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California Court of Appeal Invalidates Default Interest Provision on Nonconsumer Loan

November 4, 2022

California Court of Appeal Invalidates Default Interest Provision on Nonconsumer Loan

November 4, 2022

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Lenders in California should carefully review and discuss with counsel their loan documents to determine whether they contain default interest or late fee provisions which could be impacted by this decision.

In Honchariw v. FJM Private Mortgage Fund, LLC, 83 Cal.App.5th 893 (Cal. Ct. App. 2022), the California Court of Appeal held that default interest and late fee charges are unlawful when they are assessed against the full outstanding principal balance on a partially matured note, regardless of whether the loan is a consumer or nonconsumer loan.

Background

In 2018, the Honchariw plaintiffs obtained a $5.6 million nonconsumer loan from the defendant-lender. The loan agreement provided in relevant part that, in the event of a default, the plaintiffs would owe a one-time 10 percent fee assessed against the overdue payment and a default interest charge of 9.99 percent assessed annually against the total unpaid principal balance.

In 2019, the plaintiffs missed a monthly payment, which triggered the late payment provisions. The plaintiffs commenced arbitration and argued, among other things, that the “Late Fee” provisions in the loan agreement (i.e., the 10 percent fee and the default interest of 9.99 percent) were unlawful under Section 1671 of the California Civil Code, which requires liquidated damages provisions to bear a “reasonable relationship” to the actual damages that would flow from a breach. The arbitrator rejected the plaintiffs’ arguments and ruled in favor of the lender. On appeal, the Superior Court of Sonoma County affirmed the arbitrator’s award. The plaintiffs appealed to the Court of Appeal, which reversed the lower court’s ruling and vacated the arbitration award.

Ruling

The Court of Appeal held that the late fee and default interest provisions in the loan agreement, which the court addressed jointly as a “Late Fee,” were unlawful under Section 1671. Specifically, the court ruled that “a charge for the late payment of a loan installment which is measured against the unpaid balance of the loan must be deemed to be punitive in character,” and therefore unenforceable. The court acknowledged that, in the nonconsumer loan context, liquidated damages provisions are presumed to be valid under Section 1671. However, the court nonetheless found that default interest assessed against the entire unpaid balance of a loan, in the absence of a maturity default, necessarily does not bear the requisite “reasonable relationship” to actual damages and therefore must be invalidated.

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

The Court of Appeal also distinguished more recent cases enforcing default interest imposed against the full principal balance upon a borrower’s default on fully matured obligations, finding that in the case at hand, the fact that the loan was only partially matured was dispositive.

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

Conclusion and Commentary

The Honchariw court’s sweeping reading of Garrett could have significant implications for lenders operating in California. At present and if Honchariw stands on any further appeal, lenders operating in California should be prepared for borrowers to challenge the imposition of default interest applied against the entire unpaid principal balance in the event of a nonmaturity default. Lenders in California should carefully review and discuss with counsel their loan documents to determine whether they contain default interest or late fee provisions which could be impacted by this decision.

With that said, and given the Honchariw court’s express distinction between partially and fully matured obligations, the Honchariw decision does not appear to have any impact on the ability of lenders to impose default interest against the entire unpaid principal on accelerated loans. Lenders imposing default interest after accelerating loans should, as always, be mindful of other implications of loan acceleration.

For More Information

If you have any questions about this Alert, please contact Meagen E. Leary, Marcus O. Colabianchi, Elinor H. Murarova, Allison M. Midei, 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 contact.

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.