Here’s a not uncommon scenario in California business litigation and employment litigation: Plaintiff sues Defendant in state court for breach of contract for millions of dollars. Perhaps it is a breach of a loan agreement where the borrower failed to pay back the moneys borrowed, or breach of an agreement for goods or services, or a fraud or breach of fiduciary duty claim. The case proceeds through litigation, and at some point the parties agree to settle for a reduced amount, subject to a “payment plan” whereby the settlement amount will be amortized over a set period with installment payments and, perhaps, a balloon payment.
In these sorts of settlement agreements, the parties sign the agreement on Day 1, but Plaintiff will not actually receive the payment until certain dates in the future (i.e. monthly or quarterly). If defendant does not make payments, then plaintiff can seek to enforce the settlement agreement as a breach of contract, which, after all, is a binding agreement among the parties. However, Plaintiff isn’t back where they started, they will only have a claim in the reduced amount. You can see how this can start to be a problem, as the Defendant can keep agreeing to settle at a discount, progressively shaving down the amount they owe to ever smaller amounts.
For this reason, the parties will typically put into the settlement agreement a provision for a stipulated judgment which both parties sign, providing that, if there is a payment default, then judgment will be entered against the Defendant for “x” amount. The parties will typically agree to make “x” an amount that is higher than the discounted settlement. This incentivizes Defendant to honor the agreed settlement. The stipulated judgment will be signed by the parties concurrently with the settlement agreement, with Plaintiff holding onto the judgment in his “back pocket”. Typically, there is language in the settlement agreement providing that, upon default, Plaintiff can have the judgment entered on an ex parte basis (i.e. on a shortened timetable without notice), and that Defendant waives arguments and consents to having the stipulated judgment entered upon a default. The parties will put into their settlement agreement that the Court in the action shall retain jurisdiction to enforce the terms of this Agreement pursuant to California Code of Civil Procedure section 664.6, which provides that, where parties settle their claims, “[i]f requested by the parties, the court may retain jurisdiction over the parties to enforce the settlement until performance in full of the terms of the settlement.”
Here’s where the problem arises, and where we get to the case of Red & White Distribution, LLC v. Osteroid Enterprises, LLC (2019) 38 Cal.App.5th 582, which was decided by the Court of Appeals on August 9, 2019. California Civil Code, section 1671, prohibits contracts from imposing on parties “liquidated damages” clauses that are unreasonable penalties. A liquidated damages clause is a provision in an agreement which seek to “guestimate” the amount of damages if there is a breach of contract, in which case the parties agree that the damages will be an agreed-upon amount. These provisions find themselves in all sorts of loan documents, leases, and other contracts, providing that, upon breach, the borrower will pay a penalty of “x” amount in addition to amounts owed. Civil Code section 1671 is designed to prevent these from becoming unreasonably harsh penalties, by requiring that the liquidated damages amount has to bear some reasonable relation to the estimated actual costs that will be incurred as a result of the breach. In our examples, it’s realistic that breaching a loan or lease will involve increased administrative costs, but to impose an enormous surcharge, for example, six months worth of loan or lease payments, begins to look like an unreasonable penalty.
In Ridgley v. Topa Thrift & Loan Assn. (1998) 17 Cal.4th 970, 977, the California Supreme Court held that a liquidated damages clause will generally be considered unreasonable if it “bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach.” In Ridgley, the Supreme Court looked at the example above and ruled held “the charge of six months’ interest on the entire principal, imposed for any late payment or other default, cannot be defended as a reasonable attempt to anticipate damages from default.” (Ridgley, 17 Cal.4th at p. 981.)
The issue of whether this applied to a stipulated judgment arose in the 2008 case Greentree Financial Group, Inc. v. Execute Sports, Inc. (2008) 163 Cal.App.4th 495, 501, in which the Court held that a $45,000 stipulated judgment constituted an unenforceable penalty where the underlying settlement was for $20,000.
This brings us to Red & White Distribution, decided August 9, 2019: the stipulated judgment was for $2.8 million against a settlement of $2.1 million. The Court rejected this as an unreasonable penalty not permitted by section 1671 because “the stipulated judgment for $2.8 million bears no reasonable relationship to the range of actual damages the parties could have anticipated from a breach of the agreement to settle the dispute for $2.1 million.” The Court explained that the judgment “provided for interest at the legal rate from the date of the execution of the stipulated judgment, attorneys’ fees to enforce the judgment, plus $700,000 more than the parties agreed to in their settlement agreement. This additional $700,000 was an unenforceable penalty.”
From a public policy perspective, in which settlement which makes economic sense for the parties to a dispute should be encouraged, Greentree and Red&White Distribution don’t seem to make a lot of practical sense, particularly given the practical benefit that a stipulated judgment at an amount above settlement incentivizes parties to honor the settlement, rather than have the case proceed in litigation, not to mention costly judgment enforcement processes.
Luckily, Red & White Distribution provides some helpful guidance on how section 1671 issues can be avoided: “if the parties stipulate that the debt is a certain number, they may agree that it may be discharged for that number minus some amount. They may also agree that in the event the debtor does not timely make the agreed payments, a stipulated judgment may be entered for the full amount.” In other words, rather than settling at a given amount with a stipulated judgment in a higher amount (thus triggering penalty issues), drafters should prepare the settlement agreement for the full amount, but include a discount if all payments are timely made.