Dear constituency list members of the Insolvency Law Committee, the following is a case update written by David McAllister, a partner at Aldridge Pite, LLP, analyzing a recent case of interest:
In Milestone Financial, LLC v. Moon, (In re Moon), 648 B.R. 73 (B.A.P. 9th Cir. 2023), the Bankruptcy Appellate Panel for the Ninth Circuit (“BAP”) recently affirmed a bankruptcy court decision which had concluded that: (1) a forbearance agreement was usurious and not exempted from usury just because the orginal loan might have been exempt and (2) the creditor was entitled to post-maturity interest on the loan under California law.
To read the full published decision: click here.
The borrowers obtained a hard money loan, through a licensed real estate broker, that accrued interest at 11.30% per annum, provided for interest only payments, and matured within two years in order to refinance their residence. Soon after the loan was originated, the borrowers defaulted on their payments and the lender also advanced monies for real property taxes and insurance. Consequently, the parties entered into a settlement whereby the borrowers paid the lender $6,008.71 in exchange for an agreement which extended the loan maturity date, specified that the agreement was not a forbearance agreement, reduced the interest rate on the remaining principal loan balance to 11.05% per annum, provided for interest only payments, and included a provision that any past due payment amount “including the final balloon payment” would be subject to a 10% late charge.
Following the borrowers’ default under the settlement agreement and the lender’s acceleration of the loan balance, the borrowers sought to refinance the loan with a different party and requested a payoff statement from the lender. However, the borrowers allegedly received numerous conflicting payoff quotes which included incorrect and illegal amounts of late fees, past due interest, and other charges including a 10% “acceleration penalty” for the late charge related to the unpaid accelerated loan balance. After the lender commenced a non-judicial foreclosure proceeding, the borrowers filed a state court action against the lender for breach of contract, fraud, intentional interference with contract, and declaratory relief regarding the payoff quotes that allegedly exceeded the amount required by contract and included amounts that are illegal under California law. Following the state court’s denial of the borrowers’ motion for a preliminary injunction, one of the borrowers filed a bankruptcy petition. Subsequently, the borrowers removed the state court action to bankruptcy court as an adversary proceeding and filed a partial summary judgment motion wherein they requested the bankruptcy court to determine that the settlement agreement constituted a usurious forbearance, the 10% “acceleration fee” was an illegal and unenforceable penalty, and other late charges were likewise unenforceable and incorrectly and repeatedly assessed on a single missed payment. The lender filed a cross-motion for summary judgment and sought dismissal of the borrower’s complaint on the grounds that the settlement agreement was exempt from Cal. Civ. Code § 1916.1’s usury limitations because one of the lender’s owners was a licensed real estate broker who was involved with the settlement agreement (this argument was abandoned in the appeal) or, alternatively, the settlement agreement was not a loan or a forbearance agreement within the scope of California’s usury laws based upon the holdings in Ghirardo v. Antonioli, 8 Cal. 4th 791, 804, (1994), as modified on denial of reh’g (Feb. 2, 1995), and DCM Partners v. Smith, 228 Cal. App. 3d 729, 739 (1991). The bankruptcy court dismissed the declaratory relief claim for failure to state a claim, ruled that there were material issues of fact regarding the fraud and intentional interference claims, and on the breach of contract claim ultimately ruled, that: (1) the lender could not recover pre-maturity interest and the “acceleration fee” as the settlement agreement was a usurious forbearance; (2) the interest paid under the settlement agreement was to be applied to reduce the principal loan balance; (3) the remaining late fees were recoverable; and (4) the borrowers were liable for post-maturity interest at the legal rate. After the borrowers voluntarily dismissed their remaining claims with prejudice, the lender pursued an appeal of the bankruptcy court’s usury decision, and the borrowers cross-appealed the decision on their liability for post-maturity interest. The BAP affirmed the bankruptcy court’s decision in all respects.
In its opinion, the BAP cited Ghirardo, 8 Cal. 4th at 798, and provided an overview of California’s usury law which prohibited the collection of interest in excess of 10% per annum “when: (1) the transaction is a loan or forbearance; (2) the borrower’s obligation to repay both principal and interest is absolute; and (3) the lender consciously and voluntarily takes an amount of interest, which exceeds the prescribed maximum” (which was 10% at the time of the appeal). The BAP also pointed out that there are a plethora of exceptions to California’s usury law, but it explained that the only exception applicable to the appeal was the “Broker Exemption” under Cal. Civ. Code § 1916.1. In a footnote, the BAP explained that its reference to an “exception” from usury laws is meant to indicate that the usury laws are inapplicable, whereas its reference to an “exemption” means that California’s usury laws apply but the transaction is declared exempt from these laws. Finally, the BAP discussed the legislative history and development of the “Broker Exemption” to specifically include forbearances “arranged by” a real estate broker under the common law of 18th century England. With this background in mind, the BAP looked to the substance of the settlement agreement terms and determined that it was a forbearance under California’s usury laws. The BAP also declined to extend the Ghirardo and DCM Partners’ decisions to this case because these decisions related to credit sale transactions that were excepted from usury law restrictions and their treatment was based upon the time-price doctrine which is applicable when “the seller finances the purchase of property by extending payments over time and charging a higher price for carrying the financing.” Citing Sw. Concrete Prods. v. Gosh Constr. Corp., 51 Cal. 3d 701, 705 (1990). In reaching its conclusion, the BAP pointed out that the plain language of Cal. Civ. Code § 1916.1 does not include an automatic exemption for forbearances whenever the original loan agreement is subject to an exemption. As a result, the settlement agreement did not qualify for the “Broker Exemption”, since no broker was truly involved with the settlement agreement and the settlement agreement did not relate to a prior or current sale, lease, or exchange of real property.
Finally, the BAP agreed with the bankruptcy court’s reliance on the holding in Epstein v. Frank, 125 Cal. App. 3d 111 (1981), for the proposition that, irrespective of the inclusion of a usurious interest rate provision in a promissory note, a lender may recover the principal amount of the debt at maturity, along with interest at California’s legal rate when the principal sum is unpaid. In reaching its decision, the BAP agreed with the bankruptcy court’s denial of the borrower’s equitable estoppel, unjust enrichment, and breach of contract defenses excusing their obligation to pay the post-maturity interest. Likewise, the BAP ruled that the borrowers waived any other arguments against the lender’s right to recovery of post-maturity interest, including a tender of the amount owed discharging their obligation to pay interest and failure to mitigate, by not raising these arguments with the bankruptcy court or in their opening brief and by dismissing their remaining claims.
In sum, lenders who want to ensure that pre-maturity interest is recoverable should proceed with caution before entering into forbearance agreements with borrowers in California, as a subsequent forbearance may give rise to a claim that it violates state usury law. In hindsight, limiting the interest payable on the principal loan balance at a rate that was equal to or less than the maximum allowable statutory interest rate would have been the better decision for the lender in this case. Instead, the lender negotiated a higher interest rate and found itself embroiled in costly litigation that resulted in the inability to recover any pre-maturity interest under the forbearance agreement.
These materials were written by David McAllister, of Aldridge Pite, LLP, in San Diego. Editorial contributions were provided by Bankruptcy Judge, Meredith Jury.