Earnest Money Not So Earnest

Earnest Money Not So Earnest

In the automotive and real estate business in Pakistan, sale and purchase is normally transacted through an instrument commonly known as an “agreement to sell”, which is subsequently followed by a “sale agreement”. The legal effect of both instruments needs examination as one creates proprietary rights whereas the other may only creates an interest in property with possibly no legal rights accruing to either party in relation to the subject matter. The ordinary citizen (unlike a businessperson, estate agent or car dealer) is not fully aware of the legal challenges involved in transacting business through such agreements and on many occasions is dragged into unexpected, unnecessary and protracted litigation.

In addition, such transactions are generally not free of manipulation, errors and questionable provisions. For instance, stipulations relating to “earnest money” – where failure by a party to perform the contract results in forfeiture of any earnest money given, or return of ‘double’ the sum paid as earnest money to compensate the non-defaulting party – are contrary to Islamic principles of trade and business. Contract law also labels provisions with such consequences as penalty clauses with the effect that the courts strike down such clauses as void, unlawful and having no legal effect.

This writing will examine salient features of the legal instruments involved in transacting business of sale and purchase with emphasis on the concept of earnest money, its legal standing under Pakistani law and the basic principles of trade and commerce of Islamic law.

Let us examine a scenario where an individual is interested to sell his or her property, a residential house. He or she contacts a few property agents to facilitate the deal. On most such occasions, the property dealer will either find a genuine buyer for the sale or attempt to purchase the property himself or herself in the hope of short-term resale and gain.

In either case, an enthusiastic buyer will normally wish to first secure the deal through payment of “token or earnest money” which is a deposit of a moderate sum of money made by the buyer to the seller and which is generally indicative of the buyer’s good faith and seriousness in the transaction.

Normally, the effect of payment of earnest money is two-fold; firstly, it discourages or prevents the seller from transacting business with any third party or at the least binds the seller to keep the offer open for a mutually agreed time period; secondly, it allows the buyer sufficient time for arranging necessary financing to complete the transaction.

To formalize the modus operandi of the deal and record the payment and receipt of earnest money, parties will normally enter into a legal instrument labelled the “agreement to sell”, hereafter referred to as “ATS”. ATS is the basic document which enables the process of sale to go through without any hurdles. It constitutes the terms and conditions upon which the sale and transfer of the property from the seller to the buyer shall take place. In simple terms, it is a legally binding agreement whereby the seller ‘promises’ to sell the subject property to the buyer and the buyer ‘promises’ to pay the contract price in the manner required by the seller.

Depending on the construction of ATS and the intention of parties, varying rights and obligations accrue in favour of the parties. Two aspects in particular need to be closely examined:

  1. Firstly, by entering into the ATS, whether the buyer has purchased and the seller has sold the subject property.
  2. Secondly, whether a subsequent refusal to perform by either party would entitle the non-defaulting party to legally force the defaulting party to honour the agreement. In other words, would a civil suit for specific performance of the contract be maintainable and suitable?

Elaborating further on the example of sale of residential property, let’s suppose the seller demands a lump sum price of PKR 20 million. The buyer makes a payment of PKR 10 million to the seller with the promise of paying the remaining 50% within ten days. Both parties draw up an ATS recording the deal, however, before expiry of the agreed ten days, the seller gets a better offer of PKR 25 million from a third party for the premises and so, for good gain, the seller immediately sells and transfers the property to such third party.

Such exercise by the seller creates legal challenges for the buyer and leaves the buyer in a precarious position regarding legal remedies that he or she may exercise. Would the buyer be justified in legally demanding from the seller:

  • PKR 20 million as double the money advanced for breach of ATS? Or
  • the extra PKR 5 million made by the seller from the third party sale as a case of unjust enrichment along with return of his or her advance payment i.e. a total of PKR 15 million? Or
  • PKR 10 million refund? Or
  • any other sum as damages for breach of contract? Or
  • that the sale transaction in favour of the third party be reversed and effected in favour of the buyer as mutually agreed?

