Liquidated damages in California

(b) 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. (c) The validity of a liquidated damages provision shall be determined under subdivision (d) and not under subdivision (b) where the liquidated damages are sought to be recovered from either: (1) A party to a contract for the retail purchase, or rental, by such party of personal property or services, primarily for the party’s personal, family, or household purposes; or (2) A party to a lease of real property for use as a dwelling by the party or those dependent upon the party for support. (d) In the cases described in subdivision (c), a provision in a contract liquidating damages for the breach of the contract is void except that the parties to such a contract may agree therein upon an amount which shall be presumed to be the amount of damage sustained by a breach thereof, when, from the nature of the case, it would be impracticable or extremely difficult to fix the actual damage.

We conclude the trial court correctly understood the prepayment provision here to be a penalty for delinquency in meeting the contractual interest payments and thus correctly *974 held the penalty to be unenforceable, because it bore no relationship to the potential damages defendant would incur from a late interest payment. We therefore reverse the judgment of the Court of Appeal, which reversed the trial court’s judgment for plaintiffs.

This section does not apply in any case where another statute expressly applicable to the contract prescribes the rules or standard for determining the validity of a provision in the contract liquidating the damages for the breach of the contract.

In contrast to late payment fees, contractual charges for prepayment of the loan principal are generally considered valid provisions for alternative performance, rather than penalties or liquidated damages for breach. Payment before maturity is not a breach of the contract, but simply an alternative mode of performance on the borrower’s part; the prepayment charge is not a penalty imposed for default, but an agreed form of compensation to the lender for interest lost through prepayment, additional tax liability or other disadvantage.

(a) This section does not apply in any case where another statute expressly applicable to the contract prescribes the rules or standard for determining the validity of a provision in the contract liquidating the damages for the breach of the contract. (b) 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.

(c) The validity of a liquidated damages provision shall be determined under subdivision (d) and not under subdivision (b) where the liquidated damages are sought to be recovered from either: (1) A party to a contract for the retail purchase, or rental, by such party of personal property or services, primarily for the party’s personal, family, or household purposes; or (2) A party to a lease of real property for use as a dwelling by the party or those dependent upon the party for support. (d) In the cases described in subdivision (c), a provision in a contract liquidating damages for the breach of the contract is void except that the parties to such a contract may agree therein upon an amount which shall be presumed to be the amount of damage sustained by a breach thereof, when, from the nature of the case, it would be impracticable or extremely difficult to fix the actual damage.

(1) Damages for breach by either party may be liquidated in the agreement subject to and in compliance with Section 1671 of the Civil Code. If the agreement provides for liquidation of damages, and such provision does not comply with Section 1671 of the Civil Code, remedy may be had as provided in this division. (2) Where the seller justifiably withholds delivery of goods because of the buyer’s breach, the buyer is entitled to restitution of any amount by which the sum of his or her payments exceeds: (a) The amount to which the seller is entitled by virtue of terms liquidating the seller’s damages in accordance with subdivision (1), or (b) In the absence of such terms, 20 percent of the value of the total performance for which the buyer is obligated under the contract or five hundred dollars ($500), whichever is smaller.

A liquidated damages clause will generally be considered unreasonable, and hence unenforceable under section 1671(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." ( Garrett v. Coast & Southern Fed. Sav. & Loan Assn., supra, 9 Cal.3d at p. 739 (hereafter Garrett ).) In the absence of such relationship, a contractual clause purporting to predetermine damages "must be construed as a penalty."

The complication presented by this case is that the charge here was contingent on both events, prepayment of principal and late payment of an interest installment (or other default). It can be described, therefore, as both a prepayment charge and a late payment penalty. "We have consistently ignored form and sought out the substance of arrangements which purport to legitimate penalties and forfeitures." ( Garrett, supra, 9 Cal.3d at p. 737 .)

The dissent suggests a different set of rules must apply because this was an "arm's-length commercial transaction." (Dis. opn., post, at p. 983.) That plaintiffs are small business owners rather than consumers, however, does not deprive them of section 1671's protection against unreasonable penalties or of the right to relief from contractual forfeiture under section 3275.

We conclude the trial court correctly understood the prepayment provision here to be a penalty for delinquency in meeting the contractual interest payments and thus correctly *974 held the penalty to be unenforceable, because it bore no relationship to the potential damages defendant would incur from a late interest payment. We therefore reverse the judgment of the Court of Appeal, which reversed the trial court's judgment for plaintiffs.

DISPOSITION The judgment of the Court of Appeal is reversed. The matter is transferred to the Court of Appeal for consideration of plaintiffs' appeal. George, C.J., Kennard, J., Baxter, J., Chin, J., and Brown, J., concurred.