Forfeiting Earnest money under Sec.74 of Indian Contract Act 1872 Explained by Supreme Court

 Sec.74 of Indian Contract Act 1872 Explained by  Supreme Court   

Case Title: Godrej Projects Development Limited Versus Anil Karlekar & Ors.Decided On 3 Feb 2025

The Supreme Court explains Section 74 of the Contract Act, 1872.and holds that deduction/ forfeiting  of earnest money by a developer in case of cancellation of booking does not constitute penalty under section 74 0f contract act 1872

“It can be seen that this Court has held that if the forfeiture of earnest money under a contract is reasonable, then it does not fall within Section 74 of the Indian Contract Act, 1872, inasmuch as, such a forfeiture does not amount to imposing a penalty.”, the Court held.

Section 74 as defined under Indian Contract Act 1872 –

“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 covers following things –

• Penalty

If a contract specifies a penalty for breach, the aggrieved party is entitled to reasonable compensation up to the amount of the penalty.

• Interest
• If a contract specifies increased interest from the date of default, the aggrieved party is entitled to reasonable compensation up to the amount of the penalty.

What can a court do?

• A court can modify or reduce the penalty amount to make it reasonable.
• A court can reduce the amount of earnest money forfeited if it is excessive or punitive.

In nut shell Section 74 of the Indian Contract Act, 1872, deals with the compensation a party can claim if a contract is breached. It states that the aggrieved party is entitled to reasonable compensation, but the amount cannot exceed the penalty or named amount in the contract. 

A bench of Justices B.R. Gavai and S.V.N. Bhatti in the above case heard wherein Respondents, as flat purchasers, challenged the Appellant builder’s forfeiture of 20% of the basic sale price as earnest money following their cancellation of the flat booking.

The Builders argued that  Agreement explicitly allowed forfeiture of 20% of BSP as earnest money in case of cancellation. However, home buyer  called the forfeiture of 20% as earnest money to be arbitrary and unfair demanding that the forfeiture should be limited to 10%.

The National Consumer Disputes Redressal Commission (NCDRC) ruled in favour of the flat purchasers allowing the builder to forfeit only 10% of the Basic Sale Price (BSP) as earnest money instead of 20% and directed the refund of the remaining amount with 6% interest per annum.

The Court confirmed the NCDRC’s ruling to allow the builder to forfeit only 10% of the BSP as earnest money terming such an amount to be just and fair not qualifying as a penalty under Section 74 of the Contract Act.

The Court emphasized that while earnest money can be forfeited as security for performance, it shouldn’t be so excessive or punitive that it becomes a penalty. If a forfeiture is deemed excessive, the Court has the power to reduce the amount.

Referred case Maula Bux v. Union of India (1969) 2 SCC 554 and Satish Batra v. Sudhir Rawal (2013) 1 SCC 345 to hold that forfeiture of reasonable earnest money could not be categorized as penalty.

Although, the Court upheld 10% forfeiture but removed interest on refunds.

“In the facts and circumstances, therefore, we find that the NCDRC was not justified in awarding interest on the amount to be refunded by the Appellant.”, the court noted.

By Dr Prem Lata