In commercial and real estate disputes, the creditor oftentimes agrees to settle his claim for a discounted amount payable in fixed installments over time, but, at the same time, the creditor requires the debtor to secure its payment of the discounted settlement amount by, among other things, having the debtor admit it owes the full amount of the underlying debt and agree to the entry of judgment against the debtor for the full amount of the underlying debt if the debtor fails to pay the discounted settlement amount timely and/or in full. The efficacy of this common practice has been dealt a significant blow in California where the courts have refused consistently to permit a creditor to recover the full amount of the debt following the debtor's breach of the settlement agreement because they perceive the recovery of the full amount of the debt as offending California's prohibition against liquidated damages constituting a penalty.

In Purcell v. Schweitzer (2014) 224 Cal.App.4th 969, Schweitzer defaulted under an $85,000 promissory note to Purcell. After Purcell sued, the parties agreed to settle for $38,000. The settlement agreement explicitly stated that any late payment was considered a breach of the settlement agreement, making the entire $85,000 debt due and payable. Also, Schweitzer signed a stipulation to the entry of a judgment in favor of Purcell in which Schweitzer admitted that $85,000 was the total amount he owed. When Schweitzer was late in making a settlement payment, Purcell filed the stipulation for entry of judgment and obtained a default judgment for approximately $59,000, representing the difference between $85,000 (the full amount of the stipulated debt) and Schweitzer's settlement payments. Schweitzer moved to vacate the judgment, asserting that the $59,000 judgment constituted an unlawful penalty under California law (see California Civil Code section 1671, subdivision (b) which provides that liquidated damages are enforceable unless the party seeking to invalidate the provision shows that the provision was unreasonable under the circumstances existing at the time the provision was made). The trial court set aside the judgment, holding that the damages sought by Purcell violated California's prohibition against liquidated damages because the $59,000 judgment did not bear any rational relationship to the damages Purcell would actually suffer as a result of Schweitzer's breach of the settlement agreement.

On appeal, the court affirmed the trial court's ruling, relying heavily upon Greentree Financial Group, Inc. v. Execute Sports, Inc. (2008) 163 Cal.App.4th 495. In Greentree, the court refused to enforce a stipulated judgment for nearly $40,000 more than the amount that the parties had agreed to settle for, holding that the stipulated judgment constituted an unenforceable penalty because it did not “merely compensate the plaintiff – it reward[ed] the plaintiff by penalizing the defendant.” The court reasoned that because the stipulation for judgment bore no reasonable relationship to the amount of damages the plaintiff could have reasonably expected would result from the defendant's breach of the settlement agreement, the stipulated sum constituted an unlawful penalty. Likewise in Purcell, the court held that the relevant breach to be analyzed was Schweitzer's breach of the settlement agreement, and not the breach of the underlying contract between Schweitzer and Purcell. Affirming the trial court's ruling, the court held that the $59,000 judgment bore no reasonable relationship to the damages that Purcell could have expected to suffer as the result of Schweitzer's breach of a $38,000 settlement agreement.

Greentree and Purcell left many creditors fearful that no matter how carefully they crafted settlement agreements and stipulated judgment provisions, such provisions could be viewed as imposing impermissible penalties. It did not help that Greentree and Purcell placed California in the minority of states on this issue. Many states have adopted the view that agreements like those in Purcell and Greentree are in the nature of accord and satisfaction agreements in which the creditor suspends the debtor's obligations to pay the underlying (i.e., existing) debt, provided that the debtor makes all of the agreed upon settlement payments. After the debtor fully performs under the settlement agreement, the underlying debt is extinguished. On the other hand, if the debtor does not fully perform under the settlement agreement, the underlying debt is not extinguished, and the creditor may declare a breach and proceed to enforce the underlying debt. California appears to take the view that at the moment the creditor and the debtor enter into the settlement agreement, the underlying debt is immediately extinguished and is no longer enforceable. In essence, the settlement agreement is an entirely new agreement that has replaced the underlying debt for all purposes.

