Geraci LLP and Wright, Finlay & Zak have prepared a Joint Statement, which you can read in full below, providing a detailed analysis of the current state of the law and other frequently asked questions about the Honchariw v. FJM Mortgage Fund decision.
What is the case?
On September 29, 2022, the California 1st District Court of Appeals issued an important decision restricting a lender’s ability to charge default interest in California (Honchariw v. FJM Private Mortgage Fund (2022) 83 Cal. App. 5th 893). FJM is a private lender which made a business purpose loan to Honchariw (an attorney and plaintiff in several similar lawsuits). When Honchariw missed his monthly payment, FJM exercised its’ contractual right to add default interest to the loan. Honchariw disputed the default interest charge, leading to arbitration. The Arbitrator ruled in FJM’s favor. Honchariw then moved the court to vacate the Arbitration Award, where FJM also prevailed. Honchariw then appealed the denial to the California Court of Appeals, resulting in this decision. The written decision can be found here.
What is the holding of the case?
The unusual holding of this case provides that no lender may charge default interest against the entire principal balance of a loan following a monthly payment default and not a maturity payment default. This means the lender is only able to charge an installment late charge and default interest against amounts presently in default (i.e. unpaid installments) and not against the entire principal balance. The prohibition applies regardless of loan purpose (i.e. business or consumer purpose loans), collateral type (i.e. commercial, residential, or vacant land), or type of lender (commercial, equipment, business purpose, unsecured, etc.).
Since the decision is published, it is binding law in the 1st Appellate District of California (Bay Area) and non-binding precedent in the rest of California.
Why was it decided incorrectly?
We believe the Court of Appeal made several errors of law and procedure. Those are all laid out in detail in Geraci LLP’s Petition for Review by the California Supreme Court and in the Amicus Letter in support of Review by Wright, Finlay & Zak on behalf of the National Mortgage Bankers Association, California Mortgage Association, California Mortgage Bankers Association, American Association of Private Lenders and National Private Lenders Association.
Historically, default interest cases look to understand the measure of damages a lender incurs when a borrower defaults to determine whether there is a reasonable relationship between the default interest rate and the harm the lender will likely incur as a result of the default. Because these amounts are difficult to determine at the outset of the loan, the parties agree what those amounts will be in the form of liquidated damages clauses, such as default interest and late charges.
Below is a short list of some of the factors that a court may consider when determining whether the default interest charge bears a reasonable relationship to the lender’s anticipated loss resulting from the default:
- Reduction in asset value. If a lender is selling a non-performing loan, the loan buyer will likely require a discount on the purchase price, where otherwise a lender may have received par value for a performing loan.
- Increase in cost of funds. Warehouse lenders often require an originating lender to remove a defaulted loan from a line of credit, thereby increasing the cost of funds to the originating lender.
- Loss of use of funds. While the loan is in default, the lender loses the use of those funds during the default, foreclosure and potential sale of the foreclosed property.
- Increased internal and accounting costs resulting from the default: When a loan defaults a lender must divert their internal resources from other matters to address the default and attempt to obtain the borrower’s reperformance of its obligations. This includes costs of special servicing, diversion of accounting resources, and bringing in loan originators or other relationship parties to attempt to communicate with the borrower. The effort will vary depending on circumstances.
- Impact on the ability to attract other investors. A mortgage fund manager or others who solicit investors typically discloses their delinquency rate to their prospective investors. A higher default rate would usually require a higher yield to attract future investors, but without the ability to charge default interest, it becomes difficult to attract investors to account for the risk.
These are just a few examples of the harms that lenders suffer as a result of the borrower’s default. Since these amounts are hard to ascertain (especially at loan origination), a negotiated default rate is often the only way to compensate the lender for its anticipated loss.
In the Honchariw decision, the Court of Appeals correctly held that, in the context of a non-consumer loan, the borrower has the burden to show that the default interest charge does not bear a “reasonable relationship” to the lender’s expected loss Yet, instead of then analyzing whether Honchariw met this burden, the Court of Appeals summarily concluded that the mere fact of charging default interest on the entire unpaid principal balance following a payment default is, de facto, a violation of California Civil Code § 1671. We believe the case is an incorrect interpretation of both statutory and common law in California. We also believe it contradicts other established lending precedent elsewhere in the country.
