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 of a partially matured note is an unlawful penalty under California law. Even though the contract before the Court of Appeal was a non-consumer contract, making it presumptively valid under California law, the Court determined that the contract could be scrutinized under California public policy through the California Supreme Court’s opinion in Garrett v. Coast & Southern Fed. Sav. & Loan Assn, 9 Cal.3d 731 (1973). California’s public policy for liquidated damages requires provisions to “bear a ‘reasonable relationship’ to the actual damages that the parties anticipate would flow from breach.” In analyzing a note’slate payment fee provision, the Garrett court found that fees assessed against the “unpaid principal balance of the loan obligation” violated § 1671 because the fees’ “primary purpose [was] 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.”
In applying Garrett, the Court of Appeal determined that the loan document’s late fees violated California public policy because the fees were not only a one-time 10% fee on a missed payment but also an additional default interest charge assessed against the total unpaid principal balance of the loan. Though the lender asserted that the fees were the parties’ attempt to calculate the lender’s damages in case of default, the Court of Appeal held that they failed the “reasonable relationship” requirement, reasoning that the lender actually intended these fees to “coerce timely payments” because they were not related to the “range of actual damages” the lender would suffer if the borrowers defaulted. Thus, the Court found these fees to be a liquidated damage that is “punitive in character”—violating § 1671.