Daily Development for Friday, November 21 by: Patrick A. Randolph, Jr. Elmer F. Pierson Professor of Law UMKC School of Law Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri dirt@umkc.edu Today's DD is by Jack Murray. MORTGAGES; DEFAULT INTEREST: New Jersey analyzes Metlife Capital - default interest upheld. In MONY Life Ins. Co. v. Paramus Parkway Bldg., Ltd., 2003 N.J. Super. 344 LESIS (Superior Ct. of N.J., Appellate Div., November 13, 2003) The New Jersey appellate court (affirming prior New Jersey rulings) ruled that certain lender charges in commercial mortgage transactions that constitute (in the court's view) liquidated damages, such as late fees, default interest rates, and prepayment premiums are subject to the test of "reasonableness" and are not subject to an unconscionability standard where the parties to the transaction are sophisticated and experienced, and that the borrower could not challenge the default interest rate, prepayment premium, or other contractual penalties negotiated as part of a loan workout with the lender. (Although the court mentions late fees in the preamble to the opinion, there is no discussion of late fees elsewhere.) The defendant borrowed $6.9 million from the lender and executed a mortgage for this amount on the debtor's warehouse and office facility. Later, after various defaults by the borrower, the parties entered into a mortgage modification agreement that extended the maturity date, provided for a default rate of six percent over the contract rate of nine percent, and added a prepayment charge of three percent of the principal amount commencing on November 1, 1995, declining one half of one percent per year. The borrower again defaulted, and the lender filed a state foreclosure action. The borrower then filed various (and basically bogus!) defenses, alleging that the note and mortgage were void due to "Illegal and unconscionable penalties contained therein." A receiver was appointed who, after initial failure to cooperate by the borrower, began collecting the rental income. A final judgment of foreclosure was entered, which included interest at the default rate and the prepayment charge as set forth in the modification agreement. Before the sheriff's sale, the borrower found a purchaser for the property (for an amount over $2.5 million more than what was owed on the mortgage!) and paid off the mortgage "under protest and without waiver of any of [its] rights and/or remedies." The lender then dismissed the foreclosure action and the sale was closed. Subsequently, the lender revised its payoff figure downward and refunded approximately $93,500 to the borrower, stating that the check for this amount was being tendered "with a complete reservation of [the lender's] rights and remedies and a waiver of none." The borrower returned the check, claiming that it had overpaid by an amount greatly in excess of the amount tendered, and reserving all of its rights and remedies. The borrower then appealed the judgment of foreclosure, arguing that the lender's motion for final judgment should not have been granted because the borrower contested the amount that was claimed to be due and owing and had not had a chance to complete discovery of the issue of whether such amounts were reasonable. In particular, the borrower asserted that (1) the principal indebtedness had not been properly calculated, (2) the 6% default interest rate was "a penalty and unenforceable," (3) the prepayment premium was "illegal," (4) the interest on the debt had been miscalculated, and (5) the amount of attorney's fees demanded was excessive. The court first ruled that the fact that the borrower had paid off the mortgage did not extinguish its right to challenge the foreclosure judgment. The court then made short shrift of the borrower's other arguments, deeming "these remaining issues to be without merit." The court noted that the borrower had not produced any evidence that the amounts owing under the loan documents were not correct nor had it challenged the principal amount claimed to be due, or alleged fraud, duress or any other unconscionable acts. The court also noted that the lender had discovered and acknowledged an overpayment by the borrower and refunded the balance owing to the borrower. The court then dismissed the borrower's arguments regarding accrued interest, default interest, and the prepayment premium "for the same reason, "i.e., that such arguments were neither factually or legally supported by the record. The court stated that in New Jersey, "liquidated damages, such as late fees, default interest rates, and prepayment premiums are subject to the test of reasonableness, that is, whether the stipulated damage clause is reasonable under the circumstances," citing MetLife v. Washington Avenue Associates, L.P., 159 N.J. 484 (1999) (upholding as reasonable a late fee of five percent and default rate of 12.55%) and Westmark Commercial Mortgage Fund IV v. Teen form Associates, L.P., 362 N.J. Super. 336 (App. Div. 2003) (evaluating default rate in commercial contract using reasonableness standard). The court concurred with the conclusions of the courts in these cases, i.e., that various forms of special charges on default are customary and justified in commercial loan transactions between sophisticated parties represented by counsel, and are "presumptively reasonable" in such circumstances, shifting the burden of proving unreasonableness to the borrower. (Amazingly, the court notes in a footnote that "the general partner in Washington Avenue Associates, the defendant in MetLife, was Laurence S. Berger, who is also a principal of [the borrower] in this case," and was described by the judge in a prior decision as "a practicing attorney [who had] demonstrated a very high degree of sophistication in the area of mortgage lending.") The court also noted (correctly) that "[t]he certainty of