Client Alert: Stipulated Judgment For Full Amount Of Underlying Claim As Security For Compromise Settlement Void As Unenforceable Penalty

In Purcell v. Schweitzer (No. D063435 – filed February 24, 2014, certified for publication March 17, 2014), the Fourth District Court of Appeal upheld an order setting aside a stipulated default judgment for the full amount of plaintiff’s claim which had been agreed to by the parties to a settlement agreement, finding that it constituted an unenforceable penalty because the amount bore no reasonable relationship to the settling party’s actual damages resulting from a breach of the settlement agreement.

In an agreement settling a breach of contract action seeking $85,000 in damages based on an unpaid debt, the plaintiff agreed to settle the claim and to accept $38,000 in 24 monthly installments, including interest on the unpaid principal at 8.5 percent. The agreement provided that payments were due on the first day of each month and to be considered “timely,” had to be received by the fifth day of each month. If any payment was not made on time, it was to be considered a breach of the entire settlement agreement, making the entire $85,000 original liability due pursuant to a stipulation for entry of judgment for such amount. The stipulation included language to the effect that the $85,000 figure accounted for the “economics” of further proceedings. The agreement also specified that the foregoing provision did not constitute an unlawful “penalty” or “forfeiture” and that defendant waived any right to an appeal and any right to contest or seek to set aside such a judgment.

When the defendant was late on a settlement payment for the first time, the plaintiff applied for and obtained entry of the stipulated judgment. The plaintiff, however, had already accepted that particular late payment as well as further payments made by defendant until the full amount of the settlement and accumulated interest had been paid in full. The defendant then moved to set aside the default judgment for the balance of the original claim. The plaintiff argued that the agreement required strict compliance with all terms, including payment deadlines, and that the parties had expressly agreed to the amount and that it was not a “penalty” or “forfeiture.” The trial court set aside the default judgment as an unenforceable penalty.

The Court of Appeal affirmed the trial court’s order. Under California Civil Code section 1671(b), a provision in a contract liquidating damages for breach is valid unless the party seeking to invalidate the provision establishes it was “unreasonable under the circumstances existing at the time the contract was made.” Applicable case law and section 1671(d) further clarified that a liquidated damages clause becomes an unenforceable penalty “if it bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach.” (See Morris v. Redwood Empire Bancorp (2005) 128 Cal.App.4th 1305, 1314.) The court found that the stipulation for entry of judgment in the amount of the original liability was an unenforceable penalty because the amount bore no reasonable relationship to damages the plaintiff might suffer from a breach. The court found the relevant breach was not the breach of the underlying contract but the breach of the parties’ settlement agreement. The court also found that under section 1671, the public policy as expressed in that statute “may not be circumvented by words used in a contract,” but depends upon the actual facts existing when the subject contract is entered into.

These kinds of ‘stipulated judgment as security’ provisions are not uncommon in settlement agreements which contemplate partial payments over time. The lesson of this case is that counsel for a settling plaintiff should be particularly careful to articulate what all of the settling parties perceived, in good faith, would be the actual damages the settling plaintiff might sustain as a result of a breach of the settlement agreement and that such liquidated damages are, in fact, a reasonable reflection of the parties’ estimation of a fair, average compensation for such loss. Most courts addressing this issue, including the court in Purcell, have disapproved liquidated damages provisions which go beyond the settlement amount and reasonably related added expenses.

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March 19, 2014