July 2017

                                                        Penalizing Penalty Provisions

                                                                Roger Bernhardt

       Introduction

I was happy with the outcome in Krechuniak v Noorzoy (2017) 11 CA5th 713 (reported at p 91), but I am not sure how much general good it will do for other litigants attempting to settle their disputes. That plaintiff had sued her brother for allegedly defrauding her out of some $1.7 million in a real estate deal, and then she settled her claims against him. The settlement was for $600,000, of which amount $100,000 was to be paid immediately and the remaining $500,000 was to be paid in installments over the next 5 years, with a proviso in the settlement agreement that she could have a judgment against her brother for $850,000 ($250,000 more than the $600,000 settlement amount) if he defaulted on those installment payments. When he did default, the trial court entered an $850,000 judgment against him and the court of appeal affirmed.

This appellate affirmance was explained not only in terms of the logic of our liquidated damages statute (CC §1671), but also procedurally, in terms of the scope of appellate review and as a consequence of the brother’s not having properly raised any question at the trial court level about the validity of that $250,000 kicker. I suspect other courts may use these procedural peculiarities to explain away this result and to permit them to ignore the substance of the outcome, although such a narrow reading disregards the legitimate needs of parties to be able to make enforceable agreements of this sort.

           The Dangers of Installment Settlements

The sister had understandable reasons for distrusting her brother’s ability or willingness to pay her the $600,000 that she had agreed to accept in settlement. What guaranty was there that he would thereafter keep his promise to pay her $600,000 after he had already failed to honor his other obligations to pay $1.7 million, and what could she then do if he breached a second time? Would an unpaid judgment of $600,000 do her any greater good than one for $1.7 million? These concerns are probably what led her attorney to draft the settlement with the kicker that the brother would have to pay $850,000 if he failed to pay $600,000. The need for such pressure is something that anyone who has ever been stiffed on a promise to repay can appreciate, but sympathy does not make such an arrangement any easier to accomplish.

Luckily, the sister’s attorney, seeming clearly aware of these difficulties—and assisted by apparently indifferent opposing counsel, who did not appear alert to the issues until appeal time—included in the settlement agreement recitals stating that the $250,000 kicker was not a penalty and that the settlement amount did not compensate her for all her losses, involved her giving up a probably successful claim, and was motivated by family feelings. The settlement proviso added it was designed to encourage prompt payments and, finally, acknowledged that it was designed to get around the decision in Greentree Fin. Group, Inc. v Execute Sports, Inc. (2008) 163 CA4th 495 (in which a settlement that provided for installment payments of less than half of the amount originally claimed, and also included a provision that a judgment for the entire original amount would be entered if those installments were not paid, was held invalid). The appellate court in Greentree had certified its opinion for publication in order to make known its conclusion that the settlement “constitutes an unenforceable penalty because it bears no reasonable relationship to the range of actual damages the parties could have anticipated would flow from a breach of their settlement” (i.e., damages for breach of an agreement to pay $20,000 just could not equal $45,000). 163 CA4th at 497. There was a serious discrepancy between those numbers even if $45,000 was also the original amount owed. See also Harbor Island Holdings v Kim (2003) 107 CA4th 790, reported at 26 CEB RPLR 149 (July 2003), in which a lease provision that doubled the rent if the tenant breached was held invalid even though it was disguised as a rent reduction for tenant compliance rather than a rent increase for noncompliance.

The basis of those decisions is Ridgley v Topa Thrift & Loan Ass’n (1998) 17 C4th 970, reported at 21 CEB RPLR 110 (May 1998), in which a loan provision permitting a borrower to prepay its loan without penalty, only as long as he was not otherwise in default, was held by our supreme court to constitute an invalid penalty (for otherwise not making timely payments) and was not justifiable as a lawful prepayment clause. Ridgley was a decision that fit well within our body of mortgage law prohibiting a lender from collecting a pound of flesh when a band-aid would cover the scratch. (See my column, Not Otherwise in Default, 20 CEB RPLR 238 (Oct. 1997), available at http://rogerbernhardt.com/index.php/ceb-columns/169-not-otherwise-in-default-prepayment-clauses).

