Daily Development for Wednesday, October 17, 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

Here's another great contribution from Roger Bernhardt:

MORTGAGES; LATE PAYMENT FEES; BALLOON PAYMENTS:  Lender could not recover percentage late fee on promissory note's final balloon payment when fee provision applied only to interim installment payments.

Poseidon Dev., Inc. v Woodland Lane Estates, LLC 152 CA4th 1106, ___ CR3d ____(2007)

 Woodland executed a promissory note (Note) and deed of trust in favor of Poseidon which provided for monthly interest-only payments and a final payment of principal and unpaid interest. If any installment was not paid on time, the Note provided for a late charge of 10 percent of the overdue amount, described as processing and accounting charges.

Woodland failed to make the final payment of principal and interest on the due date. Poseidon recorded a notice of default and then began collection proceedings, incurring attorney fees and costs. Although Woodland eventually made the final payment of principal and interest, it refused to pay a late charge or the expenses of collection.

Poseidon sued Woodland for breach of contract, seeking to recover a late charge of 10 percent of the final balloon payment, its collection expenses and damages for lost business opportunities, costs and attorney fees. The trial court sustained Woodland's demurrer without leave to amend, concluding that the Note's late charge provision applied only to the interest payments, not the final balloon payment, that Poseidon was not entitled to costs of collection because it was not authorized to initiate foreclosure proceedings, and that Poseidon could not recover damages for lost business opportunities. The trial court granted Woodland's motion for costs and attorney fees.

The court of appeal reversed. Although the trial court correctly determined Poseidon was not entitled to the relief sought in the complaint, it erred in sustaining Woodland's demurrer without leave to amend because Poseidon was entitled to recover actual damages suffered by reason of the late payment.

Poseidon was not entitled to a late charge on the balloon payment as an element of damages. Although a final, balloon payment may be considered an installment within the common meaning of that term, the parties did not so intend here, as indicated by the plain language of the Note read as a whole, in accordance with CCC2=A7=C2=A71638, 1641, 1643, and 1644. Moreover, the trial court's interpretation saved the late charge provision from being an unlawful penalty under CC =C2=A71671(b). The Note provided that the purpose of the late charge provision was to compensate Poseidon for administrative expenses, which would not vary appreciably depending on the amount of the overdue payment. If the late charge provision was intended to apply to both interim installments and the final payment, it would be an unenforceable penalty provision because it could not possibly be considered a reasonable estimate of the damages contemplated by a breach. The only interpretation of the late charge provision that wou
ld make it lawful, operative, definite, reasonable, and capable of being carried out, as required by CCC2=A71643, is one that would make it inapplicable to the final payment.

The trial court properly took judicial notice of a recorded assignment of the Note and deed of trust whose clear legal effect was that Poseidon no longer held the beneficial interest under the deed of trust. Because Poseidon gave up its right to replace the trustee and initiate foreclosure when it assigned the Note and deed of trust, it had no power to initiate foreclosure proceedings and was not entitled to recover the cost of doing so from Woodland.

The demurrer should not have been sustained without leave to amend. It was undisputed that Poseidon was entitled to interest from the date final payment was due until it was paid and might also be entitled to other damages in the nature of administrative expenses. Although Poseidon had been given one opportunity to amend the complaint to state a claim for unpaid interest and failed to do so, it was appropriate to give Poseidon one more chance.

Reporters Comment:  When I read this decision, my immediate reaction was to wonder how real estate attorneys would respond to it and how they might advise clients to rewrite their documents (or redo their deals). It also occurred to me that non-Californians might react differently, so I decided to survey the country. To do so, I turned to leading real estate lawyers in Los Angeles, Chicago and New York.  He noted as well that a party drafting a promissory note could easily craft language that would expressly provide for a late charge to be paid with reference to monthly installments of interest and a payment of the principal balance at maturity.

