From the Desk of the CMA’s General Counsel, Robert Finlay:

Default interest is a hot button for borrowers, lenders and the courts. Most courts inherently do not like default interest because they see it as an improper “penalty”. That is the exact result reached on September 29, 2022 by the First District of the California Court of Appeals in Honchariw vs. FJM Private Mortgage Fund, LLC. 

The Facts

In 2018, the Honchariws took out a $5.6M bridge loan. In the event of default, the Honchariws agreed that FJM could charge both a one-time 10% late payment fee of roughly $39k and default interest of 9.99% on the entire loan balance. The loan documents even went so far as to explain that these charges are necessary because a default “will result in [FJM] incurring additional expense in servicing the loan, including, but not limited to, sending out notices of delinquency, computing interest, and segregating delinquent sums from the not delinquent sums on all accounting, loan and data processing records, in loss to [FJM] of the use of the money due, and in frustration to [FJM] in meeting its other financial commitments.” This language appears intended as an agreement between the parties that the late charge and default interest were justified as compensation to FJM resulting from the default. These provisions (or similar ones) are common to many non-consumer loan documents.

After missing a monthly payment, FJM declared the loan in default and assessed the one-time late charge and added the default interest to the entire loan balance. The Honchariws initiated arbitration to dispute both charges. The Arbitrator ruled in FJM’s favor, finding that the charges were NOT a penalty. The Honchariws’ attempt to vacate the Arbitrator’s award was also denied, leading to this appeal.

The Decision

In a published decision, the Court of Appeals vacated the Arbitrator’s award, finding that the default interest provision was an unlawful “penalty” and, therefore, unenforceable. The decision starts by correctly determining that liquidated damage provisions are presumed valid when involving a non-consumer loan and presumed invalid when involving a consumer loan. Since this case involved a non-consumer loan, the Honchariws have the burden to prove that the default interest provision is invalid by showing that the amount of damages bares a “reasonably relationship” to the damage that will be caused by the default. In other words, if the default interest charge is $100k, the borrower must prove that the lender will not incur $100k of additional expense or loss as a result of the default. Rather than point to any evidence presented by the Honchariws showing that the default interest was NOT reasonably related to FJM’s loss, the Court concluded that the mere fact that default interest is being charged on the entire loan balance is, in and of itself, a violation of public policy and therefore, the Honchariws had met their burden. 

Take-Aways

The Court focused its decision on default interest charged on the entire loan balance following a monthly payment default. The Court distinguished contrary case law supporting the validity of default interest charged on the entire loan balance following the maturity of the loan. As a result, charging default interest on the remaining loan balance following the maturity of the loan should be unaffected by this decision. Likewise, this decisions arguably does not affect a lenders right to charge default interest on amounts in default. Of course, the default interest charge must still be reasonably related to the potential loss caused by the default.

Going forward, lenders should avoid charging default interest on the entire loan balance following any pre-maturity default. If a lender is currently charging default interest on a pre-maturity default, it should discuss with an attorney how best to reverse its current charges. Lenders may also consider amending the default interest provision in existing deeds of trust when extending or modifying the loan, or entering into a forbearance plan. For new deeds of trust, lenders may want to consult counsel about revising default interest rate provisions to comply with this decision.  

Interesting Tidbits

While not mentioned in the opinion, Mr. Honchariw is an attorney and the Honchariws are sophisticated borrowers. In fact, they have taken out several loans on the same property, at least three of which included similar default interest provisions. Each time, the Honchariws defaulted and then disputed the default interest provision. 

FJM is currently evaluating whether to file a Petition for Rehearing and/or a Petition for Review by the CA Supreme Court. The CMA and its General Counsel will be working with FJM’s counsel on ways to assist their efforts. If you’d like to find out more about this decision, its impact on existing default provisions and whether the decision can be overturned, please join the CMA’s General Counsel, Robert Finlay, on October 13, 2022 at 2:00pm – 3:00pm for the CMA’s Legal Update Webinar. Robert will discuss this case, as well as run through recently passed laws with our lobbyist, Mike Belote.