Default Interest: New Challenges Expected
New BK Case Invalidates Generic Default Interest Clause
Dennis H. Doss and Christopher Donovan
On July 3, 2018, Los Angeles Bankruptcy Judge, Sheri Bluebond, laid to rest the notion that an innocuous 5% default interest rate increase on a commercial loan default was safe. In re Altadena Lincoln Crossing LLC, Case No.: 2:17-bk-14276-BB. In 2004, Altadena obtained $20.5M in commercial loans from East West Bank for a mixed-use project in Altadena, California. The loan documents were heavily negotiated through attorneys. However, none of them could recall discussing the default interest rate provision. Altadena defaulted, and after a series of forbearance agreements (all of which acknowledged/confirmed the accrual of default interest and contained general releases), filed for reorganization under Chapter 11.
Altadena objected to EWB’s proof of claim for its loans, arguing that the loans contained an unenforceable penalty that cannot be collected under California Civil Code Section 1671(b). Both of the expert witnesses for EWB and Altadena agreed that a 5% increase was common for these types of loans and within the range of default rates charged in the marketplace.
EWB’s expert said that: (a) one of the central purposes of default interest was to compensate the lender for the heightened risk that defaulted loans carry of non-payment of the loan’s principal and interest; (b) in order to offset the increased risk of nonpayment in the event of default at the inception of the loan (when construction was largely incomplete), the default interest rate would have had to have been at least prime plus 11.45%; and (c) in order to offset the increased risk of nonpayment in the event of default during the latter part of the forbearance period (when construction of several structures was complete), the default interest rate would have had to have been at least prime plus 8.56%. He added that the loan would be less valuable, would have to be sold at a loss if it defaulted, and the default rate helped to mitigate for that loss. Nevertheless, when the loan was written, neither party had attempted to analyze that if the borrower defaulted, then how much the potential actual cost would be, nor did they attempt to determine how much the value of the loan would decline.
The judge found that it would not have been costly or inconvenient for EWB to have estimated its actual administrative costs in servicing a defaulted loan. She went so far as to suggest that EWB could have kept timesheets of the extra time spent administering the default, and it could have passed those costs on to the borrower.
Section 1671(b) provides that “a provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.” After acknowledging that Altadena bore the burden of proving unreasonableness, the judge ruled that the borrower met that burden by proving that no attempt was made when the loan was written to quantify EWB’s damages. In addition, because the loan agreement passed onto the borrower other administrative costs, the 5% rate increase was arbitrary. The judge flatly rejected the reduction in loan value argument, finding it had no place in a Section 1671(b) analysis. Her final ruling:
As the loan agreements between the parties pass along most of the remaining types of costs that might result from a borrower’s default, the Court finds that the default interest provisions in the loan agreements do not have a reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach at the time the contracts were made. To the contrary, the Court finds that they were intended to serve as a penalty to give the Debtor a hefty incentive not to default under the agreements. Therefore, the default interest provisions contained in the parties’ agreements are not enforceable.
While an appeal is possible, there are some valuable take-aways from this decision. First, the case will likely embolden more borrowers to challenge the default interest rate provisions that are commonly used in business purpose loan documents. Second, it would be prudent for business purpose loan docs to contain an analysis of the lender’s estimated default damages, including a written record that they were considered, negotiated and agreed upon by the lender and borrower. Third, the case is somewhat of a green light for lenders to pass their administrative costs on to defaulting borrowers through their loan docs. Of course, the reasonableness of administrative costs can always be challenged by the borrower, making that an imperfect solution.
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