Garrett v. Coast & Southern Fed. Sav. & Loan Assn.

• Decision Date: 18 July 1973
• Citation: 511 P.2d 1197,9 Cal.3d 731,108 Cal.Rptr. 845
• Court: California Supreme Court
• Parties: , 511 P.2d 1197, 63 A.L.R.3d 39 Roberta L. GARRETT et al., Plaintiffs and Appellants, v. COAST AND SOUTHERN FEDERAL SAVINGS AND LOAN ASSOCIATION, Defendant and Respondent. L.A. 30107.

Page 845

108 Cal.Rptr. 845

9 Cal.3d 731, 511 P.2d 1197, 63 A.L.R.3d 39

Roberta L. GARRETT et al., Plaintiffs and Appellants, v. COAST AND SOUTHERN FEDERAL SAVINGS AND LOAN ASSOCIATION, Defendant and Respondent.

L.A. 30107.

Supreme Court of California,

In Bank.

July 18, 1973.

Jackson & Lober and David G. Jackson, Arcadia, for plaintiffs and appellants.

Alvin S. Kaufer, Los Angeles, as amicus curiae on behalf of plaintiffs and appellants.

Harry Pflaumer and Arthur E. White, Los Angeles, for defendant and respondent.

WRIGHT, Chief Justice.

Plaintiffs in a class action appeal from an order of dismissal entered after the court sustained, without leave to amend, defendant's demurrer on the ground that the complaint failed to state a cause of action.

Preliminarily, we observe that we are limited on this appeal to a determination of the sufficiency of the complaint as a matter of law and that for such purpose we treat the demurrer as admitting all allegations of material facts properly pleaded but not admitting contentions, deductions, or conclusions of fact or law. (Daar v. Yellow Cab Co. (1967) 67 Cal.2d 695, 713, 63 Cal.Rptr. 724, 433 P.2d 732; 3 Witkin, Cal.Procedure (2d ed. 1971) § 800, p. 2413.)

Plaintiffs allege that they are or were obligors under promissory notes secured by deeds of trust in favor of defendant savings and loan association; that each of them has been assessed by reason of his failure to have made timely installment payments, certain sums designated as late charges; and that each such charge is a percentage of the unpaid principal balance of the loan obligation for the period during which payment was in default. Plaintiffs seek to recover sums paid in satisfaction of the charges, contending that they constitute assessments which cannot qualify as liquidated damages and thus are void under Civil Code section 1670. ¹ For the reasons hereinafter stated we hold that plaintiffs have stated a cause of action and reverse the order of dismissal.

Plaintiffs' action is brought on behalf of themselves and other similarly situated obligors who within the applicable period of limitations (Code Civ.Proc., § 382) have paid late charges to defendant. ² They allege that of approximately 32,000 obligors some 5,000 have paid late charges totaling $1,900,000 during the four-year period immediately preceding the filing of the complaint. The promissory note signed by each obligor allegedly includes the following or similar provisions: 'The undersigned further agrees that in the event that payments of either principal or interest on this note becomes in default, the holder may, without notice, charge additional interest at the rate of two (2%) per cent per annum on the unpaid principal balance of this note from the date unpaid interest started to accrue until the close of the business day upon which payment curing the default is received.' ³

In order to evaluate the legality of a provision for late charges we must determine its true function and character. If it is as plaintiffs contend a stipulation for ascertaining damages in anticipation of breach its validity must be tested against sections 1670 and 1671. Defendant seeks to avoid the question of damages by maintaining that the lending agreement, to the extent that it requires the payment of additional interest, merely gives a borrower an option of alternative performances of his obligation. If he makes timely payments, interest continues at the contract rate; if, however, the borrower elects not to make such payments, interest charges for the loan are to be increased during the period of optional delinquency. In justification of such a construction of the provision defendant refers us to Walsh v. Glendale Fed. Sav. & Loan Assn. (1969) 1 Cal.App.3d 578, 585, 81 Cal.Rptr. 804 which relied inter alia on our decisions in Finger v. McCaughey (1896) 114 Cal. 64, 66, 45 P. 1004 and Thompson v. Gorner (1894) 104 Cal. 168, 37 P. 900. (See also O'Connor v. Richmond Sav. & Loan Assn. (1968) 262 Cal.App.2d 523, 530, 68 Cal.rptr. 882.)

The Thompson and Finger cases essentially involved obligations on promissory notes which included provisions that the loan was to bear one rate of interest if paid at maturity and a higher rate if not paid when the obligation became due. An additional provision in the note in Thompson, not relevant to the disposition of the case, related to an increased interest rate if any installment of interest was not paid as it became due.