Furthermore, had the buyer known of the third party transaction earlier in time, could he or she have legally stopped the sale/transfer through injunctive relief?

Such questions are the subject of a lot of litigation in Pakistan. These shall be examined in light of Islamic principles of trade and commerce, and the existing legal framework of national laws and practices in vogue, so that the citizen is better informed of his or her legal rights.

Philosophy of Islamic Law of Contract

Islamic law recognises a contract as a legally binding activity and encourages the parties to any agreement to perform their obligations in accordance with the terms of the contract.[1] The Quran states:

“O you who have believed, fulfil all contracts.[2]

In general, the legal requirements of a valid and binding contract in Islamic law are similar to those found in Western jurisprudence i.e. offer, acceptance, consideration and intention to create legal relations. However, Islamic contract law in certain instances does not necessarily require the agreement of all parties and remains binding and effective even without the consent of the other parties.[3]

The general letter and spirit of Islamic contract law, however, requires that promises and commercial obligations are honoured with full and free consent and satisfaction, and that no injustices, usurpation or uncertainty is at play. The Quran states:

And fulfil the covenant of Allah when you have taken it, [O believers], and do not break oaths after their confirmation while you have made Allah, over you, a witness. Indeed, Allah knows what you do.[4]


“O you who have believed, do not consume one another’s wealth unjustly but only [in lawful] business by mutual consent.”[5]

Such commands lay strong emphasis on fair play and the ability and capacity of parties to fulfil obligations mutually undertaken, and leave no room whatsoever for exploitative terms, behaviour or conduct. The personal word of an upright Muslim is deemed worthier than an abstract piece of paper – this may be evidenced from the religious standard of judicial oath having priority (unlike local law) over documentary evidence, since Islamic law assumes that no Muslim would lie under oath.

In a contract of sale, ownership must be transferred as soon as the contract is made in principle. Islamic law discourages future transfers, for there are elements of speculation or risk which produce a kind of unforeseeable gain or loss. Furthermore, scholars differ on whether future sales are valid as some argue that the subject matter must be owned at the point of sale, whereas others argue that it is only the ability to deliver on the promise and not possession that is central to future contracts.

Islamic contract law, given its divine nature, is strongly driven by ethics and as a result of the stress on morality, the real intention or motive of a contract is considered to be one of the most important elements. Therefore, while construing any contracts, the Hanbali and Maliki schools of thought would consistently seek the reality of the ‘inner side’.[6] For example, it is forbidden to purchase grapes for the purposes of producing wine – an otherwise valid contract may be a nullity simply on the ground that it is inspired by an improper or ulterior motive.

Another important aspect worth exploring is the concept of “riba”, the literal meaning of which is “increase” or “gain”.[7] Although a topic of much debate and commentary, riba in simple words refers to any gain received without giving a counter-value and is forbidden under a number of verses of the Quran. Hence, all contracts which express or imply riba are invalid and highlight the well-known concept of “unjust enrichment”.

Islamic law also provides a consumer protectionist character to contracts by allowing the buyer to fully explore the object of sale and ascertain its true counter-value. Bargaining and haggling is permissible and encouraged, provided it is reasonable to the other party – the Sunnah commands us to desire for our Muslim brothers and sisters what we desire for ourselves. This is also praiseworthy because such a person is less likely to be given an unfair deal or be deceived or cheated when buying and selling.

An agreement to sell is not considered to be a contract, rather it is the promise of a future contract. The scholars differ on whether payment of earnest money (referred to as ‘arbun’) is a non-refundable sum to the vendor who agrees to supply the goods or services at a future date. In the event that the contract is fulfilled, the sum is counted towards the agreed price, otherwise it is forfeited if the buyer withdraws from the purchase.[8] Some scholars consider it necessary, rather than commendable, to refund earnest money after covering for actual damage or loss of bargain.

