Recent California court cases have invalidated a common practice used to collect from delinquent debtors, but there is another strategy which gives hope.
When dealing with a non-paying customer who claims a current shortage of funds, many businesses will agree to a payment plan. The payment plan often provides for a reduced amount if the payments are made on time but, in the event of default, the full amount is due. It is this last element -- the “default penalty” -- which is in dispute.
Over the past few years, three decisions of the California Courts of Appeal have addressed this issues. Though they at first appear to conflict, careful drafting may provide a solution.
In two of these cases, Greentree Financial Group, Inc. v. Execute Sports, Inc., 163 Cal. App. 4th 495 (2008), and Purcell v. Schweitzer, 224 Cal. App. 4th 696 (2014), the Court of Appeal invalidated judgments for the total amount sought after the debtor had defaulted on an agreement to make payments which totaled less than the full amount sought. In both cases, the Court of Appeal ruled that the default penalty constituted impermissible liquidated damages, even though, in one case, the agreement contained language to validate liquidated damages.
A third recent case, however, reached a different result. In Jade Fashion & Co., Inc. v. Harkham Industries, Inc., 229 Cal. App. 4th 635 (2014), the parties agreed to settle a $341,000 claim with a $17,500 discount. The Court of Appeal ruled that the agreement was a “forbearance agreement” and upheld it. The court also ruled that the $17,500 was part of the original $341,000 debt, so it was not an unlawful penalty or forfeiture. The settlement documents included an acknowledgement of the full debt and a statement that “time is of the essence.”
All three of these cases remain good law. Until the California Supreme Court addresses the issue, some uncertainty will remain. Until then, the best approach is to look to the Jade Fashion case for guidance.
Though there is no guarantee, the documents should state that:
• the title should be “Forbearance Agreement“ and not “Settlement Agreement”
• the total sum is not disputed; instead, the parties affirm that the full amount is due and owing
• the payments should add up to the total amount due without discount
• if debtor makes each payment when due, then it may deduct the [agreed-upon discount amount] from the final payment due
• the discount is conditioned upon timely full payments; i.e., “Time is of the essence with respect to each of the payments set forth herein and, if debtor fails to make full and timely payment, then debtor shall not be entitled to the [agreed–upon discount amount] and the remaining balance due shall be immediately due and payable.”
• the agreement is not to settle or compromise a disputed claim, but instead to forbear on the immediate collection of the full amount
• any discount is neither liquidated damages nor an additional payment above the debt owed but instead is part of the full debt admittedly owed
• the discounted amount due is an inducement for prompt and earlier payment and not a compromise of the actual amount owed
• breach will result in the cessation of forbearance and enforcement of the debtor’s agreement to pay the amount actually due
The moral: A discount for prompt performance is different than a penalty for non-performance.
Kenneth L. Perkins, Jr. specializes in business litigation and counselling. Mr. Perkins has litigated cases in both state and federal courts at the trial court and appellate levels, as well as before related government agencies. Mr. Perkins has used various methods of alternative dispute resolution to his clients’ advantage, including arbitration, mediation and private judges.
Mr. Perkins' experience encompasses a wide range of business disputes. He has handled both simple and complex business disputes, including matters involving breach of contract, business torts, fraud, non-competition agreements, trade secrets, employee theft, collections, alter ego claims, partnership disputes (general and limited), products liability (design and manufacture), intellectual property disputes (trademark, trade dress and copyright), bankruptcy preference claims, landlord-tenant, and employment.
Mr. Perkins has substantial experience in matters involving the printing and graphics arts industries.
Mr. Perkins also serves as outside corporate counsel to not-for-profit trade associations and related entities (e.g., insurance agency, long-term disability plan, MEWA/ERISA plans).
Mr. Perkins received his B.A. from University of California, Irvine and his law degree from the University of Southern California School of Law. His full bio and contact information can be found at http://musickpeeler.com/professionals/bio.cfm?id=368