By: Jack Murray, Vice President-Special Counsel, First American Title Insurance Company
Mortgage lenders customarily charge borrowers additional interest upon default, based on a percentage increase in the contract interest rate. In addition, they usually charge borrowers a fee for late payment of installments on the note, often based on a flat percentage of the payment if not made on the payment date or within a specified period of time thereafter.
Federal and state case law is not consistent with respect to the issue of whether these charges and fees are enforceable, i.e., should they be enforceable only if they are justifiable based on the mortgagee’s actual or reasonably anticipated costs — or should they not be subjected to this, or any other, test as long as they are entered into by experienced and sophisticated parties in connection with commercial real-estate loans?
Although late charges and default interest are generally upheld by both state and federal courts in connection with commercial mortgage loan transactions and are entitled to a presumption of validity, they are occasionally disallowed in whole or in part under one or more of the following theories: 1) usurious additional interest; 2) invalid penalty; 3) unreasonableness; 4) unconscionability; and 5) unenforceable liquidated damages.
Unfortunately, the case law is conflicting and contradictory and fails to provide clear guidelines for the imposition and calculation of such charges and fees. As a result, this creates a certain amount of confusion and uncertainty. See, e.g., Crawforth v. Ajax Enterprises, LLC (In re Pheasant Cove, LLC), 2008 WL 187529 (Bankr. D. Idaho, Jan. 18, 2008), at *3 (describing “the lack of uniformity in the treatment of default interest provisions, which some courts evaluate under liquidated damages law and others under state usury laws”).
But the majority of courts realize that it is difficult for the lender to precisely calculate or quantify the exact costs incurred as a result of the borrower’s default, and they tend to look at what is common within the industry (especially in connection with commercial real estate mortgage loans).
For a general discussion of cases on this topic, see Grant S. Nelson and Dale A. Whitman, Late Payment Charges and Default Interest – Judicial Interpretation, 1 REAL ESTATE FINANCE LAW § 6.9 (updated July 2010). See also Baxter Dunaway, Acceleration of Debt, 2 L. DISTRESSED REAL EST. § 15:7 (updated June 2012) (“As a general rule, courts have upheld the right of the lender to accelerate in spite of borrowers’ arguments that acceleration acts as a penalty and despite a borrower’s good faith effort to avoid default”).
With respect to the collection of default interest and other fees or charges in connection with mortgage loans where the borrower is in bankruptcy, Section 506(b) of the Bankruptcy Code provides that if a creditor is oversecured it may be allowed a claim against the bankruptcy estate only if the fee is reasonable — which allows a bankruptcy court to disallow a late fee or default interest even if it is otherwise allowable under applicable state law. Also, in construing the lender’s claim for default interest if a bankruptcy proceeding is filed by or against the borrower, § 502 of the Bankruptcy Code generally allows a claim for pre-petition interest, including interest at the default rate if provided for in the parties’ agreement, in accordance with the terms of the contract. See In re South Side House, LLC, 451 B.R. 248, 264 (Bankr. E.D.N.Y. 2011) (“a creditor’s agreement to prepetition interest under Section 502, default or otherwise, is determined in the first instance by the agreement between the parties and applicable nonbankruptcy law”); Key Bank Nat’l Ass’n v. Milham (In re Milham), 141 F.3d 420, 423 (2d Cir.), cert denied 525 U.S. 872 (1998) (“[p]repetition interest is generally allowable [as a claim] to the extent and at the rate permitted under applicable noncontract law, including the law of contracts”).
This article is limited to a discussion and analysis of major state and federal cases with respect to the ability of the lender to charge default interest and late charges in connection with a mortgage loan that remains unpaid at the maturity date of the loan, as well as the ability of a loan holder that is an assignee of the original loan holder to charge default interest and late charges if the original loan holder previously elected not to do so. Courts generally look closely at the adequacy and sufficiency of the language in the loan documents to determine whether default interest and late charges are due on the loan, especially in connection with loans that remain unpaid at maturity. This determination is crucial and clearly emphasizes the need for precise, accurate and comprehensive drafting of default and acceleration clauses in mortgage-loan documents, in order to avoid having to rely on a court to interpret ambiguous or incomplete language.