Keeping in view the essence of law and morality, forfeiture of earnest money or return of ‘double’ the sum paid as earnest money is a recipe for unjust enrichment. How can ‘double’ the sum advanced be rationalised or substantiated by any logic? Or on what basis is complete forfeiture permissible where no sale transaction has taken place? Such practices and provisions, in fact, are devices which disturb the equilibrium of contracts that Islamic law is meticulously guarding. A non-defaulting party may, however, claim damages upon proof of actual loss, but a defaulting party’s inability or unwillingness to contract should not be penalised disproportionately.

Therefore, in my view, forfeiture of earnest money, not falling within the realm of riba, does create a case of unjust enrichment or exploitative conduct. On the other hand, Islamic law not only stresses upon Muslims to honour their commitments, it also encourages fair play and full and frank disclosure where required. So both parties are morally responsible and accountable to proceed with the promised transaction, unless there is a genuine and valid reason for not doing so.

Agreement to Sell Under Pakistani Law

Courts may specifically enforce (requiring the defaulting party to perform) any breach of any contract provided that it is likely to cause irreparable loss or harm to the non-defaulting party. The relief of specific performance is, however, purely discretionary in nature and courts are not bound to grant such relief merely on the grounds that it is lawful to do so, particularly vis à vis immovable property.

This principle is specifically enshrined in Section 22 of the Specific Relief Act 1877. For this reason, every case is generally decided on its own facts and merits. Discretion not to grant specific performance is generally exercised to prevent an unfair advantage to the plaintiff or which would result in some hardship to the defendant – even in the absence of any fraud or misrepresentation. In other words, a buyer or a seller cannot impose or force each other into performance as a matter of legal right even if existence of the agreement is proved or even if specific relief is expressly agreed upon.

In transactions relating to immovable property, time is generally not considered to be an essential condition, unless expressly agreed to be so in unmistakable terms. Therefore, a party to a contract cannot seek to enforce a contractual provision relating to time periods unless the party has specifically placed the other party on notice or made provision in the contract for compliance with time-related provisions to be an essential condition of the contract. Similarly, a non-defaulting party cannot rely upon breach of a time-period provision to walk away from an agreement, if not clearly stipulated so.

An agreement to sell is commonly understood as a promise to sell (at a future date) and creates only promissory rights in favour of the buyer, whereas a sale agreement is a commercial transaction (at a present date) which confers legal title from the seller to the buyer, hence, creates proprietary rights (rights in property) in favour of the buyer, provided other legal formalities are fully complied with.

Under Pakistani law, an unregistered sale agreement does not confer any legal title with respect to immovable property. Therefore, any sale of immoveable property has to be reduced in writing and registered at the concerned state office. An agreement to sell is not required to be registered since it does not create any rights in property nor signifies a transfer of title, however, many times this legal instrument becomes the bone of contention between potential buyers and sellers as heavy reliance is placed on an ATS in civil court proceedings to indicate the intent, rights and obligations of the parties concerning a particular commercial transaction.

A review of recent case-law does not indicate a consistent pattern of decisions, however, it does suggest a strong trend where importance has been given to the conduct and intention of the parties. Where specific performance has been declined, courts have not always struck down forfeiture clauses; where it has, they have, refreshingly, in some instances ordered repayment of earnest money in net present-value terms. Where specific performance has been ordered, it is usually because the courts have either construed the contract to be a sale agreement, irrevocable in nature, likely to cause irreparable loss, or have held that compliance with provisions relating to time-period is not an essential condition.

In the arena of unscrupulous traders, agreements to sell are used as weapons by both parties at opposite ends of the contractual spectrum to bind the other side – particularly with regard to the contractual provisions relating to time-periods – and rope the other parties into prolonged civil litigation. It is common practice for the seller to misrepresent or hide legal complications concerning the subject matter of sale. Similarly, the buyer, knowing fully well that he or she does not have the financial means to transact the sale, wilfully enters into an ATS so as to place the seller on tenterhooks. At this point, the seller usually has two options: either to wait for the buyer to arrange money for the purchase, or engage in a long, exhausting and mostly torturous civil battle in the courts of law, which can easily stretch a generation. Eventually, the seller succumbs to selling property to the buyer at the price indicated in the ATS years ago even though the price of the property may have spiked exponentially, thereby losing meaningful value and time and ending up with an extremely distressing commercial deal.

