The California Court of Appeals recently ruled that California law treats default interest measured against the outstanding principal balance of a loan as an unenforceable penalty. In Honchariw v FJM Private Mortgage Fund, LLC (see link) the court ruled that under California Civil Code Section 1671, a charge of default interest must have a “reasonable connection” to the lender’s actual damages resulting from the breach to be enforceable . The borrower in Honchariw prevailed because the court found that, on its face, a charge of 9.99% of the remaining loan principal balance imposed after a missed monthly payment had no reasonable relationship to the actual damages of the lender.
Section 1671 provides that for “non-consumer contracts” such as the one at issue in Honchariw, liquidated damages for breach are valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable in the circumstances existing at the time the contract was entered into. Here, the court determined that the default interest provision was contrary to public policy and therefore unreasonable by definition. The court cited a 1973 California Supreme Court ruling that it is California public policy that “[t]The amount fixed as damages “must represent the result of a reasonable effort by the parties to estimate a fair average compensation for any loss that may be suffered”. In the absence of such a relationship, a contractual term purporting to predetermine damages ‘must be interpreted as a sanction.'” (Garrett c. Coast & Southern Fed. Economy. & Loan Assn. (1973) 9 Cal.3d 731, 739.) The Garrett The ruling concluded that “compensation for late payment of a loan term that is measured against the outstanding balance of the loan should be considered punitive.” Garrett at 740. The Honchariw court summed up its position by saying that “Garrett remains good law for the proposition that a late fee assessed against the entire outstanding balance of a loan is an unlawful penalty and there is nothing in current section 1671 or the case law that follows Garrett holding otherwise.” Honchariw at 8.
It is important to note that the ability of a lender to charge default interest on the outstanding principal balance of a loan in the event of default or acceleration of maturity (depending on the wording of the agreement) does does not seem to be affected by Honchariw Case. By dealing with the arguments put forward by the lender in Honchariwthe court specifically distinguished between missing installments on a “partially matured obligation[s]” and a default at the final maturity of the loan. Honchariw at 12.
For those considering or currently engaged in business in California, lenders to commercial borrowers should be aware that late fees or assessed charges that do not bear a reasonable relationship to the total amount owed may amount to damages- illegal interests, unenforceable in court. in California or under California law. In addition, such commercial borrowers may claim costs and expenses as awarded in Honchariw. In addition, if other late payments are related to the provision on default interest, they also risk being invalidated.
©2022 Katten Muchin Rosenman LLPNational Law Review, Volume XII, Number 312