Most loan documents contain a default interest provision, which states that the interest rate of the loan will increase in the event of a default. Default interest is enforceable, at least in the absence of an unconscionable rate. (1) California Civil Code §1671(b) provides: “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.”

Altadena Lincoln Crossing

This brings us to the recent decision rendered by Chief Judge Sheri Bluebond of the U.S. Bankruptcy Court, Central District of California, in Altadena Lincoln Crossing, (2) which does not present an unusual situation. A borrower entered into two loans with a bank: an $18 million larger loan and a $2.5 million smaller loan. The normal note rates of interest were above the reference rate, by 1% for the larger loan and by 4% for the smaller loan. In the event of default, the interest rate of both loans could be increased by an additional 5%. The loans went into default, and modification agreements were executed in which the maturity date was extended. Multiple forbearance agreements were subsequently executed. In the various forbearance agreements, the borrower agreed the terms of the loans were valid and enforceable. In addition to the default interest provisions, the loans included a $600,000 exit fee, which actually was an extension fee and normal late-charge provision if timely payments were not made.

The borrower ultimately filed for Chapter 11. The lender filed its claims in the bankruptcy estate. The borrower objected to the default interest as an unenforceable penalty, as well as the exit fee, late charges and attorneys’ fees and costs.

Bankruptcy code §506(b) permits a secured creditor to include in its secured claim interest and any reasonable fees, costs or charges provided for under the agreement. The 9^th Circuit has held that the default interest rate should be enforced, unless the default interest rate provision is not enforceable under non-bankruptcy law. (3) A provision in a contract liquidating the damages for breach of contract is valid unless the party seeking to invalidate the provision establishes the provision was unreasonable under the circumstances existing at the time the contract was made. A liquidated damages clause will generally be considered unreasonable and unenforceable under §1671(b) if it bears no reasonable relationship to the range of actual damages the parties could have anticipated would flow from a breach at the time the contract was made. (4) The liquidated damages amount must represent the result of a reasonable endeavor by the parties to estimate a fair and average compensation for any loss that may be sustained. An amount disproportionate to the anticipated damages is termed an unenforceable penalty. A contractual provision imposing a penalty is ineffective, and the wronged party can only collect actual damages sustained. (5)

Is it Reasonable?

The reasonableness of a default interest provision must be determined based on the facts and circumstances that existed at the time the parties entered into the contract containing the default interest provision, and the amount of actual damages the bank may have sustained later based on the borrower’s breaches is irrelevant. (6)

Consequently, the court looked to the default interest provision at the time the loan was entered into but did not review the forbearance agreements, which indicated after the default that all of the terms of the loan documents were valid and enforceable.

Determining the reasonableness of the default interest rate, the court examined 1) the relationship the contract damages bore to the range of harm reasonably anticipated, 2) the relative equality of the bargaining power of the parties, 3) whether the parties were represented by lawyers or brokers when the contract was made, 4) the anticipation that proof of actual damages would be costly or inconvenient and 5) the difficulty of proving cause and foreseeability.

The court found the parties did not negotiate the default interest provision, so it was not the result of a reasonable endeavor to estimate a fair average compensation for any loss suffered by the bank in the event of a default. Instead, the default interest provision was selected arbitrarily pursuant to the bank’s standard practice. Given the amount of default interest that would have resulted from a 5% default interest rate on these loans — which later increased to $26 million because of the defaults and inability to make payments — the court found the default interest rate grossly disproportionate to administrative costs or actual damages that would have been incurred by the bank.

Two experts testified on behalf of the bank regarding the validity and reasonableness of the default interest provision. According to one expert, default interest compensated the lender for the increased risk of non-payment associated with an event of default and for the increased costs of managing a defaulted loan. The fees and expenses of engineers, appraisers, consultants, attorneys and insurance were passed along to the borrower. The bank had to show loss reserves, and its staff and senior management devoted time to managing, overseeing and reporting on the loan. Increased regulatory and audit oversight and potential reputational risk were additional reasons the bank contended the default interest was valid. Experts further testified that besides the risk involved with the loan, the value of the loan was diminished, which would translate into a reduction in the loan’s price if the bank were able to sell it.

The court focused on the fact that no evidence was presented demonstrating that any of these factors were discussed or negotiated in connection with entering into the 5% default interest rate at the time the loans were made. Interestingly, the experts testifying for both sides agreed that 5% is a typical a default interest rate in the lending industry.

Aero Drive Holdings

The court also looked to a recent decision in Aero Drive Holdings, (7) in which the default interest rate was the issue connected with a plan of reorganization. The bankruptcy court rejected the lender’s argument under Thompson v. Gorner, contending the enforceability of a default interest provision should not be analyzed under §1671(b) because it is, in substance, an alternative form of performance and not a liquidated damages clause. As in Altadena, the evidence in Thompson did not show that the parties negotiated a default interest rate. The risks had not increased since the inception of the loan, and most, if not all, of the reasonably foreseeable consequences or damages attributable to default were already passed along to the borrower in other provisions of the agreement, such as late charges. The court held that the default interest provision had nothing to do with covering expenses or compensating for additional risk but was intended simply to increase revenue. As a result, the court held the default interest clause was unenforceable, and the bank had to recalculate the amount of its claim.

Although this article is focused on default interest, the same can be said for late charges. (8) The lesson from these cases is if a the lender relies on a default interest provision, the parties should specifically discuss the default rate and the reasons for it. Simply having a boiler plate default interest clause will not suffice. Instead, the lender must set forth the criteria upon which the rate is based, and the parties must agree the rate is reasonably related to the costs incurred by the lender in the event the loan goes into default. It would also be helpful for the parties to initial a default interest clause. Unless a substantial amount is at issue, the lender will seldom attempt to negotiate this provision. However, when the default interest rate results in a substantial amount of additional interest to recover, the lender must take further precautions to document the loan for default interest to be considered a valid liquidated damages clause rather than an unenforceable penalty.