Law on recovery of advance or earnest money

Introduction

The “advance deposit”, which is being paid as part of a contract for transfer of an immovable property, has in the past been treated conceptually quite different from the “earnest money”, similarly paid.

However the difference between both is becoming indistinct and narrower over the years and both terms are now being used interchangeably.

Concepts of advance deposit & earnest money

The advance deposit the buyer pays to the seller is treated as part of the “purchase money” which has to be paid in future.  It is not basically a security but indicates the buyer’s interest in the purchase. When the contract contains a clause as to what is to be done with the advance deposit in the event of a breach of contract, the court must be guided by the terms of the contract. The advance deposit will be refunded in case of non-compliance of contract by the seller.

The amount of advance deposit the buyer pays will remain as a statutory charge in the property even if the property is sold to a third party, in the event of a breach of contract. The charge will remain for the limitation period of 12 years. However, advance deposit paid by the purchaser can be forfeited, if express or implied terms in the contract permit such forfeiture, on the ground that it is earnest money in nature.

The earnest money however is more or less a security or a pledge for the due performance of the contract by the buyer. It indicates a solemn promise that the buyer will not back out from the contract. It is paid so as to prove buyer’s good faith in the agreement and as a guarantee on his part for the fulfillment of the contract. The seller retains it so as to meet the monetary damages he may suffer under the contract. Earnest money is not an essential ingredient in a contract for sale.

In short, the earnest money basically serves two purposes: it remains as a security or earnest for performance of the contract of sale but it becomes a part payment of the purchase money immediately on fulfillment of the contract. 

The nature and character of the advance deposit/earnest money has been examined by the Supreme Court in Videocon Properties Ltd. v. Dr. Bhalchandra Laboratories and others [(2004) 3 SCC 711]. The court took the view that the words used in the agreement alone would not be determinative of the character of the “earnest money”, but the intention of the parties and the surrounding circumstances must be looked into so as to know whether a prior payment is essentially advance deposit or earnest money.

On due execution of a contract for sale, both the parties bind themselves to perform in accordance with the terms set out in it. When the buyer or seller fails to fulfill the conditions within the deadline stipulated in the contract, then there is a breach of contract. In a breach of contract, the forfeiture clause will work only when the payment is intended as earnest money. If the payment is advance deposit then it can be forfeited as penalty for breach. The advance deposit or earnest money becomes part of the purchase price if the transaction goes forward.

The basic provisions of law governing advance deposit or earnest money are sections 73 & 74 of the Contract Act, sections 21 & 22 of Specific Relief Act and Section 55 of the Transfer of Property Act.

Buyer’s right under property law

A prospective buyer, as per section 55 (6) (b) of the Transfer of Property Act, 1882, is entitled to a charge on the property against the seller or anyone claiming it under him, for the amount of purchase money (advance deposit) paid by him as part of the sale agreement.

That means even in the absence of a contract to the contrary, the buyer will have a charge on the seller's property for the part of the purchase money and the interest on such amount, unless the buyer evinces an improper unwillingness to accept delivery of property. Such a charge is available against the seller and all persons claiming under him.

Therefore, when there is no default on the part of the buyer he has the right to get the advance deposit back. The buyer, who declines to accept the delivery of the property on proper reasons, is also entitled to get the earnest money from the buyer and the cost for conducting a case for obtaining a decree for specific performance of the contract.

Remedies under Specific Relief Act

Any breach of contract entitles the aggrieved party to seek relief of specific performance by the other, under the Specific Relief Act, 1963.

The relief of specific performance is possible when there is no standard exists for ascertaining actual damage caused by the breach of contract or the compensation in money terms does not be an adequate relief for its non-performance. The relief of specific performance, under section 20 of the Specific Relief Act, is an equitable remedy that compels the defaulting party to perform exactly what has been agreed in the contract.

An equitable remedy is quite different from a legal remedy. The former is built upon the conscience and discretion of the court whereas the latter is based on individual right as per the law. The court can exercise ample discretion in granting specific performance. Therefore specific performance is a purely discretionary and equitable remedy from the court.

In cases in which the plaintiff has an unfair advantage or the defendant has extreme hardship or it is inequitable to render the contract, the court should take extreme care in the exercise of discretion in granting specific performance as relief.

Forfeiture of advance/earnest money

When a breach of contract occurs, a person suing for specific performance can simultaneously ask for the refund of earnest money or advance deposit, as per section 22 of the Specific Relief Act.

In a breach of contract, the general rule is that the advance deposit being part of the purchase price cannot be recovered alone, but it will have to be set off against any damages awarded to the innocent party. In such a case the forfeiture clause would be treated equivalent to a penalty clause. In the case of earnest money, the forfeiture alone is sustainable and that is not treated as penalty. But it will be treated as penalty when the payment is to be made in addition to forfeiture of earnest money.

In order to forfeit earnest money it is necessary to have a forfeiture clause in the contract. A right to forfeiture is a contractual right. A forfeiture clause is penal in character. Therefore the contracting parties must agree to stipulate the terms in regard to forfeiture in the contract itself. The forfeiture clause will apply only to a reasonable compensation, but not an undue compensation, as penalty for failure in performing the contract.  

Normally a party, who establishes actual loss or damage as a consequence of breach of contract, will be entitled to forfeit the advance deposit or earnest money. When a genuine pre-estimate is there by mutual agreement that itself is binding on the parties irrespective of proof of actual loss.

