What is the “Penalty Rule” and How Does it Apply in Family Court Matters? The Appellate Division Weighs in.

When entering into a settlement agreement, each party is often wary of whether the other party will comply with the agreement’s terms. As a result, oftentimes negotiated into an agreement is a provision providing that a party’s successful enforcement of the agreement against the other party “may” or “shall” result in an award of counsel fees in that party’s favor.

How about language, however, that imposes a further penalty or sanction against the violating party? For instance, is language requiring one party to comply with a payment deadline enforceable if it also includes a per diem sanction in a specified amount should the party fail to comply? Is the language automatically enforceable if it was voluntarily agreed upon by the parties in the scope of their global marital settlement agreement resolving all issues in their divorce, each party understood the provision, there was no issue with the provision at the time the agreement was signed, and it ensured each party’s compliance with the agreement?

According to the Appellate Division’s recently published decision in Holtham v. Lucas, the answer may depend on whether the contract/agreement was entered in a family court matter or a traditional contract dispute. Here are the facts that you need to know:

  • After a five-year marriage, the parties entered into a Marital Settlement Agreement (MSA). The Judgment of Divorce provided that "the parties entered into it freely and voluntarily, and that it is, therefore, binding and enforceable." The MSA enforced the parties' prenuptial agreements and resolved several property and insurance-related matters.
  • The MSA provided that if Holtham violated any obligation contained in the agreement, Lucas would be entitled to reasonable counsel fees incurred to enforce, and "a per diem penalty of $150.00 for every day that husband fails to comply . . . ."
  • Holtham, who was a multi-millionaire, represented in the MSA that he had "the ability and resources to comply with" his obligations in the agreement.
  • Despite said obligations, Holtham failed to timely pay off the car loan or transfer title of the car by the deadline contained in the agreement.
  • Holtham did not deny failing to timely comply, including his failure to transfer title of the vehicle until two weeks after Lucas filed a motion to enforce the agreement. He alleged, however, certain monies he was due by Lucas to offset the penalty amount potentially owed.
  • In his opposition to Lucas’s motion, Holtham argued that the per diem charge constituted an unenforceable penalty, rather than a reasonable form of liquidated damages. The trial court disagreed and enforced the penalty against Holtham - $150 per day for approximately four months of non-compliance plus attorney’s fees. In so holding, the trial court found Holtham had the ability to comply, but unreasonably declined to do so by claiming the offsets were due him despite same having already been forfeited/released by him in the MSA.

In addressing whether the agreed-upon/stipulated damages clause was a reasonable form of liquidated damages designed as an “estimate in advance [of] the actual damage that will probably ensue from the breach” or an unreasonable/unenforceable penalty, the court analyzed two factors: (1) the extent the stipulated amount is within a plausible range of actual damages, viewed from either the time of contracting or breach (it survives if reasonable at either point in time); and (2) the difficulty of calculating damages upon breach (the greater the difficulty in calculating, the more reasonable the damages provision will appear). How the parties describe the damages provision in the agreement is not dispositive of whether it is actually enforceable.

Based on this two-prong analysis, the Appellate Division struck down the per diem sanction under traditional contract principles for the following specific reasons:

  • Lucas retained full use of the vehicle even if the loan was not yet paid off and title transferred.
  • There was no basis in the record for the approximate loss of $18,450 ($150 per day for the above-stated four-month period).
  • The breach did not require Holtham to compensate Lucas for emotional distress or irritation potentially suffered (even if Holtham’s misconduct was purposeful).
  • When viewed at the time the agreement was made, the sanction was deemed unreasonable because it fixed a “single large sum for any breach, substantial or insubstantial”. The Appellate Division declined to consider same a “reasonable prediction of damages when those damages could range from substantial to virtually non-existent.”

The Appellate Court’s analysis did not end there, however, as it then considered whether the provision should be upheld in the divorce context where the “policies underlying those contract principles do not apply with equal force [because] judicial enforcement of agreements to settle divorce actions implicates policy goals that justify relaxing the penalty rule, and instead subjecting a penalty to the family court’s broad power to assure equity and prevent unconscionability.” In other words, the family court is not bound by penalty rule contract principles. As we know from prior family law cases, however, the court cannot make a better agreement for one/both parties than that which already exists.

The Appellate Division, as a result, then analyzed the penalty rule in the context of family court matters, noting its shortcoming in such cases because it deprives a non-breaching party of adequate compensation for “idiosyncratic value”, which can be a “sentimental attachment”, as compared to an “objective market valuation” that may exist in non-family part matters. In a compelling summary of this concept, the Appellate Division noted that “The rule does not recognize the premium that the court and parties place on post-divorce peace” and how they “presumably represent the parties’ best effort to resolve often intensely personal and vexatious problems.” In so holding the Court noted:

The penalty rule also does not account for the fact that parties to matrimonial agreements may behave far differently than the rational economic actors presumed to participate in typical contractual relationships. A party to a MSA may decide to breach not to promote efficiency but to inflict some harm, emotional or economic, on the former spouse. Consequently, a per diem fee that may fail as a penalty under traditional contract principles may reasonably deter or remedy the emotional harm caused by a breach of post-marital peace. Existing judicial sanctions to deter breach of marital settlement agreements reflect a public policy that is receptive to penalty clauses designed to achieve the same end.

The Court then noted how certain New Jersey Court Rules already allow a court to economically sanction a party for violating orders on equitable distribution, custody, parenting time, or support – specifically, 5:3-7 and 1:10-3 – and reminded how such sanctions must be “rationally related” the desired result of imposing a “sting” to deter and coerce the offending party to comply within his/her reasonable economic means.

Thus, while the Appellate Division held that the penalty rule does not apply to marital settlement agreements, it further held that the family court retains “broad power to invalidate or reform a penalty provision in an MSA if it is unconscionable or the product of fraud, undue pressure, or coercion, or where one party lacks independent counsel.” In so determining, the family court should analyze the subject provision under the totality of the circumstances to determine its enforceability and may even modify the provision to achieve fairness. For instance, the court can consider the parties’ sophistication, their respective bargaining power, whether independent counsel was involved, the size of the penalty as compared to the actual breach, the breaching party’s ability to pay, the breaching party’s good faith or lack thereof, and the like.

When considering the disputed penalty provision under family law principles, the Appellate Division upheld its enforcement because Holtham was a sophisticated businessman of great wealth, was presumed to understand the penalty provision and was prepared to abide by it when he entered into the agreement, and the breach, which lacked any reasonable justification, had a substantial impact on post-divorce peace.

Based on the Appellate Division’s decision, here are your three primary takeaways:

  • The penalty rule, which is intended to avoid “oppression, excessive recovery, and deterrence of efficient breach” does not apply with equal force in marital settlement agreements contained in final divorce judgments because the enforcement of such agreements is to “secure post-divorce harmony and stability.”
  • Penalty provision enforcement in family court matters may deter post-divorce violations that are not economically motivated and “may compensate for the emotional harm resulting from such a breach.”
  • The trial court can modify such provisions to ensure fairness and equity between the parties. A review of all facts and circumstances is necessary.
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