Vitatech International, Inc. v. Sporn: Guidance on Contractual Liquidated Damages Provisions

November 13, 2017

A recent case from the California Court of Appeal highlights the importance of not running afoul of California’s ban on liquidated penalties.

On September 29, 2017, in Vitatech International, Inc. v. Sporn, Appeal No. G053477, the Court of Appeal, Fourth Appellate District, Division 3 reversed the Orange County Superior Court’s ruling that the parties’ stipulated judgment for more than the amount prayed for by plaintiff was not a penalty under California Civil Code section 1671(b) or a liquidated damages provision subject to that statute.

Background

Plaintiff Vitatech International, Inc. (Vitatech) filed a breach of contract lawsuit against several Defendants.  Plaintiff’s complaint sought more than $166,000 in damages.  On the eve of trial, the parties settled for a one-time payment to Vitatech of $75,000.  As part of the settlement, Defendants stipulated to entry of judgment against them “in the full prayer of the Complaint,” but Vitatech agreed to “forbear” from filing the stipulated judgment and to accept the $75,000 “as full Settlement of its claims against Defendants,” if they paid by the designated date.  Defendants failed to pay the $75,000.  Vitatech then filed the stipulated judgment and the trial court entered judgment against Defendants for more than $300,000, which included compensatory damages, prejudgment interest, attorney fees, and costs.

Defendants moved to vacate the judgment under Code of Civil Procedure section 473, subdivision (d) (“Section 473(d)”), arguing that it was an unenforceable penalty per Civil Code section 1671, subdivision (b) (“Section 1671(b)”).  Defendants asserted that the judgment violated Section 1671(b)’s prohibition against liquidated damages provisions that bear no reasonable relationship to the damages likely to be caused by the breach of contract.  Vitatech opposed the motion, arguing the judgment was not a penalty or illegal liquidated damages provision, because Defendants judicially admitted and stipulated to their liability in the full amount of the prayer for relief alleged in the complaint, and the stipulated judgment merely enforced that acknowledgement.  Vitatech contended that the settlement amount was only a discount of the agreed-upon liability to encourage prompt and timely payment.

The trial court agreed with Vitatech and denied Defendants’ motion because it found the judgment’s higher amount was neither a penalty nor a liquidated damages provision subject to Section 1671(b).  Instead, the trial court concluded that the reduced amount Vitatech agreed to accept in settlement was merely a discount if Defendants paid their debt as agreed.  Defendants appealed.

Governing Principles For Liquidated Damages Provisions

California law has long recognized that a provision for liquidation of damages for contractual breach can sometimes be designed as, and operate as, a contractual forfeiture.  To prevent such operation, California’s laws place limits on liquidated damages clauses.  A liquidated damages clause will generally be considered unreasonable, and hence unenforceable under Section 1671(b), if it bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach of the underlying agreement.

The amount set as liquidated damages must represent the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that may be sustained.  In the absence of such relationship, a contractual clause that predetermines damages is an unenforceable penalty.  The validity of the liquidated damages provision depends upon its reasonableness at the time the contract was made and not as it appears in retrospect. Accordingly, the amount of damages actually suffered by the plaintiff has no bearing on the validity of the liquidated damages provision.

Penalty provisions compel performance of an act and usually become effective only in the event of default upon which a forfeiture is compelled without regard to the damages sustained by the party aggrieved by the breach.  The characteristic feature of a penalty is its lack of proportional relation to the damages which may actually flow from failure to perform under the contract.  In short, an amount disproportionate to the anticipated damages is termed a “penalty.”  A contractual provision imposing a “penalty” is ineffective, and the wronged party can collect only the actual damages sustained.

A liquidated damages provision is not invalid, however, merely because it is intended to encourage a party to perform, so long as it represents a reasonable attempt to anticipate the losses to be suffered.  A court will interpret a liquidated damages clause according to its substance, and if it is otherwise valid, will uphold it — even if the parties have referred to it as a “penalty.”  Based on section 1671(b)’s presumption that liquidated damage provisions in non-consumer contracts are valid, the party challenging the provision bears the burden to show that it was unreasonable under the circumstances existing when the parties entered into the contract.

Under Code of Civil Procedure Section 473(d), Defendants May Move to Vacate Stipulated Judgments That Are Unlawful Penalties

The Court of Appeal held that a stipulated judgment that includes an unlawful liquidated damages provision is void and may be vacated under Section 473(d), stating that “[a]ny other rule effectively would insulate such provisions from challenge and render the prohibition against them meaningless.”

The Stipulated Judgment Was an Unenforceable Penalty

The appellate court held that the stipulated judgment was void as a matter of law because no reasonable relationship existed between the damages that could have been anticipated based on Defendants’ failure to pay the $75,000 settlement amount and the stipulated judgment for more than $300,000.  Even though the parties’ stipulation for entry of judgment did not use the phrase “liquidated damages,” its legal effect was the same.  The stipulation attempted to predetermine the amount of damages Vitatech was entitled to receive if Defendants’ breached the stipulation by failing timely to pay the settlement amount. The provision establishing the amount of the stipulated judgment was therefore unenforceable unless that amount bore a reasonable relationship to the amount of damages the parties could have anticipated Vitatech would suffer if Defendants breached their obligation.  The amount of the judgment needed to reasonably relate to the damages likely to arise from the breach of the stipulation, not the alleged breach of the underlying contract, because it was the breach of the stipulation that allowed Vitatech to enter judgment.

Nothing in the stipulation or appellate record established a reasonable relationship between Defendants’ failure to pay the $75,000 settlement amount and the $303,000 judgment.  The parties made no effort to anticipate the damages that might flow from Defendants’ failure to pay the settlement amount.  Instead, the parties simply selected the amount Vitatech had sought as damages in the underlying lawsuit.  The record, however, lacked any evidence suggesting Vitatech was likely to recover all of the damages it sought if it proceeded to trial.  The appellate court concluded that the stipulated judgment illegally penalized Defendants for failing to pay the settlement amount, rather than compensating Vitatech for the reasonably anticipated damages caused by that failure.

The Court of Appeal’s Ruling

The Court of Appeal reversed the trial’s court’s denial of the motion to vacate and directed the trial court to enter judgment on remand for the settled amount of $75,000.  The appellate court also noted that Vitatech was not entitled to attorneys’ fees or prejudgment interest because the parties’ stipulation did not contain provisions for awards of them, and there was no statutory basis to provide them.  However, the court ruled that Vitatech may apply to recover its trial court costs because nothing in the stipulation for entry of judgment relinquished that right when Defendants failed to timely pay.

Thoughts on Stipulating to Money Judgments

Though this author cannot say whether Vitatech would have chosen to proceed to trial had it known that Defendants would breach the settlement and the Court of Appeal would vacate the stipulated judgment, by unwittingly agreeing to the offending terms, Vitatech forced itself to accept an amount that was less than 50% of what its complaint sought, with no right to an award of attorney’s fees or prejudgment interest.

Besides avoiding unlawful liquidated damages provisions, parties in Vitatech’s position would be well-served to require an award of attorney’s fees for work enforcing a breach of the settlement agreement and prejudgment interest at the legal rate of 10% from the time of breach of the agreement to entry of judgment.  The plaintiff might want to also consider requiring the defendant to admit liability, since the Court of Appeal noted that was a problem for Vitatech.  Of course, the difference between the admitted larger sum and the settlement amount must bear some reasonable proportion to the amount of damages the plaintiff would suffer if the defendant defaulted in settlement.

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