February 11, 2015

Presented by: Steven J. Sibley, Partner at DiNapoli & Sibley and William Charley, Associate at Diemer, Whitman & Cardosi, LLP

Common provisions in settlement agreements include liquidated damages clauses, which provide for additional amounts or conditions to be awarded to a party (usually the creditor) if the other party fails to pay or perform the settlement terms. However, not all liquidated damages clauses are enforceable. In some instances, the liquidated damages provision will be treated as an unenforceable penalty clause. These materials identify liquidated damages clauses and situations where such clauses could be unenforceable penalty clauses. For example, Creditor sued debtor for $100,000 over an unpaid commercial debt. The parties settled the case for $50,000 and entered into a settlement agreement, approved by the court that required the debtor to pay the $50,000 by Jan. 1. If the debtor did not pay the $50,000 by Jan 1, the creditor could enter a stipulated judgment against debtor for $100,000, less any debtor payments previously made. Is that liquidated damages clause enforceable?

1. Statutory Authority

a. Cal. Code Civ. Proc. § 664.6 gives the Court the ability to enter a stipulated judgment "pursuant to the terms of the settlement."

b. Civ. Code § 1670.5 gives the Court the ability to "limit the application of any unconscionable clause as to avoid any unconscionable result."

c. Civ. Code § 1671(b), states in relevant part: "[A] provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made."

2. Case Law

a. The California Supreme Court has held that a liquidated damages provision will be generally considered unreasonable, and therefore unenforceable, under § 1671, if it "bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach" and the parties must attempt to "estimate a fair average compensation for any loss that may be sustained." Ridgley v. Topa thrift & Loan Ass'n, 17 Cal, 4th 970 (Cal. 1998).

b. Liquidated Damages Clause Unenforceable Greentree Financial Group, Inc. v. Execute Sports, Inc., 163 Cal. App 4th 495 (Cal. App. 4th Dist. 2008), stands for the principle that a claimed breach of a settlement agreement is to be analyzed on its own and not in concert with the contract underlying or resulting in the litigation. Therefore, the focus on applying the liquidated damages clause breach is damages arising from breach of the settlement agreement. "If the sum extracted from the borrower is designed to exceed substantially the damages suffered by the lender, the provision for the additional sum, whatever its label is an invalid attempt to impose a penalty inasmuch as its primary purpose is to compel prompt payment through the threat of imposition of charges bearing little or no relationship to the amount of the actual loss incurred by the lender." Id. at 500.

c. Liquidated Damages Clause Unenforceable In Purcell v. Schweitzer, 224 Cal. App. 4th 969, 975 (Cal. App. 4th Dist. 2014). the Fourth Appellate Division made it clear that no contractual language can prevent the Court from striking down settlement agreements where parties stipulate to a default amount that is larger than the settlement amount. "[T]he public policy expressed in Civil Code sections 1670 and 1671 may not be circumvented by words used in a contract; that whether or not a particular clause is a penalty or forfeiture or a bona fide provision for liquidated damages depends upon the actual facts existing at the time the contract is executed and whether or not, in fact, it was then impracticable or extremely difficult to fix actual damages and that the parties did in fact then make a good faith and reasonable effort to do so; that a litigant seeking the benefits of a clause purporting to fix liquidated damages must plead and prove that the clause is valid under the facts which then existed. The applicability of Civil Code section 1671 depends upon the actual facts not the words which may have been used in the contract." In Purcell , the settlement amount was for $38,000, and the stipulated default judgment was for $85,000. Debtor's payments were due on the 1st of the month, and considered late on the 5th of the month. Creditor accepted a payment the Debtor made on the 11th. Creditor then applied for entry of the judgment minus the amount paid, which amounted to a requested judgment of $58,829.35, about one and a half times the settlement amount. Notwithstanding entry of the default judgment, Debtor continued to make (and Creditor continued to accept) the November and December settlement payments. Both parties acknowledged that the settlement was paid in full. The Court stated: "The language in the stipulation seeking to tie the $85,000 to the economies of proceeding further with the matter was an obvious attempt to circumvent the public policy expressed in [1671]". Id. 976.

d. Liquidated Damages Clause Enforceable Jade Fashion v. Harkham Industries 229 Cal. App. 4th 635 (Cal. App. 7th Dist. 2014). Clause providing for withdrawal of $17,500 discount on $341,629 claim enforceable liquidated damages provision. Settlement agreement included time is of the essence clause, debtor's acknowledgement of owing entire debt. The court determined parties' agreement was not a settlement of an obligation, but a forebearance agreement, so 1671 did not apply to invalidate the discount, since it was included in the amount debtor agreed to pay.

3. Bankruptcy Adoption

a. In October, 2014, in an unpublished decision, the BAP affirmed the Bankruptcy Court's equitable authority to modify or vacate compromise stipulations if circumstances so justify. "Even though the settlement agreement as written appears to permit such enforcement, contract reformation principles could be invoked to conform the written instrument to the parties' actual expectations at the time of contract formation." Dye v. Sachs (In re Flashcom, Inc.), 2014 Bankr. LEXIS 4215, 1 (B.A.P. 9th Cir. Oct. 1, 2014) (Liquidated damages clause unenforceable as debtor paid 90% of settlement amount, with bankruptcy trustee failing to provide payoff amount, resulting in debtor's delay in making final payment. Settlement agreement was for $750,000; liquidated damage clause provided for entry of $9,000,000 default judgment.

b. Curren v. Escamilla (In re: VEC Farms) 395 B.R. 674 (Bkptcy. N.D. Cal. 2008) (Liquidated damages clause enforceable following defendants' breach of agreement with chapter 11 trustee requiring withdrawal of claim against bankruptcy estate).

4. Public Policy vs. Effects

a. It is the strong public policy of California to encourage the voluntary settlement of litigation. To that end, the law treats as confidential statements made during settlement negotiations, provides financial incentives for settlement, and provides, in Code Civ. Proc., § 664.6, an expedited procedure for enforcing a settlement once it has been agreed upon. Osumi v. Sutton, 151 Cal. App. 4th 1355, 1356 (Cal. App. 2d Dist. 2007)

b. Chilling effect on settlement agreements.

5. Potential Workarounds

a. Articulate the actual damages if payments are missed or delayed.

b. Time is of the essence clauses.

c. Consent to owing entire balance.

d. Forebearance vs. settlement of the claim.

e. The parties' involvement in mediation or arbitration that resulted in the agreement.

f. Agreement's inclusion of specific facts supporting the liquidated damages provisions