A liquidated damages clause is a number the parties agree on in advance: if you breach, you owe this much. Business owners like them because they skip the hardest part of a contract case, which is proving what the breach actually cost. Courts like them too, within limits. The limit is the one that gets litigated. California will enforce a liquidated damages clause that represents a reasonable guess at the harm a breach would cause. It will not enforce a number designed to punish.

I see these clauses in vendor agreements, commercial leases, construction contracts, earn-outs, and more often than you would expect, in settlement agreements. The same statute governs all of them, and the same mistake sinks most of the ones that fail. This guide covers the rule, the test courts apply, the recent cases that show where the line is, and how to draft a clause that survives.

In short:

• In a contract between businesses, a liquidated damages clause is presumed valid under Civil Code section 1671(b). The party attacking it must prove it was unreasonable when the contract was signed.
• The clause fails as a penalty if the amount bears no reasonable relationship to the harm the parties could have anticipated from a breach.
• The most common failure is a settlement that escalates to the full original debt after one late payment. Structure settlements as a discount for prompt payment instead.
• Late fees and default interest must track the missed payment, not the whole balance.

The statute puts the burden on the party fighting the clause

Civil Code section 1671 is the starting point. In a contract between businesses, a liquidated damages provision is valid unless the party seeking to invalidate it proves the provision was unreasonable under the circumstances existing when the contract was made. (Civ. Code, § 1671, subd. (b).) That presumption of validity is a 1977 reversal of the old rule, which treated these clauses with suspicion. Today the clause is presumed good, and the objecting party has to prove otherwise with evidence.

Consumer transactions and residential leases are different. For those, the statute keeps the old approach: the clause is void unless fixing actual damages would have been impracticable or extremely difficult. (Civ. Code, § 1671, subds. (c), (d).) Most of what follows concerns commercial contracts, where subdivision (b) controls.

The test: a reasonable relationship to anticipated harm

The California Supreme Court stated the test in Ridgley v. Topa Thrift & Loan Assn. (1998) 17 Cal.4th 970, 977. A liquidated damages clause is an unenforceable penalty if it bears no reasonable relationship to the range of actual damages the parties could have anticipated would flow from a breach. The question is asked as of the day the contract was signed, not the day of the breach. What matters is whether the number was a genuine attempt to estimate the harm, or a stick.

The Supreme Court had put it more bluntly a generation earlier. A charge that is triggered by breach and set without regard to actual harm, serving instead to compel performance, is a penalty regardless of what the contract calls it. (Garrett v. Coast & Southern Fed. Sav. & Loan Assn. (1973) 9 Cal.3d 731, 739.) Labels do not help. Calling the number “liquidated damages” in the contract does nothing if the number itself fails the test.

Courts weigh several things under that test: how the amount compares to the harm the parties could reasonably have expected, whether actual damages would have been hard to measure, the parties' relative bargaining power, and whether lawyers negotiated the provision. In Ridgley itself, a lender's charge of six months' interest, triggered by a single late payment, failed. It had no connection to what a late payment actually costs a lender.

Where clauses fail: the settlement agreement trap

The most common failure I see is not in a commercial contract at all. It is in a settlement. A creditor agrees to accept less than the full debt, paid in installments, and insists on a stipulated judgment for the full original amount if a single payment is late. That structure feels like ordinary security. California courts have been striking it down for more than a decade.

In Purcell v. Schweitzer (2014) 224 Cal.App.4th 969, 974-975, a borrower settled an $85,000 note on an installment plan and then paid one installment six days late. The creditor took a judgment for the full balance. The Court of Appeal held the stipulated judgment was an unenforceable penalty. The damages that matter are the damages from breaching the settlement, which were a few days of interest on one payment, not the amount of the original debt.

The rule was applied again in Red & White Distribution, LLC v. Osteroid Enterprises, LLC (2019) 38 Cal.App.5th 582, 589-590. The parties settled a $1.8 million loan dispute for $2.1 million in payments, with a stipulated judgment of $2.8 million if the debtor defaulted. The extra $700,000 was a penalty and could not be enforced. And in Graylee v. Castro (2020) 52 Cal.App.5th 1107, 1113-1114, a landlord who agreed to waive $27,100 in disputed rent if tenants moved out by a deadline, with a $28,970 judgment if they missed it, lost the judgment for the same reason. Nothing tied the number to the harm of a late move-out.

