Daily Development for Tuesday, February 22, 2005
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

The Reporter here was Jack Murray of First American Title Insurance Company.  But the editor extensively revised the report and added his own comments.

MORTGAGES; INTEREST; DEFAULT INTEREST: Where mortgagor has collected a one-time 5% late payment charge, bankruptcy court will not approve default interest of 5% in excess of contract rate as a “reasonable charge” arising from default.

In re AE Hotel Venture, 2005 Bankr. LEXIS 166 (Bankr. N.D. Ill., Feb. 16, 2005).

AE Hotel Venture ("AE Hotel") owned and operated a suburban Chicago hotel property and obtained a mortgage loan on the property in 1997, in the amount of $7.6 million, from LaSalle National Bank ("LaSalle"). LaSalle was the trustee for a securitization trust, and the loan was subsequently securitized; i.e., pooled with other loans and sold to investors pursuant to the issuance of mortgage-backed pass-through certificates. LaSalle designated GMACCM Commercial Mortgage Corp. ("GMACCM") to act as special servicer of the trust; the court in this case discusses the claim of the mortgagee as if it belonged to GMACCM.

Several years later AE Hotel defaulted under the loan, and GMACCM accelerated the debt and filed a foreclosure action in Illinois State court. A few days later, AE Hotel filed a Chapter 11 bankruptcy proceeding, in order to gain time to sell the hotel.  The bankruptcy court subsequently approved a sale of the hotel property for $7.8 million. Prior to the sale, GMACCM filed its proof of claim, seeking (as set forth in the loan documents): (1) a late payment charge equal to 5% of the unpaid balance of the loan (2) default interest at the rate of 14.72% (a 5% increase over the contract rate of 9.72%); and (3) a prepayment premium based on a yield-maintenance prepayment formula, discounted to present value. AE Hotel objected to GMACCM's request for payment of the default interest and prepayment premium as part of its allowed claim (but not to payment of the late charge).

The bankruptcy court noted that no facts were in dispute and that AE Hotel had conceded, as a factual matter, that the yield-maintenance prepayment-premium provision in the loan documents (which the court "translated roughly into English") provided a "precise method" of determining GMACCM's loss and was "an exact calculation of the damage" that would result from prepayment of the loan.

The borrower did not contest the 5% late charge based upon the unpaid premium amount, perhaps because it was of the view that the default interest fee posed the greater threat.

The court denied that GMACCM's claim to post-petition default interest. The court stated that this claim was really not for default interest at all, but rather a claim for a "charge" for extra costs incurred after default, and was not "reasonable" under sec. 506(b) of the Bankruptcy Code. While acknowledging that case law to the contrary existed, the court reasoned that the original contract rate was designed to compensate the lender for the loss of the time value of money and that "[t]he time value of money of GMACCM's value of money . . . did not magically increase by 5% once AE Hotel defaulted." The court found that this charge would be "reasonable" under Sec. 506(b) only if the lender was not compensated under some other provision of the loan documents, and that several courts have held that when a creditor is paid late charges (which AE Hotel did not contest in this case), it could not also claim default interest ( which would, according to the bankruptcy court, result !

 in a "
double recovery).  The court ruled that although GMACCM would be able to collect all or some portion of the default interest "charge" if it could demonstrate that payment of the late fee failed to compensate it fully for some loss, GMACCM had waived this argument by failing to supply any evidence in this regard.

Reporter's Comment 1: The bankruptcy court in the AE Hotel case ruled that under Illinois law, GMACCM could not collect default interest in addition to the late fee - unless it could prove that collection of the late fee was insufficient to compensate it for its actual damages. But this also is less than clear. In the recent Broadway Bank bankruptcy case (see Reporter's Comment 1, supra), which applied Illinois law, the loan documents stipulated a five-percent late charge and a default-interest rate of ten percentage points over the contract rate upon default, as well as payment of attorneys' fees involved in the bank's collection efforts. The Iowa appellate court held that the language of the promissory note regarding late charges and default interest was clear and unambiguous, and that the settlement agreement between the parties did not extinguish the bank's ability to collect late charges and default interest. The case was remanded to the trial court to compute the amoun!

