Anirud Raghav*

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The Supreme Court’s judgment in Authorized Officer v. Shanmughavelu adds confusion to Section 74 jurisprudence on penalties. It artificially distinguishes between general forfeitures and earnest deposits without justifying why this distinction matters under the established “genuine pre-estimate” test. Moreover, the Court introduces a broader standard, requiring only that penalty clauses not be “in terrorem,” which shifts focus away from compensation as the main aim of damages, while failing to account for clauses which are neither penal nor compensatory.

I. Background to the dispute

In the recent judgment of Authorized Officer v. Shanmugavelu, the Indian Supreme Court had the opportunity to examine the law on sections 73 and 74 . This case featured an auction for the sale of property under the SARFAESI Act. Once the bidding was done, the successful bidder made an earnest deposit, but defaulted on the payment of the remaining sum. Consequently, the auctioneer (the bank) claimed that the earnest deposit stood forfeited. The bidder fileds a suit claiming that the amount was not forfeited, and that such alleged forfeiture would violate the principles of sections 73 and 74 of the Indian Contract Act, and would also independently constitute unjust enrichment. The issue boiled down to whether SARFAESI rules (particularly, rule 9(5)) would override sections 73 and 74 of the Indian Contract Act. The court ultimately holds [A3] [A4] that rule 9(5) controls, and that sections 73 and 74 do not apply. However, of interest to this article is the court’s dictum on earnest deposits and its relationship to penalties under section 74 of the Contract Act.

This piece makes two claims: first, that the court’s analysis confuses the law on earnest deposits by creating unsubstantiated, artificial distinctions between earnest deposits and other “general forfeitures”. Secondly, it also unsettles the existing jurisprudence on s.74 by implicitly creating a new test for penalties, thereby potentially staging a departure from the well-settled genuine pre-estimate test.

II.   Artificial distinctions and improper justifications of forfeiture clauses

As conventionally understood, forfeiture clauses require that a specific deposit will be forfeited upon the default of a related obligation. For instance, if A deposits a certain sum towards payment of a larger sum towards B, the forfeiture clause will stipulate that if A does not pay the full sum to B, his original deposit will stand forfeited towards B.

With this background, it is worthwhile to note the Court’s discussion of the nature of forfeiture of earnest deposit clauses:

“…what is discernible from the above referred decisions of Fateh Chand (supra), Maula Bux (supra) and Satish Batra (supra) is that there lies a difference between forfeiture of any amount and forfeiture of earnest money with the former being a penal clause and the latter a general forfeiture clause.”

It is in order to briefly summarize the reasoning in Fateh Chand as well as Satish Batra. In Satish Batra, the Supreme Court considered whether a certain earnest deposit stands forfeited to the seller in case the purchaser does not make the remaining payment. After surveying the judgments on the subject, including Fateh Chand, the court held in the affirmative. It reasoned that the principle of earnest deposits is that it is meant as a guarantee or a security of performance (paragraph 12). In Fateh Chand, there was an agreement to sell a particular piece of land for a consideration of Rs. 1,12,500 /-. The explicitly named earnest deposit was Rs. 1000 /-, and the seller undertook the deliver possession by a certain date, on which the buyer was to pay the seller an additional Rs. 24,000 /-. Subsequently, the buyer was to get the sale deed registered by a certain date, failing which, the sum of Rs. 25,000 /- stood forfeited to the seller. The buyer ostensibly failed to hold up his part of the bargain, leading the seller to move court seeking a decree for the Rs. 25,000 /- to stand forfeited in his favour. The court was to decide whether only the sum named as the earnest deposit, i.e., Rs.1000 /- should stand forfeited, or whether the additional Rs. 24,000 /- should remain forfeited as well. The ultimate decision was that only the Rs. 1000 /- was to be forfeited since the parties had explicitly named the Rs. 1000 /- as earnest deposit, if they so intended, they would have named the Rs. 24,000 /- as earnest deposit as well, which they did not. Absent this, the forfeiture of Rs. 24,000 /- cannot be considered earnest deposit, and thus, cannot be considered as a security for performance; hence, it was held not to be forfeited.

