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To Be Enforceable, Default Interest Must Be Supported by Contemporaneous Evidence of a Relationship Between It and Foreseeable Actual Costs

In In re Altadena Lincoln Crossing LLC, Case No. 2:17-bk-14276-BB, the Bankruptcy Court for the Central District of California disallowed default interest on a large commercial loan after conducting an exhaustive review of California law concerning the enforceability of default interest.

Bankruptcy Code section 506(b) provides that a secured creditor is entitled to include within its claim "interest . . . and any reasonable fees, costs or charges provided for under the agreement." 11 U.S.C. § 506(b). The Ninth Circuit has held that default interest is to be enforced unless the default interest provision is not enforceable under applicable nonbankruptcy law. General Electric Capital Corp. v. Future Media Productions, Inc., 547 F. 3d. 956, 961 (9th Cir. 2008). The applicable law is California Civil Code section 1671(b), which 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." Cal. Civ. Code § 1671(b). California courts have held, for example, that a liquidated damages clause will generally be considered unreasonable and unenforceable under Cal. Civ. Code § 1671(b) if it "bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach" at the time the contract was made. See, e.g., Ridgley v. Topa Thrift & Loan Ass'n, 17 Cal 4th 970, 977 (1998); Morris v. Redwood Empire Bancorp, 128 Cal. App. 4th 1305, 1314 (2005). 

Since default interest is judged by the facts and circumstances that existed at the time the parties entered into the contract and, generally, the lender's charges should be measured by the period of time the money was wrongfully withheld and the administrative costs reasonably related to collecting and accounting for late payments, some circumstances in which default interest has been upheld include: (1) the retention of a deposit approximately equal to loss of anticipated profits by breach of contract, (2) recovery of estimated future royalties lost by breach of contract, and (3) anticipated costs resulting from a failure to pay property taxes and the loss of collateral due to a tax sale.

Here, the Bank presented no evidence that at the time of contract formation, the interest rate was discussed, bargained for, or in any other way calculated to estimate future costs, the collection of which was already provided for separately in the loan agreement. Instead, the Bank argued that default interest compensates it for the heightened risk of nonpayment of principal and interest and the decline in book value of a defaulted loan. The Bankruptcy Court ultimately rejected both arguments, observing in agreement with other courts that banks already price risk into the loan's nondefault interest rate. As a matter of law, and by contrast, provisions for additional charges contingent upon the breach of the contract must be analyzed under Civil Code Section 1671(b) as liquidated damages with a concrete, evidence-based relationship to the foreseeable actual costs of a default.

The Altadena Lincoln Crossing decision is currently on appeal before the U.S. District Court (Case No. 2:18-cv-08738-JLS), but the Bankruptcy Court's thorough discussion of applicable law concerning default interest is noteworthy and may have applications for debtors and trustees alike. It could very well be the case that numerous boilerplate default interest provisions in existing loan agreements may be unenforceable in bankruptcy.

If you have any questions, please contact Brandon J. Iskander, Esq. or any of the attorneys at Shulman Hodges & Bastian LLP at (949) 340-3400.

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