It is not uncommon for loan agreements to provide for fees, penalties, and default interest in the event of the borrower’s late payment. However, a case recently published by California’s First Appellate District — Honchariw v. FJM Private Mortgage Fund, LLC — helps establish the boundaries for when penalties and default interest go too far and are unenforceable as a matter of law. For example, in Honchariw, the Court concluded that the lender’s attempt to charge 9.99% default interest on the entire principal of the loan due to the borrower missing a single payment was an enforceable penalty and the corresponding loan provision was void as a matter of law.
Facts of Honchariw v. FJM Private Mortgage Fund, LLC
The Honchariws took out a $5.6 million bridge loan from FJM Private Mortgage Fund, LLC. The loan was secured by real property and carried an 8.5% annual interest rate.
Less than a year into the loan, the Honchariws missed one of their monthly payments of $39,667, which triggered certain late-payment fee provisions in the loan agreement, including: (1) a one-time 10% fee assessed against the overdue payment ($3,967); and (2) a default interest charge of 9.99% per annum assessed against the total unpaid principal balance of the loan.
After FJM Private Mortgage sought to impose these penalties, the Honchariws filed for arbitration challenging the late-payment penalties as unenforceable under California Civil Code section 1671. The arbitrator disagreed and rejected the Honchariws’ challenges to the late-payment penalties, leading to the Honchariws filing an appeal to challenge the arbitrator’s decision.
Court of Appeal: reversed; late-payment fees tied to entire principal balance are unenforceable penalties
The appellate court began by first recognizing that in California, default interest loan provisions (referred to as “liquidated damages” provisions) are presumptively valid in the context of non-consumer contracts, such as the one at issue in Honchariw. Non-consumer are those contracts other than contracts for personal property or services for personal or household purposes or a lease of real property for use as a dwelling.
In the case of non-consumer contracts, the presumption of validity can be overcome where a liquidated damages provision does not bear a “reasonable relationship” to the actual damages that the parties anticipate would flow from a breach of the loan agreement, such as a late payment. Stated another way, the court explained that late-payment fees “may violate Section 1671 and amount to unlawful penalties 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 by the lender.”
Ultimately, the appellate court reversed the arbitrator’s decision and found that the 9.99% default interest charge against the total unpaid balance of the loan was unenforceable.
Conclusory statements in the loan documents that the late fees reflected the parties’ attempt to calculate anticipated damages did not by themselves save the late-fee penalties from being declared unenforceable. The court instead focused on the fact that the charge had been unfairly triggered based on a single missed payment and was assessed against the unpaid balance of the loan as opposed to the late payment. Supporting its conclusion, the court pointed to other cases which had similarly concluded that a charge for late payment of a loan which is measured against the unpaid balance of the loan or is measured as a percentage of the outstanding principal are indicators of an unenforceable penalty.
Late-fee penalty provisions in loan agreements are common; however, those penalties can be held unenforceable when there is an insufficient relationship between the assessed penalty and the actual harm to the lender from the breach (missed payment). In the Honchariw case, late-fee penalties assessed against the entire principal amount owing based on a single missed payment were unenforceable.