A Settlement Agreement’s Liquidated Damages Clause That Bears No Reasonable Relationship To Actual Damages Constitutes An Unenforceable Penalty

In Purcell v. Schweitzer (2014) 224 Cal.App.4th 969, the Court of Appeal disapproved of a settlement agreement providing the entire amount in dispute would be due if the debtor breached the agreement.  The court determined that this would be an unenforceable penalty resulting from any breach.


Schweitzer gave Purcell a promissory note in the principal amount of $85,000.  Schweitzer defaulted on the note, and Purcell brought a lawsuit seeking to recover the monies he loaned Schweitzer.  The parties settled the action through a written stipulation with Schweitzer agreeing to pay Purcell 24 monthly installment payments totaling $38,000 plus interest.  The stipulation provided that a missed payment constituted a breach of the entire stipulation making the original loan amount of $85,000 all due and payable.  The stipulation also provided that this provision did not constitute an unlawful penalty or forfeiture and that Schweitzer waived any right to appeal or to otherwise contest or set aside the judgment. 

After making several timely payments, Schweitzer made one monthly payment five days late.  Purcell accepted the late payment, and Schweitzer ultimately paid the full settlement amount.  Nonetheless, Purcell claimed Schweitzer breached the settlement agreement due to his late payment, and he sought entry of judgment for the full unpaid amount of the original loan.  Purcell received a default judgment against Schweitzer in the amount of $58,829.35.  At Schweitzer's request, the trial court set aside the default judgment finding that it constituted an unlawful penalty, and the Court of Appeal affirmed the trial court's decision.


On appeal, the court  found that requiring payment of the entire loan amount for breach of the settlement agreement constituted an unenforceable penalty. Civil Code section 1671 requires a reasonable relationship between liquidated damages and the amount of damages a party would reasonably expect to flow from any breach of the contract.  This inquiry focuses on damages arising from the breach of the settlement agreement and not any damages related to a breach of the underlying obligation.  Parties cannot circumvent, by words used in a contract, the public policy regarding unenforceable penalties expressed in Civil Code section 1671.

The stipulated amount of damages bore no reasonable relationship to the amount of damages Purcell would suffer due to any breach of the settlement agreement.  The record did not support the argument that obtaining a judgment would cost Purcell $85,000, so the parties could not rely on the waiver language of the settlement agreement.  Thus, the default judgment constituted an unenforceable penalty.


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