Liquidated Damages after Lakeshore

In a recent published decision from the Second Appellate District, Division Eight, filed August 24, 2026, Lakeshore Investments vs. Defendants NOW Solutions, Inc. and Vertical Computer Systems, B343435 (Cal. App. 2nd Dist., Aug. 24, 2026) (Lakeshore), the California Court of Appeal struck down the enforcement of a liquidated damages provision within a settlement agreement on the basis that the amount of the liquidated damages—according to the majority—constituted a penalty in violation of California Civil Code Section 1671(b).

While Justice Wiley’s vigorous dissent cites a variety of reasons why he believes the majority opinion is flawed, the Court of Appeal’s holding in Lakeshore highlights important lessons for California lenders and their counsel to bear in mind when negotiating settlements or workouts of loans that have gone into default.

Lakeshore

In 2023, Plaintiff Lakeshore Investments (“Lender”) and Defendants NOW Solutions, Inc. and Vertical Computer Systems (together, “Borrower”) entered into an agreement to settle a lawsuit which Lender had brought against Borrower four years prior in 2019 for Borrower’s failure to repay a prior loan.

The prior loan was documented by a promissory note executed in January 2013. The principal amount of the promissory note was $1,759,000. The promissory note initially bore an interest rate of 11% and was secured by Borrower’s intellectual property.

After making the promissory note, Borrower fell behind on payments. Borrower’s chronic pattern of defaulting led to the parties negotiating eight (8) separate amendments to the promissory note’s payment schedule, the last of which was executed in December 2017.

One month later, Borrower defaulted again by failing to make its January 2018 payment and the subsequent payments required under the eighth amendment to the promissory note.

In May 2019, Lender finally sued Borrower for breach of the promissory note and security agreement. Drawn out litigation ensued.

After over four years in litigation, in November 2023, Lender and Borrower entered into a settlement agreement (the “Settlement Agreement”) whereby Borrower agreed to pay Lender a total of $450,000 (the “Settlement Amount”) over the course of three installments, in accordance with the Settlement Agreement’s payment schedule.  The Settlement Agreement also provided that if Borrower failed to timely pay any of such installment payments and failed to cure such default, then Lender would be entitled to a stipulated judgment for damages in the amount of $1,500,000 plus interest (the “Liquidated Damages”). Both Lender and Borrower were represented by counsel in the negotiation of the Settlement Agreement.  The Settlement Agreement was silent as to why the amount of $1,500,000 was agreed to as liquidated damages for the Settlement Agreement’s underlying obligation of $450,000.

After executing the Settlement Agreement, Borrower again failed to pay, this time as required by the Settlement Agreement’s payment schedule.

Presumably, having anticipated just this sort of breach, Lender looked to enforce the Settlement Agreement’s liquidated damages provision against Borrower.  Lender filed an ex parte application with the trial court for entry of default and default judgment, which the trial court granted, thereby ordering the Borrower to pay the Liquidated Damages in accordance with the Settlement Agreement.

On appeal, Borrower argued that the trial court erroneously enforced the stipulated Liquidated Damages provision of the Settlement Agreement, which Borrower argued constituted an unreasonable penalty under California Civil Code Section 1671(b)[1].

The Court of Appeal agreed with Borrower, finding the Liquidated Damages to be “unreasonable under the circumstances existing at the time the contract was made,” and thereby invalid under California Civil Code Section 1671(b). Citing Ridgley v. Topa Thrift & Loan Ass’n. (1998) 17 Cal.4th 970, 977 (Ridgley); Morris v. Redwood Empire Bancorp (2005) 128 Cal.App.4th 1305, 1314; Greentree Financial Group, Inc. v. Execute Sports, Inc. (2008) 163 Cal.App.4th 495, 499 (Greentree Financial); Vitatech Internat., Inc. v. Sporn (2017) 16 Cal.App.5th 796, 810 (Vitatech); and Purcell v. Schweitzer (2014) 224 Cal.App.4th 969, 974 (Purcell) as applicable law, the Court of Appeal based its decision on the following reasoning:

“A liquidated damages clause will generally be considered unreasonable, and hence unenforceable under Civil Code Section 1671, subdivision (b), if it bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach. The amount set as liquidated damages must represent the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that may be sustained. In the absence of such relationship, a contractual clause purporting to predetermine damages must be construed as a penalty. . . . The amount of the judgment must reasonably relate to the damages likely to arise from the breach of the stipulation, not the alleged breach of the underlying contract, because it is the breach of the stipulation that allows judgment to be entered against the defaulting party.”

The Court focused on the disparity between the Settlement Amount ($450,000) and the Liquidated Damages ($1,500,000) and found “no reasonable relationship” between the two, which, per Ridgley, mandated construing the Liquidated Damages as a penalty and thus unenforceable.

