As interest rates rise, borrowers may find themselves in default, facing lenders who overreach by seeking to recover default interest in addition to regular interest on the principal of the loan. Borrowers may have a weapon in their arsenal to oppose unscrupulous lenders.

In Honchariw v. FJM Private Mortgage Fund, LLC, 83 Cal.App. 5th 893 (2022), a borrower alleged that a default interest rate of 9.99% per annum on the then outstanding principal was illegal. The trial court affirmed an arbitration decision rejecting the borrower’s position. The Court of Appeal reversed the trial court and vacated the arbitration award.

The case is significant for two reasons. First, it shows that arbitration awards are not always final. The Court applied the rule that arbitrators exceed their powers when issuing awards that contravene an explicit legislative expression of public policy. This well-established exception to the deference normally given to arbitrators may surprise some who think that arbitration awards will usually be upheld. Second, this case confirms that public policy exceptions apply to protect borrowers even in the non-consumer context. The Court held that the public policy reflected in California statutes such as Civil Code section 1761, which bars the application of liquidated damages penalties, extends to contracts between sophisticated parties. One might think that public policy exceptions would not extend protection to borrowers on non-consumer loans. Such thinking would be incorrect.

The Court held that even in the context of a non-consumer loan, California law precludes a loan agreement which charges a liquidated damages penalty including a default interest rate that bears no reasonable relationship to actual damages. Civil Code section 1671 requires that liquidated damages bear “a reasonable relationship” to the actual damages that are anticipated to flow from a breach. Late-payment fees may 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.” The Court found that liquidated penalties in the form of a penalty assessed during the lifetime of a partially matured note against the entire outstanding loan amount constituted unlawful penalties under Section 1671.

Thus, a borrower will have recourse if an aggressive lender seeks to collect illegal default interest rate charges on a non-consumer loan. On a consumer loan, all liquidated damages charges are presumptively invalid. But for a non-consumer loan, the default interest rate on a principal balance at the time of breach will likely be found to unenforceable as an illegal charge because it cannot possibly be related reasonably to actual damages suffered by a lender as a matter of law.