Virtually every real estate investor can benefit from this week’s success story: learning how to tell if the late fee in your promissory note is unenforceable.
Problem:  A client, who is a mortgage broker, called and said one of his borrower clients had failed to make a hefty balloon payment on a loan when it came time to pay it off.  He said the lender was claiming the borrower owed a late fee, under the promissory note, of an additional 10% of the entire balloon payment (the balloon payment was the entire principal balance, since this was an interest only note), which amounted to tens of thousands of dollars .  He asked me if I thought there was anything I could do to help his client or was the situation as “hopeless” as it seemed.  As it turned out, there was indeed hope.
Solution:  I told my mortgage broker client I needed more information.  His borrower client retained me.  I asked him to send me the promissory note so I could review the provision.  As it turned out, the late fee clause had two major problems: (1) even though it was a “standard” paragraph in one of the lender’s “standard” forms, it was missing some key language that, we argued, rendered the language fatally vague and ambiguous, and; (2) even if the vague and ambiguous language was interpreted to favor the lender, it was still unenforceable as a matter of law. 

Why? 

Because, as a matter of law, the lender’s late fee clause was a form of “liquidated damages” and, as drafted, it was an “unreasonable”, invalid “penalty” and, thus, uneforceable, as our research results explain:
A late payment charge is essentially a form of liquidated damages. Therefore, even when a late charge is not otherwise regulated by specific statute…, its validity is subject to the restrictions on liquidated damages …

 “Reasonableness” issue: Broadly, the validity of a liquidated damages clause is tested by its “reasonableness”:

“[A] provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.”

• [6:233] A late charge will be deemed invalid as “unreasonable” (an invalid “penalty”) if assessed against the entire unpaid principal balance. [Garrett v. Coast & Southern Fed. Sav. & Loan Ass’n (1973) 9 C3d 731, 740, 108 CR 845, 851—“It is an attempt to coerce timely payment by a forfeiture which is not reasonably calculated to merely compensate the injured lender”]

• [6:233.2] A promissory note’s clause requiring the obligor to pay 10% of any installment tendered late is an unenforceable penalty provision if applied to the final balloon payment. “[W]e can state as a matter of law a late charge provision covering administrative expenses that amounts to $614.67 for one late payment and $77,614.67 for another is not a reasonable attempt to estimate actual administrative costs incurred … ” [Poseidon Develop., Inc. v. Woodland Lane Estates, LLC (2007) 152 CA4th 1106, 1115–1116, 62 CR3d 59, 65–66 (noting provision expressly indicated late charge was to compensate for administrative expenses)]

Cal. Prac. Guide Real Prop.
Trans. Ch. 6-F (emphasis original; citations omitted)

Since the lender’s offending clause said borrower was obligated to pay an additional 10% of the entire delinquent final balloon payment (in other words, an additional 10% of the entire unpaid principal balance), it ran afoul of both the Garrett and Poseidon cases mentioned above.  When I pointed that out to the lender, we were quickly able to settle the amount of exorbitant lender’s liquidated damages claim for a fraction of their demand.  Obviously, the client was very pleased.
Lesson:  Too often, investors get intimidated by so-called “standard” forms.  So much so, they go into what I call “standard form hypnosis”—when they hear it’s a “standard” form, they assume it’s bulletproof.  Don’t make that mistake.  I have found a legal toehold in “standard” forms published by even the most respected companies, either in the form itself, or in the way certain blanks were completed, or in the addendum the parties attached.  More importantly, don’t ever assume a problem is “hopeless”. 

Our lawyers have combined experience of almost 100 years solving our clients’ problems.  On many occasions, through creativity, persistence, and strategic, appropriately aggressive lawyering, we have surpassed our clients’ highest expectations.  Give us an opportunity to surpass yours.


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