Last year, a California Bankruptcy Court wiped out $10.2 million in default interest (“DRI”) when it ruled that a 5% DRI was an unenforceable penalty in a Chapter 11 bankruptcy case where the construction lender fully recovered principal, interest, and other costs of collection. In acting as the borrower’s fairy godmother, the Court noted that the 5% DRI, an industry standard for construction loans, was unreasonable because it was not negotiated in detail at origination and because it did not adequately forecast the lender’s anticipated costs and damages. So much for considering prevailing practices when gauging reasonableness! The court’s decision also hinged on the fact that the lender was able to collect exit fees, late fees, and loan extension fees while the loan was in forbearance. In the court’s opinion, such fees already compensated the lender for the costs associated with the default. Now that’s novel! We sort of thought that lenders collected exit fees, late fees and loan extension fees in consideration of other things the lender did or forbore from doing. Silly us.
The Bankruptcy Court’s decision raises questions about the enforceability of DRI provisions when such provisions are placed under a Bankruptcy Court’s microscope. The decision, if widely accepted, may force lenders to change their underwriting standards and loan pricing to counteract possible challenges to DRI provisions. But hope is not lost. The US District Court for the Central District of California promptly reversed the Bankruptcy Court’s decision and found that the DRI in this case was enforceable under California law. In an unrelated case, in finding that a 5% DRI was not unconscionable, a New Jersey Appellate Court decision noted the size of the loan and the fact that the DRI was negotiated between sophisticated commercial parties who were represented by counsel.
The District Court’s decision focused on the substantive reasonableness of the DRI. In so doing, it maintained that while a DRI may not be the subject of actual negotiation, it must be reasonable in light of the potential harm that could flow from a breach. The Court concluded that the DRI was enforceable because (i) the diminution in value of the loan was within the range of actual damages that the parties could have anticipated would flow from a breach, (2) an increased interest rate is a common method of recouping such a loss, and (3) the DRI in the specific case was unlikely to overcompensate the lender.
Should lenders consider adopting strategies to increase their chances of victory in DRI courtroom battles? You can take it as gospel that the lower court’s analysis will embolden some defaulting borrowers to take their chance in court in an effort to defeat default interest.
A survey of fifteen lenders indicates that lenders do not vigorously negotiate DRI provisions or calculate the costs of running a special assets department when including a DRI in their loan documents. Can we strengthen our position through documentation? Maybe borrowers’ initials next to the default interest provision could be useful. Maybe a recital that the relevant provision was subject to negotiation in the loan document process would be useful? But between sophisticated parties, isn’t the whole document negotiable? If we start trying to specify what part of the document is “boilerplate” (whatever that means – we’ve probably negotiated every word of the suite of mortgage loan documents at one time or another) and what part of the document is negotiated, we are just going down the rabbit hole. Would it really add anything to the tenor about the agreement between the parties to add a recital that absolutely every word in this document was negotiable? Not productive!
Can lenders document their cost and show that the fee is reasonable? It may be a good idea in a blackboard sort of academic way, but in the real world, a terrible idea, and moreover almost entirely not doable. How big is your workout team? How often do you expect to incur losses? How big will those losses be? What’s the timing of receipt of cash with respect to assets following default? Putting aside the fact that we may have to figure all that out for CECL (let’s put that boneheaded idea off until later when we talk in more length about CECL), it’s just a terribly slippery slope at best and we see no upside in trying. Moreover, we see a substantial downside associated with proposing that the fee is directly determinable by some sort of modeling process and then put that modeling process into dispute in any subsequent litigation with a great borrower.
We think it remains entirely fair to continue to take the view that defaulted loans cost money and lenders are entitled to compensation for that cost and to the extent the proposed default interest rate is consistent with market practice and always negotiable as it is between any two sophisticated parties, whether the documents say it is or not that should be enough to ensure enforceability.
On balance, we agree with the District Court that the California Bankruptcy Court just got this wrong. The lower court’s decision is an outlier and unless we see a wave of similar decisions attacking default interest, we don’t see any upside in torqueing current lending practices and procedures to respond to the overruled decision. Everything in the loan document is negotiable. Every benefit and burden received or undertaken by the borrower and the lender is crystalized through negotiation. So no changes people. But, of course, we could be wrong, so stand by.