CASE LAW — COLLECTION OF DEFAULT INTEREST AND LATE CHARGES IN CONNECTION WITH LOAN UPAID AT MATURITY DATE
In In re Crystal Properties, Ltd., 268 F.3d 743 (9th Cir. 2001), the Ninth Circuit found that under the default language in the loan documents the lender could not collect default interest until it had actually accelerated the debt. The court held that the lender had never formally accelerated the loan by notice to the borrower, regardless of the fact that the applicable default provision stated that the borrower waived notice of demand or default. (The borrower filed a Chapter 11 bankruptcy case after the loan had not been paid at maturity.) The court further held that the maturity date of the loan did not constitute an automatic acceleration, and that under the language in the default clause, only an acceleration of the entire loan would trigger default interest. The court therefore upheld the bankruptcy court and district court opinions disallowing the bank’s claim in its entirety.
See generally Joshua Stein, How Some “Standard” Language in a Promissory Note Cost a Lender Five Years of Default-Rate Interest Rate, Groundbreakers, 18 No. 4 PRAC. REAL EST. LAW. 60 (July 2002) (discussing and analyzing the Crystal Properties case, and providing excellent drafting tips to minimize the risk of improper or insufficient acceleration and notice); John C. Murray, Default Interest Rates, Late Charges, and Exit Fees: Are They Enforceable?, SM002 ALI-ABA 2679 (2006), at pp. 10-11 (discussing cases dealing with late charge imposed by lender after acceleration of debt.)
See also U.S v. Neudai, Inc., 14 F.3d 598 (4th Cir. 1993), 1993 WL 537722 (C.A.4 (S.C.)), at *3 (unpublished). The court’s holding in this case is virtually identical to that of Crystal Properties, supra; i.e., the terms of the loan documents at issue dealt with acceleration of the debt, and there was no separate provision for charging default interest. The Fourth Circuit noted that “courts usually require that an acceleration be exercised in a manner so clear and unequivocal that it leaves no doubt that the borrower is apprised that the option has been exercised” (internal citation and quotations omitted). See also In re Zamani, 390 B.R. 680, 689 (Bankr. N.D. Cal. 2008) (“The record before me, as in Crystal Properties, fails to establish that ... the bank clearly and unequivocally notified [the borrower] that it was exercising its right to accelerate the notes”).
Similarly, in JCC Development Corp. v. Levy, 146 Cal. Rptr. 3d 635 (Cal. App. 2 Dist., 2012), the court agreed with the holding in Crystal Properties, supra, and held that based on the language in the loan documents, the lender could not collect interest on the matured loan at the default interest rate because the default-rate provision was part of an acceleration clause that was not triggered before the note matured. According to the court:
The plain language of the note states that once one of the circumstances occurred which would accelerate the loan, “thereafter” interest could accrue at the maximum legal rate. The default interest language appears in the same paragraph as the acceleration clause, and there is no indication in the note that this language relates to circumstances other than acceleration (e.g., failure to pay the lump-sum payment at the time the loan matured). Levy, the drafter of the agreement, could have included language stating that the default interest rate applied not only after circumstances of acceleration, but also after the loan matured and no payment was made, but he did not include such additional language.
Id. at 643.
For general commentary on the JCC Development Corp. decision, see Prof. Dan Schechter, Where Debt Was Never Accelerated and Promissory Note Conditioned Default Interest on Acceleration, Default Interest Cannot Be Charged. [JCC Development Corp. vs. Levy (Cal. App. 2012].), 2012 COMM. FIN. NEWS. (2012). The author, noting that the court in JCC Development Corp. relied on the Ninth Circuit’s holding in Crystal Properties, supra, stated that:
The [JCC Development Corp.] opinion lays out the simple drafting lesson: don’t make default interest contingent upon formal acceleration. Make it automatic. Crystal Properties was decided more than 10 years ago; any deal booked after 2001 should have incorporated the lessons of Crystal; and yet we often see antiquated language in recently drafted documents. It might be a good idea for lenders’ counsel to conduct periodic reviews of the form files, to make sure that the forms contain the “latest and greatest” provisions.
