Page 32 Summer 2019 Points of Interest Default Interest – continued from page 31 Relying on California Supreme Court precedent dating back to the 1894 case entitled Thompsonv.Gorner (1894) 104 Cal. 168, which held that 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, the Court agreed with EWB’s position that a prospective increase in interest rate of a fully matured loan upon default is not subjecttoa§1671(b)analysis. Additionally, theCourtrefusedtoviewtheDIRprovision as a penalty and instead likened the provision to an additional contract or agreement for an alternative performance (pay a higher interest rate upon default) in the event that the original anticipated performance (repay the full loan amount uponmaturity)doesnotoccur. Specifically, the Court stated: This case is similar to Thompson in all material respects. In each case, at issue was a loan where the borrower had paid 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 materials facts upon which the California Supreme Court found nounenforceablepenaltyandinstead foundthattheagreementprovidedfor an alternative performance that was not subject to the § 1671(b) analysis. Moreover, the Court found that “[i]n Thompson, higher interest was assessed ... only on the amounts in default,” and therefore, because Altadena, like the borrower in Thompson, defaulted on a fully matured obligation, the higher interest rate was assessed only on the defaulted amount, making the present caseindistinguishablefromThompson. As such, the Court concluded that§ 1671(b) was not applicable to the default interest rate provision at issue in on appeal. Notwithstanding the fact that § 1671(b) was found to be inapplicable, the Court also took issue with the Bankruptcy Court’s legal conclusions with respect to its application of § 1671(b) to the DIR provision in question. Notably, the Court pointed out that the Bankruptcy Court misinterpreted the “reasonable endeavor” language as a requirement that the DIR provision actually be subject to negotiation by the parties prior to contractformation. Thismisinterpretation ultimately led to Bankruptcy Court’s improper conclusion that the industry standard and generic DIR provision was unenforceable because the parties never engaged in any negation regarding its inclusionintheloanagreement. TheCourt expressly held that: There is no requirement that the partiesnegotiatealiquidateddamages provision for it to be enforceable; 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. After finding that § 1671(b) did not apply, the Court focused its analysis on whether Altadena met its burden of establishing that the 5% DIR increase was not, at the time of contract formation, a reasonable estimate of the potential harm to EWB if Altadena defaulted. In concluding that Altadena failed to meet its burden, the court looked to the expert testimony provided by the parties. The Court was ultimately convinced by EWB’s uncontradicted expert testimony that detailed how a borrower’s default reduces the value of the lending bank’s asset (i.e., the “loan”) in a measurable economic way. The expert testimony led the Court to conclude that the diminution invalueoftheloanasanassetheldbyEWB was within the range of actual damages that the parties could have anticipated would flow from a breach and that such increase in the interest rate upon default is a common method of recouping the type of loss incurred by a lender upon a borrower’s default. The Bankruptcy Court’s Order may have initially felt like a blow to lenders throughout California, however, thanks to the Court’s opinion on appeal, those feelingswereshortlived. However,before running out to include DIR provisions in every loan, please keep in mind that (1) theDIRmustbea“reasonableestimate”of thepotentialharmtothelendercausedby thedefault;and(2)Altadenahasappealed the decision to the 9th Circuit Court of Appeals. Stay tuned for more once the 9th Circuit rules. Disclaimer: The above information is intended for information purposes alone and is not intended as legal advice. Taylor Hubbard is an Associate in Wright Finlay&Zak'sCaliforniaoffice. RobertFinlay is a founding Partner of WFZ.