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Late clauses at risk when assessed against unmatured loans

A typical late charge provision in promissory notes for commercial loans provides that when a borrower fails to make a monthly payment, the lender may collect both (a) a one-time late charge equal to a certain percentage of the missed payment, and (b) an interest rate mark-up (referred to as “late interest”) on the entire outstanding loan balance. As discussed in an earlier client alert relating to the rights of creditors of Hopkins & Carleywhen triggered by a maturity default, the default interest rate typically lasts until the default is corrected or the loan is repaid.

A recent decision from the California Court of Appeals for the First District, however, states that this common practice of charging late interest may be unenforceable when assessed against an unmatured loan. The court in Honchariw c. FJM Private Mortgage Fund, LLC, et al. considered to be a default interest rate imposed under a provision similar to that described above. Borrowers have not paid a monthly installment of a loan secured by real estate. The promissory note provided for a late fee of 10% of the unpaid monthly installment and a moratorium interest rate which increased the pre-default interest rate of the note by 9.99%, until the default was resolved or refunded. full ticket.

The borrowers sought arbitration of their claim that the late fee was an unlawful penalty under California Civil Code Section 1671, governing damages provisions such as the late fee provision . The arbitrator disagreed with the borrowers’ argument and dismissed the arbitration request. The Borrowers then sought to have the arbitrator’s decision overturned, but again lost because the trial court found that the Borrowers had failed to prove that the default interest provision was a penalty. invalid.

The appeals court disagreed, however, reversing the trial court’s judgment. After acknowledging that liquidated damages clauses in non-consumptive contracts are presumed valid, the Court of Appeal pointed out that the presumption can be reversed. The court explained that California public policy requires liquidated damages to bear a “reasonable proportion” to the actual damages the parties anticipate would arise from the breach of an agreement. If the amount of damages does not meet this standard, it is an unenforceable penalty.

The court stated categorically that a default interest rate assessed on the entire outstanding balance of an unmatured loan did not represent a reasonable estimate of the actual damages suffered by the lender as a result of the missed monthly payment. Accordingly, the court concluded that such a moratorium interest rate constituted an illegal sanction.

This case raises serious doubts about the application of very common late fee provisions, thereby limiting the usefulness of this powerful tool to encourage borrowers to repay their loan in a timely manner. In light of this case, lenders would be well advised to review the late fee provisions in their promissory notes. Our experienced team of creditor rights attorneys have the knowledge and expertise to resolve this and all other loan documentation and enforcement issues.