          Penalties in the Deposit Context

One of the manifestations against creditor overreach can be seen in the judicial distrust of liquidated damages provisions in real estate sales contracts. There, it is customary for purchasers to accompany their offers with deposits (to show they are in earnest) and for their purchase contracts to provide for the forfeiture of such deposits if they breach. Indeed, many jurisdictions uphold a seller’s retention of the deposit after a buyer’s breach. (See ALR Anno, Modern Status of Defaulting Vendee’s Right to Recover Contractual Payments Withheld by Vendor as Forfeited, 4 ALR4th 993 (1981).) But in California, our supreme court held that such retention of a deposit could constitute improper forfeiture of that deposit, contending: “If defendant is allowed to retain the amount of the down payment in excess of its expenses in connection with the contract it will be enriched and plaintiff will suffer a penalty in excess of any damages he caused.... in effect punitive damages.” Freedman v Rector of St. Matthias Parish (1951) 37 C2d 16, 19, 21.

Similar to the rule against clogging in mortgage law, the Freedman court added a prohibition on accomplishment of the same result through the back door, saying (37 C2d at 23):

The provision of the contract providing that on plaintiff’s default defendant could retain the down payment cannot be enforced as a valid clause providing for liquidated damages. Although such a provision in a contract for the sale of real property is presumptively valid, if the down payment is reasonable in amount, when as in this case the evidence establishes that it would not ‘be impracticable or extremely difficult to fix the actual damages’, such a provision may not be enforced as one for liquidated damages.

The chilling effect that Freedman’s stern language had on the realities of the real estate market was one of the causes of the 1976 revision of CC §1671 and the reversal of our statutory hostility to liquidating damages generally. Thus, our amended version of §1671 provides that a liquidated damages provision is valid unless the other party establishes it “was unreasonable under the circumstances existing at the time the contract was made,” rather than vice versa. CC §1671(b).

But this revised statutory requirement still requires the proponent of a liquidated damages provision to satisfy a reasonableness test, which the sister likely could not have passed. (How could she justify that $850,000 would be owed if $600,000 were not paid?) Indeed, it is a common problem for sellers wanting to keep their defaulting buyers’ deposits in rising markets, and a reason why the legislature also enacted CC §1675(c), which makes a clause providing for a residential seller’s retention of a downpayment presumptively valid if it does not exceed 3 percent of the price. Reasonableness is theoretically still a requirement, but its scope is narrower (“taking into account ... the circumstances existing at the time the contract was made [and the terms of any subsequent resale]”) (CC §1675(e)) and its impact is effectively mooted by the inclusion of this alternative bright-line standard. So, attorneys and brokers advise their buyer clients in terms of making deposits of over or under 3 percent more than they do about the role of the reasonableness of the amount.

But we do not have a similar statute affording parties a similar safe harbor for their inclusion of installment kickers, even though that might make settlements easier to reach. As it is, without any statutory salvation, safe advice is harder to give.

              The Difficulty of Proving Reasonableness

Boilerplate recitals not tailored to the particular situation, such as family affection or the existence of children, are not likely to do a party much good. Justifications in terms of how much of a sacrifice is being made may appeal to the heart but are unlikely to be held to legitimately relate to the probable losses following a breach. (Nor is clever drafting, such as decreasing the amount in the event of performance instead of increasing it in the event of breach, as in Harbor Island Holdings v Kim, cited above). Perhaps some security can be demanded, but one must be careful that reaching it is not seen as just another forfeiture by a greedy creditor—what if there is a mismatch between the value of the security and the amount of the settlement? Overall, kickers are probably next-to-impossible to draft, useful as they may be.

There is probably only one certain piece of advice to give about drafting kicker provisions—that you not rely on the assistance of opposing counsel in making this agreement, even if such help is offered. Your adversary would probably like nothing better than to see you propound a settlement agreement that is ultimately found to be unenforceable. Your own client is far likelier to welcome such an agreement that is held unenforceable, even if it does make you appear to be somewhat incompetent!

40 Real Property Law Reporter  79 (Cal CEB July 2017), © The Regents of the University of California, reprinted with permission of CEB.