What Honchariw v. FJM Private Mortgage Fund, LLC, et al. Signals for California Lenders and Those Beyond the Golden State
California Supreme Court Upholds Court of Appeal Holding to Restrict Default Interest Charges:
The California Supreme Court denied review of the California 1st District Court of Appeal decision in Honchariw v. FJM Private Mortgage Fund, LLC, 83 Cal. App. 5th (2022) indicates that California lenders should be aware that default interest charges against the principal amount of a loan may no longer be legally enforceable unless such payment is for a loan already accelerated or matured.
Brief Summary of the Case:
In Honchariw v. FJM Private Mortgage Fund, LLC, et al., two borrowers, Nicholas and Sharon Honchariw, took out a $5.6 million business loan from the lender, FJM Private Mortgage Fund LLC. The loan agreement between the two parties entitled FJM to a one-time 10% fee and a default interest charge of 9.99% per year against the principal of the loan amount. Default interest charge provisions are standard practice in loan agreements to protect lenders from cost losses. Yet, the borrowers still sought legal action against FJM after a court-appointed arbitrator decided in the lender's favor, which the superior court affirmed. However, the California 1st District Court of Appeal reversed the lower trial court's decision and vacated the arbitration award. The court ruled that lenders imposing default interest penalties against the entire balance of an unpaid loan violated public policy under California Civil Code section 1671, which provides that a liquidated damages clause must show a "reasonable relationship" to the actual damages of the breach. Therefore, if no significant relationship exists between the loss incurred to the lender and the late payment imposed on the borrower, such charges will qualify as a coercive payment. Here, the appellate court held that FJM charging default interest on the entire loan amount before its maturity constituted a violation of California public policy.
Before Honchariw v. FJM Private Mortgage Fund, LLC, et al., preceding California rulings established that a borrower of a non-consumer loan required proof that the default interest payment unreasonably exceeded the lender's losses from the default as a way for the borrower to avoid full payment of such charges. Now, California borrowers are no longer required to prove that the lender exceedingly charged them more than rightfully owed to regain their losses. Moving forward, charging default interest penalties on an entire loan balance violates the state's public policy and is legally unenforceable with few exceptions.
Implications Moving Forward for California Lenders and Default Interest Penalties:
Critical Changes for California Lenders after the Ruling
This December 2022 ruling pertains not only to future loan agreements but also to current loan agreements and their governing provisions. Now that Honchariw v. FJM Private Mortgage Fund, LLC, et al. is the law of California, lenders in the state are highly recommended to review, reevaluate, and possibly revise their default interest charge provisions to align with the Court of Appeal ruling. The key takeaway for lenders in California is: 1) ensure that provisions in their loan agreement allow a loan in default to accelerate after a late installment payment or 2) ensure that any default interest charged against a borrower implicates the late installment payment of the defaulted loan rather than the principal amount, unless the default happens after the loan has matured.
Exceptions to the Ruling
California lenders should note that this ruling does not change all default interest penalties. First, lenders may still charge default interest upon acceleration (depending on the wording of the agreement in question) or on the remaining loan balance after maturity. Second, lenders retain the legal right to charge default interest on the loan amount in default but must provide evidence that such losses incurred are caused by the breach in defaulting on payment rather than punishing the borrower. Therefore, California lenders may consider altering loan documents to implement provision language which reflects that late fees or penalties relate directly to the actual damages stemming from the loan payment default. However, calculating actual damages often proves difficult to calculate, and lenders, in anticipation of borrowers challenging charges related to such damages, should gather evidence of the amount claimed.
Why Should Lenders Conducting Business Outside of California Care:
While the court's holding in Honchariw v. FJM Private Mortgage Fund, LLC, et al. does not bind or obligate courts in other jurisdictions to follow this ruling, judges outside California may follow or refer to this case to reach a similar decision. Therefore, lenders outside of California should anticipate that such possible persuasive authority may influence other jurisdictions.
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