The following is a case update written by Monique D. Jewett-Brewster, an attorney with Hopkins & Carley, ALC, analyzing a recent decision of interest:

SUMMARY

A California bankruptcy court has held that a contractual provision authorizing lender to recover default interest at the rate of 4% above the ordinary contract rate was not an unenforceable penalty under California or bankruptcy law. The court also ruled that the default rate was enforceable as a liquidated damages clause.  [In re 3MB, LLC, Case No. 18-14663-B-11, 2019 WL 6701420 (Bankr. E.D. Cal. Dec. 5, 2019).]

To view the entire opinion, click here.

FACTS

Debtor 3MB, LLC borrowed about $9.5 million in two loans from Prudential Mortgage Capital Company, LLC.  The debt was secured by 3MB’s shopping center in Bakersfield, California, and the rents generated thereby. The consolidated “Note” evidencing the debt contained an interest rate of 6.27% per annum.  The Note also contained a provision for default interest of 4% plus the note rate and, by its terms, was applicable “at all times after maturity.”

The Note later was assigned to U.S. Bank, N.A., as successor trustee (U.S. Bank).  3MB defaulted under the Note by failing to retire it upon maturity.  Thereafter, U.S. Bank initiated a nonjudicial foreclosure proceeding to enforce its deed of trust. Two days before the trustee’s sale, 3MB filed for bankruptcy protection under Chapter 11.

U.S. Bank filed a proof of claim for just under $9 million, which included over $200,000 in accruing default interest under the Note. 3MB objected to the default interest component of U.S. Bank’s claim, arguing that the default interest provision constituted an unenforceable liquidated damages clause under California and bankruptcy law.  3MB also asserted that U.S. Bank’s claim for default interest should be disallowed on equitable grounds.  U.S. Bank argued that its default rate constituted “alternative performance” under the matured note.  Alternatively, U.S. Bank contended that, even if the default rate constituted a liquidated damages clause, 3MB failed to meet its burden of proving it was invalid.  After conducting an in-depth analysis of California contract law, the bankruptcy court overruled 3MB’s objection.

REASONING

The court began its analysis by acknowledging that an oversecured creditor may file a claim to collect its contractual interest pursuant to Bankruptcy Code section 506(b).  Citing to GE Capital Corp. v. Future Media Prods., 536 F.3d 969, 973 (9th Cir. 2008) (GECC), the court noted the Ninth Circuit’s instruction that “the default rate should be enforced, subject only to the substantive law governing the loan agreement, unless a provision of the Bankruptcy Code provides otherwise.”  Id.  The bankruptcy court also noted that, under GECC, the debtor has the burden to demonstrate that a default rate is unreasonable or unenforceable under nonbankruptcy law.

The bankruptcy court found that 3MB had failed to meet its burden on a number of grounds.  As a threshold observation, the court noted that default interest following note maturity has long been allowed in California without resort to a liquidated damages analysis.  Analyzing the evidence before it, the court then evaluated—and rejected—3MB’s claim that the Note’s default interest rate constituted an unenforceable penalty under California law:

[T]he general rule for whether a contractual condition is an unenforceable penalty requires the comparison of (1) the value of the money or property forfeited or transferred to the party protected by the condition to (2) the range of harm or damages anticipated to be caused that party by failure of the condition. If the forfeiture or transfer bears no reasonable relationship to the range of anticipated harm, the condition will be deemed an unenforceable penalty. (Internal citations omitted.)

The facts here favor a finding of no penalty. U.S. Bank presented the testimony of their expert…[who] testified…that the value of the loan is seriously compromised since now the loan no longer conforms to its expected duration. So, U.S. Bank is damaged and has higher costs and expenses including the use of a special servicer to enforce the now matured loan…There is no contrary evidence that the charge here bears no relationship to the harm U.S. Bank currently experiences or would have at the inception of the loan…[T]here is no contrary testimony on the impact on the value of the loan unpaid on maturity.

Observing that “[n]o court has adopted a bright line rule that the contract rate should be refused in all insolvent debtor cases,” the court also rejected 3MB’s argument that the court should disallow U.S. Bank’s default interest because the three unsecured creditors in the case (two of whom were insiders with substantial claims) might not be paid in full in the case:

The power to modify the contract rate [of interest] on notions of equity should be exercised sparingly and limited to situations where the secured creditor is guilty of misconduct, the application of the contractual interest rate would harm the unsecured creditors or impair the debtor’s fresh start or the contractual interest rate constitutes a penalty. (Internal citations omitted.)

…Most Chapter 11 cases involve insolvent debtors, and such an exception would swallow up the rule that the over secured creditor is presumptively entitled to the ‘contract rate.’ (Internal citations omitted.) There is no allegation or proof here that U.S. Bank or its’ predecessors are guilty of misconduct. The court has determined the default interest here is not a penalty for the reasons stated. So, the question here is harm to unsecured creditors and impairing the debtor’s fresh start.

