{"id":264,"date":"2024-07-08T11:33:46","date_gmt":"2024-07-08T11:33:46","guid":{"rendered":"https:\/\/voklaw.com\/blog\/?p=264"},"modified":"2025-07-02T15:57:12","modified_gmt":"2025-07-02T15:57:12","slug":"court-strikes-down-excessive-default-interest-penalties-what-borrowers-need-to-know","status":"publish","type":"post","link":"https:\/\/voklaw.com\/blog\/court-strikes-down-excessive-default-interest-penalties-what-borrowers-need-to-know\/","title":{"rendered":"Court Strikes Down Excessive Default Interest Penalties: What Borrowers Need to Know"},"content":{"rendered":"

In a landmark decision that has significant implications for borrowers, the California Court of Appeal in Honchariw v. FJM Private Mortgage Fund, LLC<\/em> ruled that excessive default interest and late fees in non-consumer loans can be deemed unenforceable penalties. This ruling serves as a critical reminder for borrowers to be vigilant about the terms of their loan agreements and offers a pathway to challenge unfair penalty provisions.<\/p>\n

Case Background<\/strong><\/h2>\n

Nicholas and Sharon Honchariw borrowed $5.6 million from FJM Private Mortgage Fund, LLC, secured by commercial real estate.<\/a> Their loan agreement included an interest rate of 8.5% per annum, a 10% late fee on missed payments, and a default interest rate that increased to 18.49% upon any default. When the Honchariws missed a payment of $39,667 on September 1, 2019, these penalty provisions were triggered, leading to a dispute over their enforceability.<\/p>\n

The Honchariws sought arbitration, arguing that the penalties were excessive. The arbitrator upheld the lender’s provisions, but the case was subsequently reviewed by the courts. The California Court of Appeal ultimately ruled that these combined penalties were unreasonable and unenforceable.<\/p>\n

Key Legal Findings<\/strong><\/h2>\n

Under California Civil Code Section 1671(b), liquidated damages clauses in non-consumer contracts are presumed valid unless proven unreasonable when made. The Court of Appeal found that the combined late fee and default interest rate in the Honchariw case constituted a \u201cpenalty\u201d rather than a reasonable estimate of the lender’s probable loss from the default. This decision was heavily influenced by the precedent set in Garrett v. Coast & Southern Federal Savings & Loan Assn<\/em>., which requires that liquidated damages must reasonably relate to actual damages incurred.<\/p>\n

In Garrett, the lender\u2019s sin was to impose a late fee of 2%, but to impose it, not on the amount of the missed installment (like ordinary late fees, including the one in the Honchariw case), but on the full balance of the loan. The Garrett court had no trouble holding this was an invalid penalty.<\/p>\n

The Court in Honchariw ruled that imposing a 10% late fee along with an almost 10% increase in the interest rate on the entire loan balance was excessive. It noted that these combined penalties did not represent the actual costs or damages the lender would face due to a missed payment. Therefore, the court found these terms unenforceable under California law.<\/p>\n

Default interest is calculated based on the duration of the default. If a missed payment is corrected, the interest rate returns to the standard rate. For instance, the Honchariws missed a $39,667 payment on September 1, 2019. If they had made the payment five days later, on September 6, they would have incurred about $11,500 in extra interest. This amount is clearly punitive rather than a reasonable estimate of damages. Even when combined with the actual late fee of $3,396, it pales in comparison to the 2% late fee of the principal balance in the Garrett case, which would have been $168,000!<\/p>\n

This ruling contrasts with many other default interest cases across the country, where increases of 4% to 6% are typically upheld. However, the nearly 10% increase in this case is exceptionally high, although some rare cases approve even higher rates. Conversely, several bankruptcy<\/a> courts consider late fees and default interest as overlapping and have rejected enforcing default interest. For example, in the case of In re AE Hotel Venture<\/em>, the court did not enforce default interest.<\/p>\n

Other Rulings by the Court<\/strong><\/h2>\n

Beyond invalidating the penalty provisions, the court also made significant procedural rulings:<\/p>\n

    \n
  1. \n

    Review of Arbitrator\u2019s Decision:<\/strong><\/h3>\n

    The court highlighted that, while an arbitrator\u2019s award is typically final and not subject to judicial review for errors of fact or law, an exception exists if the award violates a party’s unwaivable statutory rights or contravenes an explicit legislative expression of public policy. In this case, the Court of Appeal reviewed the arbitrator\u2019s decision de novo because it found that the arbitrator\u2019s enforcement of the penalty clauses violated the public policy expressed in California Civil Code Section 1671.<\/li>\n

  2. \n

    Clarification on Liquidated Damages:<\/strong><\/h3>\n

    The court reinforced that liquidated damages provisions must bear a reasonable relation to the probable actual loss that the lender is likely to sustain. This clarification is crucial for both lenders and borrowers in drafting and reviewing loan agreements.<\/li>\n<\/ol>\n

    Implications for Borrowers<\/strong><\/h2>\n

    This ruling is particularly beneficial for borrowers, offering them a legal precedent to challenge exorbitant penalty provisions in their loan agreements. Here are some key takeaways for borrowers:<\/p>\n