Daily Development for Thursday, July 8, 1999

Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

MORTGAGES; LATE CHARGES: New Jersey High Court reverses MetLife decision, 5% late charge and 15% default rate are enforceable in commercial mortgage.

MetLife Capital Financial Corp. v. Washington Avenue Associates, 1999 WL 436126 (N.J. 6/30/99)

A lower appeals court, in a decision much bruited about the real estate community, had found that MetLife had not substantiated its 5% late charge as a valid liquidated damages provision, and therefore the charge was void as a penalty. It had voided MetLife's default interest rate as well. The rate had been stated as "the greater of five percent (5%) per annum in excess of the 'prime rate' . . . from time to time, or fifteen percent (15%) per annum,"

MetLife had not appealed the appellate court's reduction of the default interest rate to 12.55%, which was 3% greater than the nondefault 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:

(1) 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;

(2) 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;

(3) 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 . . ."

Reporter's Comment: Based on existing case law and standard mortgage practice that has existed for quite some time, the lower appellate court's holding in the MetLife case truly appeared to be an aberration one that the New Jersey Supreme Court has now rectified. As the high court noted, 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 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."

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