In a bankruptcy, a commercial lender with a lien on collateral valued more than the debt can demand to be paid default interest provided in the loan only to be faced with an objection by the borrower or trustee that the default interest constitutes an “unenforceable penalty” under California Civil Code section 1671(b). A recent decision by the District Court for the Central District of California, however, holds that section 1671(b) does not apply to a default interest rate imposed upon maturity as a matter of law. The court further held that even if the section applied, the default interest rate provision was valid because it was the result of a “reasonable endeavor” by the lender to estimate a fair compensation for its losses upon default.

In In re Altadena Lincoln Crossing, the lender made a multi-million dollar construction loan secured by the project. After negotiations to restructure the matured debt ultimately failed, the borrower filed for Chapter 11 bankruptcy. The oversecured lender asserted a claim for default interest to which the debtor in possession objected. The Bankruptcy Court reasoned that under section 1671(b), a lender must demonstrate that its default interest rate is based on the loan parties’ reasonable endeavor, at the time the loan is made, to quantify the loss to the lender upon the borrower’s default. After a lengthy evidentiary hearing, the Bankruptcy Court disallowed the lender’s default interest because the lender failed to prove that either it or the borrower had reasonably endeavored to estimate the lender’s probable loss upon the borrower’s default at the time the parties entered into the loan. The lender appealed to the District Court.

In a striking reversal, the District Court rejected the Bankruptcy Court’s reasoning in its entirety. Initially, the District Court held that section 1671(b) does not even apply to default interest provisions applicable to matured obligations. Looking to state court precedent, the District Court reasoned that a default interest rate imposed upon maturity constitutes a bargained-for provision in the loan instrument and not a penalty. Then, after examining section 1671(b)’s prohibition against unenforceable penalties, the District Court determined that the “reasonable endeavor” requirement should not be read to require that the provision be the subject of actual negotiation by the parties prior to entering the loan. Rather, as the District Court clarified, a default interest provision must be reasonable in light of the potential harm that could result to the lender, as that harm could be anticipated at the time of the loan. Thus, on the Altadena facts, the District Court concluded that the debtor had failed to meet its burden of rebutting the presumptive validity of the lender’s default interest rate because the default interest rate was, at the time the loan was made, a reasonable estimate of the potential harm to lender if Altadena defaulted.

How will this decision impact lenders? That remains to be seen, as the Altadena debtor has appealed the District Court’s ruling to the Ninth Circuit Court of Appeals and the District Court decision is not binding precedent. Nevertheless, the District Court’s reasoning offers strong support for the allowance of an oversecured lender’s claim for default interest, at least where the default interest rate is triggered by the debtor’s failure to repay upon maturity. The decision also offers guidance on the factors lenders should consider when determining the appropriate default interest rate at loan origination.