In United States v. Cardinal, 452 F.Supp. 542 (D. Vt. 1978), the court noted as follows:
The law is well settled that where the acceleration of the installment payments in cases of default is optional on the part of the holder, then the entire debt does not become due on the mere default of payment but affirmative action by the creditor must be taken to make it known to the debtor that he has exercised his option to accelerate, even though the note itself, as is the case here, waives notice of demand.
Id. at 547 (quoting Moresi v. Far West Services, Inc., 291 F.Supp 586, 588 (D. Hawaii 1968)).
See also In re Payless Cashways, Inc., 287 B.R. 482, 485 (Bankr. W.D. Mo. 2002), where the court stated that the same rule regarding acceleration of the debt applied in the Eighth Circuit as was applicable in the Ninth Circuit:
The court in Beal Bank v. Crystal Properties, Ltd., L.P. found that under both California law and the law of the Ninth Circuit, even if the terms of a note do not require notice or demand as a prerequisite to accelerating a note, the holder must take affirmative action to notify the debtor if it intends to accelerate. This is certainly true in the Eighth Circuit.
With respect to the court’s holding in Payless Cashways, at least one commentator strongly disagrees with the court’s decision, as well as the Ninth Circuit’s decision in Crystal Properties, supra. See Prof. Dan Schechter, Oversecured Creditor Is Not Entitled to “Default Interest” Without Prior Notice to Debtor of Acceleration, 2003 COMM. FIN. NEWS.7 (January 20, 2003). The author states that, with respect to the bankruptcy court’s holding in Payless Cashways:
The Ninth Circuit’s decision in Crystal was wrong, and this one [the Payless Cashways decision] is “wronger.” At least the Ninth Circuit tried to justify its result on the basis of California law, although California law does not clearly say that default interest cannot be triggered without notice when the contract provides for an automatic trigger. The Ninth Circuit’s decision on this issue was also probably dicta, since the contract at issue in that case did not provide for default interest without notice of acceleration. Finally, the Ninth Circuit failed to distinguish between the triggering of the default rate and acceleration of the entire loan. Those two issues are not necessarily linked, although they often are linked in practice.
Here, however [in the Payless Cashways case], the court adopted the flawed rule in Crystal as if it were a Federal rule, which it is not. Also, the sweeping scope of the court’s decision is unjustified, since the contract itself said that the default rate would only to the missed payment. The court had no reason to promulgate a rule of general application to all credit agreements, to the effect that there can be no default rate applied to the entire balance in the absence of notice of acceleration.
Other courts have elected not to follow the Ninth Circuit’s holding in Crystal Properties. See, e.g., Greystone Bank v. Skyline Woods Realty, LLC, 817 F. Supp. 2d 57, 62-63 (2011) (holding that when mortgage documents do not require notice of default and acceleration and provide that upon default lender may declare the entire debt due and owing, no notice is required and the “filing of a summons and complaint is sufficient notice of intent to accelerate”); In re South Side House, LLC, 451 B.R. 248, 266 (Bankr. E.D.N.Y. 2011) (bankruptcy court held default charge fully enforceable from date of default without notice to debtor, and stated that “As the Loan Documents provide that the default interest becomes due upon default, without notice to the Debtor, the default interest was due whether or not the Lender accelerated the Loan.”)
In In re Deep River Warehouse, 2005 W.L. 1513123 (Bankr. M.D.N.C., June 22, 2005), the court allowed the full default acceleration rate to the lender, and distinguished Crystal Properties as follows:
The reasoning behind the court’s refusal to allow interest at the default rate in Crystal Properties was not because the lender did not give notice of the default; it was because the lender did not perform the affirmative act of putting the debtor on notice that it intended to accelerate the debt. Id. at 749 (holding that courts have made clear the unquestionable principal [sic] that, even if the terms of the note do not require notice as a prerequisite to acceleration, the holder must take affirmative action to notify the debtor that it intends to accelerate). The Debtor’s reliance on Crystal Properties is misplaced inasmuch as Crystal Properties did not hold that notice must be given before default interest can be charged against a debtor.
Id. at *4.