In Thompson we held that a clause in a promissory note providing for a higher rate of interest if the 'principal or interest is not paid as it becomes due' is not to be treated as a penalty, but as a contract to pay such higher rate upon and commencing with the happening of one of the contingencies specified in the note, to wit, the failure to make payment of any sum when due. ⁴

In Finger the promissory note contained a provision that in the event of default at maturity a higher interest rate would apply than if the obligation had been paid when it became due. Unlike Thompson, however, the higher rate was to predate the default and relate back to the full term of the note. The court in Finger did not distinguish Thompson on the differing factual circumstances and rested its holding on Thompson in concluding that the amount so assessed was not a penalty within the meaning of section 1670.

Neither Finger, and certainly not Thompson, stand for the proposition, as defendant would have us hold, that upon a default in the payment of an installment of a note a higher interest rate may be assessed against the Whole of the unpaid balance of the principal of the note whether or not in default. Thompson held only that amounts In default may bear a higher interest rate from the date of the default, and Finger further held that amounts in default may bear a higher And retroactive interest rate. Thompson and Finger incorrectly have been held to stand for the proposition that 'It is the rule in this state that late-charge interest is not in the nature of a penalty, and is valid' in cases where increased interest charges are assessed against the unpaid balance of the principal whether or not in default. (Walsh v. Glendale Fed. Sav. & Loan, supra, 1 Cal.App.3d 578, 585, 81 Cal.Rptr. 804; O'Connor v. Richmond Sav. & Loan, supra, 262 Cal.App.2d 523, 530, 68 Cal.Rptr. 882.) Thus defendant's argument that a borrower in default is merely exercising a valid option to elect a different performance under the lending contract does find some support in the foregoing line of cases.

The mere fact that an agreement may be construed, if in fact it can be, to vest in one party an option to perform in a manner which, if it were not so construed, would result in a penalty does not validate the agreement. ⁵ To so hold would be to condone a result which, although directly prohibited by the Legislature, may nevertheless be indirectly accomplished through the imagination of inventive minds. Accordingly, a borrower on an installment note cannot legally agree to forfeit what is clearly a penalty in exchange for the right to exercise an option to default in making a timely payment of an installment. Otherwise the legislative declarations of sections 1670 and 1671 would be completely frustrated. We have consistently ignored form and sought out the substance of arrangements which purport to legitimate penalties and forfeitures. (See Caplan v. Schroeder (1961) 56 Cal.2d 515, 519--521, 15 Cal.Rptr. 145, 364 P.2d 321; Freedman v. The Rector (1951) 37 Cal.2d 16, 21--23, 230 P.2d 629.)

Thompson is not to the contrary. It did not involve a question of penalty. There the full amount of the note was in default and the parties contracted for an increased rate beginning with the moment of default on sums which became payable to the lender. No penalty was assessed as the borrower at the amount of default owed only what he had contracted to pay had there been no default, the principal amount plus accrued interest. If these amounts were not then paid the parties agreed that interest at the higher rate would accrue.

In Finger, although it purports to rely on Thompson, the question of a penalty was nevertheless involved. Because the increased interest rate was made retroactive the borrower, at the moment of default, became obligated for a sum In addition to what he had contracted to pay under the terms of the promissory note had there been no default. The validity of the provision, accordingly, should have been controlled by applicable statutory provisions relating to liquidated damages. We conclude that the Finger extension of the Thompson holding was unwarranted, and to that extent it is overruled. For similar reasons we disapprove both Walsh v. Glendale Fed. Sav. & Loan, supra, 1 Cal.App.3d 578, 81 Cal.Rptr. 804 and O'Connor v. Richmond Sav. & Loan Assn., supra, 262 Cal.App.2d 523, 68 Cal.Rptr. 882 to the extent that they are inconsistent with our views herein.

We recognize, of course, the validity of provisions varying the acceptable performance under a contract upon the happening of a contingency. We cannot, however, so subvert the substance of a contract to form that we lose sight of the bargained-for performance. Thus when it is manifest that a contract expressed to be performed in the alternative is in fact a contract contemplating but a single, definite performance with an additional charge contingent on the breach of that performance, the provision cannot escape examination in light of pertinent rules relative to the liquidation of damages. (Paolilli v. Piscitelli (1923) 45 R.I. 354, 359, 121 A. 531; Williston on Contracts (3d ed.) § 781.) ⁶

In the instant case, the only reasonable interpretation of the clause providing for imposition of an increased interest rate is that the parties agreed upon the rate which should govern the contract and then, realizing that the borrowers might fail to make timely payment, they further agreed that...