But then, of course, the question arises whether such a charge would be a penalty.  The court held as a matter of law that the 10-percent late charge was unenforceable as a penalty when applied to the principal balance. In particular, the court focused on the gross disparity in the relative amount of the late charge when applied to an installment of interest or to the principal balance of the note.                                                 

The California commentator found this analysis troubling.  He noted that the court relied on the fact that the amount of the late charge was vastly different if applied to an interest installment, as distinguished from the entire principal balance due at maturity. But he saw this reasoning as flawed because varying late charges would commonly occur as to payments other than balloon payments, for instance, if a note provided for  monthly payments of interest and quarterly payments of principal, differing late charges would result.  He noted, further, that although the Third District focused on "processing and accounting expenses," it is clear the language of the late charge provision was not intended to make these the exclusive components of damages that the parties were apparently seeking to liquidate.

The California commentator also properly noted that the court of appeal's analysis of the validity of the late charge as a matter of law did not address the seminal decision by the California Supreme Court in Garrett v Coast & S. Fed. Sav. & Loan Ass'n 9 C3d 731, 108 CR 845 (1973), which had invalidated a contractual charge in a residential mortgage and triggered the legislative adoption of CCC2=A71671 to govern the validity of liquidated damage provisions.

It is possible that the courts entire analysis of the validity of late charges in general could be viewed as dictum, since the court found that the contractual language of the note did not support late charges on the balloon payment.

The Chicago commentator, Jack Murray of the Chicago office of First American title, also noted that the case has two parts - analysis of the contractual language in particular and analysis of the validity of late charges in general.

As to the second issue, he concluded that it is virtually impossible to justify a 10-percent late fee on the entire principal balance-especially when the loan is interest-only with no principal amortization. Even if the documents clearly so provided, he believed that virtually any court (especially in bankruptcy) would find it inequitable and a penalty instead of reasonable compensation for, or estimation of, damages. Thus, he agreed with the court's holding in the Poseidon case. The lender in that case was entitled to an increased default interest rate (from 10 percent to 18 percent) on the unpaid balance if it accelerated the debt, and this should be enough to protect it.

Jack discusses this issue some in his article:   Murray, Default Interest Rates, Late Charges and Exit Fees: Are They Enforceable? https://e2k.exchange.umkc.edu/exchweb/bin/redir.asp?URL=3D http://www.firstam.com/listReference.cfm?id=3D5574.)

He opined that a  late-charge provision that compensates the lender for administrative expenses by charging $614.67 for one late payment and $77,614.67 for a late final payment is not a reasonable attempt to estimate actual administrative costs incurred. He indicates that he had not found another case with similar facts that would permit such a charge. In fact, several cases have held that a 10-percent late charge, even on regular installments, is excessive and a penalty (in one case, a 5-percent late charge on regular installments was held to be a penalty).

Jack asks whether, if the court struck down the 10% penalty, it would  still permit the lender to collect its "actual" damages? He believes the Poseidon court made contradictory statements in this regard.

The New York lawyer, DIRTer Joshua Stein,  first discussed the contract interpretation issues.  He noted that the court mentioned that the note sometimes referred to "payments" as opposed to "installments." Different words must have different meanings, the court reasoned, and "payment" would without doubt include the payment due on maturity; "installment" could well mean something else. He said:

The court's reasoning demonstrates why legal drafters should use the same word consistently when they intend to refer to the same concept. If the drafter sometimes says "payment" and sometimes says "installment," the inconsistency invites a court to infer some difference in meaning. in commenting on whether the 10-percent late charge on the final principal balance would constitute an unenforceable penalty, also speculated that the whole discussion in the case could be viewed as dicta - unnecessary to the result.

Joshua didnt entirely agree with the court's narrow reading of the word "installment." He speculated that "payment" and "installment" are probably synonymous in the context of this transaction.  Either can readily apply to any payment due on a note that requires multiple payments. There is no particular reason to treat the payment due on maturity as anything different from another "installment." Common usage, Joshua said,  would call that payment the "final installment," which would imply it's just another installment, though it happens to be the final one. Installments that are not the "final installment" might be called "monthly installments" or "periodic installments."
But he also acknowledged that the interpretational issue could go either way. If the lender really wanted to collect a late charge on the outstanding principal balance on maturity, the lender should have clearly said so. A late charge on maturity represents a rather draconian and "off market" result. Therefore, the lender should have borne the burden of being "even clearer than necessary" about the parties' intentions to impose a late charge on the outstanding principal balance. It's just the old principle that courts should construe documents against the drafter.

