On December 21, 2022, the California Supreme Court denied review of a controversial Court of Appeal decision from earlier last year that prohibited lenders from charging default interest against the principal balance of any loan, regardless of loan purpose, unless the default is a maturity default.
In September 2022, the California 1st District Court of Appeal issued a decision in Honchariw v. FJM Private Mortgage Fund, LLC.1 FJM, a private lender, had made a $5.6M business purpose loan to Nicholas and Sharon Honchariw, which was secured by a deed of trust on real property. Under the terms of the loan agreements, the Honchariws were required to make monthly payments, however, they defaulted on their monthly payment in September of 2019. Their default triggered a one-time 10 percent fee assessed against the overdue payment as well as a default interest charge of 9.99 percent per annum assessed against the total unpaid principal balance of the loan.
The Honchariws filed for arbitration, contending that the loan was in violation of California Business and Professions Code § 10240 et seq., and that the default interest charge constituted an unlawful penalty in violation of public policy as set forth in California Civil Code § 1671. The arbitrator ruled for FJM on both arguments. The Honchariws then petitioned the trial court to vacate the award. The trial court denied the petition, following which the Honchariws appealed to the Court of Appeal.
In a surprising reversal of the trial court’s decision, the Court of Appeal agreed with the Honchariws. The Court found that charging default interest against the principal balance of any loan violated the public policy expressed by § 1671. According to the Court, § 1671 requires that liquidated damages bear “a reasonable relationship” to the actual damages that are anticipated to flow from a breach, and late-payment fees may violate liquidated damages statutes 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.”2 The Court then held that liquidated damages in the form of a penalty assessed during the lifetime of a partially matured note against the entire outstanding loan amount constituted unlawful penalties under § 1671, and subsequently vacated the arbitrator’s award.
The Consequences of Honchariw for Lenders
The denial of review of this case means that the Honchariw decision is final. Lenders, therefore, may want to proceed with caution in charging default interest, and review and update any existing loan documents to ensure their terms conform to the strictures of Honchariw.
If the default interest rate bears a “reasonable relationship” to anticipated losses suffered by the lender as a consequence of the borrower’s default, a lender should be permitted to charge default interest on the missed payments, as well as default interest on the unpaid principal balance following the maturity of the loan. Lenders should not charge default interest on the entire unpaid principal balance following a payment-only default.
There is a possibility that lenders may be able to charge default interest on the entire unpaid principal balance following acceleration due to monetary or non-monetary default, but the risks associated with these charges following Honchariw are currently unclear as this specific issue was not addressed by the Court in Honchariw. Lenders should confer with counsel before proceeding.
