Forbearance Agreements in California

March 13, 2015

Real estate and commercial disputes across the country are often settled by a forbearance agreement. In these agreements, the creditor agrees to settle its claim for a discounted amount, usually payable in installments. In exchange, the debtor is required to admit that he or she owes the full amount of the debt and agree that if he or she fails to timely make the agreed upon payments that a judgment for the full amount of the debt may be entered against him or her. Historically, creditors have been hesitant to enter into these agreements in California, but because of a new court decision that may change.

History of Forbearance Agreements in California

Historically, California has taken the minority view on these forbearance agreements in that it has not enforced them. As recently as 2014, in Purcell v. Schweitzer, a California court opted not to enforce such an agreement. It determined that, on the facts before it, forcing the debtor to pay the entire original debt would violate California law because such a judgment would not bear a rational relationship to the damages the creditor would suffer due to the breach of the forbearance agreement. In other words, since the forbearance agreement was in place, the creditor was not really out the full amount of the original debt due to the debtor's failure to pay. Had the debtor made the payments the creditor never would have seen the repayment of the full original debt. This decision relied heavily on a similar earlier decision in Greentree Financial Group, Inc., v. Execute Sports.

New Decision Changes the Landscape

A new decision by the Second District of the Court of Appeals is changing the landscape in California. This decision is called Jade Fashion & Co., Inc. v. Harkham Industries, Inc. In Jade the creditor and debtor entered into a forbearance agreement. The agreement said that if the debtor timely made all of the scheduled payments to the creditor, then the creditor would "discount" the final scheduled payment by $17,500. The agreement stated that the amount being sought by the creditor was the full amount of the debt due. The trick here is that the creditor was not wiping out the debt and agreeing to new terms as the Court essentially determined was the case in Purcell and Greentree. Instead, the creditor was simply offering a discount if a portion of the total debt was paid in a timely manner. Unlike the scheme set up in the previous cases, the appellate court determined in this case that failing to honor this discount when the debtor failed to make the stipulated payments on time did not constitute an unlawful penalty.

It is also important that this forbearance agreement was clear that the $17,500 the creditor sought after the debtor failed to make payments was neither liquidated damages for a breach of contract nor an additional payment above and beyond the owed debt. The agreement was clear that the $17,500 was always a part of the debt owed and that that portion of the owed debt would have only been discounted if the debtor had complied with the terms of the forbearance agreement. The result of this decision is that forbearance agreements are actually enforceable under some circumstances in California, but they must be structured in a specific way.