Based on the above reasoning in Fateh Chand, the court in Authorized Officer v. Shanmugavelu, the court draws an artificial distinction between “forfeiture of amounts” and “forfeiture of earnest deposits”: the former are penal and thus unenforceable, whereas the latter are valid agreed sums and thus enforceable. The court justifies the differential treatment on the ground that forfeiture of earnest deposits (as opposed to other forfeitures) are enforceable because earnest deposits are not in terrorem clauses meant to sanction breach but merely to secure performance. To be sure, the distinction may be justified nominally – but the principled basis for such a differentiation remains nebulous for reasons argued below.

The court elaborates: “Ordinarily, a forfeiture clause in the strict sense will not be a penal clause, if its consequence is intended not as a sanction for breach of obligation but rather as security for performance of the obligation. This is why Fateh Chand (supra) Maula Bux (supra) and Satish Batra (supra) held that forfeiture of earnest-money deposit is not a penal clause, as the deposit of earnest money is intended to signify assent of the purchaser to the contract, and its forfeiture is envisaged as a deterrent to ensure performance of the obligation.”

It is argued that the court’s reasoning is weak for two reasons. First, there is a curious assumption at play here: that a forfeiture clause meant to deter default or non-performance would, all other things equal, suggest that it is not a penalty. However, this logic is tenuous because a penalty clause is rarely ever intended to simply punish. Often, the real purpose is to deter non-performance by inserting such a penalty clause. If the court’s logic is accepted, every disproportionate penalty clause could be justified as being inserted to secure performance, not to sanction breach. This could evidently lead to absurd consequences. Secondly, the court seems to comfortably draw a brightline distinction between the two purposes: sanctioning breach and securing performance. However, such a distinction is difficult in the case of earnest deposits because the only way in which the performance is being secured is throughthe threat of sanctioning breach by forfeiting the amount. This begs the question: how would the court discern what the true purpose of the earnest deposit is? Which party’s interpretation must it favour?

All the same, there seems to be no third purpose at play; it is not as though the earnest deposit amount is designed to compensate loss (if it were so, then a general 25% amount would seem absurd because it would necessarily have to depend on the facts of the case, such as the value of property, the bid value inter alia). If it were indeed designed to compensate loss, that would make for a much easier analysis using the genuine pre-estimate test. This brings us to the next issue with the judgment: that the genuine pre-estimate test is ignored and substituted with a potentially vaguer test.

III.  A new penalty test?

The genuine pre-estimate test holds the field today in deciding whether an agreed damages clause is a penalty or a valid liquidated damages clause. (see Fateh Chand v. Balkishan Dass, Maula Bux v. Union of India, ONGC v. Saw Pipes, Kailash Nath v. DDA). As per the genuine pre-estimate test, the primary question is whether an agreed sum clause is a genuine forecast of loss arising from breach. If it is, it would be an enforceable liquidated damages or agreed sum clause. However, if it is not a forecast of loss, and “is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach” (Lord Dunedin in Dunlop Pneumatic Tyre Co. v. New Garage and Motor Co.[1915]) it would be a penalty and would be unenforceable – only reasonable compensation based on section 73 principles will be granted. The biggest virtue of the genuine pre-estimate test is that it creates two logically coherent classes of clauses: those that are a genuine forecast of loss in case of breach, thus being enforceable; and those that are in terrorem, and unenforceable.

However, the court, for all its extensive surveying of a catena of precedents glosses over the genuine pre-estimate test with just a perfunctory reference (paragraph 87). Instead, it seems to have introduced a new test altogether to adjudge if a clause is a penalty: that it must not be in terrorem.(“a forfeiture clause in the strict sense will not be a penal clause, if its consequence is intended not as a sanction for breach of obligation but rather as security for performance of the obligation.”).  

