Summary of a Recent
Judicial Development in
Bankruptcy

Chapter 11 Trustee Successfully Enforces Liquidated Damages Clause
Against Insiders for Breach of Settlement Agreement

Eric H. Foy
National AgLaw Center Research Associate

Summary of Decision

In In re VEC Farms, LLC, 395 B.R. 674 (Bankr. N.D. Cal. 2008), the United States Bankruptcy Court for the Northern District of California refused to vacate the judgment of the bankruptcy court. The bankruptcy court held that family defendants breached a settlement agreement entered into with the Chapter 11 trustee by failing to withdraw a claim against the bankruptcy debtor by the stated deadline, thereby breaching the agreement. Pursuant to the agreement's default provisions, family defendants were ordered to pay $364,578.49. The instant court held that the bankruptcy court's approval of the settlement agreement did not prevent the court from considering the family defendants' argument that the judgment was an invalid penalty. In addition, it held that although California law was instructive regarding liquidated damage clauses, it was not binding, and the judgment was not an invalid penalty.

Background

The debtor, a limited liability corporation, conducted commercial farming activities on property owned by family defendants. Id. at 677-78. On October 21, 2004, debtor filed a Chapter 11 bankruptcy petition, and the bankruptcy court appointed a trustee. Id. In March 2006, the trustee commenced an adversary proceeding against family defendants alleging that they were insiders as defined by 11 U.S.C. § 101(31). Id. at 678. Most of the complaints were premised on alter ego liability including preferential and fraudulent transfers and avoidance of illegal distributions. Id. Family defendants denied the allegation, and the parties exchanged motions for summary judgment. Id. at 679. The two sides agreed to mediate. Id. Following mediation, the parties signed a settlement agreement in which family defendants agreed to pay money to the bankruptcy estate and withdraw all of their claims against the bankruptcy estate before the effective date. Id. at 679-80. Family defendants also consented to pay damages in the event they failed to timely perform any of their obligations pursuant to the settlement agreement. Id.

Family defendants paid the monetary amount to the trustee by the stipulated deadline, but they did not withdraw their claims against the bankruptcy estate in whole by the deadline. Id. at 681. In response, the trustee asked the bankruptcy court for monetary damages specified by the agreement. Id. On November 9, 2007, the bankruptcy court entered judgment against family defendants for the full penalty amount. Id. at 682. Family defendants filed a motion to vacate. Id.

Arguments

Family defendants contended the judgment was an invalid penalty because it was not based on a valid liquidated damages clause. Id. They claimed that a liquidated damages provision is only appropriate when damages are impracticable or extremely difficult to ascertain. Id. Because the damages were clearly spelled out in the settlement agreement, and the actual damages were so disproportionate to the damages suffered by the estate, family defendants argued the damages award was an unenforceable penalty or forfeiture. Id.

The trustee argued that family defendants were misstating the law regarding liquidated damages because the California test for determining the validity of a liquidated damages provision was whether the provision was reasonable in the circumstances as they existed at the time the settlement was negotiated. Id.

Analysis and Holdings

The settlement agreement required family defendants to waive their claims by a certain date, which they failed to do. Id. at 685. After reviewing the facts and its authority under California law, the instant court stated that the only question it would address was whether the liquidated damages clause was an unenforceable penalty. Id. For the following reasons, the court held that the provisions in the settlement agreement, setting the amount of the judgment, were not unreasonable under the circumstances at the time the settlement was reached, and not an invalid penalty: (1) family defendants freely entered into the settlement agreement; (2) the liquidated damages bore a reasonable relationship to the range of harm anticipated for breach at the time of contracting; (3) the formula for calculating the judgment amount was logically related to its function; (4) the parties made a "reasonable endeavor" to determine a fair compensation amount; and finally, (5) while the liquidated damages provision was somewhat coercive, it was not fatal. Id. at 687-92.

The case was decided on September 9, 2008.