the remedy provided by the clause undoubtedly affected the pricing of the loan," especially where, as in this case, there had been a pattern of prior defaults. With respect to the prepayment premium, the court noted that in another recent federal court case in New Jersey, Norwest Bank Minnesota v. Blair Road Associates, L.P., 252 F. Supp. 2d 86 (D.N.J. 2003), the federal district court had ruled that "a prepayment premium is not a charge for the use of money but consideration for something that unless bargained for a borrower is not entitled to; namely the right to prepay." (Note: This is a statement of the "perfect tender in time" rule, which is the majority rule in the United States.) The court in the MONY Life Insurance case reasoned that a prepayment premium of one-half of one percent was "neither punitive nor unreasonable as duplicative of default interest," and in fact was not an interest charge at all but rather a charge for the option or privilege of prepayment. The court further confirmed that the prepayment premium was enforceable even where, as in this case, the lender had accelerated the debt because the prepayment provision in the modification agreement specifically provided for payment of the premium in such a circumstance. Finally, the court noted that there was no "indication whatsoever that these clauses [regarding default interest and the prepayment premium] were at odds with common practice in a competitive industry or outside commercially reasonable rates." Comment. 1: Mortgage lenders customarily charge mortgagors additional interest upon default, based on a percentage increase in the contract interest rate. In addition, they usually charge mortgagors a fee for late payment of installments on the note, often based on a flat percentage if the payment if not made on the payment date or within a specified period of time thereafter. In recent years, especially in connection with securitized loans and mezzanine financing, mortgagees also have commonly inserted "exit fee" provisions in mortgage loan documents, requiring mortgagors to pay a specified fee for prepayment or at the maturity (whether voluntary or involuntary) of the loan. Recent case law has wrestled with the issue of whether these charges and fees are enforceable, i.e., should they be enforceable only if they are "reasonable" and justifiable based on the mortgagee's actual or anticipated costs - or should they be not be subjected to this, or any other, test as long as they are entered into by sophisticated parties and are not "unconscionable"? Unfortunately, the case law is conflicting and contradictory and fails to provide clear guidelines for the imposition and calculation of such charges and fees. Comment 2: In 1999, the Supreme Court of New Jersey, in MetLife Capital Financial Corp. v. Washington Avenue Associates, 159 N.J. 484, 732 A.2d 493 (1999), reversing the decision of the lower appellate court found that MetLife's imposition of a late charge of 5% of the delinquent payment, as well as a default interest rate at "the greater of five percent (5%) per annum in excess of the 'prime rate' . . . from time to time, or fifteen percent (15%) per annum," were not unenforceable penalties under a liquidated damages analysis. (MetLife had not appealed the appellate court's reduction of the default interest rate to 12.55%, which was 3% greater than the non-default contract interest rate). The New Jersey Supreme Court first addressed the issue of the reasonableness of the late charge. The court reviewed the history and development of stipulated damages provisions, including case law and the UCC provision on liquidated damages, and concluded that, "'reasonableness' emerges as the standard for deciding the validity of stipulated damages clauses." Utilizing the "reasonableness" test, the court held that the five- percent late charge was "a valid measure of liquidated damages." The court explicitly disagreed with the finding of the appellate court that damages arising from a late payment with respect to a larger loan would not result in a greater administrative or "opportunity cost" risk to the lender, or require greater oversight and supervision. The court also noted that it would be impractical to require the lender to calculate its exact damages with respect to a specific defaulted loan, because the lender's costs are spread over its entire portfolio of loans. It would be more realistic, the court found, to examine the statutory treatment of late charges as well as common and accepted practice in the industry. Under this standard, the court ruled that the reasonableness of the charge had been successfully demonstrated based on the following factors: the uncontradicted testimony of MetLife's representative that the charge was customary in connection with commercial mortgage loans and fairly compensated the lender for the administrative costs involved in connection with servicing delinquent loans; the express authorization, under both New Jersey statutes and numerous federal statutes and regulations governing various classes of mortgage lenders, of late charges of five percent; case law from other jurisdictions generally upholding fixed percentage late charges negotiated between sophisticated commercial entities, which were within the "industry standard" range; the "suggestion" of case law from New Jersey and other jurisdictions that a small percentage late charge was simply a normal part of the cost of doing business; and the failure to demonstrate any evidence of fraud, duress or other unconscionable acts on the part of MetLife. The court then turned to the issue of the reasonableness of the default interest rate. Consistent with its holding on late fees, the court noted that, "[d]efault interest rates, like late fees, are presumed reasonable." The court's review of New Jersey case law in this area revealed that a default interest