Think Your Contract Keeps You Safe From Interest Claims?

Don't Bet On It.

By Michaelbrent Collings

Interest is a big deal. It may not seem like much to someone getting 1% on a small savings account, but in a contract claim, it can be enormous. The difference between interest recovered and interest lost can mean a difference of hundreds of thousands or even millions of dollars.

Aware of this, and seeking to protect their clients' interests, many attorneys draft contracts trying to limit their clients' liability for interest claims. Cal. Civ. Code § 3289 ("3289") states:

Seeking to use this code to avoid interest, contract drafters often try to write a contract holding them to the lowest possible "legal rate of interest": zero. And indeed, there is no case law regarding 3289 that holds zero is not a legal rate. So drafters will often include in their contracts a clause like the following:

"Contractor shall not be entitled to any interest on amounts to be paid."

They may even get more technical, and say, "Contractor shall not be entitled to any interest on any amounts to be paid or owed to Contractor, except where required by law."

Then they wait for the ink to dry and ship out the contract, satisfied that their client is protected from claims for interest on amounts claimed due under the contract. And often, that's exactly the way it works out.

But it's not the way it has to work out.

Relevant case law in Cal. Civ. Code §§ 3302 and 3287 ("3302" and "3287") may provide a way for contracting parties to recover interest on claims that they have made that were later denied by the other party, even if they have ostensibly waived their claims to interest on the contract.

CCC 3302 states in pertinent part:

This would seem to state interest is due as a damage payment on a contract claim that is not paid when it is due under the terms of the contract. Among the cases dealing with 3302, Nesbit v. MacDonald (1928) 203 Cal. 219, is particularly helpful in demonstrating this fact. In Nesbit, a note holder loaned money to a note maker. The note maker died, and the note holder the filed a claim for payment from the note holder's estate under the note, along with a claim for six percent interest. The claim was rejected. The note holder then initiated a legal action to recover payment. The defense claimed that interest should not be allowed, and in no wise should it be allowed at greater than the original six percent demanded in the claim.

The appellate court pointed out that "the interest is not recoverable by virtue of any provision of the note or contract, but is in the nature of damages for detention of the debt." Id. at 222. It noted that, "Appellant having rejected the claim as a whole and for the smaller amount, thus forcing the claimant to institute an action for recovery, said claimant is not estopped to urge the maximum amount due on the note as per its terms." Id. In this case, the note had no interest provision, and the court held that "a prayer for 'interest' without specifying the rate is deemed a prayer for legal interest."

But what of a note whose words specify that no interest is to accrue? In such a case, the hopeful contract drafter may argue that Kohler v. Smith (1852) 2 Cal. 597, controls. In Kohler the plaintiff produced a promissory note for $1,000. The note was from the defendant to Daniel Olds, a third party, with a rate of interest due at eight per cent per month. Olds endorsed the note over to the plaintiff, who endorsed the note with the words "The within note is to run at the rate of five per cent. interest, in place of eight per cent. per month." Id. at 597. The court, finding that the interest should be charged at the rate of five per cent after it became due, discussed the Act of 1850, which, similar to 3289, held a provision "that money demands after maturity should draw interest... at whatever rate was expressed in the written contract." Id. Therefore, it held, it is only when there is no rate agreed upon that the statute allowing for a legal rate of interest take effect. Thus, it appears that a signator agreeing to zero interest might be held to its word.

However, Puppo v. Larosa (1924) 194 Cal. 717, belies this easy fix. In Puppo, plaintiffs entered into a contract with defendant in which defendant would buy the plaintiffs' grape crop. Defendant breached the agreement and paid only a portion on account of the note. The plaintiffs complained for the unpaid balance of the promissory note. The trial court granted the plaintiffs' plea, and awarded them "legal interest thereon from the date of [the note's] maturity." Id. at 720. The court pointed out that "When a legal rate of interest is stipulated in a contract, such rate remains chargeable after a breach thereof, as before, 'until the contract is superseded by a verdict or other new obligation.'" Id. (citing 3289).

This might appear to be a statement that the interest cannot accrue on a contract which provides explicitly for a rate of zero interest. However, the court went on to explain:

Thus, the court drew a distinction between interest in a claim on the contract, and interest that should be awarded when that contract claim is not rightly paid. The seeks interest to repair the damages caused by the other party's breach. And contractual agreement to the contrary notwithstanding, the courts seem disposed to grant such restitutionary awards.

Interest as an element of damages is designed to make an injured claimants whole by granting them not only the money they are owed, but the money they could have earned with that money from the date it was due. This is the point behind 3287, which states:

If the liability of a claim is disputed, but not its actual amount, and a court finds liability does in fact accrue, that will constitute damages certain under this section. Thus, claims that the contract wording disallows interest may be fruitless - void as being in direct contravention of the legislative decision to award interest as an element of damages.

It would seem, therefore, that the best way to avoid paying out (sometimes huge amounts of) interest does not lie in clever contract language purporting to waive such claims. Rather, the safer road may lie in scrupulously paying claims when due. Dazzling and seemingly "iron clad" contract language may look good on paper, but the results lie in acting quickly and fairly to satisfy legitimate claims.