This article discusses a recent district court decision reversing the bankruptcy court's order disallowing the portion of a lender's claim for default interest.

Recently, the U.S. District Court for the Central District of California (sitting as an appellate court) reversed the lower bankruptcy court’s order disallowing the portion of a lender’s claim for default interest in East West Bank v. Altadena Lincoln Crossing, LLC. [1]

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 five 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.

Bankruptcy Court's Decision

After conducting an evidentiary hearing, the bankruptcy court held that the default interest the 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), in disallowing the lender’s default interest.

Appeal to the U.S. District Court

On appeal to the U.S. District Court for the Central District of California, the lender challenged the bankruptcy court’s legal conclusions. In particular, the parties disagreed regarding whether the bankruptcy court’s application of the California Civil Code § 1671(b)[2] analysis was appropriate. The lender contended that Section 1671(b) was inapplicable.

The parties also differed on the result assuming Section 1671(b) applied. The lender argued that the default interest rate was presumptively valid and that debtor failed to overcome that presumption of validity. The debtor disagreed and contended that the bankruptcy court’s ruling, that the default interest constitutes an impermissible penalty under California law, was correct.

District Court’s Decision

Does Cal. Civ. Code § 1671(b) Apply?

Contrary to the bankruptcy court's ruling, the district court concluded that Section 1671(b) does not apply to the default interest rate provision, and even if Section 1671(b) were to apply, its application would not invalidate the default interest rate provision.

The district court stated that California Supreme Court precedent dating back to 1894 supported the lender's position that a prospective increase in interest rate of a fully matured loan upon default is not subject to a Section 1671(b) analysis. Specifically, the district court cited and discussed Thompson v. Gorner,[3] stating that, in Thompson: the California Supreme Court held that upon the borrower's default, a lender was entitled to charge the higher post-default interest rate that the parties had agreed upon at the time of the origination of the loan.[4] In doing so, the court rejected the trial court's conclusion that the default interest rate was in the nature of a penalty and instead adopted the Court of Appeal opinion that the increase should be treated as a contract to pay the higher interest rate upon the occurrence of a contingency that had been shown to have occurred.[5]

The district court found that Altadena was similar to Thompson in all material respects. The loan at issue in each case involved a borrower paying the interest due monthly but when the loan matured and the principal was due, the borrower did not satisfy the full obligation under the note. In both cases, pursuant to the loan agreement, the interest rate increased upon the failure to pay the principal amount when due. These are the material facts upon which the California Supreme Court found no unenforceable penalty and instead found that the agreement provided for an alternative performance that was not subject to the § 1671(b) analysis. In other words, the default interest provision was a bargained for exchange.

Even If Cal. Civ. Code § 1671(b) Applies, Did Debtor Rebut the Presumption of Validity?

The court also concluded that even if Section 1671(b) applied, the debtor had not met its burden to rebut the presumption of validity of the default interest rate provision. Since 1978, California law has presumed the validity of liquidated damages clauses in commercial contracts by stating, "a provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made." [6]

The district court noted that "a liquidated damages clause becomes an unenforceable penalty only 'if it bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach.'" [7] The district court further noted that “the amount set as liquidated damages 'must represent the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that may be sustained.'" [8]

In terms of the "reasonable endeavor" requirement, the district court noted that it should not be read to require that the provision be the subject of actual negotiation by the parties prior to contract formation. Instead, the "reasonable endeavor" requirement means only that a liquidated damages provision must be reasonable in light of the potential harm that could result from a breach, as that harm could be anticipated at the time of contract formation.[9] The district court also looked at the effect of debtor's default on the value of the loan held by lender for a reasonable estimate of the potential harm to lender if debtor defaulted.

Takeaways

The district court's analysis is consistent with applicable California law and its decision is appropriate in light of the parties' contractedfor bargain. There will likely be further proceedings, including a possible appeal to the U.S. Court of Appeals for the Ninth Circuit, in connection with this ruling.

Notes

[1] East West Bank v. Altadena Lincoln Crossing, LLC, 2019 WL 1057044 (C.D. Cal. 2019).

[2] California Civil Code § 1671(b) states that “a provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.” See Cal. Civ. Code § 1671(b).

[3] Thompson v. Gorner, 104 Cal. 168, 37 P. 900 (1894).

[4] Id. at 171.

[5] Id. at 170.

[6] See Cal. Civ. Code § 1671(b) (emphasis added).

[7] Ridgley v. Topa Thrift & Loan Ass'n, 17 Cal. 4th 970, 977, 73 Cal. Rptr. 2d 378, 953 P.2d 484 (1998).

[8] Id.

[9] Better Food Markets v. American Dist. Tel. Co., 40 Cal. 2d 179, 187, 253 P.2d 10, 42 A.L.R.2d 580 (1953).

Marcus O. Colabianchi is a partner at Duane Morris LLP with a national bankruptcy, creditors’ rights and real estate practice. Meagen E. Leary, a partner at the firm and co-chair of the Business Reorganization and Financial Restructuring Practice Group, maintains a national creditors' rights, commercial real estate finance, and bankruptcy practice. The authors may be reached at mcolabianchi@duanemorris.com and meleary@duanemorris.com, respectively.

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