Default interest rates and late fees are common provisions in many loan agreements. When reasonable in scope, they serve as a useful means of ensuring that a creditor can recover for the sort of incidental damages it suffers when a debtor defaults on the terms of its loan – such as administrative expenses and other costs above and beyond the underlying interest rate. But like any other contractual provision, default provisions are only useful to the extent courts are willing to enforce them, and if a default rate is too high, it is liable to be struck down. How does one tell if a default rate is too high? The answer is unclear in Massachusetts. The problem has to do with the uncertain relationship between the Massachusetts Usury Statute, M.G.L. c. 271, § 49, and principles of contract law.
At the very least, default provisions have to comply with the Usury Statute. That statute makes it a criminal offense to charge “greater than twenty per centum per annum,” and it also gives courts the discretion to void contractual provisions which exceed that amount. The Statute has been found to apply to default provisions, and at first glance, it would appear to provide debtors with significant protection against exorbitant default rates. Section 49(d) of the Usury Statute, however, goes on to state that creditors do not have to comply with the 20% cap so long as they notify the attorney general of their intent to charge usurious interest rates and comply with certain record keeping requirements. As a result, so long as creditors take fairly minimal precautions, the Usury Statute is unlikely to place much of a limitation on what default provisions they can include in their loan agreements.
But if a creditor notifies the attorney general pursuant to Section 49(d) of its intent to charge a usurious default interest rate, is it therefore free to charge whatever it wants? The Usury Statute, after all, is not the only grounds on which a default provision can be struck down. Courts, for example, have held that default interest rates and late fees constitute “liquidated damages” provisions, and not all liquidated damages provisions are enforceable. Rather, a liquidated damages provision will be held void unless (1) “at the time of contracting . . . actual damages flowing from a breach were difficult to ascertain,” and (2) “the sum agreed on as liquidated damages represents a reasonable forecast of damages expected to occur in the event of a breach.” NPS, LLC v. Minihane, 451 Mass. 417, 420 (2008) (internal quotation marks omitted). Otherwise, a liquidated damages provision will be found to be an unenforceable “penalty.” So default provisions would appear to be vulnerable if they do not reflect a reasonable forecast of uncertain harm, and plenty of default provisions have been struck down on precisely that basis. See, e.g., De Cordova v. Weeks, 246 Mass. 100, 104 (1923) (36% default interest rate found unenforceable as a penalty); SMS Fin. V, LLC v. Conti, 68 Mass. App. Ct. 738, 751 (Mass. App. Ct. 2007) (“A provision calling for double a recovery on a promissory note in a principal amount that exceeded $300,000” was unenforceable); Fleet Bank of Mass. N.A. v. One-O-Six Realty, Inc., Civ. A. No. 94-3392-G, 1995 WL 389862, at *3 (Mass. Super. Jan. 17, 1995) (Mass. Super. Jan. 31, 1995) (finding that “a 5% [monthly] late charge on a multi-million dollar balloon payment at maturity” was unenforceable).
The question then becomes whether compliance with the Usury Statute somehow immunizes a creditor from review under a “penalty” analysis. Here, the law gets unclear. On the one hand, at least one federal district court has suggested that, so long as the attorney general is notified, creditors have a defense against any challenge to a default rate. RFF Family P’ship, LP v. Link Dev., LLC, 932 F. Supp. 2d 213, 224 (D. Mass. 2013). This makes some intuitive sense. After all, it would be strange if the legislature expressly created a procedure whereby creditors could charge interest rates above 20% only to leave those rates subject to invalidation on some other basis.