rate would be invalidated as a penalty if "the[] size suggests a punitive intent." Because the interest rate increase in this case was only three percent, the court found it to be "a reasonable estimate of the potential costs of administering a defaulted loan, and the potential difference between the contract rate and the rate that MetLife might pay to secure a commercial loan replacing the lost funds." The court noted the difficulties faced by lenders in determining actual losses resulting from a commercial loan default; in predicting the nature and term of a loan default or market conditions for commercial loans in the future; in predicting their economic losses and what might ultimately be recovered from a foreclosure sale; in determining what their own borrowing costs might be in the future; and in estimating their collection costs. The New Jersey Supreme Court did rule against MetLife on the remaining issue in the case, regarding an accounting of the rents that MetLife had collected directly from the tenant after the borrower's default. MetLife had relied on its "absolute" assignment of rents under which, the court agreed, title to and possession of the rents passed to MetLife upon the borrower's default. The court upheld the ruling of the appellate court on this issue, and found that "in the absence of any accounting, and in light of prior precedent, the express contractual provision, and considerations of equity," it would remand the case for a determination of the amount that should be credited to the mortgage loan as the result of MetLife's failure to account for the rental payments or apply them to the principal balance of the loan. (The court noted that "MetLife may have secured an interest-free loan for itself at [the borrower's] expense . . . "). Comment 3: As the court noted in the MetLife decision, it has adopted the "modern trend" that permits more flexibility when analyzing the reasonableness of late charges and default interest rates in commercial loan documents. The court appears now to be moving toward a "consenting adults" approach, under which almost anything goes when sophisticated parties, represented by counsel, are involved in negotiating complex commercial real estate financing transactions -- as long as the fees and charges imposed are within industry-standard norms and ranges and don't appear to be clearly "unconscionable." At the end of its opinion the court acknowledged that the imposition of late charges and default interest rates is a "practical solution to the problem of pricing loans according to anticipated rather than actual performance and the difficulty in allocation and determining the costs and damages of late payments and default," and agreed that "[t]he alternatives are economically inefficient or judicially impracticable." Interestingly, however, the court rejected MetLife's argument that late charges and default interest rates should be analyzed strictly in accordance with contract law principles, and should not be subjected to a liquidated damages analysis because of the "fiercely competitive marketplace" and the difficulty of calculating actual damages. Although agreeing with MetLife that the imposition of such charges is a legitimate cost of doing business, the court was not prepared to go as far as to incorporate such a factor into the "reasonableness" test. Rather, the court stated its belief that courts are "accustomed to dealing with the standard of reasonableness," and that it would continue to evaluate late charges and default interest rates under this standard, instead of employing an "unconscionablity" test. According to the court, the continued use of the "reasonableness" standard would "provide[] an adequate safeguard for the lenders and better protection for the borrowers." Comment 4: Other courts, both bankruptcy and non-bankruptcy, have upheld the validity and enforceability of default-interest and late-charge provisions in commercial loan documents. 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 would have to 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 for the increased risk and expense of collection. The court also 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 court, citing MetLife Capital, supra, noted that, "under New Jersey law default interest rates that are penalties are unenforceable." Id. at 88. The court distinguished MetLife Capital, stating that "There is no question that default interest is generally permitted under New York law and is difficult to obtain under New Jersey law. Under New Jersey law a liquidated damages clause is only valid if (1) the amount fixed is related to the actual damage that is likely to be suffered, and (2) the amount of the damage caused by the breach is of the type which is incapable or very difficult to actually estimate." Id. at 99, fn. 2. The bankruptcy court also noted that under New York law default interest rates as high as 25% had been consistently held to be reasonable. However, the court held that the mortgagee would not be permitted to receive both interest at the post-default rate and late charges. The court therefore upheld the enforceability of the default-interest provision but not the provision for the payment of late charges by the debtor. Finally, the court also ruled that the mortgagee would not be permitted to receive interest on the default interest that accrued post-petition. The court noted in support of this specific holding that the loan documents did not provide for the payment of such interest-on-interest and that the allowance of such additional amounts would not be equitable. See also In re Wines, 239 B.R. 703, 709 (Bankr. D.N.J. 1999) (citing the New Jersey Supreme Court's holding in MetLife, supra, and stating that "[a]lthough that decision does not apply to residential mortgages, 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. Id.at 174. The