Liquidated Damages Provisions in Contract Did Not Bear Rational Relationship to Damages from Breach of Agreement

Purcell brought a lawsuit seeking to recover $85,000 he had lent to Schweitzer. The parties settled, agreeing that Schweitzer would pay the sum of $38,000, along with interest at the rate of 8.5 per­cent, in installments over 24 months to Purcell. The agreement provided that if Schweitzer failed to pay on time, it would be a breach of the entire agree­ment and the original liability of $85,000 would be due. The agreement also contained the following language:

• The liquidated damages provision does not con­stitute an unlawful "penalty" or "forfeiture."
• The $85,000 takes into consideration "the eco­nomics associated with proceeding further with this matter."
• Schweitzer waives his right to an appeal, con­test, or set aside the judgment.

Schweitzer failed to make a monthly payment on time, paying it 6 days late. Purcell accepted the payment, even though it was late, and pursued a default judgment against Schweitzer. The trial court entered default judgment in the amount of $58,829.35 with $58,101.85 of that amount identified as consisting of "punitive damages." Schweitzer brought a motion to set aside the judgment. The court granted the motion finding that the damages were an unenforceable penalty because they bore no rationale relationship to the damages Purcell would actually suffer as a result of Schweitzer's breach of the settlement agreement. Purcell ap­pealed, arguing that Schweitzer waived his right to challenge the judgment and that the judgment was enforceable because it fairly represented his dam­ages. The Court of Appeal affirmed that the judg­ment was an unenforceable penalty.

California Civil Code section 1671 states, "A pro­vision in a contract liquidating the damages for the 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." The liquidated damages clause, which set the liquidated damages at the amount of the originally liability, was an unenforceable penalty. The Court of Appeal reasoned as follows:

Liquidated damages must bear a rational relation­ship to the damages the parties anticipate would flow from the breach of the agreement. Here, liquidated damages in the amount of the underly­ing loan obligation did not reasonably relate to damages that Purcell would suffer for Schweitzer's untimely settlement payment.

Damages for withholding money are easily deter­minable (i.e., interest at the prevailing rate). The amount of the trial court judgment was more than triple the settlement amount.

The public policy providing that liquidated damag­es may not act as a penalty cannot be circumvented by contract language.

A party seeking the benefit of a liquidated dam­age clause has the burden to prove that the clause is valid under facts existing at time of settlement. Purcell relied on the settlement agreement lan­guage rather than the actual facts.

Note: Ensure that your liquidated damages provisions are (1) reasonable under the circumstances existing at the time the contract is made, (2) bear a rational relationship to the damages the parties anticipate would flow from the breach of the agreement, (3) nec­essary because actual damages are difficult or impos­sible to prove and (4) are not so large that they act as a penalty. Lastly, do not insert contract language in an effort to avoid these rules.

Purcell v. Schweitzer (2014) 224 Cal.App.4th 969.