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Norwest Bank Minnesota, National Association v. Blair Road Associates, L.P.

252 F. Supp.2d 86 (D. N.J. 2003)

MORTGAGES; DEFAULT; INTEREST—The Court rejects a variety of arguments that an agreed-upon default interest rate was an unenforceable penalty.

In a contested mortgage foreclosure action, the borrower argued that the default interest rate was an unenforceable penalty. Under the terms of the loan, the “Default Rate” was to be “equal to (I) the greater of (a) the applicable Interest Rate plus three percent (3%) and (b) the Prime Rate (as hereinafter defined) plus four percent (4%) or (ii) the maximum interest rate that Borrower may by law pay, whichever is lower.” The borrower made a number of arguments. First, it alleged that a Default Rate interest clause tied to the greater of two formulas was per se penal “and not intended as a reasonable forecast of just compensation for harm caused by the breach.” Second, the borrower argued that “[a]t the very least ... to save the clause the lower of the two formulas should be used.” Next, the borrower argued “that a Default Rate based on prime plus 4% could far exceed the contract rate (7.88%) depending on what the prime might be.” It pointed out that “at times, the Default Rate was 5.62% above the contract rate.” It pointed to case law where such a ratio of Default Rate to contract rate was found unreasonable and unenforceable. The borrower also argued that the Default Interest Rate “should be no greater than the amount allowed by the Supreme Court of New Jersey in MetLife Capital Financial Corp. v. Washington Ave. Associates L.P., 159 N.J. 484, 732 A.2d 493 (N.J. Sup. Ct. 1999).” As another alternative, the defendant argued that the Default Rate should have been proportionately equivalent to the ratio of the “contract interest rate” and the “default interest rate approved in MetLife.” Lastly, the borrower argued that even if using a formula for the Default Rate was not penal, the lender could not switch from electing one rate to another rate once it had elected one of the choices.

The Court found all of those arguments “unpersuasive.” The same borrower was the defendant in the MetLife case. There, the Court validated a formula providing a default interest rate of five percent above the “prime rate” from time to time, or 15% per year. In the MetLife case, the New Jersey Supreme Court “recognized that: default charges are commonly accepted as a means for lenders to offset a portion of the damages occasioned by delinquent loans. As with the cost of late payments, the actual losses resulting from a commercial loan default are difficult to ascertain.” The Court, on the other hand, pointed out that such clauses require “judicial scrutiny because [they] may constitute an oppressive penalty and hence be unenforceable.” “Adopting the ‘modern trend,’ the reasonableness test is applied either at the time the contract is made or when it is breached.” Further, default interest rate provisions are presumptively reasonable and it is the opponent who has the burden of proving unreasonableness.

With respect to the rate being tied to the greater of two formulas, the Court pointed out that this was “a commercial contract that was negotiated between financially experienced parties.” Even though the borrower wanted the Court to make the lender justify the Default Rate, the Court rejected the borrower’s approach as “an attempt to shift the burden of proving unreasonableness from the party challenging the cause.” Examining the “totality of the circumstances,” the Court upheld the Default Interest Rate provision of the loan documents.

The borrower also argued that the Default Interest Rate and the default prepayment were duplicative and together constituted a penalty. Following acceleration, the borrower was required to pay a prepayment fee. The result was to almost double the effective Default Rate being imposed by the lender. In examining the borrower’s arguments, the Court posed the question as to whether “a prepayment penalty [should] be considered interest or ... ‘a charge for some service provided by [the lender] or finance charges?’” The Court found no New Jersey case answering that question but found that other courts ruled “that a prepayment premium is not interest at all because it is not compensation for the use of money but a charge for the option or privilege of prepayment, and that such a prepayment premium is enforceable even when the lender accelerates the debt, so long as the loan documents clearly provide for the premium.” In other words, “it is a sum representing a benefit that the borrower otherwise would not be entitled to.” Moreover, “nder New Jersey law unless the note gives the borrower the right to prepay the loan, the borrower is obliged to pay the full amount of the interest that he would have to pay over the term of the loan. ... Since the lender has the right not to have the loan prepaid but rely on collecting the interest contracted for, the lender is entitled to charge a penalty to the borrower for the privilege of prepayment.” The Court also cited language from MetLife, as follows: “Because default and late charges are not liquidated damages at all in the traditional sense, but are simply part of the pricing of commercial loans between sophisticated parties, MetLife asserts that in the absence of unconscionability or illegality, those charges should be enforced. We agree in today’s competitive market that ordinarily such charges are part of the cost of doing business. We, however, prefer to incorporate that factor into the ‘reasonableness’ test.”

The borrower also tried to rely on the literal language of the note which called for a Default Prepayment “occurring in connection with ... any sale in foreclosure… .” The borrower tried to argue that the prepayment fee was not due until a foreclosure sale actually took place. It did not support its argument with any case law. The Court wrote, “[i]t is not surprising that [the borrower did] not because it would frustrate the prevailing law regarding the effect and purpose of a foreclosure judgment. The express purpose of a judgment of foreclosure is to fix the amount due under the mortgage and direct the sale of the real estate to raise funds to satisfy the amount due. ... The construction urged by the [borrower] would defeat the purpose of the judgment: to ‘declare a sum certain immediately due and [to] commit the proceeds of the sale of specific property to its satisfaction.’”


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