In 2018 Nicholas and Sharon Honchariw obtained a $5.6 million dollar bridge loan with FJM Private Mortgage Fund, LLC, a private lender, secured by a first deed of trust on commercial real property. On September 1, 2019, the Honchariws defaulted under the loan by missing their monthly payment in the amount of $39,667. The default triggered an automatic imposition of (1) a one-time late payment fee ($3,967), which was 10% of the missed monthly payment, and (2) default interest of 9.99% per annum over the note rate, charged against the unpaid loan balance (collectively, the “Late Fee Provisions”). The Honchariws filed a demand for arbitration alleging, among other things, that the Late Fee Provisions were an unlawful penalty in violation of Section 1671 of the California Civil Code. FJM Private Mortgage Fund, LLC, prevailed in the arbitration. The Honchariws then filed a petition to vacate the arbitration award on the basis that the arbitrator exceeded their authority by denying, in part, the violation of Section 1671. The trial court denied the petition finding that the Honchariws failed to meet their burden of proof to show that the default interest under FJM’s loan was an illegal penalty. The Honchariws appealed.Section 1671 of the California Civil Code provides, in part, that a liquidated damages provision under a non-consumer contract is presumed valid. Notwithstanding that presumption, the Court of Appeal in the Honchariw case concluded that a liquidated damages provision in a non-consumer contract must bear a “reasonable relationship” to the actual damages that the parties anticipate would flow from a breach under the agreement. The Court’s reasoning relied on a prior case, Garrett v Coast & Southern Fed. Sav. & Loan Assn,9 Cal. 3d 731 (1973), wherein the

imprecise, so imposing actual damages is something a borrower could challenge. If a lender opts for implementing actual damages as the late penalty, it should be prepared to back up the amount it claims.Brief BackgroundPlaintiffs Nicholas and Sharon Honchariw took out a $5.6 million bridge loan with 8.5 percent interest assessed per annum on December 12, 2018, secured by a first lien deed of trust on real property from defendant, FJM Private Mortgage Fund, LLC. Pursuant to the loan agreement, the event of a default triggered certain late-payment fee provisions, including (1) a one-time 10 percent fee assessed against the overdue payment; and (2) a default interest charge of 9.99 percent assessed annually against the total unpaid principal balance.On September 1, 2019, the plaintiffs triggered the late-payment fee provisions when they missed a monthly payment. The plaintiffs commenced arbitration and argued, among other things, that such late-payment fee provisions were unlawful under section 1671 of the California Civil Code, which provides that a liquidated damages provision is either presumptively valid or invalid depending upon the subject matter of the contract. Ultimately, the arbitrator rejected the plaintiffs’ original arguments and ruled in favor of the lender. On appeal, the Superior Court of Sonoma County affirmed the arbitrator’s award. The plaintiffs then appealed to the Court of Appeal, which reversed the lower court’s ruling and vacated the arbitration award. The Court of Appeal principally relied on Garrett v. Coast & S. Fed. Sav. & Loan Assn., 511 P.2d 1197 (Cal. 1973), in which the California Supreme Court held that a default interest provision assessed against the entire unpaid balance of a loan was punitive in character and constituted an unlawful penalty. The Court of Appeal provided that it is the public policy of California that liquidated damages bear a “reasonable relationship” to the actual damages that the parties anticipate would flow from breach, whereas late-payment fees may v

