Honchariw v FJM Private Mortgage Fund, LLC (Cal. Ct. App.)

The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), analyzing a recent decision of interest:

SUMMARY

The California Court of Appeal recently vacated an arbitration award which had been affirmed by the trial court because the award, which enforced a Late Fee provision in commercial loan documents, constituted an unlawful penalty in contravention of the public policy set forth in California Civil Code § 1671 (§ 1671).  Honchariw v FJM Private Mortgage Fund, LLC, 2022 Cal. App. LEXIS 824, 2022 WL 4544812 (Sept. 29, 2022). 

To view the opinion, click here.

FACTS

Nicholas and Sharon Honchariw took out a $5.6 million bridge loan from FJM Private Mortgage Fund, LLC in 2018, with 8.5% interest, secured by a first trust deed on real property.  The Honchariws defaulted on their September 1, 2019 payment of $39,667, which triggered late-payment fee provisions set forth in the loan documents: (1) a one-time 10% fee assessed against the overdue payment and (2) a default interest charge of 9.99% per annum assessed against the total unpaid principal balance of the loan from that date forward until the note was paid in full (collectively, the “Late Fee”).  The Honchariws filed a demand for arbitration in October 2019, alleging the loan was in violation of the Real Estate Loan Law (Cal. Bus. & Prof. Code § 10240) and the Late Fee was an unlawful penalty in violation of § 1671.

The arbitrator ruled for FJM on both points.  The Honchariws petitioned the court to vacate the award on the basis that the arbitrator exceeded her authority by denying claims in violation of “nonwaivable statutory rights and /or contravention of explicit legislative expressions of public policy,” referring to both the Real Estate Loan Law and § 1671. The trial court denied the petition to vacate, concluding that the default interest provision was not invalid as a penalty.  The Honchariws appealed to the Court of Appeal, which reversed on § 1671 grounds and declined to rule on the Real Estate Loan Law arguments as they were not necessary to the resolution.

REASONING

Although an arbitrator’s decision is not generally appealable for errors of fact or law, Cal. Code of Civ. Proc. § 1286.2 provides an exception to that rule where “the arbitrators exceeded their powers and the award cannot be corrected without affecting the merits of the decision upon the controversy submitted.”  The Court of Appeal noted that an arbitrator may exceed her powers by making an award that violated “unwaivable statutory rights or that contravenes an explicit legislative expression of public policy.”  It then considered whether § 1671 sufficiently expressed a “well-defined and dominant” public policy to allow review of an arbitral decision.

Section 1671 provides that a liquidated damages provision is either presumptively valid or invalid depending upon the subject matter of the contract.   The Court of Appeal summarized its application simply:  a liquidated damages provision is presumptively valid if it is in a non-consumer contract and presumptively invalid if it is in a consumer contract.  The contract before the Court of Appeal was a non-consumer contract.  However, it concluded that whether an agreement is a non-consumer contract or consumer contract, it may not violate public policy.  The Court of Appeal determined that § 1671 expressed a clear public policy by reviewing long-standing legal precedents on the issue.  The public policy of California is that liquidated damages must bear a reasonable relationship to the actual damages that are anticipated to flow from a breach.  As the California Supreme Court said in Garrett v Coast & Southern Fed. Sav. & Loan Assn, 9 Cal. 3d 731 (1973), a case dealing with a late fee provision in a note, late-payment fees may violate § 1671 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 b the lender.”  Id. at 740.

With that background, the Court of Appeal looked at the exact penalty provided in the loan documents and enforced by FJM: not only a one-time 10% fee on the overdue payment but also a default interest charge assessed against the total unpaid principal balance of the loan.  On the latter provision, the Court of Appeal found compelling precedent in Garrett.  There, the California Supreme Court held 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.”  Id. at 740.  FJM argued that Garrett had been decided prior to a 1978 revision of § 1671, but the Court of Appeal looked to subsequent California Supreme Court authority which had cited Garrett with approval in concluding that imposition of such a late fee was a penalty because it was intended to coerce timely payment, not compensate for an anticipated loss. 

The Court of Appeal recognized that some recent cases had allowed a default interest rate on the full balance where a loan was fully matured, but it ruled that those cases did not provide authority for such imposition for a partially matured obligation such as was assessed against the Honchariws here.  Finally, it rejected FJM’s assertion that boiler plate language in the loan documents – which justified the liquidated damages based on the parties’ agreement that calculating damages would be difficult – was not persuasive without explicit evidence regarding how the parties reached that conclusion; that further explicit evidence was missing from the record here.  The conclusionary nature of the statement was by itself insufficient to override public policy.

AUTHOR’S COMMENTS

The procedural posture of this case is unusual, because a petition to vacate an arbitration award is disfavored in general.  Courts generally uphold the finality of arbitration without delving into the underlying merits as a matter of statutory law and policy.  However, the petitioners/appellants here managed to fit this matter into the exception provided by Cal Code of Civ. Proc. § 1286.2 and the case law construing it, which approves vacating such award if issued in violation of public policy.  The public policy argument prevailed here, on an issue frequently litigated in California courts: the enforceability of liquidated damages clauses.  Here, the constraint on enforceability of such clauses was considered in light of the imposition of late fees on a delinquent installment payment.

It would appear this case was published because of the age of Garrett and the assertions that subsequent changes in § 1671 had rendered it inapplicable, a concept soundly rejected by the Court of Appeal.  One important takeaway from this case is that it does not matter whether a transaction is consumer or non-consumer when it comes to liquidated damages clauses in contravention of public policy.  If liquidated damages are facially unrelated to the actual damages caused by a breach, the damages will be construed as coercing timely payments and therefore as penal in nature.  A penalty is just that and will not be tolerated by California courts in civil matters.

This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), a member of the ad hoc group of the Business Law Section of the California Lawyers Association. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.