What is happening now?
Geraci LLP substituted in as counsel for FJM after the negative Appellate Court decision was published. Geraci immediately petitioned the California Supreme Court to review the matter. Wright Finlay & Zak, on behalf of multiple state and national lending associations filed an Amicus Letter with the California Supreme Court emphasizing the importance to the lending industry and the need for the higher court to review the decision. If the California Supreme Court agrees to review the matter, Geraci LLP will then file a brief laying out its substantive arguments to overturn the Court of Appeals’ decision. Wright, Finlay & Zak, on behalf of the same industry groups, will then file an Amicus Brief laying out the industry’s support for a reversal. Optimistically, we expect a decision on whether the Supreme Court will review the matter by the end of 2022 and, if review is granted, a decision in early 2024. A reversal will remove the decision from the books. Read Geraci LLP’s petition to the California Supreme Court here.
What can lenders do in the interim?
Lenders have traditionally used default interest as a strategic tool to create leverage with their defaulted borrowers in order to obtain “reperformance,” and often choose to voluntarily waive or reduce default interest if (and when) the borrower reperforms. Based on the Honchariw decision, the only risk-free approach available to mortgage lenders is to stop charging default interest when there is only a payment installment default that is NOT a maturity default. Lenders and their loan servicers who choose to take a calculated risk to charge default interest on the entire principal balance following a payment default should understand that, doing so violates now-established California law. The risk, of course, is resulting litigation over whether the lender violated the Honchariw decision, and potentially other state and Federal debt collection laws.
What about charging default interest in other scenarios?
The Honchariw decision does not specifically prohibit charging default interest when there is a maturity payment default. The case is also silent as to whether the lender can charge default interest on the entire principal balance, following acceleration due to a non-monetary default, e.g., an unauthorized transfer. Lastly, the decision did not address whether charging default interest on some portion of the unpaid principal balance would be allowed (although not specifically disallowed, this move could be looked negatively upon by the courts).
Notwithstanding the fact that the Honchariw decision did not prohibit these acts, a borrower may nonetheless argue the Honchariw decision applies to prohibit default interest in these scenarios as well. It will then be up to the individual court to determine if the Honchariw decision applies, and if so, did the lender violate applicable law.
Even if the Honchariw decision does not control, any default interest charge must bear a “reasonable relationship” to the loss that the lender is likely to incur as a result of the default. That analysis is the back stop for any decision to charge default interest and should be used by lenders when determining not only whether to charge default interest, but also the amount of default interest that accrues.
Does this holding apply only in California?
Honchariw is a California appeals court decision and only impacts California loans. While we disagree with the outcome of the decision, it should be noted that the analytical framework utilized by the Honchariw court is very similar to the framework in other states. Mortgage lenders in any state must be able to justify the harms they incur and have a reasonable relationship between the harm incurred and the amount charged to the borrower. Because there are very few statutory bright line rules of what is a permissible amount of default interest, courts in each state must come to their own determinations. It is often the case that states will look to cases outside of their state (and in particular to cases from a large state with ample cases such as California) to make determinations of what is appropriate, so this case may in fact have significant national repercussions if it’s not reversed.
How can you help?
Amicus Letter. Click here to read the Amicus Letter filed by Wright, Finlay and Zak. An Amicus Letter was also filed by the California Bankers Association; that can be found here. We encourage others to submit a letter to the California State Supreme Court to encourage the court to hear the matter. All letters should be submitted ASAP as the California Supreme Court could issue a ruling at any moment. Click here for an Amicus form template to fill out.
Legal Defense Fund. The litigation in Honchariw has already cost more than the amount in controversy in the underlying case. Because this case affects all lenders and impacts your contractual rights, Geraci LLP established a legal defense fund. For more information on how you can participate with the legal defense fund contact Nema Daghbandan at firstname.lastname@example.org.
Nema Daghbandan, Esq., on behalf of Geraci LLP
T. Robert Finlay, Esq., on behalf of Wright, Finlay, and Zak