A recent California Court of Appeals decision calls into question contractual provisions which expressly waive public policy prohibiting unreasonable liquidated damages clauses. In Purcell v. Schweitzer (March 17, 2014, D063435) __ Cal.Rptr.3d __ [2014 WL 1004430] (“Purcell”), the Court of Appeals concluded that a stipulated judgment in the amount of $58,829.35, which was granted after a party to a settlement agreement was six days late in making a settlement payment, constituted an unlawful liquidated damages clause even though the settlement agreement expressly provided for such a stipulated judgment in the event of a breach and further stated that such a judgment is for an “agreed upon amount” and “is neither a penalty nor is it a forfeiture.”
The Background Facts
In Purcell, defendant Michael Schweitzer owed plaintiff Lennox A. Purcell funds pursuant to a promissory note in the amount of $85,000. After the borrower defaulted on the promissory note, Mr. Purcell brought a lawsuit to recover the loan, and the parties ultimately settled for $38,000 plus interest at the rate of 8.5 percent, to be paid to the lender in installments over 24 months. Under the terms of the settlement agreement, the borrower was to make an initial payment of $20,000, followed with monthly payments of $750, ending with a final balloon payment of all remaining principal and accrued interest. Payments were due on the first of the month, and in order to be considered timely, the payment had to be received by the fifth day of the month. Any late payment was considered a breach of the entire settlement agreement, making the entire original liability of $85,000 due. Further, the stipulation for entry of judgment attached to the settlement agreement expressly stated that the $85,000 was “neither a penalty nor [was] it a forfeiture” and that this amount took into consideration “the economics associated with proceeding further with this matter. . . .” The settlement agreement also stated that the borrower waived any right to an appeal and any right to contest or otherwise set aside the judgment.
For over a year, the borrower paid the installments on time, as expected under the settlement agreement. However, about a year and half into the installment deal, with just a few scheduled settlement payments remaining, the borrower was six days late in making his monthly payment. The lender accepted the payment but nevertheless immediately moved and obtained a default judgment in the amount of $58,829.35, with $58,101.85 of that amount characterized as “punitive damages.” After the borrower made the final two installment payments, he moved to vacate the stipulated default judgment, asserting that it was an impermissible penalty under California Civil Code section 1671, subdivision (b). The trial court vacated the default judgment, finding that the damages sought by the lender did not bear any rational relationship to the damages the lender would actually suffer as a result of the borrower’s breach and that the borrower’s express waiver of his right to challenge the default judgment was unenforceable as against public policy.
The Appellate Court’s Analysis
The Court of Appeals affirmed the trial court’s order. In doing so, the Court of Appeals cited Greentree Financial Group, Inc. v. Execute Sports, Inc. (2008) 163 Cal.App.4th 495 (Greentree) for its analysis in a case with very similar facts. The Greentree court explained that under California Civil Code section 1671, subdivision (b)1, “a liquidated damages clause constitutes 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” and that “[t]he 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 such a relationship, “a contractual clause purporting to predetermine damages ‘must be construed as a penalty.’” The Court of Appeals also agreed with the Greentree court’s assertion that the “relevant breach to be analyzed ‘[was] the breach of the stipulation, not the breach of the underlying contract.’”
The lender argued Greentree did not apply because the court “was not confronted with a situation where the [borrower] provided an ‘express waiver’ of any challenges to the stipulated judgment ‘on any basis.’” However, the Court of Appeals in Purcell rejected this argument and noted that “the public policy expressed in Civil Code section 1670 and 1671 may not be circumvented by words used in a contract.”
Thus, the Court of Appeals found that the stipulation that allowed for entry of judgment in the amount of nearly $60,000, when the underlying settlement agreement was for only $38,000, bore no reasonable relationship to the damages that the lender could be expected to suffer as the result of a breach by the borrower and thus constituted an unenforceable penalty. Further, the Purcell court concluded that the lender had “suffered no damages at all because judgment was entered . . . after payment was accepted. . . .”
The Court of Appeals also rejected the lender’s contention “that the $85,000 amount under the liquidated damages clause reflected the economics associated with ‘proceeding further’ with the lawsuit” because “nothing in the record [supported] the fact that obtaining a judgment and instituting postjudgment procedures would cost $85,000.” The Court of Appeals pointed out that the lender entered a default judgment attributing $58,101 of the total default judgment amount of $58,829.35 as “punitive damages” and not for costs associated with pursuing the lawsuit. Further, the Purcell court also noted that the language in the stipulation seeking to tie the maximum stipulated judgment amount of $85,000 to the economics of proceeding further with the matter “was an obvious attempt to circumvent the public policy expressed in section 1761,” which could not “be circumvented by words used in a contract.” The Court of Appeals also placed the burden of proving the validity of a liquidated damages clause on the party seeking the benefits of the clause: “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” when the parties entered into the contract. Finally, the Court of Appeals held that judgment was improperly entered as “punitive damages because punitive damages are not recoverable in breach of contract actions.”
A few key lessons can be derived from Purcell. First, even where the parties include a liquidated damages clause or late fee in a contract, settlement agreement, promissory note, consumer contract, or elsewhere, and further agree that these damages or late fees are not to be considered “penalties,” California law will not enforce such liquidated damages clauses and late fees if they bear no reasonable relationship to the amount of liability under the contract and the range of actual damages that the parties could have anticipated would flow from the breach. A penalty is a penalty, whether or not the parties characterize it as such. Second, the Purcell court requires that the party seeking the benefits of a liquidated damages clause or late fee “plead and prove” that the clause or late fee was valid at the time the parties entered into the contract. Thus, liquidated damages must be supported by facts showing the potential damage the party seeking to enforce the liquidated damages clause will suffer as the result of a breach of the contract. Liquidated damages must reflect a reasonable approximation of actual damages flowing from the breach rather than an unsupported punitive amount. Submission of evidence concerning the actual costs of collection, including attorneys’ fees and costs, will certainly prove extremely important if a liquidated damages clause or late fee is challenged as an unlawful penalty under section 1671, subdivision (b).
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This article was originally published by Bingham McCutchen LLP.