This article is written by Ravi Shankar Pandey, a 1st-year student from Dr. Ram Manohar Lohia National Law University, Lucknow. This article discusses the law relating to earnest money and its forfeiture in the light of judicial pronouncements.

Introduction

Earnest money is a nominal sum of amount, generally a part of purchase price of the transaction, which is given by one of the parties to another to show his willingness on the execution of the contract so that it may be clearly specified that the parties have intended to come under a legal obligation on their part.

According to  English Law Dictionary, “earnest money is just a way of asserting that is used by the parties to the contract to show that they are in earnest and so they have made their mind”.[1] It was stated by the court in Charanjit Singh v. Har Swaroop [2] that “earnest money is just a part of the purchase price when the transaction goes forward and it cannot be forfeited until the transaction falls by default on the part of the vendor”.

On similar lines in HUDA v. Kewal Krishan Goel [3], the Hon’ble Supreme Court ruled quoting the remarks of Hamilton, J. in Sumner and Leivesley v. John Brown & Co[4] that “earnest money is given so that in future it may be used to put some pressure of performance on defaulter, if he does not complies with his obligations and is forfeited if the contract went off due to the giver’s fault”.

Purpose of Earnest Money

• Firstly, acts as a part of the total amount of purchase price, and
• Secondly, but mainly, acts as the security for performance of the contract.

Forfeiture of Earnest Money

Forfeiture means loss or denial of something in case if there is a penalty or fine imposed due to an action or an omission by moving away from one’s obligations. In Contract law, it is generally used to indicate that, with former consensus between the parties, the amount which is clearly indicated in terms of the contract to be given as earnest is not given back to the purchaser who has given his money, if due to his fault or failure, the contract is broken in nearby future.

Basic features of Earnest Money

• Earnest Money must be given at the same time when the contract is being concluded.
• It should be a part of the total amount of purchase.
• It must be given to make the contract binding, as a guarantee that the contract will be fulfilled.
• The forfeiture takes place only when there is a failure or fault on purchaser’s part.
• In case if there is any default by the purchaser, the seller can forfeit the earnest money (but the terms of the contract should not show any contrary intention of the parties or terms or conditions specified).

Thus, it may be said that even when court specify the damages in cases of breach of contracts, by considering the intention of the parties while they were forming the contract and the money deposited in terms of ‘earnest’ or ‘deposit’, it is forfeitable.

Earnest money v. Security deposit

Security deposit is different from earnest money in many ways:

1. Security money is given to the landlord by or for the tenant to remedy for the defaults or damages to the area or premise or failure to pay rent on time or to compensate for failure to return the return keys when the period of the tenancy ends.
2. Security money is deposited so that if there is any damage or normal wear and tear to the premises by the tenant, the landlord may clean the area and recover the cost that is incurred from the security deposit.
3. Security money is treated as a fund which is given to the landlord for future use if there is any damage caused by the act of tenant. It is not regarded as liquidated damage and is not taxable until used for compensating for the tenant’s defaults.

Now, under Uniform Residential Landlord and Tenant Act, it is an established law that security deposit cannot exceed one month rent of the premises and it must be returned by the landlord after 14 days of termination of the agreement of premise. If the landlord wants to keep some part of the earnest money with him as reparation for any damage, he is bound to give notice before expiration period of 14 days after the agreement is terminated.

Earnest money deposit: Given to the broker when the formation of contract takes place. Also known as caution money or bargain money in many places. Generally, earnest money does not exceed 1/10th  of the purchasing price and must be specified in the contract about its forfeiture if any default on the part of purchaser takes place. The money belongs to the buyer before completion of contract formation. But, even the seller is not entitled to use it until the transaction is completed fully. In the period between the two, the money is considered to be a part of the trust between the parties.

Advance deposit v. Earnest money

Earnest money performs several functions. It is used for probing into the performance of the contract. It must be paid to the person who is acting as a seller or creditor and it acts as a security in order to secure compliance with the terms of the contract. For a sum of money to be regarded as earnest money, there should be proper communication between the party and both should contemplate that the amount given is- given as an earnest.

The above discussed three features i.e. payment, probative and security distinguish earnest money from advance deposit whose forfeiture cannot take place and is just a part payment of the total sum that is required to be given.

Earnest Money in different civil law countries

In different civil law countries, the role of earnest money does not vary and is similar to that of  India also in terms of its forfeiture. However, in maximum European countries, there is a convention to take double the amount of earnest in case if there is a breach or rescindment by the purchaser.

• Germany- Under the German Civil Code, the earnest money is treated as proof that there was a contract concluded. If the contract is rescinded, the earnest money is returned. The holder is entitled to retain it if the contract is rescinded due to the fault of the purchaser. In Germany, the role of earnest money is similar to that as has been in classical law where forfeiture is not there but it is only an evidence of contract formation.

• Switzerland- Unless there is a contrary agreement, Swiss law recognises that the earnest money given is proof of the existence of a contract between the parties. Earnest has to be reverted and restored when the contract is not enforced and the party suffering from the breach is entitled to file a suit against the other. If there is a prior arrangement of forfeiture, after non-performance of the contract, the one who has received the amount can restore the double of the total amount paid and the one who has paid it is required to abandon it. The same rule is also applicable in Columbia also.

