Penalty as damages: How the SARFAESI Act trumps the Indian Contract Act

In a recent judgment titled Authorised Officer, Central Bank of India v. Shanmugavelu, the Supreme Court had the occasion to consider an important question which arises in commercial law.

The question was: when a secured creditor seeks the sale of a security interest by way of an auction, is it legally permissible for the secured creditor to seek the forfeiture of the pre–deposit made by a prospective buyer, when such a buyer is unable to/fails to complete the sale transaction? In other words, does the SARFAESI Act permit the payment of penalty as damages? Another question raised was whether the provisions of the Indian Contract Act affect the SARFAESI Act and the rules made thereunder.

As a general principle of law, if a person is aggrieved by the breach of a contract, then monetary compensation is payable to the extent of the injury that has been suffered. Damages cannot become a ruse to penalise the defaulting party. They cannot be compelled to pay a penalty/fine for the breach that has been caused. This is the scheme as set out in Section 74 of the Indian Contract Act.

However, the SARFAESI Act seemingly enacts a departure from this general law on damages. Under the scheme of the SARFAESI Act, a secured creditor is empowered to seek the sale of an asset which is held as security interest. The emphasis of the law in ensuring the expeditious settlement of financial debts is made clear by the fact that under Section 13, the secured creditor may seek the sale of the secured asset even without the intervention of the Debts Recovery Tribunal (DRT).

For this reason, Section 13(1) declares that,

“Notwithstanding anything contained in Section 69 or Section 69-A of the Transfer of Property Act, 1882 (4 of 1882), any security interest created in favour of any secured creditor may be enforced, without the intervention of the court or tribunal, by such creditor in accordance with the provisions of this Act.”

The SARFAESI Rules were enacted in 2002. Rule 8 relates to the “sale of immovable secured assets.” Rule 9 pertains to “time of sale, issue of sale certificate and delivery of possession, etc.” In Rule 9(4) and Rule 9(5), it is stipulated as follows:

“4) The balance amount of purchase price payable shall be paid by the purchaser to the authorised officer on or before the fifteenth day of confirmation of sale of the immovable property or such extended period as may be agreed upon in writing between the purchaser and the secured creditor, in any case not exceeding three months.

(5) In default of payment within the period mentioned in sub-rule (4), the deposit shall be forfeited to the secured creditor and the property shall be resold and the defaulting purchaser shall forfeit all claim to the property or to any part of the sum for which it may be subsequently sold.”

Rule 9(5) envisions a clear departure from the general rule of damages in contract law. Under Rule 9(5), the forfeiture of the earnest money in favour of the secured creditor, upon the purchaser defaulting on the full payment for the secured asset, is immediate and absolute. It is a form of penalty for committing a default.

As a matter of law, it is now well-recognised that subordinate legislation made under the auspices of the parent enactment is deemed to be a part of the main legislation itself.

Thus, since Rule 9 is deemed to be a part of the SARFAESI Act itself, then under the scheme of this Act, it is legally permissible for the secured creditor to seek the forfeiture of the pre–deposit as a penalty even though no injury may have been suffered. Furthermore, and more particularly, under the non–obstante clause contained in Section 35 of the SARFAESI Act, the scheme set out in the Contract Act has been rendered entirely inapplicable to proceedings arising under the SARFAESI Act.

The important aspect of the judgment in Shanmugavelu pertains to the impropriety of reading in the prohibitions against the payment of penalties contained in the Indian Contract Act, into the SARFAESI Act. The SARFAESI Act and the Indian Contract Act operate on completely different planes. As the Supreme Court observed, since the rigour of the SARFAESI Act stipulates the forfeiture of the earnest money paid in an auction, there is no scope of introducing the requirements of the Contract Act into Rule 9. As the Supreme Court held:

“No doubt, the forfeiture is a result of a breach of obligation, but the consequence of forfeiture in such case is taking place not because of the breach but because of operation of the statutory provision providing for forfeiture that is attracted as a result of the breach.”

At a more fundamental level, the Supreme Court held that if Rule 9 were to be interpreted in a manner where the principles of Section 74 of the Contract Act are read into the Rules, then effectively the Court would be reading down Rule 9(5) and giving it a meaning contrary to its express terms. As the Supreme Court held, without showing that the provision is unconstitutional, a court can never resort to “reading down” a provision. Simply stated, “reading down” is resorted to only to save the statutory provision from unconstitutionality.

Another important aspect of this judgment is that it restates some of the salient legal principles which apply in the case of sale of secured assets under the SARFAESI Act, namely, that the Act and the Rules together form one complete scheme. The ultimate aim of the scheme is to ensure that the debt that is owed to the secured creditor is effectively and expeditiously realised.

As a result, the clear terms of the Act and the Rules alone ought to prevail. This assumes even greater relevance because only in 2023, in Authorized Officer State Bank of India v. C. Natarajan, the Supreme Court had declared that the 2002 Rules together with the SARFAESI Act form a composite legal scheme. As a result, Rule 9 validly enacts a departure from the Contract Act and will prevail over the latter. It was held:

“While the Contract Act embodies the general law of contract, the Sarfaesi Act is a special enactment, inter alia, for enforcement of security interest without intervention of court. Rule 9(5) providing for forfeiture is part of the Rules, which have validly been framed in exercise of statutory power conferred by Section 38 of the Sarfaesi Act. Law is well settled that rules, when validly framed, become part of the statute. Apart from the presumption as to constitutionality of a statute, the contesting respondent did not mount any challenge to sub-rule (5) of Rule 9 of the Rules. The applicability and enforcement of sub-rule (5) of Rule 9 on its terms, therefore, has to be secured in appropriate cases.”

To be sure, the forfeiture of earnest money before an actual contract is made between the parties stands on a different footing even under Section 74 of the Indian Contract Act. This is for the reason that the principles of Section 74 apply when a contract is validly made between the parties and the breach of this contract results in a claim for damages. Thus, the steps taken before a valid contract is executed between the parties may not properly fall within the four corners of Section 74. In Kailash Nath Associates v. DDA, the Supreme Court observed:

“It must, however, be pointed out that in cases where a public auction is held, forfeiture of earnest money may take place even before an agreement is reached, as DDA is to accept the bid only after the earnest money is paid. In the present case, under the terms and conditions of auction, the highest bid (along with which earnest money has to be paid) may well have been rejected. In such cases, Section 74 may not be attracted on its plain language because it applies only when a contract has been broken.”

It is this which led the Supreme Court in Shanmugavelu to observe:

"Since, the forfeiture under Rule 9(5) of the SARFAESI Rules is also taking place pursuant to the terms & conditions of a public auction, we need not dwell any further on the decision of Kailash Nath (supra) and leave it at that. Suffice to say, in view of the above discussion, Section(s) 73 and 74 of the 1872 Act will have no application whatsoever, when it comes to forfeiture of the earnest-money deposit under Rule 9 sub-rule (5) of the SARFAESI Rules."

Indeed, in Shanmugavelu this principle of law was applied to delineate between formed contracts under which liabilities may arise if the contract is broken (to which Section 74 of the Contract Act may apply) and steps prior in time to the formation of a contract in public auctions. Shanmugavelu together with the judgment in C Natarajan have set out the principles as to how the SARFAESI Act is to be implemented and understood in respect of auction of secured assets. Indeed, as per these decisions, no matter how strict and onerous the provisions of the SARFAESI Act are, principles from the Contract Act ought not to be imported into the law to make their operation less onerous.

About the author: Rohan J. Alva, a graduate of Harvard Law School, is an Arguing Counsel in the Supreme Court and Delhi High Court.