In a decision issued June 23, 1998, the Appellate Division of the Superior Court of New Jersey held that a flat 5% late charge and a stepped up default interest rate of 5% in excess of the then prevailing note rate were unenforceable penalties and therefore the lender would have to prove its actual damages resulting from the default. MetLife Capital Financial Corporation v. Washington Avenue Associates, LP and Lawrence S. Berger v. United States of America (A-5382-96T5).
The case involved a typical five year mortgage loan by the lender with a balloon payment upon maturity. Upon the failure by the borrower to make the balloon payment, foreclosure proceedings were commenced. The lower court found that the lender was entitled to foreclose, but held that there were material issues of fact regarding the 5% late fee and the default rate. The loan documents provided that a late fee of 5% of the payment due would be imposed if any scheduled payment was not paid within ten days of its due date. Further, upon an event of default, the interest rate would be increased to the greater of 5% in excess of The Chase Manhattan Bank prime rate or 15%, provided that the default rate could not exceed the maximum interest rate allowable by law. Upon the borrower's payment default, the lender imposed both a late charge and default interest rate.
The Court first analyzed the 5% late charge and concluded that it represented a liquidated damage clause which was an unenforceable penalty. The basis for this decision is long-standing New Jersey case law which holds that damages for breach by either party may be liquidated and agreed upon in advance but only in an amount which is reasonable in light of the anticipated or actual harm caused by the breach, the difficulties of proof of loss and the inconvenience or non-feasibility of otherwise obtaining an adequate remedy.
The 5% late charge was deemed unreasonable for several reasons. First, the charge was fixed without any reference to or consideration of the duration of the breach or the amount of the late installment. Testimony by the lender failed to demonstrate that the actual costs suffered by the lender through late payments were uniform in all cases without regard to the length of the time of default or the amount of payment missed. Further, the actual cost to the lender of the loss of the use of money was easily ascertainable. Finally, the Court concluded that one of the reasons for the late charge was clearly to "coerce" timely payment by the borrower and a purpose to coerce timely payment renders such a charge a penalty, by definition.
Regarding the default rate of interest, the Court, based on its prior analysis, easily concluded that it was also an unenforceable penalty. The evidence presented by the lender did not support its contention that the default rate was reasonable in light of the anticipated or actual harm caused by the default or addressed a loss which was not otherwise easily ascertainable.
Thus, in one broad stroke, the Court rejected a flat 5% late charge as well as the increased interest rate upon default. The analysis in the case seems so clear one wonders why definitive judicial decision in this area was not earlier available. Virtually all loan documentation in New Jersey commercial transactions contains some sort of late charge and default rate provisions. In many circumstances, the late charge is a flat fee irrespective of amount o r timing of payment. The Court suggests that late charges which are imposed only for the actual duration of the late payment may be supportable so long as they are otherwise tied to some recognizable loss of return which the lender suffers as a result of the late payment. Often, loan documents include statements that the late payment is intended to compensate the lender for the loss of the use of proceeds and is not intended as a penalty. Whether these "self serving" provisions will assist remains to be seen.
As to default rates of interest, one might read the case as holding that such default rates are unenforceable under any circumstance. The trial court concluded that a 15% default rate was excessive and had reduced the rate to 12.55%, 3% over the original contract rate. The Appellate Division reversed finding that if, in fact, the default rate was a penalty and therefore unenforceable, the proper approach would be to require the lender to prove its actual damages as a result of the default. Based upon the inadequate proofs put forth by the lender, the Court concluded that it was "entirely speculative that any unascertainable or difficult to calculate actual damages suffered by [lender] by reason of the default are reasonably related to a three per cent enhancement over the contract rate." While the burden of proof will continue to be on the party challenging late charges and default rates of interest, it appears that there is little sympathy in the New Jersey courts for these provisions and lenders may now be "put to their proofs" in order to recover these enhanced charges.