Settlement clauses can survive. In Gormley v. Gonzalez (2022) 84 Cal.App.5th 72, 80-83, defendants settled twenty malpractice suits for $575,000, with liquidated damages accruing at $50,000 a month on default, capped at $1.5 million. The court enforced the clause. Both sides had counsel, the agreement went through several drafts, the plaintiffs had taken a steep discount for prompt payment, and the defendants had conceded $1.5 million was a reasonable estimate of what trial would have produced. The objecting party then offered no evidence at all that the number was unreasonable. Under subdivision (b), silence loses.

The practical lesson from these cases is simple. Structure the settlement as a discount for prompt payment from the real amount owed, not as an increase above the settled amount for late payment. The first is enforceable. The second usually is not. See our guide to enforcing settlement agreements under section 664.6 for the rest of the enforcement mechanics.

Where clauses fail: late fees and default interest

Lenders run into the same statute. In Honchariw v. FJM Private Mortgage Fund, LLC (2022) 83 Cal.App.5th 893, 899-900, a borrower missed one monthly payment on a $5.6 million bridge loan. The loan documents imposed a one-time charge on the overdue installment and, separately, default interest of nearly 10 percent assessed against the entire unpaid principal. The Court of Appeal held that charging the default rate on the whole balance, rather than on the missed payment, was an unlawful penalty, and it vacated an arbitration award that had enforced it. A late charge has to relate to the harm of the late payment. Charging a fee on money that is not yet late does not.

The same reasoning applies to the late-fee schedules in commercial leases, equipment financing, and vendor contracts. A fee that scales with the missed payment is defensible. A fee that scales with the whole contract is not.

Where clauses hold

The clauses that survive share a few features. They cover harms that are hard to measure: delay on a construction project, a lost exclusive territory, a leaked trade secret, a key employee walking out mid-project. The number has a rational basis, often documented at the time, such as the daily cost of delay or a percentage of the contract value tied to lost margin. Both sides had bargaining power and counsel. And the amount is not wildly out of proportion to what a court would award anyway.

Where those features are present, section 1671(b) does what the Legislature intended. The party attacking the clause has to come forward with evidence, and generalized complaints that the number is high do not meet that burden.

What I tell clients before they sign

Write down why the number is what it is. A sentence in the contract reciting that damages would be difficult to calculate and that the amount is a reasonable estimate of anticipated harm is helpful. A contemporaneous email or memo showing the actual estimate is better.

Tie the amount to the breach, not the contract. Per-day delay figures and percentage-of-affected-order figures survive. Flat sums triggered by any breach of any size tend not to.

In settlements, discount for timely payment. Never escalate for late payment above the amount actually owed.

Keep late fees proportional to the late installment. Default interest on the whole balance is the structure Honchariw struck.

Decide whether you want the clause at all. A liquidated damages provision caps your recovery as much as it secures it. If your actual damages from a breach could far exceed the number, you may be better off proving them. Our breach of contract practice page covers what that proof looks like.

If you are already in a dispute over one of these clauses, the burden rules decide a lot. Under subdivision (b), the party attacking the clause must produce evidence, and the party defending it should be ready to show the number's origin. Both sides should model the outcome before filing. A section 998 offer built on a realistic view of whether the clause survives is often the most useful move in the case.

Frequently asked questions

Are liquidated damages clauses enforceable in California?

In contracts between businesses, yes, presumptively. Civil Code section 1671(b) makes the clause valid unless the party challenging it proves it was unreasonable when the contract was made. Consumer contracts and residential leases are judged under a stricter standard.

What makes a liquidated damages clause a penalty?

A number with no reasonable relationship to the harm the parties could have anticipated from a breach. If the amount was set to compel performance rather than estimate loss, it is a penalty, whatever the contract calls it.

Can a settlement agreement include liquidated damages for late payment?

Yes, but the amount must relate to the harm of breaching the settlement, not the original claim. A stipulated judgment for the full original debt after a short payment delay is routinely struck as a penalty. A discount for prompt payment from the real amount owed is the safer structure.

Are late fees and default interest subject to the same rule?

Yes. A late charge tied to the missed installment is generally fine. Default interest or fees assessed against the entire unpaid balance after one missed payment have been held unenforceable.

Who has to prove the clause is unreasonable?

In a commercial contract, the party trying to escape the clause. If that party offers no evidence beyond the argument that the number is large, courts have enforced the clause as written.

This article is provided for general informational purposes and is not legal advice.

Need help? Contact Kolmogorov Law, P.C. at (909) 235-6420 or visit kolmogorovlaw.com to schedule a consultation with our business litigation team in Irvine, California.