• Italy- The party who is not at fault if the contract is rescinded can ask for the double of the amount taken as earnest (known as Caparra). Earnest money is considered as a guarantee that if there will be damage, the party which suffers from the same will be entitled to reparations.

Forfeiture of Earnest money: Rules established on the basis of judicial pronouncements-

• • Fateh Chand v. Balkishan Das[5]- In this case, the Supreme Court drew the distinction between earnest money and security deposit. The facts of the case were- The seller and buyer agreed on the term that if there will be any default on the part of the buyer, the whole amount of purchase i.e. 25000 which included Rs. 1000 as earnest money will be forfeited. The seller after default by the purchaser forfeited the earnest amount of Rs. 1000 and filed a suit for recovery of the remaining amount of Rs. 24000. The Hon’ble Court held that “as there was no stipulation of the remaining amount in the contract as earnest money and they were referred as ‘out of sale price’, there cannot be the recovery of the remaining amount”.
  • Mohammad Sultan v. Naina Mohammad[6]- It was held that if there is no forfeiture clause in the contract, there cannot be any forfeiture. The seller or the aggrieved party due to the breach will be entitled to reasonable compensation only.

• Union of India v. Rampur Distillery and Chemical Co. Ltd. – When the Govt. forfeited the entire security deposit of Rs. 18500 after the rum delivered by the plaintiff did not conform to the quality stipulated which was later delivered on the required level of quality, the decision of forfeiture of entire money was declared to be illegal by the Court.

• Shri Hanuman Cotton Mills and Ors. v. Tata Air Craft Limited– When the contract was repudiated by the appellants due to misrepresentation regarding the quantity of the material of area scrap and respondents forfeited that entire amount, the action of respondents of forfeiture was held invalid on the ground that there was a breach of Contract.

• Sri Tarsem Singh v. Sri Sukhminder Singh- When the contract formed between the parties was discovered to be under a mistake as to the matter of fact on part of both the parties, it was held that the earnest money cannot be forfeited as the contract was void ab initio.

The facts were– Both the parties entered into a contract for the sale of a certain area of land and the amount of earnest was given. The petitioner did not execute the sale deed discovering the mistake of the fact. The respondent filed a suit for specific performance and forfeited the earnest money. The High Court did not allow specific performance but allowed the forfeiture. Aggrieved with the decision, a Special Leave Petition was filed before the apex court and the court ruled in favour of the appellant.

Rules relating to forfeiture of Earnest Money

There are certain rules which the courts must consider while deciding on the issue of forfeiture of earnest money. Some of these are as follows:

• Neither the earnest money nor any kind of money can be forfeited if the contract is void. In cases when the contract is void, the refund is awarded under Sec. 65 of the Indian Contract Act.[7]
• When no contract arises due to revocation or due to any other reason, no forfeiture can be made.[8]
• Forfeiture can be made only in terms of liquidated damages.[9]
• There is no absolute right to forfeit the entire amount without measurement of exact loss. Forfeiture cannot go beyond the extent of the loss.
• Take advantage of forfeiture for self-enrichment is not allowed.[10]
• Forfeiture under the contract of sale does not fall under Sec. 74 is the amount of earnest is reasonable.
• Forfeiture is allowed only when it is reasonable to do so.
• No forfeiture is permitted when the extra cost may be recovered.[11]
• No forfeiture is allowed if the contract is still not performed and the amount if forfeiture is refundable.[12]
• To invoke Sec. 74, it is not mandatory that the contract is broken entirely.
• Forfeiture without giving notice is a violation of the principles of natural justice.[13]

Conclusion

While concluding, we may say that the tool of earnest money helps in increasing the seriousness of parties to the contract. Especially, it pressurizes the purchaser so that he sticks to his obligations. The fear of forfeiture also puts the burden on the shoulders of the purchaser that helps in the execution of the contract according to its terms.

References

[1] The dictionary of English Law, 689.

[2] Charanjit Singh v. Har Swarup AIR 1926 PC I.

[3] HUDA v. Kewal Krishan Goel (1996) 4 SCC 249.

[4] Sumner and Leivesley v. John Brown & Co (1909) 25 TLR 745.

[5] Fateh Chand v Balkishan Das [1964] 1 SCR 515(SC).

[6] Mohammad Sultan v. Naina Mohammad, AIR 1973, Mad. 233.

[7] Tarsem Singh v. Sukhminder Singh, (1998) 3 SCC 471.

[8] Food Corporation of India v. Sujit Roy, AIR 2000 Gau. 61.

[9] Amarjeet Singh v. Zonal manager, FCI, (2002) 4 ICC 47 (P&H).

[10] GattaRattaiah v. Food Corpn. Of India, AIR 2011 AP 65.

[11] State of U.P. v. Chandra Gupta & Co., AIR 2004, Kant 155.

[12] Commr of HR & CE Deptt.v. S. Muthekrishnan, AIR 2012 Mad. 43.

[13] S.R.S. Infra Projects (P) Ltd. v. Gwalior Development Authority, (2010) 2 MPLJ 142.