California Court of Appeals Overturns Default Interest on Installment Note

In an opinion dated September 29, 2022, the California Court of Appeals for the First Appellate District held that a default interest rate and late fee charges are unlawful when assessed against the entire outstanding loan amount following the failure to pay one installment and thus could not be collected by the lender. Honchariw v. FJM Private Mortgage Fund, LLC, 83 Cal.App.5th 893.

Nicholas and Sharon Honchariw took out a $5,600,000 commercial loan from FJM Private Mortgage Fund, LLC (“FJM”), with an 8.5% annual rate of interest. The Honchariws defaulted on a $39,667 monthly installment payment during the first year of the loan term. By missing the payment, the Honchariws triggered (1) a one-time 10% fee was assessed for the overdue payment and (2) a default interest rate of 9.99% per annum was assessed against the entire unpaid balance of the loan until the specific default was cured (the fee and the default interest are together referred to as the “Late Fee”). The Honchariws contested the Late Fee alleging that the Late Fee was an unlawful penalty under Civil Code section 1671.

Section 1671 provides a presumption that a commercial contract provision liquidating the damages for a breach of the contract is valid unless it is established that the provision was unreasonable under the circumstances existing at the time the contract was made. The Court stated that the public policy of California is that liquidated damages must bear a “reasonable relationship” to the actual damages that the parties anticipate would flow from breach and that the amount set must represent the result of a reasonable endeavor by the parties to estimate a fair average compensation for any loss that may be sustained. Further, the Court stated that late payment fees “may violate section 1671 and amount to unlawful penalties if their “primary purpose is to compel prompt payment through the threat of imposition of charges bearing little or no relationship to the amount of the actual loss incurred by the lender.” The Court then cited the California Supreme Court decision in (Garrett v. Coast & Southern Fed. Sav. & Loan Assn. (1973) 9 Cal.3d 731, 740 (“Garrett”)) for the proposition that “a charge for the late payment of a loan installment which is measured against the unpaid balance of the loan must be deemed to be punitive in character” because it is “an attempt to coerce timely payment by a forfeiture which is not reasonably calculated to merely compensate the injured lender.” FJM argued that its loan documentation included the parties’ statement that FJM would incur “difficult to estimate expenses as a result of a default,” however, the Court held that FJM failed to demonstrate a reasonable relationship between the Late Fee and the range of damages that the parties could have anticipated would flow from such a breach.

The Court’s reading of Garrett could have broad implications for commercial lenders and their impositions of Late Fees. Lenders would be well advised to revisit the Late Fee provisions in their loan documentation to address the concerns raised in the Honchariw decision. That said, FJM filed a petition for review with the California Supreme Court on November 4, 2022, so this issue may not yet be settled.