Settling a case with a penalty

Here's a scenario that illustrates a pitfall for attorneys who settle California civil cases:

Imagine you represent a company that has filed a $45,000 breach of contract lawsuit against another company.

Shortly before trial, you and your client decide it would be in the client's interest to settle for a lesser amount of money and be paid fairly promptly.

So you reach an agreement. The defendant company will pay only $20,000 in two installments. You want to ensure that the defendant has an incentive to pay this reduced amount. So the parties agree that, if a payment is not made, the court will immediately enter judgment for the full $45,000 sought in the complaint, plus interest, attorney fees, and costs, with credit for any amount actually paid.

This agreement is memorialized in a "stipulation for entry of judgment." You consider your client well-protected: Either the client gets the $20,000 settlement paid in quick installments, or it will receive the full judgment as if it had won at trial.

The time comes for the first installment, and the defendant company fails to pay. So you go to court seeking a $45,000 judgment based on the stipulation, offering a declaration that explains that the defendant defaulted by missing its first payment, invokes the $45,000 damages provision, and justifies about another $15,000 in interest, attorney fees, and costs.

Will this judgment be easy for you to obtain? After all, bargained-for contracts are enforceable, and you are armed with a clear contract (the settlement agreement) that requires an immediate judgment upon a breach, an undisputed breach of that contract, and support for your damages.

In fact, however, your client faces a problem, at least if the defendant opposes entry of judgment. The damages provision of your contract is mostly unenforceable. These facts come directly from Greentree Financial Group, Inc. v. Execute Sports Inc., 163 Cal. App. 4th 495 (2008), which held as much.

The penalty in your agreement - the amount you are seeking to recover above the $20,000 in payments contracted for - is, in substance, a "liquidated damages" provision. Under Civil Code Section 1671 and the case law interpreting it, a liquidated damages provision creates an unenforceable penalty if it "bears no reasonable relationship" to the actual damages that would flow from a breach.

In determining whether damages in a settlement agreement are an unenforceable penalty, the amount that the lawsuit sought is a red herring. The key to analyzing the damages is the amount to which the parties agreed; here, payments totaling $20,000. The $45,000 penalty (plus interest and fees) bears no relation to damage from the breach of the obligation to pay that amount. For one thing, the judgment sought far exceeds the amount of the defaulted payments. For another, regardless of how much money that the defendant had paid toward the $20,000, the penalty is the same.

In Greentree, the Court of Appeal held that the correct result was to remove the effect of the penalty provision from the judgment amount awarded, and thus enter judgment for the plaintiff for only $20,000 (plus costs in the trial court and post-judgment interest, which generally are awarded under the civil procedure rules).

Greentree stated it does not matter that the settlement agreement did not use the term "liquidated damages" or "penalty"; what mattered was that the substance of the agreement contained an unenforceable penalty. In an opinion decided last year, it also did not matter that a settlement agreement stated that the judgment upon default was not a penalty, and it even did not matter that the defendant expressly waived any right to contest that judgment. The penalty provision still was unenforceable. Purcell v. Schweitzer, 224 Cal. App. 4th 969 (2014) (plaintiff who settled for $38,000 cannot after default enforce penalty provision allowing recovery of the full $85,000 promissory note on which he sued).

For similar examples of unenforceable penalty provisions in settlements, see Sybron Corp. v. Clark Hosp. Supply Corp., 76 Cal. App. 3d 896 (1978) (plaintiff cannot enforce penalty provision requiring $100,000 judgment upon breach of settlement installment payments totaling $72,000, even though lawsuit sought $144,000); and In re Flashcom Inc., 2013 WL 817399 (Bkrtcy. C.D. Cal. 2013) ($9 million penalty provision unenforceable where debtor failed to pay $62,500 settlement amount).

So what are attorneys to do if they are in the position of the Greentree attorney and wish to compromise a case with an incentive to encourage payment on schedule?

Three approaches are worth considering.

First, the agreement could be drafted to include late fees and penalties of interest on the specific amounts for which a payment was missed. Greentree stated that the judgment would have been enforceable if it were designed to encourage the defendant to make its settlement payments and to compensate the plaintiff for its loss of use of the money plus its reasonable costs in pursuing the payment. To this end, the court analogized to cases approving standard late fees on commercial loan payments.

It is not clear precisely how high a "late payment fee" could be and still constitute enforceable compensation to the plaintiff rather than an unenforceable penalty. But it seems clear that this approach would permit such damages that are only modestly higher than the settlement amount, and nothing close to the level requested in Greentree. A settlement agreement, however, likely could provide that attorney fees incurred in enforcing the award are recoverable as part of the costs, as such fees bear a reasonable relationship to the cost of the breach.

Secondly, an attorney may be able to lay the groundwork for a larger post-default judgment if the defendant expressly admits liability for the full amount sought. Greentree emphasized that the settlement agreement contained no admission of liability; the plaintiff may well have agreed to the $20,000 settlement simply because its success at trial was not guaranteed. Greentree thus suggests that it might have enforced the judgment if, in the settlement agreement, the defendant had admitted liability.

This may make sense in that, with an admission of liability, the full $45,000 would constitute actual damages to the plaintiff, rather than simply a penalty. Put another way, because the plaintiff could proceed to obtain $45,000 at trial, a damages judgment in that amount bears a reasonable relationship to the damages from the breach of a settlement agreement.

Published cases have not yet approved of this approach, but in an unpublished order, U.S. District Judge Dean Pregerson entered a $3.5 million judgment for this reason, even though the settlement amount was much lower. Rose v. Enriquez, 2012 WL 6618261 (C.D. Cal. 2012).

Finally, an attorney may be able to craft an agreement that achieves the outcome of the Greentree settlement agreement while avoiding the issue of liquidated damages entirely.

That is, parties could agree that a full judgment is to be immediately entered, but that it will be satisfied by the completion of a payment plan totaling a lesser amount. This approach would render the agreement governed by the law of accord and satisfaction (see Civil Code Sections 1521-23) rather than by the law applicable to contract defaults.

Settlements of this form are common in eviction cases in Los Angeles, yet they seem uncommon in other civil cases. Commonly invoked in civil cases is the procedure in Code of Civil Procedure Section 664.6, whereby the trial court dismisses a case yet retains jurisdiction to enforce the settlement agreement upon default. The Greentree agreement would run aground in that process.

In contrast, the accord-and-satisfaction approach would involve the court actually entering the larger judgment initially. In that manner, similar substance to that Greentree rejected may fly.

The Greentree settlement agreement at first blush appears to be a solid contract, but its penalty provision is not. An attorney who is drafting a settlement agreement that includes a monetary incentive to encourage payment would do well to understand Greentree and ensure the agreement does not involve an unenforceable penalty.