On August 13, 2018, California’s Supreme Court published a decision on unconscionability that sent shockwaves through the California lending industry. We expect to see it being used, not only against non-prime consumer loans, but also against business purpose and commercial loans, which are popular with private money lenders.
In a unanimous decision, De La Torre v. CashCall, Inc., the Supreme Court held that interest rates on consumer loans could be unconscionable. It said courts “have a responsibility to guard against consumer loan provisions with unduly oppressive terms,” including interest rates. This was true even though the California Financing Law allows lenders to charge whatever the market will bear.
Borrowers of CashCall filed a class action lawsuit against the notorious lender. They said they borrowed money from CashCall at rates of 96% to 135% between 2004 and 2011. Their suit alleged that these interest rates were unconscionable under California’s Unfair Competition Law (“UCL”).
The District Court certified the class as borrowers who obtained a loan of at least $2,500 from CashCall with an interest rate of 90% or higher. At first, the District Court denied CashCall’s motion for summary judgment. But then, it reversed itself, saying that, because no statute dictated a maximum rate, the courts should not be required to “regulate economic policy.” De La Torre v. CashCall, Inc., 56 F. Supp.3d 1105, 1107 (N.D. Cal. 2014). It also observed:
Only one California court has ever found a challenged interest rate unconscionable. See Carboni v. Arrospike, 2 Cal. App. 4th77…(1991).In Carboni, the defendant had signed a $4,000 note in favor of the plaintiff, at a 200% interest rate, secured by a deed of trust. … When the defendant failed to make payments, the plaintiff filed a complaint for judicial foreclosure. … The defendant asserted unconscionability as a defense to the enforcement of the note with its 200% interest rate. The trial court found that the 200% interest rate was unconscionable, and permitted interest on the principal sum at a rate of 24% per annum, up to that date.
Consequently, the District Court gave summary judgment to CashCall.
The borrowers then appealed to the federal Ninth Circuit Court of Appeals. It, in turn, asked the California Supreme Court: “Can the interest rate on consumer loans of $2,500 or more render the loans unconscionable under section 22302 of the Financial Code?” The Supreme Court replied: Yes. An interest rate on a loan is the price of that loan, and “it is clear that the price term, like any other term in a contract, may be unconscionable’.” Perdue v. Crocker National Bank (1985) 38 Cal.3d 913, 926, 216 Cal. Rptr. 345, 702 P.2d 503.
The Court went on to explain that unconscionability has two required aspects: procedural (surprise) and substantive (onerous terms), in a sliding scale. If surprise is strong, then less onerous terms will still render the contract unconscionable. If surprise is present but not dominant, then more onerous terms will still render the contract unconscionable. All of this requires a court to consider the sophistication of the parties, the context for the contract, their relative bargaining power and the terms of the contract itself. In other words, some surprise (such as unsophisticated borrower or a buried provision in the loan contract) coupled with above market pricing, will allow the borrower to move forward with an unconscionability challenge to a loan.
What impact will this case have on private money lenders making business purpose and commercial loans?
In our view, the case will give borrowers a greater probability to have their day in court rather than have their unconscionability claims dismissed at the beginning of the case by demurrers (state court) or motions to dismiss (federal court). Borrowers will cite this language from the Supreme Court opinion to try to get past these early motions:
[W]hether an interest rate is unconscionable is fundamentally a different inquiry than whether the rate exceeds a numerical cap. Unconscionability is a flexible standard in which the court looks not only at the complained-of term but also at the process by which the contractual parties arrived at the agreement and the larger context surrounding the contract, including its “commercial setting, purpose, and effect.” … [“An evaluation of unconscionability is highly dependent on context. … The ultimate issue in every case is whether the terms of the contract are sufficiently unfair, in view of all relevant circumstances, that a court should withhold enforcement.” ….[“a claim of unconscionability often cannot be determined merely by examining the face of the contract, but will require inquiry into its setting, purpose, and effect”].
The only way a court can inquire into the “setting, purpose and effect” of a loan contract is by taking evidence in a courtroom and that means a costly trial.
What can we do to minimize the impact of this case?
There are two things you can do to minimize the risk of an unconscionability defense to your hard money loan:
- Substantive Element of Unconscionability. Don’t stick out like a sore thumb by exceeding rates and terms common in the marketplace. If you go in front of a judge, you will need an expert witness who will state with confidence your rates and terms were in the ballpark.
- Procedural Unconscionability. Call your borrower’s attention (with initials and/or clear language) to arguably harsh or unusual provisions in your loan documents, such as provisions for default interest, penalties imposed on balloon payments, guaranteed interest and the like. One aspect of unconscionability is the element of surprise. Eliminate it by showing your borrowers were aware of any harsh or unusual terms, and you will be one step ahead. See, e.g., Ilkhchooyi v. Best, 37 Cal. App. 4th395(1995) (deciding that party preparing contract has burden of proof to show the other party had knowledge of any unusual or unconscionable terms of the contract). Mortgage brokers operating under a DRE license should also consider a separate disclosure form that requires their borrowers to initial next to each item in a summary of the key terms of the loan.
© 2018 Doss Law. These materials have been prepared for educational purposes only and are not legal advice. This information is not intended to create an attorney-client relationship. Consult a knowledgeable lawyer before implementing any of the ideas in this publication.