California law allows a commercial lender to recover default interest from a borrower under certain circumstances. Separately, bankruptcy law permits a secured creditor with a lien on collateral valued more than the debt to recover its default interest from the bankruptcy estate. Both state and federal law mandate that the default rate of interest should not be a penalty. However, these principles do not address what happens when the borrower or bankruptcy trustee objects to a lender’s recovery of its default interest on the grounds that such interest constitutes an unenforceable penalty. The bankruptcy court for the Eastern District of California recently considered the question in the context of a maturity default and concluded that default interest triggered by a such a default is not a penalty under California law.

In In re 3MB, LLC, debtor borrowed $9.5 million from lender, and secured its debt by granting a lender a deed of trust and assignment of rents against its shopping center. Debtor failed to pay the debt upon maturity and subsequently sought chapter 11 bankruptcy protection after lender’s successor in interest (U.S. Bank) began to foreclose upon its deed of trust. U.S. Bank filed a proof of claim in the case which included over $200,000 in default interest. Debtor objected to U.S. Bank’s claim for default interest, arguing that the default rate of “4% plus the contract rate” constituted an “unenforceable penalty” under California Civil Code section 1671(b).

The court upheld U.S. Bank’s claim for default interest. In doing so, the court pointed out that California law permits a creditor to collect its default interest following note maturity without the need to analyze whether the default interest constitutes a penalty under section 1671(b). The court further held that even if the section applied, the default interest rate provision was valid because U.S. Bank presented expert evidence which established that borrower’s failure to pay the loan at maturity had a detrimental impact on the value of the loan. The court noted that U.S. Bank also demonstrated that the default interest rate bore a reasonable relationship to its anticipated future damages upon debtor’s failure to timely pay the loan.

This decision, when combined with other courts’ recent rulings on similar facts, offers substantial guidance to a commercial lender seeking to recover default interest. First, when faced with an objection to the allowance of its default interest in bankruptcy, lender should be prepared to assert facts showing that the default interest rate was reasonable at the time the loan was made, as well as to present expert evidence to support that assertion. Second, if the right to default interest is triggered by loan maturity, lenders should assert that the California penalty law does not even apply. Finally, in drafting the loan documents, a lender should include robust wording establishing that the default interest rate is the result of the parties’ attempt to anticipate and compensate for the lender’s losses arising from borrower’s default.