8, the plaintiffs, Nicholas and Sharon Honchariw, took out a $5.6 million-dollar commercial bridge loan with an 8.5% annual interest rate from the defendant, FJM Private Mortgage Fund, LLC. When the Plaintiffs missed a monthly payment, it triggered the late-payment fee provision set forth in the loan agreement, and a default interest charge of 9.99% per annum was assessed against the entire principal balance of the loan. Pursuant to the terms of the loan agreement, this new default interest rate of 9.99% assessed against the entire principal balance of the loan would be applied monthly to the entire unpaid loan balance from the time of default until the loan was paid off, or until the specific default had been cured.Current California law provides that a liquidated damages provision, i.e. a late-payment fee, is presumptively invalid if it is related to a consumer contract, but a liquidated damages provision is presumptively valid if it’s related to a non-consumer contract.According to Section 1671 of the California Civil Code, a consumer contract is one that involves the “retail purchase, or rental of personal property or services, primarily for personal, family, or household purposes, or a lease of real property for use as a dwelling.” All other contracts are non-consumer contracts, i.e. business contracts.Regardless of whether the contract is a consumer or non-consumer contract, the amount of liquidated damages must bear a reasonable relationship to the actual damages that the parties would anticipate be caused by the breach. (Garrett v. Coast & Southern Fed. Sav. & Loan Assn. (1973) 9 Cal.3d 731, 739.) In the absence of such relationship, a liquidated damages clause may be construed as a penalty, which is unlawful and invalid.Late-payment fees serve a dual purpose – first, to compensate the lender for its administrative expenses and the cost of money wrongfully withheld, and second, to encourage the borrower to make timely future payments. (Garrett, supra, 9 Cal.3d at pp. 739-740.) However, late payment

The California Supreme Court recently declined to review a Court of Appeal opinion holding that under California law “liquidated damages in the form of a penalty assessed during the lifetime of a partially matured note against the entire outstanding loan amount are unlawful penalties.” The Court of Appeal decision vacated an arbitration award enforcing a non-consumer bridge loan’s late fee provision, which constituted an unlawful penalty per California Civil Code § 1671’s public policy concerns.The borrowers had obtained a non-consumer bridge loan secured by a first-lien deed of trust on their real property. They then defaulted on one of their monthly payments, for which the lender charged a one-time late fee equal to 10% of the overdue payment and imposed default interest of 9.99% per annum assessed against the loan’s total unpaid principal balance. The lender imposed the fees per the loan agreement’s late fee provision. The borrowers filed a demand for arbitration alleging, among other things, that these assessed late fees were an unlawful penalty under California Civil Code § 1671. The arbitrator disagreed with the borrowers and found that the late fees did not violate § 1671. The borrowers then petitioned the trial court to vacate the arbitrator’s decision and the trial court denied the petition.The Court of Appeal reversed the trial court, holding that any default interest assessed against the entire outstanding loan amount during the lifetime o

California Civil Code Section 1671 provides that a liquidated damages provision is either presumptively valid or invalid depending upon the subject matter of the contract. If the contract involves “the retail purchase, or rental . . . of personal property or services, primarily for . . . personal, family, or household purposes,” (§ 1671(c)(1)), or involves “a lease of real property for use as a dwelling,” (§ 1671(c)(2)), then a liquidated damages provision in that contract is presumptively void. (§ 1671(d).) For all other contracts (i.e., non-consumer contracts), “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.” (§ 1671(b).) Last fall, a California Court of Appeal held thatliquidated damages in the form of a penalty assessed during the lifetime of a partially matured note against the entire outstanding loan amou

of any loan, regardless of loan purpose, unless the default is a maturity default.In September 2022, the California 1st District Court of Appeal issued a decision in Honchariw v. FJM Private Mortgage Fund, LLC.1 FJM, a private lender, had made a $5.6M business purpose loan to Nicholas and Sharon Honchariw, which was secured by a deed of trust on real property. Under the terms of the loan agreements, the Honchariws were required to make monthly payments, however, they defaulted on their monthly payment in September of 2019. Their default triggered a one-time 10 percent fee assessed against the overdue payment as well as a default interest charge of 9.99 percent per annum assessed against the total unpaid principal balance of the loan.The Honchariws filed for arbitration, contending that the loan was in violation of California Business and Professions Code § 10240 et seq., and that the default interest charge constituted an unlawful penalty in violation of public policy as set forth in California Civil Code § 1671. The arbitrator ruled for FJM on both arguments. The Honchariws then petitioned the trial court to vacate the award. The trial court denied the petition, following which the Honchariws appealed to the Court of Appeal.In a surprising reversal of the trial court’s decision, the Court of Appeal agreed with the Honchariws. The Court found that charging default interest against the principal balance of any loan violated the public policy expressed by § 1671. According to the Court, § 1671 requires that liquidated damages bear “a reasonable relationship” to the actual damages that are anticipated to flow from a breach, and late-payment fees may violate liquidated damages statutes and amount to unlawful penalties if their “primary purpose is to compel prompt payment through the threat of imposition of charges bearing little or no relationship to the amount of the actual loss incurred by the lender.”2 The Court then held that liquidated damages in the form of a penalty assessed during the lif

