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By Adrian Reyna and David J. Vogel
March 22, 2024
A recent California 1st District Court of Appeal decision, Honchariw v. FJM Private Mortgage Fund, LLC (83 Cal. App. 5th 893) (“Honchariw”), held that default interest charged on the entire outstanding principal balance of a defaulted commercial loan constitutes an unenforceable penalty.
The court’s decision in Honchariw imposes limitations on a party’s right to enforce “liquidated damages” provisions in contracts (contractually required payments resulting from the defaulting party’s non-compliance). Although Honchariw arose out of a commercial loan gone bad, the court’s decision has broader implications for any contract containing a “liquidated damages” provision.
Background of the Case
FJM made a “private” commercial loan to Honchariw. The loan was secured by real property and contained a customary late fee provision and a default interest provision. The late fee was 10% of the overdue payment and the default interest rate was 9.99% (the non-default interest rate was 8.5%). The loan provided that the default interest rate would be assessed against the total unpaid principal balance of the loan until the loan was paid in full, or until the specific default was cured.
Honchariw failed to make a regular installment payment of $39,667. FJM charged a one-time late fee of $3,967, and commenced charging default interest on the entire principal balance outstanding on the loan at the default interest rate.
Honchariw commenced arbitration, arguing that the default interest charged constituted an unlawful penalty in violation of California Civil Code Section 1671 (“Section 1671”). The arbitrator denied Honchariw’s claim. Honchariw petitioned the trial court vacate the arbitration award, which the trial court denied. Honchariw appealed the case.
The Court’s Analysis
The case turned on the application of Section 1671, which provides that in commercial contracts, a liquidated damages provision is presumed 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.”
The Court’s analysis relied heavily on a 1973 California Supreme Court case, Garrett v. Coast & Southern Fed. Sav. & Loan Assn. (“Garrett”), in which the Supreme Court had previously interpreted Section 1671. Citing to Garrett, the Court explained that California public policy requires liquidated damages provisions to bear a “reasonable relationship” to the actual damages that the parties anticipate would result from a breach of contract. 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,” and if they do not, they constitute unenforceable “penalties.”
The Court acknowledged that the sum of the late fee and the default interest charged, (collectively, the “late fee”), serve a dual purpose by encouraging on-time payments and serving as compensation to the lender. However, the Court explained, late fees which have the primary purpose of compelling timely payment through threatening charges which have little to no relationship to the amount of the lender’s actual loss may constitute unlawful penalties which violate Section 1671.
In Garrett, specifically, the lender had similarly charged a 2% per annum late fee measured against the entire unpaid principal balance of the loan. The Supreme Court deemed this to be punitive, and therefore an unlawful penalty due to its coercive nature and because it was not reasonably calculated to compensate the lender.
In Honchariw, the Court found that FJM had failed to demonstrate that the late fees bore a reasonable relationship to the actual damages the parties had anticipated would flow from the breach. Therefore, just as in Garrett, because the late fees included a default interest rate assessed against the entire unpaid principal balance if a single payment is missed, the late fees were deemed an unlawful penalty and void under Section 1671.
Conclusion
Although the Court of Appeals found the late fee unenforceable, it is possible a lender could charge an enforceable late fee and default interest under other circumstances, including after the acceleration of a loan’s maturity, or where the default interest is assessed only against the amount in default, rather than the entire unpaid principal balance.
Though late fee and default interest provisions can serve important purposes in a commercial loan, such fees can be unenforceable if they rise to the level of an unlawful penalty under California law. As such, lenders should review the late fee and default interest provisions in their loan documents and proceed with caution before enforcing these provisions.
More broadly speaking, this case serves as a reminder that a “liquidated damages” provision in any commercial contract is subject to attack if the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.
Our team of attorneys is prepared to assist you in understanding the enforceability of liquidated damages provisions in commercial contracts. If you have any questions, please contact David Vogel at dvogel@hechtsolberg.com or Adrian Reyna at areyna@hechtsolberg.com.