 t of t
he award of late fees, default interest, and attorney fees.
The bankruptcy case law in general is split on the issue of whether a lender should be able to collect both a late fee and default interest (and whether a late fee or default interest is a "charge" as opposed to interest), and the reasonableness of such charges, although the majority of decisions prohibit the recovery of both. See, e.g., In re Route One West Windsor Limited Partnership, 225 B.R. 76 (Bankr. D.N.J. 1998), in which the court, applying New York law (the parties had stipulated New York law would apply in a choice-of-law provision in the loan agreement), held that a provision in the debtor's mortgage-loan agreement with an oversecured creditor to pay interest following default at the post-default rate of 15.125% was not an unenforceable penalty and must be paid by the debtor. The court found that the increased default rate of interest was justifiable and reasonable because it merely compensated the mortgagee f or the increased risk and expense of collection. The c!

 ourt a
lso held that the allowance of default interest on a claim in bankruptcy is determined by federal law, but noted that state law would be relevant because if the amount exceeded the allowable legal rate, then the bankruptcy court would not permit the mortgagee to recover such a windfall amount in a bankruptcy proceeding. The court also noted that the principal of the debtor was a sophisticated businessman who had knowingly and freely allowed the debtor partnership to contract for the post-default interest rate. The court further found that no other non-insider creditors of the debtor would bear the adverse effects of the increased rate of interest paid to the mortgagee. The bankruptcy court also noted that under New York law default interest rates as high as 25% had been consistently held to be reasonable. But the court also held that the mortgagee would not be permitted to receive both interest at the post-default rate an d late charges. The court therefore upheld the enforc!

ty of the default-interest provision but not the provision for the payment of late charges by the debtor. See also In re Wines, 239 B.R. 703, 709 (Bankr. D.N.J. 1999) ("courts have traditionally allowed late charges according to the contract of the parties"). In a similar decision, In re Dixon, 228 B.R. 166 (Bankr. W.D. Va. 1998), the court held that although the default interest rate of 36% (double the pre-default rate) was high, it would accept the creditor's representation -- without requiring testimony or evidence -- that the default rate was proportionate to the reasonably anticipated damage from default and was not a penalty. The court stated that it did not have the "power to alter commercial contracts or to substitute [its] judgment for that of the parties" where the transaction was lawful, no other creditors were harmed, the default rate did not violate state usury laws, and there was no threat to the reorganization of the debtor by imposition of the default rate. T!

 he cou
rt, citing In re Terry Ltd. Partnership, 27 F.3d 241, 243 (7th Cir. 1994), cert. denied sub nom Invex Holdings, N.V. v. Equitable Life Ins. Co. of Iowa, 513 U.S. 948 (1994) and In re Consolidated Properties Ltd. Partnership, 152 B.R. 452, 457 (Bankr. D.Md. 1993) (both of these  cases were cited by the bankruptcy court in the AE Hotel case), also stated that "[d]efault interest rates are also necessarily higher than basic interest rates in order to compensate creditors for both the predictable and unpredictable costs of monitoring the value of collateral in default situations." The court noted, however, that "[e]ven when the late charge is reasonable . . . a creditor may be denied recovery where it also asserts a claim to a default rate of interest". See also Greenwood Trust Co. v. Commonwealth of Massachusetts, 971 F.2d 818, 825 (1st Cir. 1992) (holding that late charges are a form of interest, and that the State of Massachusetts could not bar an out-of-state bank from charg!

 ing la
te-payment fees on delinquent credit-card accounts, and stating that "federal case law has long suggested that, in ordinary usage, interest may encompass late fees and kindred charges," 4 A. Resnick and H. Sommer, Collier on Bankruptcy P506.04[2][b][ii] at 506-112 (15th rev. ed. 2004 ("in general a default rate of interest is properly a form of interest").

Editor’s Comment: This court, and perhaps some others, are not quite getting the arguments right. The earlier cases striking down default interest rates when late fees also were charged dealt with late fees charged on a late balloon payment - in other words applied to the whole principle amount, or late fees that were compounded - charged every month as additional defaults were claimed.  To the extent such claims are valid (and many common law courts have found these sorts of fees invalid), they are valid because the operate exactly like default interest - compensating the creditor for the additional risks of carrying the loan.

But in this case, it appears (from the size of the charge), the late charge was a more typical late charge - charged only upon the amount of a single late payment.  This fee is designed to compensate the lender only for administrative expenses related to that fee, and not to the additional risk of carrying the whole loan.

The cases that the court relies upon here talk about late fee provisions and default interest provisions that each compensate the lender for the same risk or cost.  The rule, properly, that the lender shouldn’t be able to get both.  But that was not the situation here.  The two provisions compensated for two quite different costs, and charging the late fee should not have precluded the lender from charging for default interest.

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