Introduction
A contract is an enforceable agreement between two or more parties consented to it for a lawful consideration and lawful object. Any breach of contract entitles the aggrieved party to seek legal remedies.
In a breach of contract by the seller, 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 breaches 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.
The major remedies available to the aggrieved party for a breach of contract by the other party are specific performance of the contract, substituted performance of contract, refund of earnest money and compensation for loss or damages.
Penalty is a slightly excessive amount than the compensation. Imposing penalty is for punishing the non-performer.
Specific performance of contract
The remedy of specific performance of contract by the other, when there is a breach of contract, is under the Specific Relief Act, 1963 (SRA).
The relief of specific performance is allowable on two situations: one when there is no standard exists for ascertaining actual damage caused by the breach and another when any compensation in terms of money cannot be considered an adequate relief for its non-performance.
The relief of specific performance is provided under Section 10 of the SRA with some exceptions contained in Sections 11, 14 & 16. It compels the defaulting party to perform exactly what has been agreed to in the contract.
Till 2018 amendment of the SRA it was an equitable remedy. An equitable remedy is built upon the conscience and discretion of the court. A legal remedy, on the other hand, is based on individual right as per the law. Therefore the court could exercise ample discretion in granting specific performance as it was a purely discretionary and equitable remedy.
Since 2018 amendment to SRA, things have drastically changed. Specific performance of contract has been made a general rule rather than an exception.
Substituted performance of contract: Further it is required to provide for substituted performance of contract. Where a contract is broken the party who suffers would be entitled to get the contract performed by a third party or by his own agency. Substituted performance is an alternative remedy under Section 20 of the SRA.
Substituted performance of contract cannot be enforced where a party to the contract has obtained substituted performance of contract, under Section 14 (a) of the SRA.
Refund or forfeiture of advance/earnest money
In a breach of contract, a person can ask for the refund of earnest money or advance deposit when suing for specific performance, as per Section 22 of the Specific Relief Act.
The “advance deposit”, which is being paid as part of a contract for transfer of an immovable property, had in the past been treated conceptually quite different from the similarly paid “earnest money”. However both terms are now being used interchangeably.
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 a security. But it 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 breach 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. 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 in the nature of earnest money.
The “earnest money: however is more or less a security or a pledge for the due performance of the contract, paid by the buyer. It indicates a solemn promise that the buyer will not back out from the contract. It shows buyer’s good faith in the agreement and guarantees the fulfillment of his part of the contract.
On the other hand the seller retains it so as to meet the monetary damages he may suffer under the contract. Earnest money basically is not an essential ingredient in a contract for sale.
In short, the earnest money serves two purposes: it remains as a security or earnest for performance of the contract of sale and it later becomes a part payment of the purchase money.
Nature and character of earnest money
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.
In a breach of contract, the forfeiture clause will work only when the payment is intended as earnest money. If the payment made is treated as advance deposit then it can be forfeited only as penalty for breach. But both the advance deposit and the earnest money will become part of the purchase price, if the transaction goes forward.
Law governing breach of contract
The basic provisions of law governing breach of contract are Sections 73 – 75 of the Contract Act, Sections 9 to 25 of Specific Relief Act and Section 55 of the Transfer of Property Act.
In the case of advance deposit, when a breach occurs, it alone cannot be recovered. This is because it forms part of the purchase price. But it will have to be set off against any damages awarded to the innocent party. In such a case its forfeiture would be treated equivalent to a penalty.
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 there must be a forfeiture clause – a penal clause – in the contract. The contracting parties must agree to stipulate the terms in forfeiture. The forfeiture clause may include a reasonable compensation alone. That amounts to a penalty for breach.
In other words, forfeiture of a “reasonable amount” of earnest money is not a penalty. But forfeiture of a substantially large amount is penalty. Even if the contract includes a penalty clause for a huge amount the aggrieved party is eligible only for a reasonable amount of penalty.
However if a party establishes actual loss or damage as a result of breach he will be entitled to forfeit the advance deposit or earnest money. When a genuine mutually agreed pre-estimate of loss is included in the agreement that itself is binding on the parties. In such a case proof of actual loss is not essential.
If the suit for refund of advance deposit/earnest money does not include a pleading for specific performance simultaneously the court can allow its amendment so as to include that claim at any time of the proceedings. Such a refund can be pleaded in addition to compensation, allowable under Section 22 of the Specific Relief Act.
Requirements for 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.
- It must be given at the moment at which the contract is concluded.
- It represents a guarantee that the contract will be fulfilled or, in other words, “earnest” is given to bind the contract.
- It is part of the purchase price when the transaction is carried out.
- It is forfeited when the transaction falls through by reason of the default or failure of the purchaser.
- 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.
Advance deposit remains as a charge on the property
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 advance deposit he pays as part of the sale agreement.
That means, the amount will remain as a charge on the seller’s property for the part of the purchase money and its interest. Such a charge remains against not only the seller but also any person claiming under him.
Therefore, if the buyer is at no fault, he has the right to get the advance deposit back from the property even if it is sold. The buyer, who declines to accept the property on valid reasons, is also entitled to get the earnest money back, along with the cost for obtaining a decree in that regard.
Compensation for broken contract
In a breach of contract, the party who suffers is entitled to compensation from the other party. Adequate compensation in addition to or in substitution of specific performance is to be pleaded in the suit.
The compensation is permissible when specific performance is insufficient to do justice and the breach suffered need to be compensated in addition. This is as per Section 21 of the Specific Relief Act.
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 party has to prove in the court the essential particulars entitling him to claim damages.
The liquidated damages, mutually agreed to by the parties on the basis of pre-estimate, can be included in the contract. If the contract provides for liquidated damages, that amount alone will be paid if the pre-estimate is a reasonable one. If so, no excess amount, as penalty, needs to be paid. If the pre-estimate is an unreasonable or extravagant one, it would be considered as a penalty clause. Then the penalty can be allowed when the actual loss is proved.
In the case liquidated damages are not provided, a 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 have to be paid.
When a claim is not raised in the suit, the court cannot grant compensation. The compensation should be assessed in a realistic manner with due consideration to the remedial measures.
Penalty in a contractual breach
In a breach of contract the penalty refers to the penal amount that the defaulting party has to pay to the other party.
The penal amount should be greater than the reasonable loss suffered due to a breach. If penalty clause exists in the contract, then the party can impose that amount as compensation, as per the clause.
The parties are not at liberty to charge exorbitant compensation even if a clause of the contract patently permits it. If the amount fixed is penal in nature, then a reasonable compensation, not exceeding the penal amount so fixed, can alone 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 at 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 as per law.
No damages when both are at fault
When both parties in a contract are at fault, any of them cannot claim damages. But when a party in a contract sustains a loss by breach of contract by the other the party who suffers is eligible to get damages. The damages are awarded as a pecuniary compensation for the injury the party sustains in a contract on account 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 difference at all.
In a suit for specific performance on breach of a contract, the court can grant three things to the innocent party: the Specific Performance, substituted performance of contract, refund of earnest money and Compensation for loss or damages.
