California Supreme Court Upholds Restrictions on Default Interest Penalties

The California Supreme Court (Cal. Supreme Court Case No. S277159) denied review of the California 1st District Court of Appeal decision in Honchariw v. FJM Priv. Mortg. Fund, LLC, resting the holding as current law in California. The Court of Appeal’s December 2022 holding provides that no lender may charge default interest against the principal balance of a loan following a payment-only default unless such default is a maturity default. As a consequence, lenders may, subject to certain fact-based exceptions detailed below, only charge default interest on the unpaid installment amount presently in default.

Interestingly, a lender’s ability to impose default interest on the outstanding principal balance of a loan upon acceleration does not appear to have been impacted by the recent case. In addressing arguments made by the lender in Honchariw, the court distinguished charging default interest on a maturity date default from charging default interest calculated using the full loan amount because of a missed installment payments on partially matured obligations.

It may be prudent for lenders who do business in California to review and revise their default interest policy to align with the new ruling such that either its loans can be accelerated after a missed installment payment or any default interest would only apply to the amount of the missed payments and not the entire principal balance unless the default occurred post-maturity.

Separately, in California, liquidated damages must bear a “reasonable relationship” to the actual damages that the parties anticipate would flow from breach, so one additional alternative would be to implement changes to loan documents so that any late fees or penalties relate directly to the actual damages stemming from the default. Such damages could include attorneys’ fees, credit line charges, personnel time, and other actual expenses. It should be noted, however, that calculation of a lender’s actual damages stemming from a default can be imprecise, so imposing actual damages is something a borrower could challenge. If a lender opts for implementing actual damages as the late penalty, it should be prepared to back up the amount it claims.

Brief Background

Plaintiffs Nicholas and Sharon Honchariw took out a $5.6 million bridge loan with 8.5 percent interest assessed per annum on December 12, 2018, secured by a first lien deed of trust on real property from defendant, FJM Private Mortgage Fund, LLC. Pursuant to the loan agreement, the event of a default triggered certain late-payment fee provisions, including (1) a one-time 10 percent fee assessed against the overdue payment; and (2) a default interest charge of 9.99 percent assessed annually against the total unpaid principal balance.

On September 1, 2019, the plaintiffs triggered the late-payment fee provisions when they missed a monthly payment. The plaintiffs commenced arbitration and argued, among other things, that such late-payment fee provisions were unlawful under section 1671 of the California Civil Code, which provides that a liquidated damages provision is either presumptively valid or invalid depending upon the subject matter of the contract. Ultimately, the arbitrator rejected the plaintiffs’ original arguments and ruled in favor of the lender. On appeal, the Superior Court of Sonoma County affirmed the arbitrator’s award. The plaintiffs then appealed to the Court of Appeal, which reversed the lower court’s ruling and vacated the arbitration award.

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 balance of a loan was punitive in character and constituted an unlawful penalty. The Court of Appeal provided that it is the public policy of California that liquidated damages bear a “reasonable relationship” to the actual damages that the parties anticipate would flow from breach, whereas late-payment fees may violate liquidated damages statutes and amount to unlawful penalties if they bear no relationship to the loss incurred by the lender and their chief purpose is to coerce prompt payment. In such a scenario, the court indicated it viewed it as a form of penalty that violated public policy in California.

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 Honchariw, the fact that the loan was only partially matured was dispositive. The court’s review of case law indicated that it found no instances in which a liquidated damages provision was upheld when a borrower missed a single installment and then was charged interest on the full amount outstanding while such remaining amount was yet to be due.

The Court of Appeal held that “liquidated damages in the form of a penalty assessed during the lifetime of a partially matured note against the entire outstanding loan amount are unlawful penalties” under section 1671 and concluded “Garrett remains good law for the proposition that a late fee assessed against the entire unpaid balance of a loan constitutes an unlawful penalty and there is nothing in current section 1671 or the case law following Garrett holding otherwise.”

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