By contrast, in In re 201 Forest Street LLC, 409 B.R. 543 (Bankr. D. Mass. 2009), the Bankruptcy Court determined that compliance with Section 49(d) did not prevent a court from reviewing a default provision under the liquidated damages framework. While the Court did not provide a detailed explanation for its holding, there are certainly arguments that could be made. For one, Section 49(d), according to its plain text, creates an exception only to the Usury Statute itself – it says nothing regarding other non-statutory defenses. Furthermore, reading Section 49(d) as abrogating a liquidated damages defense would be illogical from a policy perspective. The Usury Statute and the liquidated damages analysis, after all, address distinct concerns – the former seeks to regulate rates which are simply too high whereas the latter is concerned more with ensuring that default provisions are proportional to the likely foreseeable harm. Moreover, if Section 49(d) really did allow creditors to impose what would otherwise constitute unlawful “penalties,” the Usury Statute would create rather bizarre incentives. Creditors who charged interest rates above 20% would be granted immunity whereas creditors who charged less could conceivably be subject to higher judicial scrutiny because they fall outside of the Usury Statute’s scope. Creditors, therefore, might be encouraged to charge higher interest rates – precisely what the Usury Statute is intended to curb.
Unfortunately, Massachusetts state courts have provided little guidance regarding the interplay between the Usury Statute and contract law. The closest the SJC has come was in Begelfer v. Najarian, 381 Mass. 177 (1980). In Begelfer, the creditor charged a default interest rate in excess of 20%, and because it failed to first inform the attorney general as per Section 49(d), the Court affirmed the Superior Court’s decision to strike down the default interest rate as being usurious. The Court, however, then went on to conclude that “[w]ere [it] to treat the default charges in [that] case as ‘liquidated damages’ [it] would strike the default provision as” an unlawful penalty as well. The Court’s language here was somewhat unclear; the SJC may have been saying that default provisions have to pass muster under both the Usury Statute and the common law liquidated damages framework, or it may have been saying that the liquidated damages inquiry would only have applied had the Usury Statute not. But because the creditor in Begelfer failed to comply with Section 49(d), the Court never had to squarely address this issue.
More recently, in Olde Center Ventures, Inc. v. Dinapoli, No. 13–P–1307, 2014 WL 4211117 (Mass. App. Ct. Aug. 27, 2014), a case before the Massachusetts Appeals Court, the creditor did comply with Section 49(d) and argued that its doing so defeated the debtor’s claim that a late fee constituted a penalty. The Court was therefore squarely presented with the question of whether compliance with the Usury Statute precludes a penalty defense. While the Court acknowledged this issue, however, it determined that it did not need to resolve the scope of Section 49(d) because it determined that the late fee was not a penalty in any event. As a result, the question of whether compliance with Section 49(d) permits creditors to impose default obligations that would otherwise be penalties remains an open question in Massachusetts.
In the face of this uncertainty, what should parties who enter into loan transactions do? For creditors, it is important to understand that simply complying with Section 49(d) may not be enough when it comes to default provisions. Creditors, rather, should, at the very least, be prepared to justify why they chose the rates and fees that they did and ideally be able to relate those rates and fees to their actual costs. Creditors can also draft the penalty provisions in such a way that they are calibrated to rise as the costs of default gets higher, such as by having default rates and fees grow larger as the default continues over time. The burden of proving a penalty, ultimately, will lie with the debtor, so creditors should be able to successfully defend default provisions so long as they are adequately prepared to do so.
As for debtors faced with onerous default provisions, it is important to remember that while the Usury Statute may not be much of a sword with which to attack default rates, it is not necessarily a shield for creditors either. Certainly, any debtor trying to argue that a default provision is an unlawful penalty faces an uphill fight. But default provisions are more vulnerable than many other contractual terms, and if a creditor raises Section 49(d) as a defense, a debtor should be prepared to argue to the contrary.
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Ultimately, it is unclear in Massachusetts as to how high default rates in loan agreements can be – and the higher they get, the less clear it becomes. The Usury Statute may not help debtors very much, but at the same time, it may not help creditors either. Absent more guidance from the courts of the Commonwealth, parties to loan agreements should be aware of this uncertainty and take appropriate steps. For creditors, that may mean more caution when drafting default provisions; for debtors, that means an opportunity to get out of them.
If you have any questions, please contact Thomas R. Sutcliffe, an associate in Prince Lobel’s Litigation Practice Group and the author of this post. You can reach Tom at 617 456 5054 or [email protected].