Cancellation of Contract-Security Deposit - Forfeiture for default

The law is well settled that the party to a contract taking security deposit from the other party to ensure due performance of the contract is not entitled to forfeit the deposit on ground of default when no loss is caused to it in consequence of such default."

 in Union of India v. Rampur Distillery and Chemical Co. Ltd. [(1973) 1 SCC 649], this Court stated :
3. Only one contention was urged on behalf of the appellants before us : that the security deposit was taken from the respondents in order to ensure the due performance of the contract and respondents having defaulted, the entire amount was liable to be forfeited. A similar contention was advanced before this Court but was rejected inMaula Bux v. Union of India.The appellant therein had entered into a contract with the Government of India for the supply of certain goods and had deposited a certain amount of security for the due performance of the contract . As in the instant case, it was stipulated in the contract there that the amount of security deposit was to stand forfeited in case the appellant neglected to perform his part of the contract. On the appellant committing default in the supply, the Government rescinded thecontract and forfeited the security deposit . It was held by this Court that forfeiture of earnest money under a contract for sale of property does not fall within Section 70 of the Contract Act, if the amount is reasonable, because the forfeiture of a reasonable sum paid as earnest money does not amount to the imposition of a penalty. But, where under the terms of the contract the party in breach has undertaken to pay a sum of money or to forfeit a sum of money which he has already paid to the party complaining of a breach of contract , the undertaking is of the nature of a penalty". It was further held that the amount deposited by way of security for guaranteeing the due performance of the contract cannot be regarded as earnest money."
The distinction between a security and an earnest money has also been pointed out by this Court in Maula Bux v. Union of India [(1969) 2 SCC 554] in the following terms :
4. Under the terms of the agreements the amounts deposited by the plaintiff as security for due performance of the contracts were to stand forfeited in case the plaintiff neglected to perform his part of the contract . The High Court observed that the deposits so made may be regarded as earnest money. But that view cannot be accepted. According to Earl Jowitt in Dictionary of English Law at p. 689; Giving an earnest or earnest-money is a mode of signifying assent to a contract of sale or the like, by giving to the vendor a nominal sum (e.g. a shilling) as a token that the parties are in earnest or have made up their minds". As observed by the Judicial Committee in Kunwar Chiranjit Singh v. Har Swarup :
Earnest money is part of the purchase price when the transaction goes forward; it is forfeited when the transaction falls through, by reason of the fault or failure of the vendee."
In the present case the deposit was made not of a sum of money by the purchaser to be applied towards part payment of the price when the contract was completed and till then as evidencing an intention on the part of the purchaser to buy property or goods. Here the plaintiff had deposited the amounts claimed as security for guaranteeing due performance of the contracts . Such deposits cannot be regarded as earnest money."
Referring to Section 74 of the Indian Contract Act, it was observed :
There is authority, no doubt coloured by the view which was taken in English cases, that Section 74 of the Contract Act has no application to cases of deposit for due performance of a contract which is stipulated to be forfeited for breach, Natesa Aiyar v. Appayu Padayachi; Singer Manufacturing Company v. Raja Prosad;Manian Pattar v. Madras Railway Company. But this view is no longer good law in view of the judgment of this Court in Fateh Chand case. This Court observed at p. 526 : AIR 1915 Madras 896 (FB)
Section 74 of the Indian Contract Act deals with the measure of damages in two classes of cases : (i) where the contract names a sum to be paid in case of breach, and (ii) where the contract contains any other stipulation by way of penalty.........., The measure of damages in the case of breach of a stipulation by way of penalty is by Section 74, reasonable compensation not exceeding the penalty stipulated for. "
The Court also observed :
It was urged that the section deals in terms with the right to receive from the party who has broken the contract reasonable compensation and not the right to forfeit what has already been received by the party aggrieved. There is however no warrant for the assumption made by some of the High Courts in India, that Section 74, applies only to cases where the aggrieved party is seeking to receive some amount on breach of contract and not to cases whereupon breach of contract an amount received under the contract is sought to be forfeited. In our judgment the expression the contract contains any other stipulation by way of penalty" comprehensively applies to every covenant involving a penalty whether it is for payment on breach of contract of money or delivery of property in future, or for forfeiture of right to money or other property already delivered. Duty not to enforce the penalty clause but only to award reasonable compensation is statutorily imposed upon courts by Section 74. In all cases, therefore, where there is a stipulation in the nature of penalty for forfeiture of an amount deposited pursuant to the terms of contract which expressly provides forforfeiture , the court has jurisdiction to award such sum only as it considers reasonable, but not exceeding the amount specified in the contract as liable to forfeiture , and that, There is no ground for holding that the expression contract contains any other stipulation by way of penalty is limited to cases of stipulation in the nature of an agreement to pay money or deliver property on breach and does not comprehend covenants under which amounts paid or property delivered under the contract , which by the terms of the contract expressly or by clear implication are liable to be forfeited."
