California’s public policy has long been to encourage settlement over litigation in the interests of efficiency and economy for the courts and for the parties involved. See, e.g., Kaufman v. Goldman, 195 Cal. App. 4th 734, 745 (2011); Osumi v. Sutton, 151 Cal. App. 4th 1355, 1359 (2007); Zhou v. Unisource Worldwide, Inc., 157 Cal. App. 4th 1471, 1475 (2007); Brown v. Guarantee Ins. Co., 155 Cal. App. 2d 679, 696 (1957). This February, however, in Purcell v. Schweitzer, 224 Cal. App. 4th 969 (2014), the Fourth District Court of Appeal declined to enforce a liquidated damages provision in a settlement agreement on the basis that the damages were actually a penalty provision unrelated to actual damages arising from the breach of the settlement agreement. This decision raises the prospect that the terms of carefully negotiated and crafted settlement agreements will themselves be subject to litigation and potential invalidation by California courts.
The dispute in Purcell involved a settlement of a suit arising from Schweitzer’s default on a $85,000 promissory note to Purcell. The settlement agreement stated that Schweitzer would pay Purcell $38,000 plus interest over 24 months, with a $20,000 initial payment followed by installment payments due on the first day of each month. The stipulation central to this case stated that if any payment was not made by the fifth day of the month, it would be considered a breach of the entire settlement agreement, and a judgment for the original liability of $85,000 could be entered against Schweitzer. The settlement agreement stated that this provision was “neither a penalty nor . . . a forfeiture,” and explained that the $85,000 took into account, inter alia, limiting future attorney’s fees, “elimination of uncertainties relating to collection of a Judgment in contrast to a full, voluntary payment and performance by Defendant,” and “the public policy of judicial economy.” The agreement further included a provision waiving Schweitzer’s right to appeal or otherwise contest a default judgment.
After 18 months of timely payments, Schweitzer was six days late on a single payment. Accordingly, Purcell sought and obtained a default judgment for $58,829.35. Purcell also accepted Schweitzer’s late payment and his subsequent monthly payments until the entire amount due under the settlement agreement was paid.
Schweitzer brought a motion to set aside the default judgment, arguing that the liquidated damages provision of the settlement agreement was an unenforceable penalty for breach. The trial court agreed. The Fourth District Court of Appeal affirmed, finding the stipulation allowing for default judgment “an unenforceable penalty” because, at nearly $60,000, it could have no reasonable relation to actual damages Purcell would suffer from a single late installment payment of about $750.
The court, relying on Greentree Financial Group, Inc. v. Execute Sports, Inc., 163 Cal. App. 4th 495 (2008), held that the test for whether stipulated damages constitute an unenforceable penalty or an enforceable liquidated damages provision centers on whether the damages were a reasonable anticipation of harm caused by breach of the settlement agreement, not of the underlying loan contract. The facts of Greentree were similar; there, the underlying default was $45,000, and the settlement was for $20,000 in two installments with a judgment for the full $45,000 plus interest in the case of default. The key difference, however, was that the settlement agreement in Greentree did not include any provision attempting to clarify that the default judgment was not a penalty. Although the Purcell settlement agreement included such clarification, the court held that the language denying the stipulation was a “penalty” had no import because “public policy may not be circumvented by words used in a contract”—thereby foreclosing the possibility that a more carefully drafted provision might have been enforced.
The Fourth District Court of Appeal’s analysis focused on California policy disallowing penalty provisions in contracts, ignoring the countervailing policy of encouraging settlement. See e.g., Kaufman, 195 Cal. App. 4th at 745 (recognizing the “strong public policy favoring settling of disputes”). Though settlements are evaluated under the same legal standards as other contracts, there are several reasons why settlement agreements might deserve broader deference than contracts generally merit.
First, settlement agreements are usually entered into with the considered advice of attorneys on both sides, and are presumably highly negotiated; this diminishes concerns a court might otherwise have about, for example, contracts of adhesion or imbalances in information or bargaining power. The Purcell case is a particularly clear example of the foregoing, as the settlement agreement expressly sought to show that the agreed-upon amount was reasonably connected to the anticipated harm to Purcell by stating that neither party considered it a penalty and by explaining that the $85,000 amount took into account “the economics associated with proceeding further with this matter.” It is likely that, in deciding to settle with a party who had already proven himself to be unreliable in making payments, Purcell relied on the inclusion of a strong incentive for Schweitzer to make his settlement payments.
Second, negotiations over settlement agreements occur in the shadow of an already extant dispute, with the increased knowledge that brings of damages and litigation costs, adding to both parties’ negotiating capability.
Third, a primary attraction of settlement is often the ability to avoid litigation costs. The risk of being required to litigate over the terms of a settlement agreement could greatly diminish this benefit, thereby significantly working against California’s policy to encourage settlement over litigation.
Though the facts make Schweitzer’s case sympathetic—he was liable for an extra $58,000, despite being only six days late on one payment and having paid the entire liability by the time of the default judgment—it is easy to imagine a more borderline fact pattern where, in the absence of a substantial liquidated damages provision, a party would fail to make many or most of its payments on time. Additionally, the inability to enforce such damages provisions in settlement agreements may make parties in Purcell’s position less likely to settle, thereby making it much harder for parties that have defaulted on a loan to obtain a settlement allowing for installment payments with a discount from the original liability.