If your business has been sued over a debt it couldn’t pay, can it settle the lawsuit? The answer is yes. It can often settle and pay the amount owed in installments over time. But don’t believe your ears. There is a subtle catch. The settlement agreement may include a “stipulated judgment as security” clause. This says if you are late on one of your installment payments the creditor can get a judgment entered for the original full amount. The creditor doesn’t have to wait for you to completely stop making payments. These clauses also say the judgment is “not a penalty” and you can’t appeal the judgment or take any other action against it. Why would anyone agree to such a crazy provision that can have such disastrous consequences for small business? Because it’s how they get the deal done.
Purcell V. Schweitzer (2014)
But a California appellate case, Purcell v. Schweitzer (2014), shows that a clause like this can be beaten.
Here’s what happened. A creditor sued for $85,000 on an unpaid debt. The parties reached a settlement, and the creditor agreed to accept $38,000 in 24 monthly payments, with 8.5% interest on the unpaid principal balance. All payments were to be due on the first of each month, and to be timely were required to be received by the 5th. Any late payment constituted a default of the entire settlement. If the debtor defaulted, the agreement provided for entry of judgment for the full $85,000. The agreement further provided that the amount of $85,000 reflected the “economics” of the additional proceedings, and that it was not a penalty or forfeiture; it also included a waiver of any right to appeal or set the judgment aside.
When the debtor was late on one payment (the first time), the creditor obtained judgment for $85,000. But the creditor then accepted the late payment, and all payments thereafter until the settlement, including interest, had been paid in full. The debtor filed a motion to set aside the judgment, and the trial court granted the motion, characterizing the agreement as a penalty. The Court of Appeal affirmed.
An Unenforceable Penalty
Why did the court side with the debtor? The creditor argued that its agreement required full adherence to all the terms of the agreement, including due dates for payment. Sure, the parties said they agreed on the dollar amount, and that it wasn’t a penalty. The court looked past that and applied California’s rule on liquidated damages clauses. These provisions are enforceable unless unreasonable under the circumstances existing at the time the contract was made. (Civ. Code § 1671(b).) Put another way, if the stipulated damages are a reasonable estimate of the damages that would flow from breach at the time the contract is made, then it is an enforceable liquidated damages clause and not a penalty. A liquidated damages clause is an unenforceable penalty “if it bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach.” (Morris v. Redwood Empire Bancorp (2005).) If it looks like a duck, walks like a duck, and quacks like a duck, it’s probably a duck. (Or, a penalty.)
In this case, the relevant breach was the breach of the settlement agreement, not the underlying contract. The creditor had agreed to take $38,000, and the stipulated judgment was for $47,000 more than what it got in settlement. The $85,000 stipulated judgment bore no reasonable relationship to the damages resulting from the breach of the settlement, and was thus a penalty.
Notice something else about the agreement in Purcell. The debtor had signed away its right to appeal and any right to contest or set aside the judgment. The debtor challenged it anyway. And it won. The reason? The public policy behind section 1671 “may not be circumvented by words used in a contract”; it depends on the actual facts when the contract was entered. Keep in mind the debtor had to pay the full settlement amount of $38,000, plus interest. The court’s decision helped the debtor avoid the extra judgment, not avoid paying the agreed amount in the settlement.
Pay Attention to the Default Provisions
A lesson for creditors’ lawyers: your default amount should be an amount that in good faith the parties believe will accurately reflect the loss the creditor would suffer due to the breach of the settlement agreement, reflecting an average compensation for that loss. In other words, it should fairly represent the amount the creditor would actually lose. It’s not uncommon for installment settlements to have “stipulated judgment as security” clauses. Most courts (including the court in Purcell) have held liquidated damages provisions that exceed the settlement amount and reasonably related added expenses as impermissible.
So, can a business judgment be settled? Yes, and a settlement is still most often the best resolution for a business facing a collection lawsuit. A compromise is almost always better than a hard fight, but it depends on what that compromise will cost you. But do pay attention to the default provisions. Be aware of the payment deadlines. In Purcell, a payment only counted if received by the 5th of the month. And don’t let the default amount you are agreeing to be based on the full amount of the claim. A better clause would make clear that if the debtor defaults on a payment, then the creditor could get a judgment for the remaining balance of the settlement amount (and any added expenses reasonably incurred), not the entire original claim amount. If the default clause in the creditor’s draft settlement agreement spells out a default penalty of judgment for the full amount of the original claim, then you should probably challenge the agreement before you sign it.
This post has discussed, at a high level, an area of law that can be quite complicated, depending on the precise wording of the installment plan and of any default provision. It is only a brief overview.
You want to be very careful about entering into a settlement agreement that lets the creditor pursue its original claim if you default. Those kinds of agreements are risky, and usually not in the interests of the business owner. Don’t just assume that the creditor will be reasonable. Check carefully. It’s on you to make sure you know what the contract says before you agree to it.
