A recent decision out of the California First District Court of Appeal
calls into question a lender’s ability to impose default interest after
default but prior to maturity on a nonconsumer loan.
In Honchariw v. FJM Private Mortgage Fund, LLC, et al., the appellate court reversed the trial court’s refusal to overturn an
arbitrator’s decision that the plaintiffs failed to establish that their
lender’s imposition of default interest was an unlawful penalty under
California Civil Code section 1671. The appellate court found that the mere
fact that default interest was being charged on the entire loan balance
prior to full maturity was, in and of itself, a violation of public policy.
In Honchariw, the plaintiffs took out a nonconsumer loan secured
by a first-lien deed of trust on real property. After the plaintiffs
defaulted on their Sept. 1, 2019, monthly payment, their lender charged a
one-time late fee equal to 10% of the overdue payment and imposed default
interest of 9.99% per annum assessed against the total unpaid principal
balance of the loan (collectively, the late fee), as provided in the loan
agreement. Plaintiffs filed a demand for arbitration, alleging, among other
things, that the late fee was an unlawful penalty in violation of section
1671. The arbitrator found that the late fee did not violate section 1671
and denied the demand for arbitration. Plaintiffs petitioned to vacate the
arbitrator’s decision and the trial court denied the petition. Plaintiffs
Section 1671 provides that a liquidated damages clause must bear a
“reasonable relationship” to the actual damages the parties anticipate
would flow from a breach, or such clause would be construed as an
unenforceable penalty. While the appellate court acknowledged the
presumption under section 1671(b) that liquidated damage provisions in
nonconsumer contracts are valid unless the party challenging the provision
establishes that the provision was unreasonable under the circumstances
existing when the parties entered into the contract, its decision does not
discuss any such evidence being submitted by the plaintiffs. To the
contrary, the appellate court determined that the plaintiffs had met their
burden, holding that any liquidated damages in the form of a penalty
assessed during the lifetime of a partially matured note against the entire outstanding loan amount is unlawful.
The appellate court found the late fee to be indistinguishable from the
late-payment fee in Garrett v. Coast & Southern Fed. Sav. & Loan Assn., 9
Cal.3d 731 (1973), where the California Supreme Court held that the
imposition of an additional 2% interest against the entire unpaid principal
balance after a single payment default was punitive and therefore void
under section 1671. The appellate court went on to state that Garret stands for the proposition that liquidated damages assessed
against the unpaid principal balance of a loan are unreasonably related to
the lender’s expected damages as a matter of law.
The Garret decision, however, does not appear to support this
proposition. The Supreme Court noted in Garret that the defendant
might have been able to establish the impracticability of prospectively
fixing its actual damages resulting from a default in an installment
payment to evade its holding but failed to establish the same.
Additionally, the Garret decision was based upon a consumer loan
and a prior version of section 1671 that made all liquidated damages
provisions presumptively invalid. Under the current section 1671(d), such
provisions are deemed void only in consumer contracts, which was not the
circumstance in Honchariw.
There is an opportunity for this decision to be redecided as FJM filed a
petition for rehearing on Oct. 14, 2022.
Absent a change on rehearing or appeal, lenders in California should
understand that their nonconsumer customers may challenge the imposition of
default interest after a payment default if it is applied to all unpaid
principal (and not just the matured portion of the loan). Further, such
commercial customers may seek fees and costs as awarded in Honchariw. Additionally, if other late payments are tied to the
default interest provision, they may be found invalid as was done in Honchariw. The ability to impose default interest upon a maturity
default or acceleration (depending on the wording of the agreement) does
not appear to be impacted by Honchariw and would appear not to be an
unlawful penalty under section 1671.
For questions about this ruling and its implications, please reach out to
one of the authors or your regular McGuireWoods contact.