge bench of Shree hanuman cotton mills & ors v. Tata Aircraft Ltd. 1969 INSC 309 (Hanuman Cotton Mills), laid down the law that the innocent party can forfeit the earnest money, but left open two questions (i) can the court ever go into the question of reasonableness of the amount of earnest money which can be forfeited; [Page 142] (ii) whether the forfeiture of earnest money can come within the ambit of section 74. The Supreme Court in the case of Satish Batra v. Sudhir Rawal 2012 INSC 480(Satish Batra) followed the law laid down in Hanuman cotton mills.

Revisiting Kailash Nath Associates v. DDA 2015 INSC 22(Kailash Nath)

Then, comes the case of Kailash Nath which analysed all the previous judgments and laid down the law that earnest money comes within the ambit of section 74 of the ICA and laid down that law does not provide for the windfall. The analysis of all previous judgments was right apart from the court following the ratio of Fateh Chand which never really was the ratio of the judgment. It is pertinent to note that Satish Batra which also was a two -judge bench decision was not considered in the judgment.

Justice R.F. Nariman, in order to bring the earnest clause within the ambit of section 74, grounded his reasoning on Fateh Chand. The judgment relies on a para where the constitutional bench stated that “The section is clearly an attempt to eliminate the sometime elaborate refinements made under the English common law in distinguishing between stipulations providing for payment of liquidated damages and stipulations in the nature of penalty”. Relying on this para, Justice Nariman observed that all stipulations naming 'amount to be paid' in case of breach would be covered by section 74. The reasoning can be open to challenge for three reasons –

1. As already described in above paragraphs, the English law was at variance when it came to liquidated damages and penalty clause. Section 74 was an attempt to do away with this differentiation by providing 'reasonable compensation' in case there is an amount to be paid in case of breach or there is a stipulation of any other kind which amounted to a penalty. In English law as pointed out in above para, there was never any confusion regarding forfeiture of earnest money and English courts traditionally allowed its forfeiture, save with regard to principles of equity. So, the proposition of law relied on in Kailash Nath to reach this conclusion does not appear to be correct. Nor did the Supreme Court explicitly lay down the law in Fateh Chand that forfeiture of earnest money clause would come within section 74. Moreover, in Fateh Chand, it was stated that “We are in the present case not concerned to decide whether a contract containing a covenant of forfeiture of deposit for due performance of a contract falls within the first class”.

2. In Sudhir Rawal v. Satish Batra 2011:DHC:5603, the Delhi HC after referring to Fateh Chand, held that the forfeiture of earnest money clause within the ambit of section 74, and as there was no loss which was proved by the defendant, it ruled that only nominal amount may be forfeited. Reversing this ruling the Supreme Court in Satish Batra held that HC misread the dictum of Fateh Chand, and after relying on hanuman cotton mills allowed the forfeiture of earnest money. In Kailash Nath Supreme Court also relying on Fateh Chand held that earnest money comes within the ambit of section 74. Although in Kailash Nath the judgment relies on its own reasoning of Fateh Chand, but this could not have been done because both Satish Batra and Kailash Nath are co-ordinate judge benches. So, the judgment of Kailash Nath viewed through this lens appears to be per incuriam.

3. The judgment in Kailash Nath does not follow Hanuman Cotton Mills, by stating that in that case breach of contract was already conceded, but while it was distinguishing the facts of that judgment, it was looking at the law laid down in section 74 with the position that 'even if it is believed' that appellant had breached the contract, otherwise there was no need to visit section 74, because in previous paras of the judgment it explicitly held that there was no breach committed by appellant. This is internally inconsistent.

It would be apposite here to refer to a judgment of Privy Council in Linggi Plantation limited v. Jagatheesan [1972] 1 MLJ 89. The appeal raised three issues, two of which were (a) whether section 75 of the contracts (Malay state) ordinance 1950, which was pari materia with section 74 of ICA, would apply to the forfeiture of deposit? (b) was the seller entitled to forfeit the whole deposit, despite suffering no loss? The Privy Council after elaborating the law, stated that in case of failure by the purchaser, section 75 has no application, when the contract is properly terminated and deposit (earnest money) is forfeited whether or not damage is proved. It also pointed out that there may be cases where the purchaser, who paid the deposit, defaulted and equity still allowed the money to be paid back to the defaulter. After the passing of law of property 1925, section 49(2) law is settled that court has the power to give back the earnest money as the justice of the case requires.

The latest judgment to add to the list is K.R. Suresh v. R. Poornima & ors 2025 INSC 617. Justice J.B. Pardiwala, penning down the judgment, scanned all the authorities on forfeiture of earnest money and concluded in paragraph 51 that it is evident that a clause for forfeiture of earnest money is not penal in ordinary sense, rendering section 74 inapplicable. This correctly describes the law that so far as the earnest money is reasonable it can be forfeited.

Piercing the veil of earnest money clause

As the English law also provides that under the garb of a deposit the party cannot forfeit a sum which is actually in nature of penalty. In Fateh Chand, it was contended by the plaintiff that Rs. 24,000 was in the nature of earnest, the court held that the clause was in essence a penalty. So, the courts should be allowed to see whether the money stated to be as earnest is reasonable or not, and allow the forfeiture in case it is reasonable, or if it comes to a finding that it is a penalty as stated under section 74, then only reasonable sum can be given and only after loss is proved.

The reason that reasonable earnest money cannot come under section 74 limb 1 i.e “sum is named in the contract as the amount to be paid in case of such breach”, is that this limb talks about a sum which is agreed between the parties about the genuine loss that may occur in case of breach so that in cases in which it is very hard to proof the extent of loss, the court can grant them reasonable compensation which may extend to the amount stated. While on the other hand earnest is given to bind the contract, something to be used to put certain amount of pressure on defaulter to not breach the contract.

Absurd results would follow. For example, if both parties fix a reasonable or meagre sum as earnest in case of breach, and court says that it comes under limb 1 of section 74, then the court will be able to fix the compensation only up to the highest level of earnest money which is in fact, not a calculation of pre-estimate of actual loss suffered. This will be against the principle of compensation. Moreover, the earnest money is something which is paid at the time of execution of contract and not “an amount to be paid in case of breach”, so textually also it doesn't fit in. Although reasonable earnest money is not considered as penalty and cannot come within second limb of section 74, but if under the garb of earnest money, it is in reality a penalty then it does come under the second limb of section 74.

Author is an Advocate based in Delhi. Views are personal.

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