court, 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, 115 S.Ct. 360 (1994) and In re Consolidated Properties Ltd. Partnership, 152 B.R. 452, 457 (Bankr. D.Md. 1993), 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." However, the court noted 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". Id. at 172. See also In re Southland Corp., 160 F.3d 1054, 1060 (5th Cir. 1998) (holding that recovery by the debtor of the contractual postpetition default rate was not inequitable where the 2% spread between the default and non-default rate was "relatively small," the mortgagee was "not obstructing the [bankruptcy] process," and no junior creditors would be harmed if the mortgagee was awarded default interest); In re Liberty Warehouse Assoc. Ltd. Partnership,, 220 B.R 546, 551-52 (S.D.N.Y. 1998) (stating that "[the mortgagee] is entitled to accrue pendency interest on its claim because it is oversecured" and finding that the default rate of 22.8% was reasonable and not a "disguised penalty," where the non-default rate was 14%; the court, citing In re Ace-Texas, Inc., 217 B.R. 719,721 (Bankr. D. Del. 1998), also held that where the underlying debt has matured by its own terms, there is nothing for the mortgagor to reinstate and any attempt by the mortgagor to "cure" the default and reinstate the original terms would constitute an impairment of the mortgagee's right to immediate payment); Bruce v. Martin, 845 F.Supp. 146 (S.D.N.Y. 1994) (ruling that a default rate of 24.9% was allowable under New York Penal Law and was not usurious); In re Terry Ltd. Partnership, 27 F.3d 241, 243 (7th Cir. 1994) (finding that there is "a presumption in favor of the contract rate subject to rebuttal based on equitable considerations"); Citicorp Mortgage, Inc. v. Morrisville Hampton Village Realty Limited Partnership, 443 Pa.Super. 595, 600-01, 662 A.2d 1120, 1123 (1995) (finding that attorney's fee award of ten percent was reasonable, even though trial court did not specifically state reasonableness finding, where amount was provided for in loan documents and mortgagor had not set forth any evidence establishing its claim of unreasonableness); In re Richardson, 63 B.R. 112, 113 (Bankr. W.D.Va. 1986) (holding that oversecured creditor could recover late charges); Mack Financial Corp. v. Ireson, 53 B.R 118, 120 (Bankr. W.D.Va. 1985) (holding that a creditor can obtain late charges if the creditor is oversecured and the charges are reasonable); Melanie Rovner Cohen, Jeff J. Marwell, and Richard A. Gerard, Entitlement of Secured Creditors to Default Interest Rates Under Bankruptcy Code Sections 506(b) and 1124, 45 Bus. Law. 415 (1989); Annot., Validity and Construction of Provision Imposing "Late Charge" or Similar Exaction for Delay in Making Periodic Payments on Note, Mortgage, or Installment Sale Contract, 63 A.L.R.3d 50, 5 (1975); Foreclosure: New Jersey High Court Upholds Late Charges, 29-OCT Real Est. L. Rep. 8 (1999); Harris Ominsky and Stuart D. Poppel, Loans: Late Charges Challenged, 116 Banking L.J. 4 (1999). Comment 5: The court's holding with respect to the prepayment premium is refreshing and in accord with most recent case law in this area, especially with respect to the issue of whether a prepayment premium is collectible when the loan has been accelerated. What is unusual in the MONY Insurance Co. case is the type of prepayment provision involved, i.e., a "sliding percentage" clause instead of the various forms of "yield maintenance" and "defeasance" provisions that are commonly inserted in commercial mortgage loans today. It can be argued that yield-maintenance prepayment provisions are much more likely to be judged "reasonable" by a court than sliding-percentage provisions (which were common in the 70s and early 80s), because they are tied to the actual cost of the borrower's funds and are the current standard in the commercial marketplace. For an analysis of current case law in this area (and also with respect to the "perfect tender in time" rule, which negates any right of the borrower to pay the loan before its stated maturity date unless otherwise provided in the contract, and which rule was upheld by the court in the MONY Insurance Co. case), see my article on the enforceability of prepayment premiums (entitled "Enforceability of Prepayment-Premium Provisions in Mortgage Loan Documents," which can be found on my website (in the "Mortgages and Financing" section) by clicking on the following URL: http://www.firstam.com/faf/html/cust/jm-articles.html. Also, on the DIRT website, Pat Randolph has discussed all the prepayment penalty cases in his 2001 article posted there (although at the time of that article that there may not have been many cases regarding the issue of the enforcement of a prepayment penalty upon default acceleration where the clause specifically provided the lender with such right). The Reporter for this item was Jack Murray of First American Title Insurance in Chicago. Readers are encouraged to respond to or criticize this posting. Items reported on DIRT and in the ABA publications related to it are for general information purposes only and should not be relied upon in the course of representation or in the forming of decisions in legal matters. The same is true of all commentary provided by contributors to the DIRT list. Accuracy of data provided and opinions expressed by the DIRT editor the sole responsibility of the DIRT editor and are in no sense the publication of the ABA. Parties posting messages to DIRT are posting to a source that is readily accessible by members of the general public, and should take that fact into account in evaluating confidentiality issues. ABOUT DIRT: DIRT is an internet discussion group for serious real estate professionals. Message volume varies, but commonly runs 5 - 15 messages per work day. 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