In my view, ATS should never be specifically enforceable and should be construed only as a ‘promise’ of sale and not a ‘sale’ itself. The defaulting party should be proportionately held accountable for breaching a promise but never forced to part with his or her property or handed out heavy compensation as penalty. The reason is that earnest money is generally not given and should not be considered as a counter-value for the subject matter of the agreement, however, as things presently stand, the quantum of earnest money seems to be an important determining factor as to its nature and intent.

Nonetheless, the general public continues with the trend of construing agreements to sell as sale agreements in most commercial transactions in the automotive and real estate business and the courts continue to uphold such intentions. Cases of specific performance in connection with agreements to sell form a significant part of the 1.8 million cases pending in Pakistan’s courts.

Coming back to the sale example mentioned above, the buyer’s claim would largely depend on whether the payment of PKR 10 million was intended (and understood) to be contribution (part-payment) towards the sale price i.e. part of the agreed counter-value, or intended to be money advanced to place the seller in the position of a debtor, or payment as a collateral till full financing was arranged, or payment to keep the offer/sale open, etc. Such questions are not always easy to answer. It is advised that they be noticeably, rather distinctly, drafted in the contracts to avoid ambiguous meanings and intentions. In any case, forfeiture of ‘double’ the earnest money has no legal or rational basis in the law relating to contracts and must be treated as a “penalty clause”.

For the sake of precedent, PLD 1969 SC 80 is an interesting case where the Supreme Court of Pakistan rightly refused forfeiture of earnest money (nor did it award any nominal damages) since breach by the defaulting party did not result in any ‘actual loss’ to the non-defaulting party.

Conclusion

The practice of earnest money has varied from time to time and place to place. In our social and judicial structure, agreements to sell and provisions relating to earnest money have been largely abused and continue to result in exploitative conduct as they clearly make it possible for one party to the contract to benefit unfairly at the expense of the other. Sometimes, it may merely be a symbolic amount, at other times, it can be a substantial sum. The relationship between practice and theory is an area of uncertainty.

One must always ensure that a clear distinction is made between an “agreement to sell” and a “sale agreement” since both create varying rights, obligations and consequences. Mere label or title of a document is not sufficient to identify its intent or rely upon its contents. Always seek legal assistance where required and conduct due diligence to filter out transactions which a party does not have the capacity to transact. Avoid paying or taking earnest money in a commercial transaction as it may lead to unethical practices, unjust enrichment, unnecessary and complicated litigation and situations which Islamic law does not endorse. Furthermore, it may even place an irrational upper cap on the amount of damages a non-defaulting party may be able to claim through courts.

The classic Islamic way to avoid uncertainty is to have the exchanged counter-values in existence at the time of the formation of the contract, to inspect, to decide to enter into a contract during the session and to transfer ownership (where possible) before the parties part ways. In simple words, stick to sale agreements only and honour your commitments.

In this regard, a quote by Colin R. Davis is worth pondering over:

The road to success and the road to failure are almost exactly the same.

———-

References

[1] Shari’a Law in Commercial and Banking Arbitration – Law and Practice in Saudi Arabia by Abdul Rahman Yahya Baamir
[2] Ibid; Quran 5:1
[3] fn 1 supra
[4] Quran – 16:91 translated by Sahih International
[5] Quran – 4:29 translated by Sahih International
[6] Philosophy of The Islamic Law of Contract – A comparative study of contractual justice – Hideyuki Shimizu
[7] Ibid
[8] “Earnest Money” and The Sources of Islamic Law – Gerald Hawting and David M. Eisenberg

 

The views expressed in this article are those of the author and do not necessarily represent the views of CourtingTheLaw.com or any organization with which he might be associated.

Suleman Khan

The writer is a partner at Khan & Muezzin Barristers and holds an LL.B degree from the University of London and an LL.M degree from London School of Economics.



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