An arbitrary decision - Honchariw v. FJM Private Mortgage Fund, LLC

In the recent, published opinion in Honchariw v. FJM Private Mortgage Fund, LLC, 2022 DJDAR 10369, the Court of Appeal for the First Appellate District reversed an arbitration award in favor of defendant, a private lender. The arbitrator had determined that the default interest clause in the loan documents was an unlawful penalty under Civil Code Section 1671 and the Superior Court confirmed the award. The borrower appealed and found a more sympathetic ear in the appellate court, which ruled that the provision was an unenforceable penalty notwithstanding the arbitrator's conclusion to the contrary.

While certainly not inevitable, it was not surprising that a court might find a particular liquidated damages provision in a contract to be an unenforceable penalty. What was unusual was the appellate court's reasoning rejecting the arbitrator's award and its finding - essentially as a matter of law - that the default interest provision at issue there was an unlawful penalty.

As stated by the California Supreme Court in Moncharsh v. Heily & Blase, Inc. 3 Cal. 4th 1, 11 (1992): "[I]t is the general rule that, with narrow exceptions, an arbitrator's decision cannot be reviewed for errors of fact or law. In reaffirming this general rule, we recognize there is a risk that the arbitrator will make a mistake. That risk, however, is acceptable for two reasons. First, by voluntarily submitting to arbitration, the parties have agreed to bear that risk in return for a quick, inexpensive, and conclusive resolution to their dispute." One of the narrow exceptions is where: "The arbitrators exceeded their powers and the award cannot be corrected without affecting the merits of the decision upon the controversy submitted." California Code of Civil Procedure Section 1286.2(a)(4). That is the exception upon which the appellate court relied in rejecting the arbitrator's award, noting that the case law holds that arbitrators act in excess of their powers when their decision violates a "well-defined and dominant" public policy.

Specifically, the appellate court found that the arbitrator had exceeded her powers because it deemed the default interest provision violated the public policy behind Section 1671: "It is the public policy of California that liquidated damages bear a 'reasonable relationship' to the actual damages that the parties anticipate would flow from breach; conversely, if the liquidated damages clause fails to so conform, it will be construed as an unenforceable 'penalty.' (Garrett v. Coast & Southern Fed. Sav. & Loan Assn (1973) 9 Cal.3d 731, 739...)". The problem is that, although the appellate court acknowledged that, in non-consumer contracts, such as the one at issue here, Section 1671 presumes liquidated damages provisions are valid - and that the burden of proof is on the party challenging the provision to establish it was unreasonable under the circumstances existing when it was entered into - the court then flipped that standard on its head and found that the lender had not met its burden to show that the clause was reasonable under the circumstances. The appellate court then compounded this problem by holding the default interest provision was per see invalid as against public policy because it sought to charge the default interest rate on the entire unpaid balance, concluding: "Put another way, by its very existence, the Honchariws have met their burden of showing an unlawful penalty."

This is troubling for two main reasons. First and foremost, the public policy analysis by the appellate court strains to fall under the "exceeded their powers" exception of Section 1286.2(a)(4) in an attempt to circumvent the rule in Moncharsh that "an arbitrator's decision cannot be reviewed for errors of fact or law." It relies primarily on Garrett, which was decided prior to the amendment making non-consumer liquidated damages provisions presumptively valid, and the post-amendment case of Ridgley v. Topa Thrift & Loan Ass'n, (1998) 17 Cal.4th 970, which did not address the question of default interest at all but focused just on whether a late payment fee and a prepayment penalty violated Section 1671.

Second, by disregarding the requirement that the clause be evaluated under the circumstances existing at the time it was entered into, and, instead, judicially imposing a per see rule of invalidity, the appellate court ignored both the legislative intent behind the amendment to Section 1671 (making liquidated damages provisions in non-consumer contracts presumptively valid) and the direction of Ridgley, at 977, that Section 1671(b) still "requires an inquiry into whether '[the provision] bears no reasonable relationship to the range of actual damages that the parties could have anticipated would flow from a breach.'" The appellate court here did not engage in that inquiry, nor did it remand the action for further findings by the arbitrator. Instead, it just invalidated the clause as a matter of law, usurping the parties' contractual agreement to have any disputes resolved by arbitration. Therein lies a concern that goes beyond the question of just one lawsuit. Indeed, it is a concern that goes beyond just lender-borrower disputes as the appellate court's analysis and treatment of the arbitrator's award could apply to any case in which an arbitrator is determining whether to apply a liquidated damages provision.

Notably, a different appellate district recently reached a different conclusion as to the validity of a liquidated damages clause (albeit in the context of a settlement agreement rather than a loan). In Gormley v. Gonzalez, 2022 WL 6924078 (3rd A.D. Oct. 12, 2022), the appellate court affirmed the validity of a liquidated damages clause, finding that, in amending Section 1671, the Law Commission specifically stated that "'All circumstances existing at the time of the making of a contract' should be considered when determining whether a liquidated damages provision in a non-consumer contract is unreasonable."

FJM has a petition for review pending before the California Supreme Court seeking review of the Honchariw opinion. The conflicting decision in Gormley adds impetus to the need for that review, though the challenge to the arbitrator's authority should itself suffice for that purpose.