The new test proposes the following: a clause is penal if it has an in terrorem quality (it is meant to terrorize/punish breach, and not to compensate). How does this test interact with the genuine pre-estimate test? While the two tests overlap, the genuine pre-estimate test primarily focuses on whether the clause is meant to compensate. If it does not, it is inferred to be a penalty. However, the penalty test here primarily has a far more restricted scope of inquiry: it asks simply if the clause was meant to punish. In this analysis, if the clause were indeed meant to punish (because, for instance, it was disproportionate), then one infers that it was not meant to compensate. Effectively, the inferences are reversed altogether: one would now start by asking if it were meant to punish, and if the answer is yes, the inference would be that it is not meant to compensate. However, under the genuine pre-estimate test, the starting question would ask whether the clause was meant to compensate, and if the answer is no, the inference would be that it was meant to punish. Analytically, the new penalty test is broader in scope: there could be clauses that are not meant to punish, but are nonetheless not compensatory. The earnest deposits here are a good example. Undoubtedly, earnest deposits by their very nature are meant to secure performance, not to compensate loss. Just because the forfeiture of the earnest deposit may go some way in compensating lost profits does not mean that they were designed with a compensatory function in mind.

IV. When are earnest deposit clauses valid?

Some authors, in the context of English law, have argued that earnest deposit clauses can never be penalties,[1] with the result that they would always be valid. The said authors have argued that earnest clauses, by their very nature, cannot be penalties because their unusual case does not satisfy the penalty rule jurisdiction by not satisfying the detriment prong. It would be useful to distinguish between the English position and the Indian position here. In English law, the penalty rule jurisdiction requires two elements: a) detriment; b) breach. In the Indian position, there is no clear requirement to prove detriment – it could be discounted as a precondition for the penalty analysis. The line of cases on liquidated damages starting from Fateh Chand to Kailash Nath have only utilized the genuine pre-estimate test, whose only criteria were the Dunlop factors – whether the agreed sum was a genuine forecast of loss due to breach? However, since there is no detriment prong in Indian penalty jurisprudence, earnest clauses can very much be penalties. 

From what has been argued above, the distinction between sanctioning breach and securing performance is incoherent, effectively implying that earnest deposits must be considered as being meant to punish. If this is true, are all earnest deposits penalties and thus, unenforceable? The answer is no. If an earnest deposit clause stipulates a reasonable proportion of the total amount that would be forfeited, it may indeed be justifiable as “reasonable compensation” for lost profits under section .74. In some ways, they would act as an atypical liquidated damages clause. This type of reasoning is visible in Privy Council judgments in Union Eagle Ltd v Golden Achievement Ltd [1997] AC 514 (PC) 518 and Workers Trust and Merchant Bank Ltd v Dojap Investments Ltd [1993] AC 573 (PC). This defence is brought out in the court’s understanding as well:  the court says that the forfeiture being only 25% of the total amount, it will not be invalid (paragraph 79). In other words, the court construes 25% as “reasonable compensation” for lost profits, or in more familiar terms, a genuine pre-estimate of loss. Needless to say, what is “reasonable” proportion will vary depending on the facts surrounding the transaction.

V. Conclusion

The liquidated damages and penalty jurisprudence in India is still nascent. Not many illuminating judgments have come since ONGC v. Saw Pipes or perhaps more recently, Ultratech Cements v. Sunfield Resources (Bombay High Court). In this judgment, the Supreme Court had a valuable opportunity to clarify the law on s.74. However, it appears that the Court’s holdings have added an additional layer of confusion in the penalty analysis under s.74. It will be interesting to see how the law evolves henceforth.

[1] Conte C. Deposit Clauses. In: Virgo G, Worthington S, eds. Commercial Remedies: Resolving Controversies. Cambridge University Press; 2017:390-413.

*Anirud Raghav – 3rd year undergraduate student at NLSIU