Daily Development for Tuesday, August 21, 2007
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

MORTGAGES; INTEREST; DEFAULT INTEREST: Default interest rate of 30% in commercial lending instrument is not unconscionable and is enforceable.

The Cantamar, L.L.C. v. Champagne, 142 P.3d 140 (Utah App. 2006) 

This case raises a number of interesting issues concerning fraudulent inducement, ambiguity and integration, but these will be considered elsewhere.  The sole focus of this report is on the issue of default interest. 

The a financial consultant and loan broker had arranged for a series of notes to be executed by the borrowers.  These notes provided that the principal would not be payable unless and until the consultant had located a satisfactory equity investor who would provide $15 million in capital.  They had very onerous terms otherwise.  (70% and 60% interest rates, respectively).  Ultimately, the broker arranged a refinancing of the earlier debt with another loan from another lender.  The documentation for this last loan provided for an 8% interest rate, a specific due date, and a default interest rate of 30%. 

Ultimately, the borrowers stopped paying interest on the note and argued that the obligation to pay principal was contingent, as with the prior notes, upon the $15 million capital infusion.  They further argued that the 30% default interest claimed by the lender was unconscionable and unenforceable.  The trial court found for the lender on all issues, but the appeals court here remanded for further consideration of the question of whether the obligation to pay principal was subject to the alleged contingency.  But the appeals court refused to conclude that the 30% default interest rate was unconscionable.  Thus, if the contingency ultimately was found not to be an obstacle to payment, the borrower (and the guarantors) were stuck with the 30% default interest.

The court acknowledged that default interest rates are in fact unenforceable if unconscionable, but evaluated the discrete factors followed by Utah courts in determining unconscionability, and concluded that this transaction was not unconscionable.

The court commented that it would not assume the paternalistic role of declaring that one who has freely bound himself need not perform because the bargain is not favorable, and further noted that Utah places no usury limit on the bargaining of the parties for interest rates in commercial loans of this nature.  

The specific analysis of the court may prove useful, so we will set it forth verbatim here:

Unconscionability "has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which  are unreasonably favorable to the other party.". . . . Utah courts engage in a two-pronged analysis to determine whether a contract is unconscionable: (1) substantive unconscionability and (2) procedural unconscionability. . . . .While a determination of substantive unconscionability may by itself lead to our concluding the contract was unconscionable, procedural unconscionability alone "rarely render[s] a contract unconscionable."

Under the substantive unconscionability prong, we "focus [ ] on the contents of the agreement.". "Even if a contract term is unreasonable or more advantageous to one party, the contract, without more, is not unconscionable." Instead, the terms must be " 'so one-sided as to oppress or unfairly surprise an innocent party or ... there exists an overall imbalance in the obligations and rights imposed by the bargain ... according to the mores and business practices of the time and place.' "

Turning to the second prong, procedural unconscionability, we "focus[ ] on the negotiation of the contract and the circumstances of the parties.". In considering procedural unconscionability, "[o]ur princip[al] inquiry is whether there was overreaching by a contracting party occupying an unfairly superior bargaining position." Factors that we consider in our determination include:

(1)whether each party had a reasonable opportunity to understand the terms and conditions of the agreement; (2) whether there was a lack of opportunity for meaningful negotiation; (3) whether the agreement was printed on a duplicate or boilerplate form drafted solely by the party in the strongest bargaining position; (4) whether the terms of the agreement were explained to the weaker party; (5) whether the aggrieved party had a meaningful choice or instead felt compelled to accept the terms of the agreement; and (6) whether the stronger party employed deceptive practices to obscure key contractual provisions.

None of the above factors is dispositive and we consider the factors in light of the unconscionability doctrine's objective of preventing oppression and unfair surprise.

This statement of the factors tips off the likely result here.  This was a venture capital project.  The borrowers readily admitted that there was no way they would be able to pay off the loan if they didnt get the $15 million capital that they were seeking.  Under these circumstances, the court noted, terms that might otherwise appear overly harsh become less so.  Further, the court noted that if the borrowers were correct in their claim that no principal was payable unless the capital was found, the lender was certainly entitled to a significant protection against default in the payment of interest. 

As to the procedural issues, assuming that they could be dispositive, the court found no real evidence that there was oppression or unfair surprise. 

Comment 1: It is a rare appellate case that is so clear in affirming a high default interest rate in a note carrying such a low initial rate.  The circumstances of the loan, of course, are somewhat special, but most of these circumstances are simple allegations, and the court more or less ignores them in approving the rate.

Comment 2: Borrowers attempted to argue that the default rate was not a proper liquidated damages clause, and operated as a penalty.  The court indicated that it would not reach the question of whether default interest in promissory notes should be analyzed as liquidated damages.  It commented that even if the rate did not meet the liquidated damages test, the overriding question was unconscionability.  This strikes the editor, frankly, as nonsense.  If the provision operated as a penalty, then unconscionability factors might not have to be considered.  But many courts have a high tolerance for default interest - viewing it as a bargained for return for repayment under specialized circumstances: i.e.  acceleration. 

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