Generally speaking, the enforceability of a liquidated damages provision in a contract is governed by Civil Code section 1671, with the relevant part reading:
(b) Except as provided in subdivision (c), 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.
On the other hand, according to the Cal Supremes:
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. 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." [ Citation omitted]. Ridgley v. Topa Thrift & Loan Assn. (1998) 17 Cal.4th 970, 977.
This brings us to this month's Court of Appeal decision in Greentree Financial Group, Inc. v. Execute Sports, Inc. (May 6, 2008, Ordered published May 28, 2008) ___ Cal.App.4th___ (Fourth Dist. No. G039326). Greentree provided financial advisory services to Execute, which allegedly failed to pay the $45,000 bill. The parties settled, and memorialized the settlement in a stipulated judgment. The stipulation provided that Execute would pay a total of $20,000 in two installments, but that if it missed either payment, the judgment could then be entered for the entire $45,000, plus interest, attorneys' fees and costs.
Execute defaulted on the first payment (that's why there's a case, right?) and Greentree proceeded to get a judgment entered for $61,232.50. Better luck next time, said the Court of Appeal. First of all, while Greentree argued that the amount set forth in the stipulation was reasonably related to its damages from the breach of the underlying contract, "...the breach we are analyzing is the breach of the stipulation, not the breach of the underlying contract."
Furthermore, "Greentree and [Execute] did not attempt to anticipate the damages that might flow from a breach of the stipulation. Rather, they simply selected the amount Greentree had claimed as damages in the underlying lawsuit, plus prejudgment interest, attorney fees and costs." So the Court ordered the trial court to correct the judgment by reducing it to $20,000, the amount in the stipulation that Execute had failed to pay.
Now, here's one from real life, and I've been on both sides of it: the parties enter into a settlement for installment payments, say, $500,000 in thirty days and $550,000 in ninety days, but with a discount of $50,000 if the second installment is paid in sixty days rather than ninety. In other words, if the settling defendant pays everything within sixty days, it costs him a million bucks, but if he takes longer to pay, it costs an extra $50K. Is that a liquidated damages provision, or simply a bargained-for discount? I think that it's a lawful discount, but I don't have any cases that say so. Anybody else have experience with this?