Justice Wiley’s dissent argued that the Court should have applied Gormley v. Gonzalez (2022) 84 Cal.App.5th 72 (Gormley) for the proposition that, contrary to the method followed by the majority, the proper method for analyzing the reasonableness of liquidated damages under California Civil Code Section1671(b) is “to compare the liquidated damages number to the sum the underlying case sought and not to the discount for which the underlying case settled”. In other words, using Gormley’s method of comparing the liquidated damage sum to the amount sought at trial, the Court should have compared the Liquidated Damages ($1,500,000) to the amount Lender sought at the commencement of trial in 2019 ($2,261,324.60), which sum, with interest, had allegedly ballooned to a sum of $4,421,142.65 by the time the trial court signed the default judgment order in 2024. The dissent reasoned, “Compared to $4.4 million, $1.5 million was reasonable”, and therefore, the Court should not have invalidated the Liquidated Damages.

Key Takeaway: Draft the Record into the Four Corners of the Debt Workout or Settlement Agreement

On multiple occasions, the Court in Lakeview cited the fact that the record, which included the parties’ 10-page Settlement Agreement, “lacks facts to establish that $1.5 million represents the range of actual damages the parties anticipated would flow from [Borrower’s breach of the Settlement Agreement].” This lack of a factual basis is the ultimate reason that the Court declined to apply the method set forth in Gormley—the evidentiary record in Lakeview lacked a record of facts explaining the connection between the $1.5 million Liquidated Damages agreed to in the Settlement Agreement and the $2.2 million sum Borrower was alleged to have owed by the time trial began (or, for more effect, the alleged $4.4 million sum Borrower owed by the time trial settled). Therefore, in the absence of such facts, the Court had no basis upon which to judge the reasonableness of the Liquidated Damages amount relative to the Settlement Amount. Without concrete evidence to support the reasonableness of the instant Liquidated Damages, the Court found them to be unreasonable and a penalty. Accordingly, the Court invalidated the entire liquidated damages concept from the Settlement Agreement and ordered Lender to recalculate a more reasonable amount of damages (i.e., an amount of damages more evidently commensurate with the $450,000 Settlement Amount) that it theoretically should have anticipated suffering at the time the parties were negotiating the Settlement Agreement if Borrower later breached the Settlement Agreement. The Court makes no mention of how Lender could recover on Lender’s claims for damages related back to the original loan (rather than damages arising from the breach of the Settlement Agreement) which Lender is alleged to have suffered.

Lakeshore is a cautionary tale of a loan workout that went horribly wrong for the lender. For California lenders and their counsel, the lesson of Lakeview is clear: Draft the Record into the Four Corners of the Workout Agreement. Recite the record of events, facts, owed amounts, and ongoing accumulating interest which led up to the negotiation of the settlement agreement[2] at issue, and make this record so clear within the document itself that if the document’s liquidated damages provision is ever challenged for being “unreasonable,” then the four corners of that document contain the reasoning and evidence of the mutual assent of the parties pursuant to which they agreed to the defensible liquidated damages amount. Recite the precedent facts in the recitals, attach a chronology and ledgers as exhibits, and require the Borrower to acknowledge and agree to the accuracy of the recitals and the concepts therein. Pack the document with clear evidence that the parties reasoned and negotiated to arrive at the liquidated damages amount with evidentiary relation back to the original defaulted obligation and not just the negotiated settlement amount. As one of our favorite maxims of jurisprudence provides, “Superfluidity does not vitiate,”[3] and in fact, in the case of a loan workout agreement which includes a liquidated damages provision, super superfluidity may be required to prevent a court from invalidating the liquidated damages provision altogether.

The result of Lakeview—the Court’s invalidation of a negotiated liquidated damages provision between sophisticated parties, each represented by counsel—may come as a surprise to those who view borrowing and lending through theoretical lenses. But for practitioners, Lakeview is a reminder of the importance of building an evidentiary record into negotiated agreements.

Why We Should Care: Loan Workouts on the Horizon

With over $2 trillion[4] in commercial real estate debt scheduled to mature by the end of 2027 and with segments of the commercial real estate industry still not recovered from the effects of the COVID-19 pandemic, lenders would be wise to factor the lessons of Lakeview into their workout strategies and look to counsel who will thoroughly and thoughtfully document the story behind each workout.

[1] California Civil Code Section 1671(b) reads: “Except as provided in subdivision (c), a provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.”

[2] If a lender elects to structure a workout as a forbearance – i.e., where Lender conditions a discount of admittedly-owed debt on borrower’s timely payments towards said debt—then, per Jade Fashion & Co., Inc. v. Harkham Industries, Inc. (2014) 229 Cal.App.4th 635, the admitted debt to be repaid is not construed as liquidated damages and thus, California Civil Code Section 1671(b) and Lakeshore are not applicable. But keep in mind, a forbearance agreement still needs to be carefully drafted to include a record of stipulations—what is owed, what the offered discount is, and the mechanism for borrower to earn the discount.

[3] Maxims of Jurisprudence, California Civil Code § 3537, enacted in 1872.

[4] 2026 CRE Maturity Wall: $936B in Commercial Loans Coming Due

Rimon’s Real Estate attorneys have decades of domestic and international experience in real estate development, acquisitions, finance, and leases. They work closely with Rimon’s Tax, Corporate, Litigation, Financial Services, and Private Client teams to ensure a full spectrum of efficient representation for the issue at hand. Learn more about our Real Estate Practice Group here.