The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:
A district court in California has held that a state statute invalidating contractual penalty provisions was inapplicable to a default interest rate clause contained in loan documents. [East West Bank vs. Altadena Lincoln Crossing, LLC, 2019 Westlaw 1057044 (C.D. Cal.).]
Facts: A lender and a commercial borrower entered into two related real estate construction loan agreements, both of which contained clauses increasing the base interest rate by 5% in the event of default. The agreements also contained late fee provisions, which were intended to compensate the lender for any additional administrative costs arising from late payments.
After the developer filed a Chapter 11 petition, the lender sought to recover interest at the default rate set out in the parties’ governing documents. The debtor objected, claiming that the default rate of interest was an unenforceable penalty under California Civil Code §1671(b). The bankruptcy court ruled in favor of the debtor, but the district court reversed.
Reasoning: Citing Thompson v. Gorner, 104 Cal. 168 (1894), the court held that default interest provisions are simply not treated as penalties under §1671(b).
As a fallback, the court reasoned that even if §1671 were applicable, the default rate in this case would have been enforceable as liquidated damages. Citing numerous California appellate cases, the court acknowledged that a liquidated damages provision must represent the result of a “reasonable endeavor” by the parties to estimate the probable losses resulting from a breach.
The bankruptcy court had held that there was no evidence that the lender and the borrower had negotiated the default rate; therefore, they had not engaged in a “reasonable endeavor” to set the default rate. However, the district court held that the bankruptcy court’s focus on contractual negotiations was too narrow:
This “reasonable endeavor” requirement is imprecisely phrased and, contrary to the Bankruptcy Court’s discussion, should not be read to require that the provision be the subject of actual negotiation by the parties prior to contract formation. Specifically, the Bankruptcy Court improperly concluded that there was no such “reasonable endeavor” because “there was no endeavor at all by either of the parties at the time they entered into the loans . . . to estimate any losses that might be suffered by [the lender] in the event of a default . . . .” There is no requirement that the parties negotiate a liquidated damages 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.
The court went on to hold that the borrower’s defaults had devalued the overall loan package, from the standpoint of the lender:
The loan is a liability to [the borrower], but it is an asset to [the lender], and an uncured default affects the value of that asset. Below, the Bankruptcy Court rejected [the lender’s] argument that the diminution of the value of [the lender’s] asset is not the type of harm or damage that can be used to measure anticipated harm or damages under §1671(b); instead, the Bankruptcy Court held that damages must be realized – must be “out-of-pocket damages” – in order to be considered in determining the reasonableness of a liquidated damages provision . . . .
The Bankruptcy Court cited no authority for this proposition, and the Court rejects it.
The district court relied on the lender’s expert, who testified that the defaults had diminished the value of the loan package:
[T]he diminution in value of the loan as an asset held by [the lender] was within the range of actual damages that the parties could have anticipated would flow from a breach. Expert evidence of record establishes that an increased interest rate is a common method of recouping this type of loss, and that the increase in the interest rate upon default in this case is not likely to overcompensate [the lender]. As such, it not an unenforceable penalty.
Author’s Comment: Does the ancient Thompson line of cases still stand for the proposition that a default interest provision, no matter how Draconian, can never be attacked as a penalty under §1671? It has been a long time (over a hundred years) since the California Supreme Court has squarely addressed this issue; the courts have become much less tolerant of harsh liquidated damages provisions in the last century.
Thus, if this case were proceeding in the state courts, I would predict reversal. However, since this is now in the federal court system, I am not sure that the Ninth Circuit will have the courage to hold that Thompson is no longer good law.
In any event, I think that lenders would be wise to support default interest rate provisions with carefully-worded factual recitals, right in the body of the agreement, demonstrating as a factual matter why the provision is needed and why it is the parties’ best approximation of the anticipated losses. Could the borrower later repudiate those factual recitals? Maybe not. See Cal. Evid. Code § 622: “The facts recited in a written instrument are conclusively presumed to be true as between the parties thereto . . . .” (For a discussion of a case in which that drafting technique was successful, see 2015-30 Comm. Fin. News. NL 60, Liquidated Damages Claim for Default Interest Is Enforceable Because Promissory Notes Recite Difficulty of Ascertaining Lender’s Actual Damages.)
Given the bankruptcy courts’ perennial antipathy to default interest rates, I am surprised that the finance industry still uses bland and generic “one-size-fits-all” default interest provisions, without including anticipatory verbiage to forestall the borrower’s inevitable liquidated damages attack.
For discussion of the bankruptcy court’s decision in this case, see 2018-30 Comm. Fin. News. NL 59, Default Interest Rate is Unenforceable Penalty Because Loan Agreements Did Not Contain Estimate of Probable Costs to Lender Resulting from Borrower’s Default.
For discussions of other cases dealing with related issues, see:
- 2016-45 Comm. Fin. News. NL 89, When Plan of Reorganization Cures Debtor’s Default, Creditor is Entitled to Interest at Default Rate Specified by Promissory Note.
- 2006 Comm. Fin. News. 20, Postdefault Interest Rate of 36% Is Approved Because Congress Did Not Impose “Reasonableness” Requirement.
- 2005 Comm. Fin. News. 22, Oversecured Lender’s Claim for Default Interest Is Actually a “Charge” That Must Be Reasonable and Cannot Be Awarded in Addition to Late Fees.
- 2004 Comm. Fin. News. 19, Contract Rate Governs Cramdown Interest, Unless Creditor Produces Evidence to Show That Default Rate Reflects Actual Damages.
These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.