Late Fees and Default Interest Revived: Metlife Case Overturned
 
September 1, 1999
 
Henry J. "Hank" Brothers- Washington

On June 30, 1999, the New Jersey Supreme Court sided with lenders and upheld, in general, the validity of late fees and default interest in commercial loan transactions. The ruling in MetLife Capital Financial Corp. v. Washington Avenue Associates, 1999 N.J. LEXIS 828, 1999 WL 436126 (N.J.) puts to rest heightened concerns among lenders nationwide, who had feared lengthy, and costly, loan-by-loan and payment-by-payment battles over actual damages arising from late payments and other defaults. Indignant (and/or jubilant) commentary and analysis since the 1998 lower-court decision will now need to be revisited.

This case arose out of a 1992 loan secured by commercial property. The note and mortgage provided for a late fee equal to five percent of each payment not made on time, as well as an increased rate of interest in the event of a default. The borrower made all 48 scheduled loan payments, but 40 payments were late. The borrower failed to pay the balloon payment due at the end of the term, and the lender declared the loan in default. When the lender foreclosed, the borrower challenged the lender's right to collect the late fees and interest at the default rate.

The trial court held that the five-percent late fee was reasonable and allowed it. However, this court said the 15-percent default interest rate was in the nature of penalty and set it aside. The court then substituted its own default rate of 12.55 percent (three percentage points above the contract rate), and held that this rate was reasonably related to actual damages.

The Appellate Division applied a 1964 New Jersey case, which adopted a two-pronged test, derived from the Restatement [1st] of Contracts (1932), for evaluating late fees and default interest. First, was the charge reasonably related to the anticipated or actual damages? Second, were these damages difficult to establish? The court concluded that the lender's collection costs would be the same regardless of the size of the payment or duration of the breach, and therefore held that MetLife's late fee failed the first test. The court also concluded that the late fee failed the second test, because it found that collection costs and the value of the loss of use of the late payment could easily be calculated. Finally, the Appellate Division rejected the default interest rate for the same reasons, and, in the bargain, threw out the trial court's 12.55 percent substitute rate as "entirely speculative."

The New Jersey Supreme Court looked to the Restatement (2nd) of Contracts (1981), as well as Uniform Commercial Code § 2-718(1), and adopted the more modern view that the two-pronged test should be treated as two elements of "reasonableness" rather than as separate tests. In a 1994 case, this court had ruled that reasonableness is the "touchstone" for evaluating stipulated damages clauses, and noted that "the difficulty in assessing damages, intention of the parties, the actual damages sustained, and the bargaining power of the parties all affect the validity of a stipulated damages clause." The court also commented, relying upon a 1983 Wisconsin case, that "the overall single test of validity is whether the [stipulated damage] clause is reasonable under the totality of the circumstances."

Applying this reasonableness test, the court found the five-percent late fee to be a valid measure of liquidated damages. The court rejected the Appellate Division's conclusion that the damages from a late payment would not vary with the size of the payment, because "late payments on larger loans would present a greater risk to the lender, and would require more intense and expensive supervision." Moreover, a larger late payment causes a larger lost opportunity and thus the lender suffers larger damages. The court also rejected the Appellate Division's apparent suggestion that a lender must establish its actual costs with respect to each late payment for which a late charge is sought. This approach "underestimates the difficulties and impracticalities involved in determining the actual damages incurred in dealing with delinquent borrowers." Also telling were the court's observations that a five-percent late fee is normal industry custom in similar commercial mortgages, and that the New Jersey Legislature and the U.S. government had endorsed late fees as a percentage of the defaulted payment in other contexts. The court thus held that "liquidated damages provisions in a commercial contract between sophisticated parties are presumptively reasonable and the party challenging the clause bears the burden of proving its unreasonableness."

The court next turned to the default interest rate of three percent over the contract rate. (MetLife did not appeal the trial court's reduction of the default rate from 15 percent to 12.55 percent.) The court applied here the same reasonableness test that it had applied to late fees, and upheld the default rate in question because it "appear[ed] to be a reasonable estimate of potential damages [and] f[ell] well within the range demonstrated to be customary, and because a stipulated damages clause negotiated between sophisticated commercial entities is presumptively reasonable." Important to the court's conclusion was the difficulty of determining or predicting actual losses from defaults which might have very short or very long duration and might occur many years in the future when market conditions, borrowing costs and other factors might be radically different.

The court also noted that "New Jersey cases have invalidated enhanced default rates if their size suggests a punitive intent," but did not go anywhere with that comment. Left unanswered is how the court would have ruled if the original 15-percent default rate had been before it.

The New Jersey Supreme Court noted that MetLife - and, one expects, the many lenders' associations that filed amicus curiae briefs - urged the Court to view late fees and default interest as "variable-pricing provisions," a term of borrowing money in a highly competitive industry. This is a strictly contractual approach, rather than a liquidated-damages analysis. Under this view, late fees and default interest would be enforced unless they were found to be unconscionable or illegal. The court agreed that late fees and default interest are "part of the cost of doing business" among sophisticated parties. However, the court declined to adopt an unconscionability standard, stating that the reasonableness standard provides an adequate safeguard for the lenders and better protection for the borrowers.

So what does this mean? Narrowly, it means that a five-percent late fee and a default interest rate of three percentage points over the contract rate will pass New Jersey's "reasonableness" test for commercial loans. More broadly, we should acknowledge that this case was widely reported and debated when the Appellate Division held to the contrary last year, and that this new decision will also be widely hailed (and condemned) in the lending (and borrowing) industry. Therefore - and because many viewed the lower court's opinion as an aberration - lenders should now rest easier, for it is now likely that such late fees and default interest provisions will face fewer substantive challenges.

For more information, contact Mr. Brothers at 202-957-7089, or hbrothers@hklaw.com.