When You Cannot Get Default Interest By Default

Nov 28 2016

Law360, New York (October 02, 2012, 3:26 PM ET) -- In connection with commercial and residential
loans which have gone into default, whether as a result of a payment default, technical default or
maturity, the imposition of default interest can quickly add up. These fees may render the borrower’s
ability to cure the default impossible or, on the other hand, generate a handsome profit for the lender
or loan servicer.

However, the recent decision in JCC Development Corp. v. Hyman Levy, 208 Cal. App. 4th 1522 (2012), in
the Court of Appeal for the Second Appellate District, is a reminder to all parties in a loan transaction
that the language of the loan agreement governs the availability of default interest. A loan in default
does not necessarily entitle the lender to default interest.

In JCCDC, Levy loaned JCCDC $2.7 million secured by a deed of trust on the real property owned by
JCCDC and housing a Jewish community center. During term of the loan, Levy and JCCDC were
negotiating a potential sale of the property to Levy. Ultimately, the parties were unable to agree to sale
terms and Levy commenced efforts to enforce the terms of the loan.

The terms of the loan were that JCCDC agreed to pay the entire principal sum and interest, at the rate of
5 percent per year, on or before Sept. 30, 2006. Critically, the note contained the following default and
acceleration provision:
If: (i) Maker shall default in the payment of any interest, principal, or any other sums due hereunder, or
(ii) Maker shall default on performance of any of the covenants, agreements, terms or provisions of the
deed of trust securing this Note, or (iii) Maker shall sell, lease, convey, hypothecate, transfer, encumber
or alienate the Property (defined below), or any part thereof, or any interest therein, or shall be
divested of title or any interest therein in any manner or way, whether voluntarily or involuntarily,
without the written consent of the Holder being first had and obtained; then, at Lender's option, all
sums owing hereunder shall, at once, become immediately due and payable. Thereafter, interest shall
accrue at the maximum legal rate permitted to be charged by non-exempt lenders under the usury laws
of the State of California.

After negotiations to sell the property ceased, Levy’s counsel prepared a payoff demand which included
principal, interest, default interest and fees. JCCDC recognized the excessive charges in the payoff
demand and paid the entire amount under protest, including interest at the default interest rate. JCCDC
then filed suit.

At trial, JCCDC argued that Levy could not implement the default interest rate under the plain language
of the default and acceleration provision. JCCDC pointed to the language which, in its reading, required
Levy to first declare the loan to be default and then accelerate the entire principal balance of the loan,
before he could charge default interest. The trial court rejected JCCDC’s argument and ruled that the
default interest rate was automatically triggered upon the maturity date, without a requirement that
Levy accelerate the loan.

The court of appeal overturned the decision of the trial court. In interpreting the language of the
promissory note, the court determined that the default interest provision was part of the acceleration
provision. The court stated, "[t]he plain language of the note states that once one of the circumstances
occurred which would accelerate the loan, “thereafter” interest could accrue at the maximum legal rate.
The default interest language appears in the same paragraph as the acceleration clause and there is no
indication in the note that this language relates to circumstances other than acceleration (e.g., failure to
pay the lump-sum payment at the time the loan matured).”

The court made this determination even though requiring Levy to place the loan in default and
accelerate the balance is an extremely unlikely event. Specifically, the loan would almost never be in a
payment default because it merely required a lump sum payment of principal and interest at maturity.
Thus, the court explained that there were a few limited circumstances under which default interest
would ever be available on this loan. For instance, Levy could accelerate the loan if JCCDC sold the
property without Levy’s consent, or breached another term of the deed of trust. The court
acknowledged that the only possible payment defaults under the note would be if costs were required
to be advanced under the deed of trust. However, this did not change the analysis because, these were
the circumstances defined by the executed documents.

In reaching its decision, the court looked to an analogous case decided by the Ninth Circuit Court of
Appeals in 2001, In re Crystal Properties Ltd. LP (9th Cir. 2001) 268 F.3d 743. In that case, the Ninth
Circuit interpreted similar language in the loan agreement. There, the note language stated, “Should
default be made in any payment provided for in this note, ... at the option of the holder hereof and
without notice or demand, the entire balance of principal and accrued interest then remaining unpaid
shall become immediately due and payable, and thereafter bear interest, until paid in full, at the
increased rate of five percent (5%) per annum over and above the rate contracted for herein."

As in JCCDC, the occurrence of an event of default permitting the lender to charge default interest, did
not include the maturity of the loan. Further, because the default interest provision was included in the
acceleration clause, “by its very terms, the default interest cannot be charged post-maturity.”
In JCCDC, the court recognized the important lesson to be learned by Levy, and others who find
themselves drafting promissory notes: “the drafter of the agreement, could have included language
stating that the default interest rate applied not only after circumstances of acceleration, but also after
the loan matured and no payment was made."

Lenders and borrowers should carefully scrutinize the default interest provisions in their loan
agreements. With respect to lenders, loan documents generated by commercially marketed software,
generally split the default rate provision from the acceleration clause. Thus, for example, the loan
agreement may state, “Interest After Default. Upon default, including failure to pay upon final maturity,
Lender, at its option, may, if permitted under applicable law, increase the interest rate on this Note to X
percent per annum, if and to the extent that the increase does not cause the interest rate to exceed the
maximum rate permitted by applicable law.”

Similarly, lenders who generate loan agreements specific to the transaction, should also ensure that
their promissory notes separately reference the acceleration and default interest. For example, “Interest
Upon Default. During the period of an uncured Event of Default (including, without limitation, the failure
of Borrower to pay any sum herein specified when due and after the expiration of any applicable grace
period), the unpaid principal sum evidenced by this Note, all accrued and unpaid Interest thereon, and
all other sums evidenced and/or secured by the Loan Documents shall bear Interest at a rate per annum
(the "Default Rate")."

In the case of borrowers, review of the loan documents with respect to default interest may provide
them with significant defenses to the total liability claimed by lenders. First, the language may reveal
that the lender cannot charge default interest without first accelerating the loan, just like Levy. Further,
if the lender wrongfully charges default interest, or improperly includes default interest in the payment
demand, they may incur further liability like Levy, under Civil Code section 2943. Section 2943 requires
lenders to prepare a payoff demand statement including a complete breakdown of all applicable
charges, within 21 days of the demand. A willful failure to comply may render the lender liable for
damages.

Second, they should be aware of the potential for the default interest provisions to run afoul of usury
laws. In California, generally speaking, unless the lender falls into a recognized exception, interest is
capped at 10 percent or 5 percent over the rate established by the Federal Reserve Bank of San
Francisco at the time of entering into the loan. (Cal Const, Art. XV § 1.) However, those making loans
secured by real property often fall into a recognized exception to the usury law, including license real
estate brokers, credit unions or consumer finance lenders.

Because the default interest rate calculations can quickly add up, often exponentially increasing the
amount of due under the loan, counsel for both lenders and borrowers should carefully scrutinize the
default interest provisions in their loan agreements. Most importantly, counsel must recognize that the
entitlement to default interest under the loan agreement is not perfunctory. Rather, it is a contractual
term subject to the same interpretation as other language in the contract.

--By Mark Madnick, Robins Kaplan Miller & Ciresi LLP

Mark Madnick is an associate in Robins Kaplan's Los Angeles office. He practices in the areas of real
estate litigation and business litigation.

The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its
clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general
information purposes and is not intended to be and should not be taken as legal advice.

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