A decision reported in State of Gujarat v. Dahyabhai Zaverbhai, (AIR 1997 SC 2701). wherein, it was held under Section 74 of the Contract Act-
"When there was abandonment of a contract forfeiture of the security deposit as per clause of the contract is not illegal".
Decision reported in Managing Director M/s. Hindustan Shipyard Private Ltd. Visakhapatnam, v. Attili Appalaswami, ( AIR 1963 Andhra Pradesh 71). Therefore, according to him, the plaintiff is not entitled for any amount. In this connection, it is useful to refer to Section 74 of the Contract Act.
74. Compensation for breach of contract where penalty stipulated for:- 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".
 It is useful to refer to the decision reported in Fateh Chand, v. Balkishan Dass, (AIR 1963 SC 1405), wherein it has been specifically held in Para Nos. 8 and 10, as follows:
"8. The Section is clearly an attempt to eliminate the somewhat elaborate refinements made under the English common law in distinguishing between stipulations providing for payment of liquidated damages and stipulations in the nature of penalty. Under the common law a genuine pre-estimate of damages by mutual agreement is regarded as a stipulation naming liquidated damages and binding between the parties: a stipulation in a contract in terrorem is a penalty and the Court refuses to enforce it, awarding to the aggrieved party only reasonable compensation. The Indian Legislature has sought to cut across the web of rules and presumptions under the English common law, by enacting a uniform principle applicable to all stipulations naming amounts to be paid in case of breach, and stipulations by way of penalty.
 Section 74 of the Indian Contract Act deals with the measure of damages in two classes of cases (i) where the contract names a sum to be paid in case of breach and (ii) where the contract contains any other stipulation by way of penalty. We are in the present case not concerned to decide whether a contract containing a covenant offorfeiture of deposit for due performance of a contract falls within the first class. The measure of damages in the case of breach of a stipulation by way of penalty is by Section 74 reasonable compensation not exceeding the penalty stipulated for. In assessing damages the Court has, subject to the limit of the penalty stipulated, jurisdiction to award such compensation as it deems reasonable having regard to all the circumstances of the case. Jurisdiction of the Court to award compensation in case of breach of contract is unqualified except as to the maximum stipulated; but compensation has to be reasonable, and that imposes upon the Court duty to award compensation according to settled principles. The section undoubtedly says that the aggrieved party is entitled to receive compensation from the party who has broken the contract whether or not actual damage or loss is proved to have been caused by the breach. Thereby it merely dispenses with proof of "actual loss or damage"; it does not justify the award of compensation when in consequence of the breach no legal injury at all has resulted because compensation for breach of contract can be awarded to make good loss or damage which naturally arose in the usual course of things, or which the parties knew when they made the contract, to be likely to result from the breach".
 In fact, the same view has been reinforced in the decision reported in Maula Bux v. Union of India, (AIR 1970 SC 1955).
Both the above decisions clearly lays down that when an amount of compensation was fixed either as security deposit or liquidated damages, consequent on the breach, it is not mandatory that the entire amount has to be forfeited and the Court can consider as to what is the actual loss and the quantum of compensation the party will be entitled to. The above decisions have been reiterated in recent decision of the Supreme Court reported in Ashokan v. CCE[5], wherein the power of the Court to grant reasonable compensation even inspite of stipulated liquidated damages were recognized.