The following is an update analyzing recent cases of interest:
Two Recent Cases Show How To, And How Not To, Structure Settlement Agreements Calling for Future Payments
Plaintiffs must often accept promises to pay in the future as part of the consideration under a settlement agreement. In order to motivate the settling defendant, plaintiffs want to insist on including in the settlement agreement penalties for failure to make a future payment. Or, instead of “penalty for failure to pay,” make that a “substantial discount for timely payment.” Even if the economic substance is the same, words matter. Two recent California decisions, decided within days of each other, apply the same legal principle to reach opposite results in cases arising from the attempted enforcement of settlement agreements calling for future payments. Mitsuwa Corp. v. Wehba, 2019 WL 3561928 (Cal. App. Aug. 6, 2019) enforces a $2.5 Million incentive for prompt payment. Red & White Distribution, LLC v. Osteroid Enterprises, LLC., 38 Cal. App. 5th 582 (2019), voids a $700,000 penalty for late payment.
Red & White Distribution, supra, began with an action by Osteroid Enterprise, LLC and its principal Eric Oster, to collect on a $1,800,000 promissory note. Red & White alleged that the note was usurious and unenforceable. After the Court granted a motion for summary adjudication on the contract claim, the parties settled the case by entering into a “Payment Agreement” which provided for $2,100,000 in payments by Red & White over a one-year period. Part of the settlement was a stipulation for entry of judgment which stated that in the event of any default in payments, Osteroid could obtain a judgment in the amount of $2,800,000, plus interest and attorney fees, on an ex parte application.
A notice of default and opportunity to cure was served on behalf of Osteroid. In a supplemental brief filed in the enforcement proceedings, Red & White claimed that the settlement obligation had been satisfied during the cure period by a combination of payments by check and the delivery (allegedly acknowledged by an “electronic receipt”) of “32 kilos of pure gold valued at $1,177,000 and $83,000 in cash.” The trial court entered a judgment in the amount of $3,664,655, which included the extra $700,000. The Court informed Red & White that it could file a demand for partial satisfaction of the judgment and request a stay of enforcement pending an evidentiary hearing on the alleged payments.
First, the Court of Appeal held that the trial court was “well within its discretion in declining to give any weight to a ‘receipt’ purportedly containing Osteroid’s electronic signature or testimony offered in support of its authentication.” Under the ruling, Osteroid was free to try again to establish payment. Second, the Court of Appeal vacated the judgment, holding that the additional $700,000 was a liquidated damages provision subject to Civil Code section 1671, which voids such provisions when they are “unreasonable under the circumstances existing at the time the contract was made.” Calif. Civ. Code § 1671(b). The Court held that “the stipulated judgment for $2.8 million bears no reasonable relationship to the range of actual damages the parties could have anticipated from a breach of the agreement to settle the dispute for $2.1 million.”
The opinion states: “[w]e publish to remind practitioners whose clients settle a dispute involving payments over time how to incentivize prompt payment properly, and what may happen if done incorrectly.” The Court cites with approval Jade Fashion & Co. v. Harkham Indus., Inc., 229 Cal. App. 4th 635, 650 (2014), which held that, “it is permissible under section 1671 for the parties to agree to a discount for timely payment of an admitted debt.” The Court then observed that this “is not how the parties in this case structured their agreement. Despite the Osteroid Parties’ repeated claims to the contrary, nothing in the settlement agreement nor the appellate record demonstrates R&W admitted it owed $2.8 million.”
Mitsuwa Corp. v. Webha II, supra., began with an action by Mitsuwa to collect two promissory notes in the principal amounts of $4,000,000 and $4,200,000, respectively. Mitsuwa filed a motion for judgment on the pleadings as to the causes of action for breach of the notes, which was granted as unopposed. The parties then entered into a settlement agreement which provided in part that the defendants “agree to pay Mitsuwa the total amount of Fifteen Million Dollars ($15,000,000) to settle the Action” and that the defendants “agree[d] and stipulate[d] that the rights Mitsuwa is relinquishing by entering into this Agreement have a value in excess of $15,000,000.”
Under the settlement agreement, Webha was required to make two payments of $4 Million and 6.5 Million, respectively. The settlement agreement also stated that if defendants made both payments in full and on time, they would not be required to pay Mitsuwa the remaining $4.5 million. However, if any defendants breached a provision of the Agreement or failed to make timely or complete payments, the full $15 million would be immediately due and payable.
The Court cited Jade Fashion, supra., in holding that “the provision of the Agreement requiring defendants to pay the full $15 million is neither a liquidated damages clause nor a penalty.” The opinion distinguishes a number of cases voiding penalty provisions in settlement agreements, including Vitatech Internat., Inc. v. Sporn, 16 Cal. App. 5th 796 (2017) and Greentree Fin. Grp., Inc. v. Execute Sports, Inc., 163 Cal. App. 4th 495 (2008). The difference, the Court explained, was that “defendants in this case did not agree to settle the underlying dispute for an amount that was disproportionately lower than the amount Mitsuwa could recover as liquidated damages for a breach of the Agreement. Rather, defendants expressly agreed to pay Mitsuwa the same amount of money to settle their dispute ($15 million) that Mitsuwa would be entitled to recover if defendants breached the Agreement.”
In contrast to Red & White, supra., a published decision expressly intended “as a reminder to practitioners,” the Mitsuwa opinion was not published.
In analyzing the $700,000 “penalty,” intended as an incentive for payment, Red & White applies Civil Code section 1671, which invalidates liquidated damages provisions which were unreasonable at the time that the contract was made. On the other hand, Mitsuwa holds that the $4,500,000 “discount,” also intended as an incentive for payment, should not be regarded as liquidated damages in the first place. The holding of Mitsuwa is therefore that any incentive which is denominated as a discount for early payment of an admitted liability need not be shown to be reasonable.
Neither opinion discusses how the penalty/discount amount was arrived at. For example, did it relate to some disputed element of the note obligations themselves (such as usury)? The numbers do not suggest this. The two notes in Mitsuwa totaled $8.2 Million in original principal amount. The opinion does not tell us whether the complaint prayed for damages in the amount of $15 Million or more. These circumstances might be considered relevant in assessing reasonableness, but Mitsuwa, expressly rejects consideration of the underlying dispute in enforcing the settlement agreement.
In both the Red & White and the Mitsuwa cases, defendants who failed to make scheduled future payments under a settlement agreement were required to pay more than if they had made the scheduled payments on time. Characterizing that extra amount as an imposed “penalty” or a lost “discount” is a matter of semantics, not substance. This confused body of law creates another proverbial trap for the unwary.
These materials were prepared for the Commercial Transactions Committee (CTC) by Dean T. Kirby, Jr., Kirby & McGuinn, A P.C., San Diego.