Properly drafting settlement agreements with payments

Many mediated settlement agreements provide for payments over time, especially where the party making payments has limited cash flow. A common practice is for the parties to agree upon an acceptable amount, negotiate an installment payment schedule, and provide for entry of judgment for a larger amount in the event of default. Judgment is entered on an expedited, ex parte basis after notice and opportunity to cure. The notion is to motivate the obligated party to make timely payments and avoid default. So long as default does not occur, the lesser sum will satisfy the obligation.

The recent case of Red & White Distribution v. Osteroid Enterprises, 2019 DJDAR 7516 (Cal. Ct. App. Aug. 9, 2019), is yet another stark reminder of the severe consequences when this is done improperly. The holding confirms existing law that a settlement agreement may not include an impermissible penalty by requiring a defendant to pay more than the agreed upon sum in event of default. It is the latest of several California appellate opinions directly on this point. However, the case is noteworthy because the court provides a specific roadmap as to how to "incentivize prompt payments properly" by providing for a discount off an agreed upon sum if payments are timely made.

Red & White Distribution

Red & White Distribution, LLC (R&W) borrowed $1.8 million from Osteroid Enterprises, LLC. After Osteroid declared the loan in default, R&W filed a complaint alleging the loan was usurious and unenforceable. The parties then settled the dispute for $2.1 million pursuant to a "Payment Agreement," which included a schedule with varying installment amounts to be paid by R&W over time. The parties also executed a stipulation for entry of judgment that stated in the event of a default on the payment plan, R&W was "liable to pay $2,800,000 to the Osteroid Parties," less payments made. Years later, Osteroid filed an ex parte application to enforce the stipulated judgment, which the trial court granted. R&W appealed, arguing the additional $700,000 was an impermissible penalty.

The appellate court agreed with R&W and reversed. Generally, California law has viewed liquidated damages after breach of contract as a forfeiture thereby rendering void that part of the contract. Civil Code Section 1671 continues to apply that strict standard to liquidated damages clauses in certain contracts (consumer goods and services, and leases of residential real property). However, as to commercial and business contracts, the law is more liberal: "[A] provision in a contract liquidating the damages for breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made." (Section 1671, subd. (b).)

Liquidated damages are generally considered not enforceable and viewed as a penalty under Section 1671(b) if they bear no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach. The defining feature is the lack of proportional relation between the penalty and the damages that may actually result. Where no proportional relation exists, the wronged party may recover only the actual damages sustained.

In this case, the parties entered into a settlement agreement providing that if R&W defaulted, Osteroid could file a stipulation for entry of judgment, with the amount of the judgment totaling $700,000 more than the settlement amount, plus interest and attorneys' fees. The trial court erred in entering the stipulated judgment because the additional $700,000 was an unenforceable penalty under Section 1671.

How to Properly Incentivize Timely Payments?

The appellate court's opinion provides guidance regarding how to "incentivize prompt payments properly" when drafting a settlement agreement and stipulation for entry of judgment. If the parties stipulate that the debt is a certain number, they may agree that it would be discharged for that number minus some amount. They can also agree that if the debtor does not timely make the agreed payments, a stipulated judgment will be entered for the full amount.

Here, the parties structured their agreement as an impermissible penalty. R&W never admitted it owed $2.8 million. Rather, the settlement agreement stated R&W was "liable to pay to the Osteroid Parties $2,100,000.00 ("Total Payment Plan Amount") plus interest thereon" and provided that judgment would be entered for $2.8 million upon default. Had the parties intended to settle for $2.8 million, but apply a discount for timely payments, they could have done so expressly by including terms in the agreement stating R&W was liable to pay the Osteroid $2.8 million, but so long as all payments were timely made in accordance with the payment schedule, the amount due would be discounted to $2.1 million.

Conclusion

Red & White Distribution provides a cautionary tale in drafting a settlement agreement and stipulation for entry of judgment. However, it also instructs on how to include language that complies with the restrictions on liquidated damages. The settlement agreement must state the larger amount is owed, and then provide for a discount if payments are timely made. Because the agreed-upon number in virtually every negotiated settlement will be less than plaintiff's initial demand, counsel can easily draft the settlement agreement to reflect a larger number that will then be discounted with timely and complete payments. By adhering to these guidelines, parties may draft an enforceable settlement agreement and stipulation for entry of judgment, one that provides incentive to the defendant to timely pay the discounted amount, while also giving the plaintiff some comfort in knowing that an adequate judgment will be entered in the event of default. 