In theory, if the lender had hit the borrower over the head with the "late charge on maturity," the borrower might have negotiated the note to eliminate that particular burden. Well-represented, sophisticated commercial borrowers do routinely add language to negate a late charge for the payment due on maturity. Lenders almost always agree to that concession with little debate. So, the "standard in the market" probably contemplates that lenders cannot collect late charges on the outstanding principal balance on maturity. Correspondingly, if lenders truly do intend to collect such a late charge, they bear the burden of being absolutely clear about it. I have certainly seen it, though only in a small minority of loan documents.

As to the validity of a late charge on a balloon in general, Joshua commented that he was not convinced that the theory of "contract damages" offers the right test to validate or invalidate various payment alternatives available to a borrower under a promissory note.

A note typically allows the borrower to pay on maturity, in which case the payment is one amount. It also (often) allows the borrower to pay before maturity, in which case the payment may include some formula to make up for some or all of the lender's loss of interest. Finally, the note also recognizes the possibility that the borrower might pay after maturity, in which case the payment becomes some other amount (in this case, 110 percent of what was due-perhaps to compensate the lender for the greater risk of nonpayment at this point).

It is unclear to me why consenting adults should not be allowed to negotiate a menu of commercial alternatives just like these. The court treats only one of those alternatives as the "contract," and then treats the "payment after maturity" alternative as a breach of that contract. It just doesn't make a great deal of sense to me. Even the usury law (which generally doesn't make much sense to me, either) tolerates higher interest rates, or other consideration for the use of money, if the borrower fails to pay when due.

Joshua asks whether  the Poseidon court would invalidate an "exit fee"-a payment as additional consideration for making the loan, but due only on maturity.

At what point would the court invalidate such a fee? But why shouldn't the parties be able to agree to one? If they can, then why can't they also agree that the lender will waive the "exit fee" if the borrower repays the loan strictly when due (thus dramatically reducing the risk profile of the loan for the lender)?

In Joshuas view, the Poseidon court's invalidation of a late charge on maturity drags the judicial system into a thicket of discretionary line-drawing, with the result that borrowers and lenders never know what agreements the courts will deign to enforce. The resulting lack of certainty probably imposes burdens that far outweigh the random benefits bestowed on occasional lucky borrowers.

Finally, Joshua found another lesson here.  He noted that the Poseidon  lender pledged its deed of trust to another lender as security for a loan to the holder of the deed of trust (sometimes called a "hypothecation" or a "mortgage warehouse line"). But instead of recording a collateral assignment, it seems the parties recorded an absolute assignment and never undid the mistake. Thus, as a matter of technical legal rights, the party that thought it was the lender actually had no right to foreclose the deed of trust, because that right had been assigned to someone else.

Silly defects like these offer any borrower wonderful fodder for defenses. If the borrower can somehow establish that the would-be lender doesn't actually hold the loan, then the borrower can conceivably unwind the entire enforcement process. The borrower can do this even though the putative holder of the loan gave the borrower every notice and all the "process" to which the borrower was entitled, even though the borrower was, and is, in default under the loan.

To prevent such defenses, a lender needs to make sure that any post-closing documents say what they were intended to say and do what they were intended to do. As a practical matter, though, many lenders try to consummate post-closing transactions with the least possible involvement by lawyers.

Even if a lender saves legal fees by using chimpanzees to handle its post-closing transactions, once a loan goes into default, the lender might be well advised to have counsel take a close look at the file to try to find problems of the type that arose here. Even that exercise, however, may be more than lenders are willing to undertake. They may regard the resulting risk of surprises as just a cost of doing business-far preferable to paying the level of legal fees that would be necessary to proactively identify and solve problems like the one that occurred here.  .

The Reporter for this item was Roger Bernhardt of Golden Gate Law School in San Francisco, writing in the California CEB Real Estate Reporter.  The editor has edited Rogers piece substantially, especially in summarizing the views of the three other commentators. 

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