It is with this background that the California Court of Appeals recently decided Jade Fashion & Co., Inc. v. Harkham Industries, Inc. (2014) 2014 Lexis 807. The Jade court held, under circumstances ostensibly similar to those set forth in Greentree and Purcell, that offering a discount for the timely repayment of a stipulated sum did not constitute an unlawful penalty.

In that case, the parties entered into a forbearance agreement pursuant to which Harkham Industries agreed to make weekly payments to Jade, provided that if all such payments were timely made, Jade would "discount" Harkham's final payment by $17,500. The agreement further provided that time was of the essence and included an acknowledgement by Harkham that the amount claimed by Jade was, in fact, the full amount due. Although Harkham remitted all of the required payments to Jade, several of those payments were late. Despite this fact, Harkham nevertheless discounted the final payment it made to Jade by $17,500, asserting that because it had made all of its required payments it was entitled to the discount. Jade countered that the plain language of the forbearance agreement explicitly stated that Harkham was only entitled to the discount if it made all of its payments on time. When Harkham refused to pay the $17,500 to Jade, Jade initiated legal proceedings to collect the additional amount.

Harkham argued that, like the default provisions in Greentree and Purcell, the $17,500 discount was an impermissible penalty because it bore no reasonable relationship to the damages that Jade actually suffered as a result of Harkham's late payments. The Court of Appeals, however, distinguished Greentree and Purcell, reasoning that the parties in those cases agreed to settle their pending lawsuits for a stipulated sum that was less than the damages allegedly due to the creditor. If the defendant then breached the settlement agreement, it would be required to pay an additional amount of damages that was higher than the agreed upon settlement amount. The Jade court held that in contrast to the settlement agreements in Greentree and Purcell, the agreement between Jade and Harkham was not an agreement to settle a disputed claim, but rather it was an agreement to forbear on the collection of a debt that was undisputedly and admittedly owed to Jade.

The court further noted that the express language of the forbearance agreement “established that the $17,500 discount was not liquidated damages for a breach of contract, nor was it an additional payment over and above any debt that was owed. Instead, the $17,500 was part of the [underlying] debt which Harkham Industries specifically admitted it owed to Jade Fashion...” As such, the court held that California's prohibition against liquidated damages constituting a penalty did not apply because Harkham expressly agreed to pay the entire balance of the underlying debt to Jade and to take the $17,500 discount only if it paid each weekly installment on time.

Despite the court's ruling in Jade, creditors would be wise to view the court's decision as muddying the waters, rather than providing clarity. For example the Jade court distinguished itself from Purcell and Greentree by stressing that the parties in those cases agreed to enter into a settlement agreement during the pendency of litigation, whereas Jade involved a forbearance agreement made before any litigation was commenced. In most jurisdictions, other than California, it makes no difference whether the settlement agreement goes into place before or after litigation commences. Whether or not this difference in timing proves determinative in California is yet to be seen. For now, perhaps it would be best to keep the following tips in mind when preparing workout agreements:

  • Include an affirmative representation from the debtor that the total debt is due and owing and is not disputed.
  • Craft the agreement as a forbearance agreement, as opposed to a compromise, settlement or novation, pursuant to which the creditor agrees to not enforce the underlying debt as long as the debtor performs its obligations under the forbearance agreement.
  • Clarify that any breach of the forbearance conditions will result not in the imposition of an impermissible penalty, but rather in the termination of forbearance and the institution of the debtor's obligation to pay the full amount of the debt.
  • Consider obtaining and entering a confession of judgment on the underlying debt due and owing to the creditor, and under the forbearance agreement, forbear from enforcing the judgment so long as the debtor makes the settlement payments.
  • Consider obtaining and entering a stipulated judgment against the debtor for the full amount of the underlying debt, and under the forbearance agreement, forbear from enforcing the judgment so long as the debtor makes the settlement payments.

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