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Liquidated Damages Good / Penalties Bad / Default Interest

This article reviews the requirements for liquidated damage provisions (including default interest) in residential contracts, commercial loans and other contracts.

California Civil Code Section 1671 provides that liquidated damages are valid unless the party seeking to avoid the liquidated damages establishes that the provision was unreasonable at the time the contract was made.

California courts have determined that liquidated damages are unreasonable if the liquidated damages bear no reasonable relationship to the actual damages the parties might have reasonably anticipated would flow from a breach. Specifically, it is required that the liquidated damages must be the result of a reasonable endeavor by the parties to estimate fair average compensation for the loss sustained. Courts have held that liquidated damages that bear no reasonable relationship to the range of damages the parties could have anticipated would flow from the breach will be considered unreasonable and unenforceable. A liquidated damage that bears no relationship to the damages anticipated is a "penalty" and the wronged party can only receive actual damages. Ridgley v. Topa Thrift & Loan Assn., 17 Cal. 4th 970, 977 (1998); Vitatech International, Inc. v. Sporn, 16 Cal. App. 796, 805-806 (2017).

It should be noted that California Civil Code Section 1671(a) provides that Section 1671 does not apply in cases where a statute specifically prescribes rules or standards for determining liquidated damages.

Residential Purchase Contracts

California Civil Code Section 1675, which deals with residential real estate contracts, provides in twin sections (c) and (d) that a 3 percent liquidated damages provision is valid, unless the buyer establishes that amount is unreasonable, and that more than 3 percent is unreasonable, unless the person seeking to uphold the provision establishes that it is actually reasonable. The specific language is as follows:

(c) If the amount actually paid pursuant to the liquidated damages provision does not exceed 3 percent of the purchase price, the provision is valid to the extent that payment is actually made unless the buyer establishes that the amount is unreasonable as liquidated damages.

(d) If the amount actually paid pursuant to the liquidated damages provision exceeds 3 percent of the purchase price, the provision is invalid unless the party seeking to uphold the provision establishes that the amount actually paid is reasonable as liquidated damages.

See Cal. Civ. Code § 1675(c) & (d).

The bottom line is that a liquidated damage provision of 3 percent fits within the statutory guideline, but is not necessarily a safe harbor depending on all the facts and circumstances.

Commercial Loans

Most commercial loans include an enhanced interest rate while the loan is in default (commonly default interest). Generally the rate is set by the lender, without negotiations with the borrower.

In Cal. Bank & Trust v Shilo Inn, Seaside East, LLC, 2012 U.S. LEXIS 163134 (Nov. 15, 2012), a United States District Court for the District of Oregon held that default interest is liquidated damages to which the above rules apply. The case involved a default interest rate increase of 5 percent. The Court, applying the above discussion regarding California Civil Code Section 1671, concluded that the 5 percent increase in interest did not bear a reasonable relationship to the anticipated actual damages. The court noted a lack of any responsive evidence on the part of the lender to reflect that the 5 percent increase in interest was in fact reasonable. Id. at *16. The Court held the default rate to be unenforceable. Id. at *17.

For a commercial lender, there are two important considerations which arise from Shilo Inn. First, the default rate as to payment defaults must bear a relationship to the reasonably anticipated costs associated with such a default. Lenders would be wise to provide borrowers, at the time of the loan, the rationale with supporting evidence for the default rate increase and then request a sign off. While such actions are unlikely to be dispositive, it would provide the lender with the basis of an argument before a court. Second, this analysis suggests that the lender should be careful about applying a "one size fits all" to all types of defaults, particularly non-monetary defaults. For example, should the lender require an in-house property manager be replaced with a national third party property manager, there would have to be a reasonable relationship between a default on such a provision and the damages anticipated from such a breach. Certainly, it would be an entirely different analysis from a monetary default. Given that many commercial loans include a plethora of covenants, the breach of which would be a default, it seems clear that a "one size fits all" liquidated damages or default interest rate is not appropriate, notwithstanding that this is a common practice among lenders.

For commercial borrowers, this strongly suggests that some thought to the liquidated damages issues and limitations be given before simply paying the default interest rate.

Other Contracts

It is important in all contracts to recognize that an enforceable liquidated damage provision cannot be a penalty. The amount set must reasonably relate to the anticipated damages which would be incurred in the event of a breach. Lawyers should caution clients against penalties and overreaching liquidated damages provisions which cannot be tied to reasonably anticipated losses as that can invalidate the liquidated damages provision.

If you have any questions on the above, please contact Michael Petersen, Esq. or any of the attorneys at Shulman Hodges &Bastian LLP at 949-340-3400.

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