California Court of Appeals Strikes Late Interest Provision on Non-Consumer Loan – Financial Restructuring


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In Honchariw v FJM Private Mortgage Fund, LLC83 Cal.App.5th 893 (Cal. Ct. App. 2022), the California Court of Appeals held that default interest and late fees are unlawful when assessed against the outstanding principal balance on a partially matured note, regardless of whether the loan is a consumer or non-consumer loan.

California lenders should carefully review and discuss with an attorney their loan documents to determine if they contain default interest or late fee provisions that may be affected by this decision.

Background

In 2018, the Honchariw the plaintiffs obtained a non-consumer loan of $5.6 million from the defendant-lender. The loan agreement provided in the relevant part that in the event of default, the applicants would be liable for a one-off indemnity of 10% calculated on the overdue payment and default interest of 9.99% calculated annually on the total outstanding principal balance.

In 2019, the plaintiffs missed a monthly payment, triggering the late payment provisions. The plaintiffs commenced arbitration and argued, among other things, that the “late fee” provisions of the loan agreement (that’s to say, 10% costs and 9.99% default interest) were illegal under California Civil Code Section 1671, which requires liquidated damages clauses to bear a “reasonable relation” to the damages that would result from a violation. The arbitrator rejected the plaintiffs’ arguments and ruled in favor of the lender. On appeal, the Sonoma County Superior Court upheld the arbitrator’s decision. The plaintiffs appealed to the Court of Appeal, which reversed the lower court’s decision and set aside the arbitration award.

Decision

The Court of Appeal ruled that the late fee and default interest provisions in the loan agreement, which the court treated together as “late fees”, were unlawful under Section 1671 Specifically, the court ruled that “a charge for late payment of a loan installment that is measured against the outstanding balance of the loan should be considered punitive,” and therefore unenforceable. The court recognized that, in the context of non-consumer loans, liquidated damages clauses are presumed valid under Section 1671. However, the court nevertheless concluded that default interest assessed on the entire outstanding balance of a loan, in the absence of a default in maturity, does not necessarily have the required “reasonable relation” to the actual damages and should therefore be invalidated.

The Court of Appeal relied primarily on Garrett c. Coast & S.Fed. Economy. & Loan Assn., 511 P.2d 1197 (Cal. 1973), in which the California Supreme Court held that a default interest clause assessed against the entire outstanding principal balance of a partially matured consumer loan had a “punitive character”. The Honchariw lender argued that
Garrett interpreted an outdated version of Section 1671 and was therefore no longer good law. The court, however, rejected this argument and held that Garrett reviewed and asked the court to invalidate the default interest provision in question.

The Court of Appeal also singled out more recent cases in which default interest was imposed on the full principal balance in the event of default by a borrower on fully maturedobligations, noting that in this case, the fact that the loan was not partially ripened was decisive.

The lender requested a rehearing of the Court of Appeal’s decision, but that request was denied on October 26, 2022.

Conclusion and commentary

The Honchariw the court’s radical reading
Garrett could have significant implications for lenders operating in California. Currently and if Honchariwstands on any further appeal, lenders operating in California should be prepared for borrowers to contest the imposition of late payment interest applied to the entire outstanding principal balance in the event of a default. California lenders should carefully review and discuss with an attorney their loan documents to determine if they contain default interest or late fee provisions that may be affected by this decision.

That said, and given the Honchariw the court’s express distinction between partially and fully matured obligations, the Honchariw The decision does not appear to affect the ability of lenders to charge default interest on the full principal amount outstanding to
accelerated loans. Lenders who charge late interest after accelerating lending should, as always, be aware of the other implications of accelerating lending.

For more information

If you have any questions about thisAlertplease contact Meagen E. Leary, Marcus O. Colabianchi, Elinor H. Murarova, Allison M. Midei, one of the attorneys in our Corporate Reorganization and Financial Restructuring Practice Group or the attorney at the firm you regularly deal with in touch.

Disclaimer: This alert has been prepared and posted for informational purposes only and is not offered and should not be construed as legal advice. For more information, please see the full disclaimer.

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