Facts of Honchariw v. FJM Private Mortgage Fund, LLCThe Honchariws took out a $5.6 million bridge loan from FJM Private Mortgage Fund, LLC. The loan was secured by real property and carried an 8.5% annual interest rate.Less than a year into the loan, the Honchariws missed one of their monthly payments of $39,667, which triggered certain late-payment fee provisions in the loan agreement, including: (1) a one-time 10% fee assessed against the overdue payment ($3,967); and (2) a default interest charge of 9.99% per annum assessed against the total unpaid principal balance of the loan.After FJM Private Mortgage sought to impose these penalties, the Honchariws filed for arbitration challenging the late-payment penalties as unenforceable under California Civil Code section 1671. The arbitrator disagreed and rejected the Honchariws’ challenges to the late-payment penalties, leading to the Honchariws filing an appeal to challenge the arbitrator’s decision.Court of Appeal: reversed; late-payment fees tied to entire principal balance are unenforceable penaltiesThe appellate court began by first recognizing that in California, default interest loan provisions (referred to as “liquidated damages” provisions) are presumptively valid in the context of non-consumer contracts, such as the one at issue in Honchariw. Non-consumer are those contracts other than contracts for personal property or services for personal or household purposes or a lease of real property for use as a dwelling.In the case of non-consumer contracts, the presumption of validity can be overcome where a liquidated damages provision does not bear a “reasonable relationship” to the actual damages that the parties anticipate would flow from a breach of the loan agreement, such as a late payment. Stat

In Honchariw v. FJM Private Mortgage Fund, LLC, et al., the appellate court reversed the trial court’s refusal to overturn an arbitrator’s decision that the plaintiffs failed to establish that their lender’s imposition of default interest was an unlawful penalty under California Civil Code section 1671. The appellate court found that the mere fact that default interest was being charged on the entire loan balance prior to full maturity was, in and of itself, a violation of public policy.In Honchariw, the plaintiffs took out a nonconsumer loan secured by a first-lien deed of trust on real property. After the plaintiffs defaulted on their Sept. 1, 2019, monthly payment, their lender charged a one-time late fee equal to 10% of the overdue payment and imposed default interest of 9.99% per annum assessed against the total unpaid principal balance of the loan (collectively, the late fee), as provided in the loan agreement. Plaintiffs filed a demand for arbitration, alleging, among other things, that the late fee was an unlawful penalty in violation of section 1671. The arbitrator found that the late fee did not violate section 1671 and denied the demand for arbitration. Plaintiffs petitioned to vacate the arbitrator’s decision and the trial court denied the petition. Plaintiffs appealed.S

Otherwise, the security deposit is susceptible to a re-characterization as prepaid rent. Since the landlord retains other rights under the lease for a tenant default (unlawful detainer and damages actions, for example), it is typically not viewed as liquidated damages and therefore not subject to the reasonableness and other requirements of California Civil Code Sections 1671 to 1681.Impact of Prohibitions on Evictions and Security DepositsIn the current COVID-19 crisis, there are restrictions that have been imposed on commercial evictions in many jurisdictions by state or local order. However, these restrictions have not generally to date restricted commercial landlords from applying security deposits in the event of a tenant’s failure to timely pay installments of rent or perform other obligations under the tenant’s lease.

The Second Appellate District of the California Court of Appeal recently issued a decision in Constellation-F, LLC v. World Trading 23, Inc. finding that a holdover provision in a commercial lease providing for significantly increased rents during the holdover period is not an unenforceable penalty under California Civil Code section 1671. While this decision directly implicates holdover provisions in commercial leases, its broad language focusing on the contracting parties' respective bargaining powers may implicate other contractual relationships.