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Arizona Supreme Court Invalidates Late Fee Assessed on Unpaid Principal Balance at Maturity

Financial Institutions Law Alert Scott A. Klundt

The Arizona Supreme Court filed an opinion on April 25, 2017, in which the Court invalidated a five percent late fee assessed against the unpaid principal balance when the loan matured, holding that it was an unenforceable penalty.

The promissory note at issue provided that the borrower would pay a five percent late fee on any late payment, including the final balloon payment. The borrower failed to pay the balloon payment on the maturity date. The lender then assigned the promissory note and the deed of trust to a third party (the "Noteholder"), which recorded a notice of trustee's sale.

Prior to the trustee's sale, the borrower requested a payoff statement. The Noteholder provided a payoff statement that included a late fee in the amount of $1.4 million, which represented five percent of the balloon payment that was due upon maturity. The borrower disputed the late fee and tendered payment of all amounts except for the late fee. When the Noteholder refused to release the deed of trust, the borrower sued for a declaratory judgment, asking the court to declare that the borrower was not obligated to pay the late fee.

The trial court granted summary judgment in favor of the Noteholder, finding that the late fee was enforceable as liquidated damages "because it reasonably forecasted the harm caused by the default and the harm was otherwise difficult to accurately estimate." The borrower appealed.

On January 28, 2016, the Arizona Court of Appeals reversed the trial court's judgment and held that imposing a five percent late charge on the balloon payment was unreasonable. The court reversed the entry of summary judgment in the Noteholder's favor and directed that the trial court enter summary judgment in the borrower's favor on its claim for declaratory relief. The court also granted the borrower's request for an award of the attorneys' fees the borrower had incurred in connection with the appeal. The Noteholder filed a Petition for Review, asking the Arizona Supreme Court to hear the case.

In its Opinion, the Court recognized that "[p]arties to a contract can agree in advance to the amount of damages for any breach," but explained that parties "do not have free rein in setting liquidated damages." [¶¶8, 9.] In order to determine whether a liquidated damages provision, such as a late fee, would be enforceable, the Court adopted the test stated in Restatement (Second) of Contracts, §356(1), which provides that a liquidated damages provision is enforceable, "but only at an amount that is reasonable in light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss." [¶12.] Applying this test, Court held that the late fee "did not reasonably forecast anticipated damages likely to result from an untimely balloon payment" and also "did not reasonably approximate" the actual loss suffered by the Noteholder. [¶¶20, 29, 32.] Significantly, the Court noted that the Noteholder was adequately compensated for its loss of use of the balloon payment as a result of the default interest rate that the borrower was required to pay. [¶31.]

Having decided that a five percent late fee on a balloon payment was unenforceable, the Court directed the trial court to enter summary judgment in favor of the borrower and also awarded the borrower its attorneys' fees incurred in connection with the appeal.

The Lesson: Arizona courts will evaluate the enforceability of a liquidated damages provision, including a provision imposing late fees, based on whether the amount being imposed reasonably approximates the actual loss suffered by the lender. A nominal late fee assessed against untimely monthly payments may be enforced, but a late fee assessed against a balloon payment due upon maturity likely will not be enforced, unless the lender can demonstrate that the amount of the late fee reasonably approximates the actual loss suffered by the lender.

For more information, please contact Scott Klundt at (602) 229-5212 / scott.klundt@quarles.com or your local Quarles & Brady attorney.