The California Court of Appeals for the First Appellate District recently reversed a trial court's decision to affirm an arbitration award that upheld the validity of a late payment fee assessed to borrowers in the event of a borrower's default.
In so ruling, the Court of Appeals held that:
1 – Arbitration awards regarding liquidated damages provisions that allegedly violate California's prohibition on unlawful penalties under California Civil Code § 1671 involve "well-defined and dominant" public policy, and are therefore subject to de novo review;
2 – "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";
3- The late fee at issue here was an unlawful penalty under § 1671.
A copy of the opinion is available at: Link to Opinion
Two borrowers took out a $5.6 million business loan with 8.5% interest assessed per annum ("Loan"). The Loan was secured by a first lien deed of trust on commercial real property. The terms of the Loan provided that, "based on even one missed monthly payment at any time during the life of the Loan", the borrower would be charged "a one-time 10% fee of the overdue monthly payment" and "a default interest charge of 9.99% per annum assessed against the total amount of unpaid principal balance of the Loan."
The borrowers defaulted when they missed one monthly payment. The default triggered the late fee provisions in the loan.
The borrowers filed a demand for arbitration challenging the validity of the late payment fee. The borrowers alleged the loan violated California Business and Professions Code § 10240 and California Civil Code § 1671 because the late fee was an unlawful penalty.
The arbitrator ruled against the borrowers and for the lender and upheld the validity of the late fee. The borrowers filed a petition to vacate the arbitration award with the trial court and argued that the arbitrator exceeded its authority by denying claims in violation of nonwaivable statutory rights and/or contravention of explicit legislative expressions of public policy under the Real Estate Loan Law which prohibits lenders from charging over 10% of the installment due and section 1671 which generally provides that contractual liquidated damages that constitute penalties are unenforceable.
The trial court disagreed with the borrowers and held that the borrowers did not meet their burden of proof to show that the default interest provision in the loan was invalid as a penalty. The trial court also concluded that the arbitrator did not exceed its powers by denying borrowers claims. The borrowers appealed.
ARBITRATION AWARDS INVOLVING § 1671 REVIEWABLE DE NOVO
In California, an arbitrator's decision "is generally reviewable for errors of fact or law, whether or not such error appears on the face of the award and causes substantial injustice to the parties." See Moncharsh v. Heily & Blase (1992) 3 Cal. 4th 1, 6. However, California Code of Civil Procedure § 1286.2 provides an exception to this rule when "[t]he arbitrators exceeded their powers and the award cannot be corrected without affecting the merits of the decision upon the controversy submitted." In California, arbitrators are considered to exceed their power when they either 1) issue awards the violate a party's unwaivable statutory right or 2) issue an award that contravenes an explicit legislative expression of public policy.
The Appellate Court held that California Civil Code § 1671 involves a "well-defined and dominant" public policy. Therefore, arbitration awards involving alleged violations of California's prohibition on unlawful penalties under California Civil Code § 1671 are subject to de novo review.
Because the borrowers raised an issue on appeal that properly invoked the public policy considerations under section 1671, and argued that an arbitrator exceeded its powers by enforcing a contract in violation of public policy, the Court of Appeals conducted a de novo review.
LATE FEE VIOLATED § 1671
The Appellate Court noted, in California, a liquidated damages provision is generally "presumed valid if it is in a non-consumer contract but presumed invalid if it is in a consumer contract." The loan at issue here was a business loan, as it was "neither for the purchase of property for personal use nor does it involve a primary dwelling."
Under § 1671, for business loans, "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." In California, lawful liquidated damages provisions must bear a "reasonable relationship" to the "actual damages that the parties anticipate would flow from breach; conversely, if the liquidated damages clause fails to so conform, it will be construed as an unenforceable 'penalty.'"
In Garrett v. Coast & Southern Fed. Sav. & Loan Assn, the California Supreme Court held that a charge for the late payment of a loan installment assessed against the unpaid balance of the loan must be deemed punitive in character.
Here, the lender argued that Garrett was not applicable because it was legislatively overruled when section 1671 was revised. The Court of Appeals disagreed, holding that "[w]hile the current version of section 1671 declares all liquidated damages clauses presumptively invalid as to consumer contracts (as opposed to all contracts), Garrett remains good law for the proposition that a late fee assessed against the entire unpaid balance of a loan constitutes an unlawful penalty."
Explaining its ruling, the Court of Appeals discussed a California Supreme Court opinion rendered after the legislative amendment which upheld Garrett and held the late payment fees at issue there were disproportionate to the anticipated damages and as a result should be considered a penalty. Ridgley v. Topa Thrift & Loan Assn. (1998) 17 Cal. 4th 970, 977.
The lender further argued that the late fees represent the parties' attempt to adequately calculate the lender's damages in the event of a default and that the actual damages are not relevant because the parties agreed to the reasonableness of the liquidated damages in the loan.
The Court of Appeals again disagreed because there was not sufficient evidence in the record to support lender's arguments. The Court held that the that testimony proffered by a representative of the lender, without supporting documentation regarding the reasonableness of the late fees, was not sufficient or persuasive to support their arguments.
Therefore, the Court of Appeals held that the 10% late fee provision here amounted to an unlawful penalty under California law, and reversed the trial court's order affirming the arbitration award.
Ralph T. Wutscher
Maurice Wutscher LLP
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