In re 3MB, LLC, Case No. 18-14663-B-11, 2019 WL 6701420 (Bankr. E.D. Cal. Dec. 5, 2019).
The United States Bankruptcy Court for the Eastern District of California (the “Bankruptcy Court”) held that a provision in a promissory note, governed by California law, that provided for default interest at the rate of 4% per annum above the non-default rate was an enforceable charge for interest under California law and was not a liquidated damages clause. Even if the provision were viewed as a liquidated damages clause, it would nevertheless be valid.
3MB, LLC (the “Debtor”), a California limited liability company, borrowed approximately $9.5 million from Prudential Mortgage Capital Company, LLC (“Prudential”) under a promissory note (the “Note”), which was governed by California law. The Note was subsequently assigned to U.S. Bank, N.A. (“U.S. Bank”). The Note was secured by the Debtor’s shopping center and the rents generated by the center. The Note bore interest at the non-default rate of 6.27% per annum, with an additional 4% per annum charged as default interest upon the occurrence of an event of default. The Debtor explicitly acknowledged in the default interest section of the Note that “it would be extremely difficult or impracticable to determine Lender’s actual damages resulting from any late payment, Event of Default or prepayment, and the late charges, default interest and prepayment fees, premiums, fees and charges described in this Note are reasonable estimates of those damages and do not constitute a penalty.” The Debtor made all required monthly payments but did not pay the “balloon” on the Note at maturity and was unable to refinance the Note. U.S. Bank commenced foreclosure proceedings and the Debtor filed for chapter 11 relief to prevent the foreclosure.
U.S. Bank filed a proof of claim in the chapter 11 case seeking payment of principal, non-default interest and default interest. The Debtor objected solely to the default interest portion of the claim, contending that it was unenforceable as an invalid liquidated damage clause under California and bankruptcy law. The Bankruptcy Court overruled the objection, finding the default interest provision was not a liquidated damages clause or, if the Debtor was correct that it was a liquidated damages clause, it would be valid.
First, the default interest provision was not liquidated damages. Section 506(b) of the Bankruptcy Code includes in a claim of an over-secured creditor “interest…and any reasonable fees, costs, or charges provided for under the agreement … under which such claim arose.” Here, it was undisputed that U.S. Bank was oversecured. The Bankruptcy Court cited the Supreme Court case of Travelers Cas. & Sur. Co, of Am. v. PG&E, 549 U.S. 443, 450 (2007), which affirmed the proposition that creditors’ rights in bankruptcy arise from underlying substantive law, subject to any qualifying or contrary provisions of the Bankruptcy Code. The Ninth Circuit, in GE Capital Corp. v. Future Media Prods.m 563 F.3d 969, 973 (9th Cir. 2008) interpreted Travelers to mean the default rate should be enforced, subject only to the substantive law governing the loan agreement, unless a provision of the Bankruptcy Code provides otherwise. The Bankruptcy Court found that this Ninth Circuit precedent (A) required it to look to substantive California law (the law of the Note), not the Bankruptcy Code, to determine enforceability of the default interest provision and (B) placed the burden on the Debtor to demonstrate that the default rate was unreasonable or unenforceable under non-bankruptcy law.
California law allows a creditor to recover default interest from a borrower. The Debtor failed to meet its burden for the following reasons. First, California courts have long allowed default interest following note maturity without resort to a liquidated damages analysis. Second, the 4% default interest rate was not a penalty because U.S. Bank presented uncontroverted testimony that the default had caused it to incur higher costs and expenses and that the default interest charge was well within the range charged in similar commercial loans. Third, application of the default interest provision was equitable because there was no allegation or proof that U.S. Bank or its predecessors were guilty of misconduct. Moreover, the Bankruptcy Court rejected the Debtors’ contention that allowing default interest would prejudice unsecured creditors or harm the Debtors’ fresh start. Even if allowing default interest meant that unsecured creditors were not paid in full, this result was not unfair because unsecured creditors frequently receive less than their full claims in a bankruptcy case. Further, unsecured creditors had benefited from the Debtor’s bankruptcy, which stayed the appointment of a receiver, allowed an additional year of operation instead of foreclosure and allowed them to vote on a plan. As to the Debtor’s “fresh start,” the Debtor had failed to provide any quantifiable evidence for its assertion that allowing default interest would impair its fresh start. Therefore, the default interest provision of the Note was enforceable and need not be examined under the liquidated damages rubric.
Second, even under a liquidated damages analysis, the default interest provision was enforceable. California Civil Code section 1671(b) provides that a liquidated damages clause 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.” Under California case law interpreting section 1671(b), to invalidate the default interest provision, the Debtor had to show both that the provision “bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach” and that the parties had failed to make a “reasonable endeavor” to estimate the fair average compensation for any loss that may be sustained.
As to the “reasonable relationship” prong, the evidence supported U.S. Bank for three reasons. First, U.S. Bank presented uncontroverted testimony that the 4% default rate was consistent with similar commercial loans. Second, the Debtor, in the Note itself, had expressly acknowledged the reasonableness of the default interest provision. Thus, reasonableness was conclusively presumed as between the Debtor and Prudential (now U.S. Bank). Third, other relevant conditions for a valid liquidated damages clause were present: both parties had counsel when the Note was signed; both parties were sophisticated; and there was uncontradicted testimony that when the Note was made, the default interest component of the Note was within the range of expected damages the lender would experience in the event of a default.
As to the “reasonable endeavor” prong, the Debtor’s contractual acknowledgements created a conclusive presumption of reasonableness. In any case, the validity of the clause did not depend on actual negotiations over its provisions. Rather, the focus was on the motivation and purpose in imposing the charges and their effect. Because (i) the evidence showed that the extent of losses that the lender would suffer beyond default was unknown or not quantifiable at the time of contracting and (ii) the default interest rate was well within market standards for commercial contracts, the second prong was satisfied. Thus, if the clause were a liquidated damages clause, it would be valid.
Article courtesy of David P. Simonds (Hogan Lovells US LLP) and Edward McNeilly (Hogan Lovells US LLP).
Link to the full decision: Memorandum Decision – 3MB LLC – POSTED.