…Unsecured creditors often receive less than their full claims in a bankruptcy case… On balance, the treatment of unsecured creditors does not mandate disallowance of the claim.

Separately, the bankruptcy court also opined that the default interest provision constituted a valid and enforceable liquidated damages clause under California law.  Citing the Law Revision Commission Comments to Civil Code section 1671(b), the court noted that the validity of a liquidated damages clause depends on “its reasonableness at the time the contract was made and not as it appears in retrospect.”  Examining the record, the court ruled that the evidence established the reasonable relationship of the default provision to the anticipated actual damages.  The court also pointed out that when the Note was signed, 3MB expressly acknowledged (i) the difficulty in determining actual damages arising from its default and that (ii) default interest is a reasonable estimate of the damages.  Finally, the court ruled that the validity of the liquidated damages clause did not depend on the parties’ actual negotiations over default interest, reasoning that the clause at issue was a reasonable endeavor to estimate the lender’s losses in the event of default.

AUTHOR’S COMMENT

Effective July 1978, the California Legislature amended the statute governing enforceability of liquidated damage provisions, adopting in full a California Law Revision Commission Recommendation.  As a result, former California Civil Code section 1670 was repealed and California Civil Code section 1671 was amended “to provide a new general rule favoring liquidated damages except in certain consumer cases and residential leases.”  In re Vec Farms, LLC, 395 B.R. 674, 685 (Bankr. N.D. Cal. 2008).

In its present form, California Civil Code section 1671(b) provides that “a provision liquidating the damages for the breach of a 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.”  Under a plain reading of the statute, the objecting party bears the burden of proof that the default interest provision at issue is “unreasonable.”  See Radisson Hotels Int.’l, Inc. v. Majestic Towers, Inc., 488 F.Supp.2d 953, 956 (C.D. Cal. 2007).  As noted by the bankruptcy court in 3MB, after the amendment, the California Supreme Court explained that a liquidated damages provision only becomes an unenforceable penalty “if it bears no reasonable relationship to the range of actual damages that parties could have anticipated would flow from a breach.”  Ridgley v. Topa Thrift and Loan Ass’n., 17 Cal.4th 970, 977 (1998).

The Central District of California recently considered the same issue of law in East West Bank v. Altadena Lincoln Crossing, LLC, 598 B.R. 633 (C.D. Cal. Mar. 6, 2019).  There, borrower Altadena took out a loan from East West Bank to finance a construction project but was unable to repay the loan upon maturity. Nonpayment triggered a default interest rate provision and led to a series of forbearance agreements between the parties over the course of eight years. After EWB refused to renew the last forbearance agreement, Altadena filed for bankruptcy. Altadena also objected to EWB’s secured claim for default interest arguing, among other things, that the default interest rate was not a “reasonable endeavor” by the parties to reach a fair estimate of the lender’s losses upon default.  The bankruptcy court sustained Altadena’s objection to EWB’s default interest claim and EWB appealed.

Reversing the bankruptcy court’s decision, the district court held that Civil Code section 1671(b) did not apply to default interest provisions applicable to matured obligations.  The district court’s analysis in Altadena adopts the reasoning set forth in Thompson v. Gorner, 104 Cal. 168 (1894), affirmed by Garrett v. Coast & Southern Fed. Sav. & Loan Ass’n, 9 Cal. 3d 731 (1973), both of which cases were examined by the court in 3MB.  The precedent established from this line of cases is that a default interest provision is not subject to the strictures of section 1671(b) if it operates prospectively.  Altadena, supra, 598 B.R. at 640.

Setting that holding aside, and assuming Civil Code section 1671(b) did apply, the district court in Altadena further held that the default interest provision did not constitute an unenforceable penalty.  Among other things, the district court concluded that (1) EWB presented evidence that the default interest reflected its efforts to reasonably estimate the fair average loss to be suffered in the event of borrower default, (2) the diminution in value of the loan as an asset held by EWB was within the range of actual damages that the parties could have anticipated would flow from a breach and (3) there is no requirement that the parties negotiate a liquidated damage provision for it to be enforceable.

This is a timely topic and one which continues to be heavily litigated: i.e., Altadena has appealed the district court’s decision to the Ninth Circuit.  However, as demonstrated by the thoughtful analysis presented by the bankruptcy court in 3MB, the legal landscape as presently developed offers substantial guidance regarding the enforceability of default interest provisions in the commercial lending context.

For discussions of cases involving similar issues, 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.
• 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. 62, Solvent Debtor Cannot Escape Payment of Default Interest Rate.

These materials were authored by Monique D. Jewett-Brewster, an attorney with Hopkins & Carley, ALC, a member of the ad hoc group and 2018-19 Chair of the CLA Business Law Section.  Editorial contributions were made by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal, Ret.), also a member of the ad hoc group.  Thomas 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 Thomas Reuters.