Lenders Beware – Default Interest in California May Be Unlawful

October 28, 2022

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 appealed.

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.