In the recent case of Honchariw v. FJM Private Mortgage Fund LLC, the Court of Appeal of the State of California, First Appellate District, held that default interest is unlawful when a lender assesses it against the full outstanding principal balance on a partially matured loan, and where there is no evidence that the amount was a reasonable estimate of the lender's anticipated damages when the parties executed their loan agreement.
The Honchariw decision could therefore affect lenders attempting to enforce loans governed by California law. This article discusses the decision and key takeaways for lenders.
Background
In 2018, the Honchariw borrowers obtained a $5.6 million commercial loan governed by California law.
The loan agreement provided in relevant part that, in the event of a default, the borrower had to pay a one-time 10% fee assessed against the overdue payment and a default interest charge of 9.99% assessed annually against the total unpaid principal balance of the loan.
The default interest provision specifically provided, "any unpaid principal balance of the loan at the time of default shall bear interest at the rate of [9.99%] … automatically and without notice, from the time of default, until this Note has been paid in full, or until the specific default has been cured."
In 2019, the borrowers missed a monthly payment and thereby triggered the late fee and default interest provisions. The borrowers subsequently commenced arbitration against the lender seeking to invalidate both the late fee and the default interest provisions.
The borrowers argued, among other things, that the late fee and default interest provisions violated Section 1671 of the California Civil Code, which provides that liquidated damages provisions in commercial contracts are presumptively valid and liquidated damages provisions must bear a "reasonable relationship" to the actual damages that flow from a breach.
The arbitrator rejected the borrowers' arguments about Section 1671 and ruled in favor of the lender, and the Superior Court of Sonoma County affirmed the arbitrator's award.
The borrowers appealed to the First Appellate District, which reversed the lower court's ruling and vacated the arbitrator's award by finding that the award enforced a contract that violated public policy, and therefore exceeded the arbitrator's powers.
Ruling
In short, the First Appellate District held that the default interest provision violated Section 1671 of the California Civil Code because "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."
While at times the court lumped the late fee and default interest provisions together, the court's ruling and reasoning focused on the default interest provision, which unlike the late fee provision, charged interest against the full unpaid principal balance of the loan.
Specifically, the First Appellate District reasoned that default interest assessed against the entire unpaid principal balance of this loan was not reasonably related to actual damages as required by Section 1671 because the loan had not yet matured and the lender did not offer any specific or nonconclusory evidence as to reasonableness.
The First Appellate District primarily relied on the 1973 decision in Garrett v. Coast & Southern Federal Savings & Loan Association, a California Supreme Court decision invalidating a default interest provision assessed against the entire unpaid principal balance of a partially matured consumer loan.
The Honchariw lender argued that Garrett interpreted an outdated version of Section 1671, which made all liquidated damages provisions in both consumer and commercial agreements presumptively invalid, and was therefore inapplicable.
But the First Appellate District rejected this argument, finding that Garrett controlled even under the current Section 1671.
The First Appellate District therefore followed Garrett and found that default interest is an unenforceable penalty when it is assessed against the entire unpaid principal balance after a single missed installment payment, and where there is no meaningful evidence to prove that the default interest reasonably estimated the lender's damages following the borrowers' default.
The First Appellate District also distinguished recent cases allowing default interest on the full principal balance upon a borrower's default on a fully matured loan, finding that the First Appellate District should reach a different conclusion with the Honchariw partially matured loan.
The lender asked the First Appellate District to rehear the ruling, but the court denied the request on Oct. 26, 2022. The lender also filed a petition for review in the California Supreme Court, but it denied the petition on Dec. 21, 2022. The First Appellate District's ruling is therefore final.
Conclusion and Takeaways for Lenders
Honchariw has potentially significant implications for lenders enforcing defaulted loans — particularly unaccelerated and unmatured loans — governed by California law. Moreover, we expect borrowers to increasingly rely on Honchariw when challenging default interest.
That said, Honchariw appears to leave open the possibility that lenders seeking to impose default interest against the entire principal balance of a partially matured loan could attempt to offer evidence that the default interest is not a penalty but is instead a reasonable estimate of the lender's anticipated damages following a default.
Lenders should therefore carefully consider the evidence they may have — or don't have — on that issue prior to charging default interest.
Moreover, the Honchariw court expressly distinguished between partially and fully matured loans. The Honchariw decision therefore does not appear to affect lenders' ability to impose default interest against the entire unpaid principal on fully matured loans — where allowed under the loan documents — including accelerated loans.
The First Appellate District also did not find that lenders must, even with fully matured loans, offer evidence that default interest is a reasonable estimate of anticipated damages. We expect, however, that borrowers may attempt to rely on Honchariw even in the fully matured loan context to argue that lenders must make such a showing.
Counsel should therefore carefully review and discuss loan documents with lenders both before and during enforcement to determine whether the loan documents contain any provisions potentially affected by Honchariw. Lenders could also consider monitoring cases applying Honchariw, as they may further affect this issue under California law.
