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Monday, March 31, 2014

More on the Fairness of Contractual Penalties

More on the Fairness of Contractual Penalties

By Myanna Dellinger

In my March 3 blog post, I described how the Ninth Circuit Court of Appeals just held that contractual liquidated damages clauses in the form of late and overlimit fees on credit cards do not violate due process law.  A new California appellate case addresses a related issue, namely whether the breach of a loan settlement agreement calling for the repayment of the entire underlying loan and not just the settled-upon amount in the case of breach is a contractually prohibited penalty.  It is.

In the case, Purcell v. Schweitzer (Cal. App. 4th Dist., Mar. 17, 2014), an individual borrowed $85,000 from a private lender and defaulted.  The parties agreed to settle the dispute for $38,000.  A provision in the settlement provided that if the borrower also defaulted on that amount, the entire amount would become due as “punitive damages.”  When the borrower only owed $67 or $1,776  (depending on who you ask), he again defaulted, and the lender applied for and obtained a default judgment for $85,000. 

Liquidated damages clauses in contracts are “enforceable if the damages flowing from the breach are likely to be difficult to ascertain or prove at the time of the agreement, and the liquidated damages sum represents a good faith effort by the parties to appraise the benefit of the bargain.”  Piñon v. Bank of Am., 741 F.3d 1022, 1026 (Ninth Cir. 2014).   The relevant “breach” to be analyzed is the breach of the stipulation, not the breach of the underlying contract.  Purcell.  On the other hand, contractual provisions are unenforceable as penalties if they are designed “not to estimate probable actual damages, but to punish the breaching party or coerce his or her performance.” Piñon, 741 F.3d at 1026. 

At first blush, these two cases seem to reach the same legally and logically correct conclusion on similar backgrounds.  But do they?  The Ninth Circuit case in effect condones large national banks and credit card companies charging relatively small individual, but in sum very significant, fees that arguably bear little relationship to the actual damages suffered by banks when their customers pay late or exceed their credit limits.  (See, in general, concurrence in Piñon).  In 2002, for example, credit card companies collected $7.3 billion in late fees.  Seana Shiffrin,  Are Credit Card Law Fees Unconstitutional?, 15 Wm. & Mary Bill Rts. J. 457, 460 (2006).  Thus, although the initial cost to each customer may be small (late fees typically range from $15 to $40), the ultimate result is still that very large sums of money are shifted from millions of private individuals to a few large financial entities for, as was stated by the Ninth Circuit, contractual violations that do not really cost the companies much.  These fees may “reflect a compensatory to penalty damages ratio of more than 1:100, which far exceeds the ratio” condoned by the United States Supreme Court in tort cases. Piñon, 741 F.3d at 1028.  In contrast, the California case shows that much smaller lenders of course also have no right to punitive damages that bear no relationship to the actual damages suffered, although in that case, the ratio was “only” about 1:2. 

The United States Supreme Court should indeed resolve the issue of whether due process jurisprudence is applicable to contractual penalty clauses even though they originate from the parties’ private contracts and are thus distinct from the jury-determined punitive damages awards at issue in the cases that limited punitive damages in torts cases to a certain ratio.  Government action is arguably involved by courts condoning, for example, the imposition of late fees if it is true that they do not reflect the true costs to the companies of contractual breaches by their clients.  In my opinion, the California case represents the better outcome simply because it barred provisions that were clearly punitive in nature.  But “fees” imposed by various corporations not only for late payments that may have little consequence for companies that typically get much money back via large interest rates, but also for a range of other items appear to be a way for companies to simply earn more money without rendering much in return.

At the end of the day, it is arguably economically wasteful from society’s point of view to siphon large amounts of money in “late fees” from private individuals to large national financial institutions many of which have not in recent history demonstrated sound economic savvy themselves, especially in the current economic environment.  Courts should remember that whether or not liquidated damages clauses are actually a disguise for penalties depends on “the actual facts, not the words which may have been used in the contract.”  Cook v. King Manor and Convalescent Hospital, 40 Cal. App. 3d 782, 792 (1974).

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