2 Real Estate Financing Concepts To Review During COVID-19

By Steven Herman and Eunji Jo
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Law360 (September 10, 2020, 3:53 PM EDT) --
Steven Herman
Steven Herman
Eunji Jo
Eunji Jo
Given the effects that COVID-19 has had on the economy in general and the real estate industry in particular, it seems prudent to review the concepts of late charges and default rate interest in real estate financing transactions.

Since March, there has been a significant increase in the number of real estate financings which are experiencing distress due to the impact of COVID-19, and while there have been many defaults and late payments which have accrued, it is likely that this trend will continue for some time before it abates. The following is a refresher on the concepts of late charges and default rate interest in light of the foregoing.

In mortgage loan transactions, lenders will customarily charge a fee for late payments and additional (or default) interest upon a default. The late fee is often a percentage (e.g., 5%) of the unpaid installment and is meant to compensate the lender for its administrative costs in handling and processing the delinquent payment and for the loss of the use of such delinquent payment.

Default rate interest, on the other hand, is an increase in the interest rate by a specified percentage in the event of a default and is meant to compensate the lender for its increased risk in dealing with a borrower that has defaulted. Default interest is also meant to compensate the lender for any lost opportunity cost in reinvesting the loan proceeds and for its costs in administering a defaulted loan.[1] Finally, default interest serves as a deterrent to a borrower from defaulting a loan.

One issue that arises with respect to late charges is whether a late charge may be applied on the payment at maturity. Borrowers routinely object to charging a late charge on the balloon payment. In Trustco Bank New York v. 37 Clark Street Inc., the mortgage note provided that a late charge of 6 cents for each dollar overdue could be assessed "for the purpose of defraying the expense incident to handling delinquent payment."

The borrower failed to make a payment of the entire amount due under the note at maturity, and following that default, the lender accelerated payment. The lender sought to recover the late charge for the failure to make the balloon payment, and the borrower objected, arguing that the late charges were an oppressive forfeiture and impermissible penalty.

The Supreme Court of the State of New York, County of Saratoga, held that the late charge provision must be construed to apply only to defaults in monthly payments giving rise to collection expenses, not defaults of payments at maturity, such as a balloon payment resulting in acceleration. Such defaults, the court noted, terminate the borrower's right to correct the default. As a result, late charges did not apply to the balloon payment.[2]

In determining the enforceability of both late charges and default rate interest, courts have considered whether the amounts charged have a punitive intent. If charges are so high as to suggest a punitive intent rather than an intent to compensate the lender for its costs, courts have invalidated them.

In Emigrant Funding Corporation v. 7021 LLC, the contract interest rate was 7.25% and the default rate interest was 24%. The Supreme Court of the State of New York, County of Queens, reasoned that parties are free to agree that a contract rate of interest will increase upon a default, so long as the interest rate is not usurious or does not constitute a penalty.

In this case, the lender charged the borrower both the contract rate of interest and the default rate interest during the periods of time when the borrower defaulted in making timely installment payments. The court held that the charging of default rate interest in the amount of 24% in addition to the contract rate of interest of 7.25%, which results in a total charge of interest of 31.25%, was criminally usurious.

While each case is fact-specific, criminal usury in New York rarely applies to larger loans with sophisticated parties given existing statutory exemptions. However, the court rejected the borrower's argument that a 24% default rate of interest was a penalty and void as against public policy.

The court held that the default rate interest provision was valid and enforceable, noting that "it is well settled that an agreement to pay interest at a higher rate in the event of default or maturity is an agreement to pay interest and not a penalty."[3]

Another consideration for default rate interest is when it should be triggered — upon the occurrence of an event of default or when the lender accelerates the loan. Lenders would prefer the former, while borrowers would prefer the latter.

In in re: Crystal Properties Ltd. LP, the promissory note stated:

Should default be made in any payment provided for in this note, … at the option of the holder hereof and without notice or demand, the entire balance of principal and accrued interest then remaining unpaid shall become immediately due and payable, and thereafter bear interest, until paid in full, at the increased rate of five percent (5%) per annum over and above the rate contracted for herein. No delay or omission on the part of the holder hereof in exercising any right hereunder, … shall operate as a waiver of such right or any other right under this note…

The lender argued that because the note expressly stated that default rate interest is due and payable upon default without notice or demand, the default rate interest should have accrued at the moment of default. However, the U.S. Court of Appeals for the Ninth Circuit disagreed, noting that the language "at the option of the holder" provides that the right to accelerate the unpaid debt is at the lender's option.

Further, if the option is exercised, the note will thereafter bear interest at the default rate, and that can only mean that the default rate interest does not become effective unless the holder of the note exercises its option to accelerate. Consequently, the court concluded that the language of the note required the holder to exercise its option to accelerate before the default interest rate is triggered.[4]

In financing transactions, many borrowers will negotiate default rate interest provisions further to clarify whether the default rate interest accrues from the occurrence of the default or from the occurrence of an event of default. Many times, an event of default may not occur until a significant grace period has elapsed (such as 30, 60 and 90 days), and many lenders are loath to allow the accrual of default rate interest to be tolled for such an extended period of time.

Lenders will argue that if the default never ripens into an event of default, then the default would have been cured and the relevant issue would be rendered moot.

Late charges and default rate interest are monetary issues which should be carefully drafted to ensure that the parties have contracted for what ultimately will be enforceable and what was intended by the parties.

Steven Herman is a partner and Eunji Jo is an associate at Cadwalader Wickersham & Taft LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] The Law of Real Estate Financing, § 5:106.

[2] Trustco Bank New York v. 37 Clark St., Inc., 157 Misc. 2d 843, 599 N.Y.S.2d 404 (Sup. Ct. 1993).

[3] Emigrant Funding Corp. v. 7021 LLC, 25 Misc. 3d 1220(A), 901 N.Y.S.2d 906 (Sup. Ct. 2009).

[4] In re Crystal Properties, Ltd., L.P., 268 F.3d 743 (9th Cir. 2001).

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