Most lawsuits alleging a breach of contract seek monetary damages—i.e., financial compensation for harm the plaintiff suffered as a result of the defendant’s breach. This is of course subject to proof; plaintiff must prove with reasonable certainty that the damages for which recovery is sought were in fact suffered and were in fact caused by the defendant’s breach. But can contracting parties short-circuit this process by agreeing in advance what the damages for breach will be? Well, as we say in the law: It’s complicated….

A contract provision predetermining the monetary harm for breach is known as one for “liquidated damages.” California Civil Code §1671 governs the use of these clauses. In contracts not involving a consumer or residential lease, a liquidated damages provision will be deemed valid unless it “was unreasonable under the circumstances existing at the time the contract was made.” Caselaw interprets “unreasonable” to mean that the amount “bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach.”

The idea here is that California law eschews contractual penalties—i.e., where a party must pay or lose something by way of punishment or windfall to another, rather than as compensation for actual injury to the aggrieved party. As the old cases say, “The law abhors forfeitures,” and as the modern California Supreme Court has explained, “Courts traditionally have awarded damages for breach of contract to compensate the aggrieved party rather than to punish the breaching party.” The Civil Code speaks directly to this topic as well. Section 3275 provides that parties incurring a forfeiture may be relived therefrom, and need only compensate the harmed party for detriment actually caused. The obvious interplay between these two code sections is that, where the amount is unreasonable, “a contractual clause purporting to predetermine damages must be construed as a penalty.”

Penalties Unenforceable Despite Agreement

Notably, the unenforceability of this type of penalty is a matter of public policy in California. Thus, a court can decline to enforce such a provision even if the party seeking to escape it explicitly agreed to it in the contract. A judgment enforcing a penalty is deemed “void” and subject to vacatur under California Code of Civil Procedure §473(d). Unfortunately, there exists a long line of California cases where a party explicitly agreed to liquidated damages—gaining some advantage in the process—and then attempted to litigate their way out of them after breach, often successfully.

Allowing this practice undermines the main goal of contract law, i.e., that commercial parties enjoy some predictability about the cost of their business relationships. And while the rule against forfeitures is a so-called “maxim of jurisprudence,” permitting a contracting party to wiggle out of its agreement would trample other maxims, for example, that “He who takes the benefit must bear the burden” (Civ. Code §3521).

A Recent Case Upholding a Settlement Agreement

A recent California Court of Appeal decision, Creditors Adjustment Bureau v. Imani, features a Second District panel clearly exasperated at yet another litigant’s attempt to escape his agreed-upon contract provision setting the cost of default in advance. The opening lines set the tone:

Over twenty-five years ago, we stated the unremarkable: “The purpose of the law of contracts is to protect the reasonable expectations of the parties…. There is … a price to be paid for breach of contract.” Here, we protect the reasonable expectations of the parties. And there is still a price to be paid for breach of contract.

The defendant/appellant leased hair salon space from the plaintiff. He soon defaulted, and the plaintiff pursued him for the balance of unpaid rent it had been unable to mitigate, $251,200.13. After some litigation, the parties reached a settlement which they documented in a stipulation for entry of judgment that was signed by all parties and recited in open court. It was exceedingly generous to the plaintiff: He was to pay only $30,000, and in installments! But if he defaulted on the payments, the stipulation provided that plaintiff could “declare the then entire balance due and payable, together with reasonable attorneys‘ fees and costs in the collection of said obligation,” and seek entry of judgment accordingly. Defendant acknowledged that “he has read and agreed to the terms of the stipulated judgment, and that he does not dispute the amount of the stipulated judgment, and further acknowledges that the amount of $251,200.13 is due and owing….”

Defendant did not make a single payment; and so the court entered judgment against him for the full amount of damages. Six years later, however, he filed a motion to vacate, arguing that it was void because the amount of the stipulated judgment bore no reasonable relationship to the damages caused by his failure to pay respondent the $30,000.

By measuring the judgment amount against the harm from his non-payment of the $30,000, defendant was trying to fit into the mold of cases holding liquidated damages unreasonable because they did not fairly approximate the anticipated harm caused by the breach that triggered them. For example, in Ridgley v. Topa Thrift & Loan Assn., the California Supreme Court stated that the damages a liquidated damages provision must bear a reasonable relationship to are those caused “by the breach.” As applied to situations involving breach of an agreement to settle a disputed contractual claim, the Court of Appeal in Greentree Financial Group v. Execute Sports held that the relevant breach to be analyzed “is the breach of the stipulation, not the breach of the underlying contract.” Other Court of Appeal decisions, Purcell v. Schweitzer and Vitatech Int’l v. Sporn, feature the same approach.

The Creditors Adjustment Bureau court, however, held this type of analysis inapplicable to the facts of the case. This was not a disputed claim, but rather an admitted one, given defendant’s acknowledgement that the $251,200.123 was “due and owing.” Thus the court would not focus on the harm cause by breach of the settlement agreement, but rather on that of the underlying contract. Where the amount of a stipulated judgment represents the admitted damages from breach of the underlying contract, no penalty is involved. In fact, such a provision is not even properly considered one for liquidated damages:

We cannot isolate the relevant breach of contract as only the breach of settlement agreement or stipulation for entry of judgment and excluding the underlying contract. Here, the $251,200.13 damage provision in the stipulation for entry of judgment is not arbitrarily drawn from thin air. It is the actual and stipulated amount of damages. This is not a penalty or a liquidated damage provision.

The court distinguished Greentree and Vitatech on the basis that “[t]hose cases involved disputed claims and here, appellant admitted owing the $251,200.13 as unpaid rent, i.e., damages.” Indeed, in the former case, defendant “disclaim[ed] any admission of wrongdoing, fault, liability, or violation of law,” and in the latter, defendant “never admitted liability on the underlying claims or the amount of damages allegedly caused by the breach of the underlying contract.”

Instead, the approach of Jade Fashion v. Harkham was apposite. In that case, Jade Fashion agreed to sell garments to Harkham at an agreed price. After a payment dispute, in a pre-litigation agreement Harkham admitted that it owed Jade Fashion approximately $341,000. It agreed to make weekly payments of $25,000 until the balance was paid, and Jade Fashion agreed to a discount on the final payment if all were timely made. Harkam was late on the payments—but it nevertheless deducted the discount from its final payment. In litigation over the discount, the Court of Appeal held it not an unenforceable penalty or forfeiture because there “was no[] agreement to settle or compromise a disputed claim. Rather, it was an agreement to forbear on the collection of a debt that was admittedly owed.”

Similar guidance is found in another recent case:

[B]ased on Jade Fashion, 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.

An Incentive Provision Requiring Full Payment of the Admitted Amount Due is Enforceable

Practitioners drafting an agreement that seeks to incentivize prompt payment—whether for a business transaction or to settle litigation—need to be aware of the law in this area. Enforceability is better assured when the payor admits the full amount as due and owing, and is merely provided a discount for early payment. If the agreement suggests the amount of the claim is still the subject of dispute, the proponent may be called upon to defend the higher payment as reasonable compensation for the anticipated harm flowing from breach of the lower payment. A treatise advises drafters to “[h]ave the defendant agree to the total amount owing and acknowledge that it is actually due, owing, and undisputed,” and to avoid “the word ‘compromise’ or settlement, but use ‘forbear’ when possible.”

Of course, the equities of the situation can be expected to matter as well. It was not lost on the Creditors Adjustment Bureau court that the defendant breached the initial contract, received a sweetheart deal, breached that second contract, and enjoyed use of the disputed money for years. Enough was enough.