Alerts and Updates

California Bankruptcy Court Holds That Default Interest Rate Is Unenforceable Penalty Under State Law

November 26, 2018

Regardless of whether this decision is binding on your next dispute, lenders should consider taking steps to address the issues raised in this case. 

In In re Altadena Lincoln Crossing LLC, 2018 Westlaw 3244502 (Bankr. C.D. Cal.), a California bankruptcy court held that a default interest rate provision was an unenforceable penalty under applicable California law because, among other things, the applicable loan agreements did not contain an estimate of the probable costs to the lender resulting from the debtor’s default.

Background

Commencing in mid-2004, the debtor sought financing from the lender for the construction of a mixed-use project in Altadena, California. The loan negotiations spanned several months, involved numerous draft agreements and resulted in two separate loans and loan agreements. The final form of the loan agreements included clauses that increased the base interest rate by 5 percent in the event of default, late fee provisions and provisions that required the debtor to pay lender’s out-of-pocket expenses. 

Subsequently, the debtor failed to repay the loans at maturity and the parties executed a series of forbearance agreements. The debtor then filed a chapter 11 bankruptcy petition and the lender sought to recover the outstanding loan amount at the default interest rate set out in the parties’ governing documents.

Court’s Decision

After a multiday, contested evidentiary hearing on debtor’s objection to lender’s proofs of claim, the bankruptcy court held that the default interest that lender sought to collect from the debtor was an unenforceable penalty that may not be collected and disallowed the lender’s inclusion of the accrued amount of default interest in its proofs of claim. The court relied on California state law, in particular California Civil Code section 1671(b) (i.e., California’s liquidated damages statute), and not the applicable Bankruptcy Code section 506, which permits a secured creditor to include in the amount of its secured claim “interest on such claim, and any reasonable fees, costs or charges provided for under the agreement,” and disallowed the lender’s default interest. 

Relying on California Civil Code section 1671(b) and California case law, the bankruptcy court stated “the standard is whether the default interest provisions were the result of a reasonable endeavor at the time the parties entered into the agreement to estimate a fair average compensation for any loss that might later be suffered.” The bankruptcy court found that there was no evidence that the parties had attempted to quantify the probable loss to the lender resulting from a default at loan inception and that neither side presented any testimony regarding the lender’s selection of the 5 percent default interest rate, when it was selected or why the rate was selected. The court rejected the lender’s argument that because a 5 percent default interest rate provision is the industry standard, the provision was reasonable, stating that what other lenders charge in terms of default interest rate may be relevant, but is not dispositive. 

Notably, the court did allow lender’s forbearance or “exit” fee of $600,000 and late fee. The bankruptcy court found that the late fee was intended to serve as compensation for administrative costs that lender may have incurred in processing debtor’s late payments. By extension then, the bankruptcy court found that the default interest rate could not have been intended to compensate lender for such administrative expenses.

Finally, the court found the debtor to be the prevailing party and awarded the debtor (as a credit against lender’s claims) its reasonable attorneys’ fees and costs incurred in connection with the default interest dispute.

The lender has already appealed the bankruptcy court’s opinion.

Takeaways

While this decision presents several challenges for commercial lenders, here are few key points:

  • This ruling is not controlling on other bankruptcy courts. It is a trial court level ruling based on California state law. That said, courts may certainly consider the ruling and borrowers will be looking for opportunities to use this opinion to avoid payment of default interest.
  • Regardless of whether this decision is binding on your next dispute, lenders should consider taking steps to address the issues raised in this case. For example, lenders may take steps to actively negotiate (or at least address) default interest rate provisions with borrowers and include language with factual recitations as to why the provision is needed and why it is the best estimate of lender’s anticipated losses that might later be suffered should the loan default. 
  • Reading between the lines, it seems that the court may have viewed the lender’s “penalty charges” as too rich despite the plain language of the applicable contracts. In this case, the lender was seeking to recover an exit fee, a late fee and default interest. While we are not suggesting that lenders should refrain from seeking to recover all amounts they are entitled to under their loan contracts, lenders should be prepared for a potential discount if a judge views a lender’s overall penalty fee package as being excessive.

For Further Information 

If you have any questions about this Alert, please contact Marcus O. Colabianchi, Meagen E. Leary, any of the attorneys in our Business Reorganization and Financial Restructuring Practice Group or the attorney in the firm with whom you are regularly in

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.