May 2019

 

                                                                                              Making Default Interest Safe

 

In bankruptcy case, CC §1671 (regulating contractual liquidated damages) did not apply to higher interest rate assessed only on amount defaulted on fully matured commercial obligation. Higher default interest rate was not unenforceable penalty.

East W. Bank v Altadena Lincoln Crossing, LLC (CD Cal, Mar. 6, 2019, No. 2:18-CV-08738-JLS) 2019 US Dist Lexis 36200

Developer took out two bank loans ($26 million and $2.5 million) to finance a construction project. The loans were secured by deeds of trust on the property under construction. Developer could not repay the principal on maturity and Bank applied a default interest rate provision. Over 8 years, the parties entered into several forbearance agreements, extending the maturity date of the larger loan. After Bank refused to renew the last forbearance agreement, Bank began foreclosure proceedings and Developer filed for bankruptcy. The bankruptcy court held the contractual 5 percent default interest rate increase under CC §1671 was unenforceable. The district court reversed and an appeal to the Ninth Circuit has been filed.

Civil Code §1671(b) states that “a provision in a contract liquidating the damages for the breach of the contract is 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.” Developer had the burden of proof to show the contractual default interest provision was unreasonable. The bankruptcy court held that Developer had established the invalidity of the default interest provision because the parties had used an industry standard or customary interest rate rather than an individualized interest rate that would give Bank a fair average compensation for any loss that it might have suffered in the event of a default. The district court, however, noted that California Supreme Court precedent instructs that a CC §1671(b) analysis should not be applied to default interest rate provisions when the defaulting party fails to make payment on a fully matured note. Here, the higher interest rate was assessed only on the defaulted amount, which mirrors the circumstances in Thompson v Gorner (1894) 104 C 168 (lender entitled to charge higher post-default interest rate).

Assuming arguendo that CC §1671(b) applied here, Developer failed to satisfy its burden to rebut the presumptive validity of the default interest rate provision and to show the clause to be an unreasonable, unenforceable penalty. The bankruptcy court misinterpreted the “reasonable endeavor” requirement in Garrett v Coast & S. Fed. Sav. & Loan Ass’n (1973) 9 C3d 731, 739, to require the parties to actually negotiate over the interest rate provision before the contract is executed. At contract formation, Developer was represented by counsel, the loan agreement terms were negotiated over a course of months, and the agreements went through a number of drafts. The district court considered these facts in determining that the liquidated damages provision here was reasonable, given the potential harm that could result from a breach (as anticipated at the time of contract formation).

Developer argued other contractual fees protected Bank in the event of a default, so the default interest rate provision was intended primarily to provide Developer with an added incentive to perform under the loan agreements. But this argument focused too narrowly on Developer, particularly when Bank suffered a loss of property value when the default remained uncured. The bankruptcy court, without legal authority, required Bank’s damages to be realized, “out-of-pocket damages” before those damages could be used to judge the reasonableness of the liquidated damages provision. 2019 US Dist Lexis 36200 at *8. The district court on appeal rejected this requirement “that the range of damages that may be taken into account in determining §1671(b) reasonableness is limited to out-of-pocket damages.” 2019 US Dist Lexis 36200 at *19. The increased interest rate here was not an unenforceable penalty because it may be considered a standard method of recouping the diminution in property value on default and was not likely to overcompensate Bank in the event of a default.

 

THE EDITOR’S TAKE: Making Default Interest Safe. To my knowledge, this is the first decision applying CC §1671 to default interest. Garrett v Coast & S. Fed. Sav. & Loan Ass’n (1973) 9 C3d 731, 739, our leading case in this area, involved a late charge fee rather than a default interest rate, and so may not be applicable. The decision arises out of a bankruptcy, and may not apply outside that context.

Steven Bender and Michael Madison—two scholars who keep track of this issue—offer a series of thoughtful suggestions for lenders to stay out of trouble in The Enforceability of Default Interest in Real Estate Mortgages, 43 Real Prop Tr & Est LJ 199, 217 (Summer 2008). I will summarize some of them here:

1.Set the default rate “with an eye toward the market” and be ready to justify it in terms of the actual or threatened risk posed by a default.

2.Don’t be greedy. A default rate more than double the contract rate will probably need special justification.

3.Be sure the loan is procedurally fair, particularly when the default rate (or the contract rate) appears to be excessive. Have the borrower sign a separate default rate rider, and have the borrower and his or her attorney certify that he or she appreciates the consequences of the default provisions.

4.Ensure that the default rate operates separately from the late fee provision.

There is more in the article, but compliance with these should help a lot.

Thanks to Steve and Mike for their thoughtful suggestions. —Roger Bernhardt

 

Reprinted from 42 Real Property Law Reporter 64 (Cal CEB May 2019), copyright 2019 by the Regents of the University of California. Reproduced with the permission of Continuing Education of the Bar - California (CEB). No other republication or external use is allowed without permission of CEB. All rights reserved.  (For information about CEB publications, telephone toll free 1-800-CEB-3444 or visit our website - CEB.com)

 

 

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