Default Interest Held Unenforceable Penalty: In re Altadena Lincoln Crossing LLC

By: Alana Porrazzo, attorney with Jennings Haug Cunningham

A recent federal bankruptcy court decision should give lending institutions pause—or at least some cause to revisit the terms of their loan agreements and finance leases. In In re Altadena Lincoln Crossing, LLC, the United States Bankruptcy Court for the Central District of California disallowed a secured lender’s claims to the extent they included default interest, ruling that the increased rate of interest charged by the lender was an "unenforceable penalty" under California law.1

Default interest provisions are almost expected features of contracts calling for the payment of interest. The borrower’s delinquent payment or default triggers the imposition of a higher, default interest rate. For the lender, default interest is both cushion and compensation for the increased costs of servicing a defaulted obligation, such as internal administrative and workout costs, attorney’s fees, increased loan loss reserves, etc. A great majority of courts recognize that it is difficult for lenders to precisely quantify the additional expenses incurred due to a given borrower’s default. As a result, courts usually look to what is common within the industry when considering whether default interest provisions are reasonable and enforceable2. But not in Altadena.

The Altadena case involves a debtor who took out two bank loans to finance the construction of a mixed-use development. Both loans were subject to an increased interest rate of 5 percent in the event of default. The story is an all-too familiar one: The debtor failed to repay the loans, entered a series of forbearance agreements with the lender, and ultimately ended up in Chapter 11 bankruptcy. When the lender filed claims that included the value of the accrued default interest3, the debtor objected to the default interest as an unreasonable penalty.

The court analyzed the enforceability of the default interest provisions through the lens of California state law on liquidated damages. Under California Civil Code § 1671(b), a liquidated damages provision is deemed enforceable unless "unreasonable under the circumstances existing at the time the contract was made."4 Reasonableness, at least in the commercial loan context, is a question of how well the liquidated sum approximates the lender’s actual damages. "Absent a relationship between the liquidated damages and the damages the parties anticipated would result from a breach, a liquidated damages clause will be construed as an unenforceable penalty." 5

In the bankruptcy court, witnesses testified that a fixed 5 percent default interest rate was industry-standard at the time the parties contracted. However, the Altadena court sided with the debtor and faulted the lender for making no attempt to approximate or estimate its potential default losses at the inception of the loan relationship.6 A "one-size-fits-all," default interest rate for all of the bank’s construction loans was not appropriate, the court concluded. Evidence of standard default interest rates was relevant, but not dispositive.7 Interestingly, the court also singled out other loan agreement provisions that required the debtor to pay the lender’s out-of-pocket costs for servicing a default. Given that these other contract provisions appeared to compensate the bank for its actual damages associated with default, the court determined that "the default interest rate was not intended to compensate [the bank] for any of these types of expenses"8 and was instead an unenforceable penalty.

It is far from certain whether and to what extent other courts will sign on to Altadena’s reasoning. For example, the court found that it "would not be costly or difficult" for the bank to estimate its losses when first contracting with the borrower, particularly given the ease with which the experts estimated such loss during litigation.9 Yet, approximating losses in hindsight is far different from staring into the uncertain future of a multi-year loan relationship. In Altadena, the parties’ loans originated as one-year loans, but maturity dates were successively extended for more than a decade. Under the court’s view, the bank would have been required to approximate its future losses many years out, without in fact knowing that its losses would arise many years out. The Altadena opinion’s emphasis on loss approximation at the time of contracting appears to pose practical problems.

What is to be done? For one, consider contractually selecting some other body of law—not California law—to govern agreements containing default interest provisions. It may also be beneficial to calculate actual damages associated with default for loans of varying types and amounts, with the aim of tailoring default rates as narrowly as possible to individual loan arrangements. Lastly, it may be possible to manipulate the language of your contracts’ default interest provisions to survive the liquidated damage analysis undertaken in Altadena.

Alana Porrazzo is an attorney with Jennings Haug Cunningham, who practices in surety & fidelity law, creditors’ rights and construction litigation. She can be contacted at: 602.234.7856 or [email protected]

1No. 2:17-bk-14276-BB, 2018 WL 3244502, at *1 (Bankr. C.D. Cal. June 20, 2018).

2Although default interest provisions are generally upheld by both state and federal courts, courts may strike down such provisions as usurious, unreasonable, or unconscionable—or sometimes as invalid penalties if viewed as a type of liquidated damages. See, e.g., Crawforth v. Ajax Enterprises, LLC (In re Pheasant Cove, LLC), 2008 WL 187529, at *3 (Bankr. D. Idaho, Jan. 18, 2008) (noting "the lack of uniformity in the treatment of default interest provisions, which some courts evaluate under liquidated damages law and others under state usury laws").

3Section 506(b) of the U.S. Bankruptcy Code permits a secured creditor to include in the amount of its secured claim "interest on such claim, and any reasonable fees, costs or charges provided for under the agreement."

4Emphasis added.

5In re Altadena, 2018 WL 3244502, at *1 (quoting Morris v. Redwood Empire Bancorp, 128 Cal. App. 4th 1305, 1314, 27 Cal. Rptr. 3d 797 (2005)).

62018 WL 3244502, at *2.

7Id. at *5, *7.

8Id. at *4.

9Id.