The court in Deep River Warehouse determined that the following factors should be examined to determine whether a specific default-interest provision should be enforced:
(1) the creditor faces a significant risk that the debt will be paid;
(2) the lower rate of interest payable pre-default is shown not to be the prevailing market rate;
(3) the difference between the default and the pre-default rates, and whether the differential between the two rates are reasonable; and
(4) whether the purpose of the higher interest rate is to compensate the creditor entitled to interest for losses sustained as a result of the fact that it was not paid at maturity or is simply a disguised attempt to penalize the debtor. Id. at *3-4.
The court in Deep River Warehouse specifically noted the importance of clarity in the applicable terms of the loan documents, stating that it must “read the terms of the Loan Documents in context, giving each term its plain meaning.” Id. at *5. See also In re Harvest Oaks Associates, LLC, 2011 WL 124495, at *11 (Bankr. E.D.N.C. Jan. 14, 2011), which followed Crystal Properties in disallowing imposition of charges not claimed by prior holder. The court examined the facts of the case and the specific language set forth in both the promissory note and the deed of trust, stating that it “must first look to the language of the relevant loan documents.” Id. at *6. The court held that “In this case, with respect to the payment default, there are insufficient grounds on which to deviate from the terms set out in the parties’ agreement.” Id. at *8. The court acknowledged that “whether interest will be allowed at the default rate is determined on a case-by-case basis and is fact specific,” Id. at *7, and that it must “read the terms of the Loan Documents in context, giving each term its plain meeting.” Id. at *3.
See also In re Croatan Surf Club, Inc., 2012 WL 1906386 (Bankr. E.D.N.C., May 25, 2012) In this case the court held that based on the factors considered by the bankruptcy court in Deep River Warehouse, supra, the default rate in question was within the range of reasonableness, “primarily because the difference between the default and pre-default rates is a mere 3% and therefore does not appear to be intended as a penalty.” Id. at *4.
CASE LAW — COLLECTION OF DEFAULT INTEREST AND LATE CHARGE BY ASSIGNEE OF LOAN
Courts generally will not allow a loan holder that is an assignee of the original loan holder to charge default interest if the original loan holder previously elected not to do so. For example, in In re Sweet, 369 B.R. 644, 651 (Bankr. D. Colo. 2007), the note stated that “in the event of a default, the terms of the Note specifically provide the Note holder may in its discretion determine all amounts due and owing . . .” The assignee of the note argued that this language allowed it to retroactively apply the default rate of interest from the time the debtor ceased making payments on the note even though the assignee was not the holder of the note when the default occurred. The court rejected this argument, stating that “the original loan holder had never expressed any intent to charge default interest,” and that the assignee of the note could not “retroactively substitute his discretion for that of [the original lender] in order to apply default interest to the [notice] when [the lender] first noted a default in the Note.” Id. at 651.
See also In re Lichtin/Wade, LLC, 2012 WL 3260287 (Bankr. E.D. N.C., Aug. 8, 2012), at *5, where the court stated that “because the original loan holder . . . did not express an intent to charge default interest on the date of maturity, the assignee . . . cannot retroactively substitute its judgment for that of [the original loan holder]”; In re Crystal Properties, Ltd., LP, supra, 268 F.3d at 747 (finding it inequitable to allow present loan holder to recalculate interest for period when predecessor did not and considering the right to have been waived); Harvest Oaks Drive Assoc., LLC, supra, 2011 WL 124495 at *11 (Bankr. E.D.N.C. Jan. 14, 2011) (following Crystal Properties in disallowing retroactive imposition of charges not claimed by prior holder); In re 400 Walnut Associates, L.P., 461 B.R. 308, 314 (Bankr. E.D. Pa. 2011) (holding that waiver by mortgagee’s predecessor of its contractual right to compound interest during time period when it held loan prevented assignee from retroactively compounding unpaid interest for that period of time).
* Nothing contained in this Article is to be considered as the rendering of legal advice for specific matters, and readers are responsible for obtaining such advice from their own legal counsel. This article is intended for educational and informational purposes only. The views and opinions expressed in this article are solely those of the author and do not necessarily reflect the views, opinions, or policies of the author’s employer, First American Title Insurance Company.