Beware of Putting an Unenforceable Penalty into Your Settlement Agreement

I was pretty surprised to find this case.  As a mediator, this comes up all the time.  Plaintiff will take a smaller amount in payments but wants a big penalty if the agreed upon amount is not paid.  I wonder if it is different if approved by the bankruptcy court.   A tip of the hat to attorney D. Brian Reider for sending me this case.

PURCELL v. SCHWEITZER, 224 Cal.App.4th 969 (2014)

Issue:  Where a settlement agreement provides that in the event of a default, an additional amount is owed, can the additional amount be found to be an unenforceable penalty?

Holding:  Yes.  “The amount set as liquidated damages `must represent the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that may be sustained.”

Defendant borrowed $85,000 from Plaintiff.  Plaintiff sued when defendant defaulted.  The parties settled for $38,000.  The settlement agreement provided that if a payment was missed, the amount owed would be the original $85,000.  The parties agreed that $85,000 was “monies actually owed, jointly and severally, by the Defendant [(Schweitzer)] to the Plaintiff [(Purcell)] and is neither a penalty nor is it a forfeiture.”  Defendant made some payments but finally defaulted on the settlement.  Plaintiff asked for and got a default judgment for $58,000 (apparently $85,000 less payments).  Defendant moved to set the judgment aside arguing that the additional amount of the settlement “constituted an unenforceable penalty because the amount of the judgment bore no reasonable relationship to the amount of damages [plaintiff] would actually suffer as a result of [defendant’s] breach.”  The court agreed and set aside the judgment.

The court of appeals affirmed.  “The amount set as liquidated damages `must represent the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that may be sustained.’  Absent a relationship between the liquidated damages and the damages the parties anticipated would result from a breach, a liquidated damages clause will be construed as an unenforceable penalty.”  Further, the relevant breach to be analyzed “is the breach of the stipulation, not the breach of the underlying contract.”  “The stipulation bore no reasonable relationship to the damages that it could be expected that [plaintiff] would suffer as a result of a breach by [defendant].”  “[P]laintiff’s contention that the $85,000 amount reflected the economics associated with ‘proceeding further’ with the lawsuit is also unavailing.  That provision in the settlement agreement bore no reasonable relationship to damages he would be expected to actually suffer as a result of a breach, such as the late payment that occurred in this case.  There is nothing in the record to support the fact that obtaining a judgment and instituting postjudgment procedures would cost $85,000.”

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