The forfeiture of earnest money does not usually amount to imposing a penalty. A mere clause to agree forfeiture is not sufficient to make it a penalty. If earnest money is much more than a mere token amount, then the forfeiture of it is to be treated as a penalty. If so, the loss has to be pleaded and proved by the seller in order to seek forfeiture. When a reasonable amount of earnest money is retained for forfeiture against loss suffered, the other party can plead for refund of remaining part of earnest money.

That means, forfeiture of a “reasonable amount” of earnest money is not penalty as such, but a substantially large amount is penalty. A party guilty of breach of contract however is eligible only for a reasonable amount of penalty even if the contract includes a penalty clause.

In a breach of contract, the buyer has right to cancel the contract and obtain refund of the advance deposit or earnest money, along with interest and compensation for any loss sustained.  Similarly if the buyer violates the terms of the contract or does not complete the deal within the stipulated time frame, the seller has right to forfeit the advance or earnest money as the terms of the contract stipulate.

In case, the suit for recovery of advance deposit/earnest money does not plead for specific performance the suit can be amended at any time of the proceedings to include that claim. Such a relief is without prejudice to or in addition to the compensation the petitioner can seek under section 21 of the act. 

View of SC on forfeiture of earnest money

The Supreme Court in Satish Batra v. Sudhir Rawal [(2013) 1 SCC 345] reaffirmed the following ingredients which must be present in the contract so as to enable the seller to forfeit the earnest money.

1. It must be given at the moment at which the contract is concluded.
2. It represents a guarantee that the contract will be fulfilled or, in other words, “earnest” is given to bind the contract.
3. It is part of the purchase price when the transaction is carried out.
4. It is forfeited when the transaction falls through by reason of the default or failure of the purchaser.
5. Unless there is anything to the contrary in the terms of the contract, on default committed by the buyer, the seller is entitled to forfeit the earnest.

Compensation for broken contract

When there is a breach of contract, the party who suffers from such breach is entitled to receive compensation for any loss or damages caused to him from the party who has broken the contract, as per section 21 of the Specific Relief Act. The term damages basically refer to pecuniary compensation due to a breach, loss or injury.

A litigant suffering a breach should be adequately compensated in addition to or in substitution of specific performance. The compensation is permissible when specific performance is insufficient to satisfy justice and the breach suffered need to be compensated in addition. The damages for breach of contract must be something equal to the sum the plaintiff would have received had the contract been fully performed. It may include lost profits as well. The incumbent has to prove in the court the essential particulars entitling him to claim damages. 

The liquidated damages agreed to mutually by the parties on the basis of pre-estimate can be included in the contract. If the contract provides for liquidated damages, the liquidated amount only will be paid when the pre-estimate is a reasonable one. If so, no excess amount needs to be paid as penalty. To make liquidity clause valid the pre-estimate of damages must be reasonable. If the pre-estimate is an unreasonable or extravagant one, it would be considered as a penalty clause. Then the actual loss or damages must be proved.

In the case of un-liquidated damages, reasonable compensation has to be arrived at based on legal principles provided for in the section 73 of the contract act. When actual loss is proved, that would be paid. But if actual loss cannot be proved the pre-estimated amount can only be awarded as per section 74 of the act.

No compensation can be granted when a claim is not raised. The compensation should be assessed taking into account the measures available for remedying the inconvenience caused due to breach in a realistic manner.

Penalty in a contractual breach

Penalty in a breach of contract refers to the penal amount the defaulting party has to pay to the other party. The penal amount should be greater than the reasonable loss suffered due to such a breach. If penalty clause exists in the contract, then the party can impose compensation as per the penalty clause in the case of a breach.

The parties are not at liberty to charge exorbitant compensation even if a clause of the contract permits doing so. If the amount fixed is penal in nature, then only a reasonable compensation, not exceeding the penal amount so fixed, can only be claimed. Then there is no need to prove the actual loss occurred. So recovery of damages will become an easy job.  If the loss is un-assessable, then the amount noted in the contract would be taken as a reasonable amount.

Since the compensation and penalty need to be reasonable, there is no much distinction exist between liquidated damages and penalty in arriving the net amount to be paid in a breach. The court will allow only a reasonable amount not exceeding what is agreed to in the contract. If penalty stipulated in the contract is excessive, the court is at liberty to reduce it to a reasonable sum.

No damages when both are at fault

When both parties in a contract are at fault, no party can claim damages. But when a party in a contract sustains a loss by breach of contract by the other the former is eligible to get damages. The damages are awarded as a pecuniary compensation for the injury the party sustains in a contract as a result of the default of the other.

The object of payment of damages is to place the plaintiff in the same situation with reference to damages, as far as money can do it. The payment of damages for breach is compensation for loss suffered but not an instance of punishment for inflicting any wrong.

Conclusion

The earnest money paid would be forfeited by the seller in case of buyer’s breach of contract. In the converse, if the seller fails to perform the contract the purchaser can also get the amount, if it is so stipulated in the contract.

Similarly, the advance deposit (part payment of purchase price) cannot be forfeited unless it is a guarantee for the due performance of the contract (earnest money). In other words, if the payment is made towards part payment of purchase price but not intended as earnest money then that advance deposit cannot be forfeited. But the actual damages from the defaulting party can be claimed. However, the distinction between advance deposit and earnest money does no longer exist in practical terms. Both terms are interchangeably used in contracts with no much difference.

In a suit for specific performance on breach of a contract, the court can grant three things to the innocent party: the specific performance of contract, the refund of earnest money, and a compensation for damages.

The author can also be reached by email at rajankila@hotmail.com