Cautionary Tale: Late Fees in Loan Documents Might Not Hold Up in Court
Banks and their attorneys go to great lengths to protect the lenders in case a borrower fails to repay a loan. Sometimes, a court recently decided, those efforts go too far.
Many promissory notes include a late fee -- typically 5 percent -- if a payment is not made on time. While this may be a standard provision in many promissory notes, an appeals court recently found late fees applicable to balloon payments to be punitive in nature and unenforceable against the borrower.
The case described below is a cautionary tale to lenders that even if a late fee provision is included in the loan documents and the borrower agrees to it, the court may not necessarily uphold it.
In 2006, Canadian Imperial Bank of Commerce lent $28.6 million to Dobson Bay to finance the acquisition of four commercial properties in Arizona. A promissory note included a late fee of 5 percent of any amount not paid within a certain number of days when due to “defray the expenses incurred by lender in handling and processing [the] delinquent payment and compensate lender for the loss of the use of such delinquent payment… ” The promissory note also stated that, upon an event of default, Dobson Bay was required to pay default interest as well as the cost of collection and reasonable attorneys’ fees.
In 2012, after failed negotiations to extend the term of the loan, Canadian Imperial sent a notice of default to Dobson Bay. Canadian Imperial also informed Dobson Bay that it had assigned the promissory note and deed of trust to La Sonrisa de Siena. La Sonrisa foreclosed on the property and gave Dobson Bay a payoff statement showing a principal balance of $27,778,698.07 as well as a 5 percent late fee of $1,392,784.90. Dobson Bay was able to obtain additional financing to pay off the unpaid principal balance but challenged La Sonrisa’s right to the late fee.
Late Fee Unenforceable
In Dobson Bay Club II DD LLC v La Sonrisa De Siena, Dobson Bay argued that the late fee was “vastly disproportionate” to La Sonrisa’s actual damages, and that La Sonrisa had been compensated under the default interest, attorneys’ fees, and trustees fees provisions of the loan documents. La Sonrisa, on the other hand, argued that the late fee should be enforceable because it was a negotiated liquidated damages provision.
The court found the late fee as liquidated damages must be compensatory and not punitive. If the liquidated damage provision in a document established an “unreasonably large sum of liquidated damages,” that provision would be unenforceable because it would be deemed a penalty.
The court used a two-factor test to determine whether the late fee was reasonable, whether:
1) “The amount fixed is a reasonable forecast of just compensation for harm caused by the breach.”
2) The harm caused is “incapable or very difficult of accurate estimation.” The court noted the more difficult the estimation, the more latitude is granted in determining the amount of damages.
In Dobson Bay, the court found that the amount of the late fee was not in line with the anticipated or actual losses La Sonrisa suffered. The court reasoned when a lender makes a conventional loan, “the parties negotiate the interest rate, the default rate, the foreclosure of the collateral and numerous other provisions that compensate the lender in the event of a borrower’s default. The lender’s losses are not very difficult to estimate.”
The court further noted that “under most circumstances the imposition of a additional 5% late-fee on a balloon payment” for a conventional, fixed-interest rate loan is “strictly punitive in nature” and “not enforceable as liquidated damages.”
Lenders should make sure that their damages and out-of-pocket expenses are covered by other provisions of the loan documents (like default interest and attorneys’ fees provisions) because a late fee provision, even when negotiated, is not guaranteed to hold up in court. For more information, my colleague Larry Lerman wrote "Should Lenders Agree to Requests to Remove Late Fees From Promissory Notes?" about how to handle requests to remove the late fee from a promissory note.
Matt DiMeglio is a real estate and lending attorney who helps national, regional and local banks, credit unions and SBA lenders close loans. For more information on guaranty agreements, contact Matt at (301) 657-0721 or firstname.lastname@example.org.