Forfeiture of Earnest Money Not Automatic on Breach

Source: Delhi High Court

Why in News? 

Justice Neena Bansal Krishna of the Delhi High Court decided Sh. Somnath Kharbanda (Since Deceased) Through His LRs v. Smt. Arvinder Kaur (Since Deceased) Through Her LRs (2026). The Court dismissed an appeal filed by the legal representatives of two deceased sellers and upheld the trial court’s order to refund the ₹4 lakh earnest money to the prospective buyer.

What was the Background of Somnath Kharbanda v. Arvinder Kaur (2026) Case? 

• On 21st June 2008, the parties signed an agreement to sell a property in Ramesh Nagar, Delhi, for a sale price of ₹40 lakh. 
• The buyer paid ₹4 lakh as earnest money. The remaining ₹36 lakh was due on or before 5th September 2008. 
• The agreement set out what would happen if either side defaulted:  
  • If the buyer failed to complete the deal, the earnest money could be forfeited. 
  • If the sellers defaulted, they had to pay the buyer double the earnest money. 
• The buyer sued to recover ₹8 lakh (double the earnest money). She alleged that the sellers had not provided the property’s title documents for verification. 
• The sellers argued that:  
  • The buyer had failed to pay the balance amount, so they were entitled to forfeit the earnest money. 
  • They had suffered a loss because a purchase of another property fell through, and they forfeited ₹4.60 lakh they had paid as earnest money in that deal. 
• The trial court rejected the buyer’s claim for double the earnest money. It directed the sellers to refund the original ₹4 lakh with interest. 
• The sellers’ legal representatives then filed an appeal before the Delhi High Court (RFA 814/2026). 

Question before the High Court: 

• Can a seller forfeit earnest money automatically when the buyer breaches an agreement to sell, or must the seller prove the loss suffered?

What were the Court’s Observations? 

On Section 74 of the Indian Contract Act, 1872: 

• The Court referred to Section 74, which allows reasonable compensation for breach where the contract names a sum payable on breach or contains a penalty clause. 
• The Court said that the amount named in the contract only sets the outer limit of compensation. It is not an amount the party is automatically entitled to. 

On the precedents relied upon: 

• Relying on Fateh Chand v. Balkishan Das and Kailash Nath Associates v. Delhi Development Authority, the Court repeated that a sum stipulated in a contract does not become recoverable just because a breach has happened. 
• A party that wants to keep such an amount must show that legal injury resulted from the breach. Where the loss is capable of proof, it must be proved. 

On the sellers’ claimed loss: 

• The sellers said they lost ₹4.60 lakh in another property deal because the buyer did not perform her part. 
• However, the receipt and agreement to sell for that other deal were de-exhibited, because the sellers could not produce the original documents. 
• No other reliable evidence was produced to prove either:  
  • that the other transaction existed, or 
  • why it was not completed. 
• The loss could have been proved through documents or by examining the seller in the other transaction. Because the sellers did neither, they failed to establish the loss they claimed. 

Decision: 

• The Court held that the trial court was right to order the refund of earnest money. 
• The appeal was dismissed.

What is Section 74 of the Indian Contract Act, 1872? 

About: 

• Section 74 deals with compensation for breach of a contract where a penalty is stipulated. 
• It applies when a contract names:  
  • a sum to be paid if the contract is breached, or 
  • any other stipulation by way of penalty. 
• In either case, the party who suffers from the breach can receive reasonable compensation from the party in breach. This compensation cannot exceed the amount named or the penalty stipulated. 
• The party is entitled to this whether or not actual damage or loss is proved to have been caused by the breach. 

Key Features: 

• No distinction between liquidated damages and penalty: Indian law does not follow the English distinction between the two. Both are treated alike, and only reasonable compensation is awarded. 
• Ceiling, not entitlement: The amount named in the contract is the maximum that can be awarded. It is not automatically the amount payable. 
• Proof of loss: The words “whether or not actual damage or loss is proved” do not remove the need to prove loss where loss can be proved. They only cover cases where loss is difficult or impossible to prove. 
• Legal injury is necessary: Compensation under Section 74 assumes that the breach has caused some legal injury. 

Relation with Section 73: 

• Section 73 provides compensation for loss or damage caused by breach of contract. This covers loss that arises naturally in the usual course of things, or that the parties knew, when they made the contract, was likely to result from the breach. 
• Section 74 applies where the parties have agreed in advance on a sum or penalty. Even then, the Court awards only reasonable compensation within that limit.