Understanding Late Fees & Default Interest
By: Michael Witt, Founder - Witt Law & LEAN Member
Friends, here’s a quick primer on something you may already know—but can you explain the difference? Do you understand the difference between late fees and default interest? Do your lease forms provide for the charging of both on late payments? If not, you should read on…
I’m often surprised how many lessors and their collection managers are under the mistaken belief that late fees and default interest are duplicative or at least overlapping remedies, and therefore that their lease form cannot provide for the recovery of both. The fact is, they are two entirely different remedies, with different legal considerations applying to each. A well-written lease intended for general use should contain both if the lender wants to reserve all opportunities to maximize the recovery of damages resulting from late payments.The legal justification for charging a late fee on a late payment is that the late payment is a breach of contract requiring the creditor to take collection action, and that the costs of taking action (e.g., the costs of employing collection personnel, mailing demand letters, and making distance phone calls) are damages recoverable under general principles of contract law. Since it is impossible to know, at the time the contract is formed, what the exact amount of those damages will be in any given future situation, the law of liquidated damages permits the creditor to recover a liquidated amount (usually expressed as a percent of the late amount) stated in the contract, provided only that the amount is determined to be a reasonable estimate of actual damages and not a penalty.
A default interest clause is also a kind of liquidated damages provision. By contrast with a late fee clause, however, it is not designed (or at least should not be designed) as a remedy to recoup the lessor’s internal collection expenses, but only as a means of compensating the lessor for the time-value of money that is paid late. In the typical lease (whether it is a true lease or a lease intended as security) the periodic payment amount is pre-determined when the contract is formed. This amount is priced to bring the lessor a pre-determined return on its investment. Since a lease is not an interest-bearing instrument, if an installment is paid late, the lessor will not receive its bargained-for return without being able to charge default interest. Hence, the law allows for default interest in addition to late fees.
It is beyond the scope of this note to delve into all the factors that should be considered by a lessor in establishing a contractual late-fee amount and default interest rate. However, I will briefly mention two potential class-action risks that exist mostly in the small-ticket space. The first deals with grace periods. Since the a late fee provision is designed to allow a lessor to recoup its internal collection expenses and must be reasonably related to its estimated actual expenses, it would be wise to have a grace period that does not end until the time (i.e., number of days delinquent) that the lessor’s collection activity generally begins pursuant to its collection policy. The second deals with default interest rates.
The rate should be reasonably aligned with the lessor’s estimated average annual lease investment returns over the term of the lease. Estimating on the high side probably will not be problematical, but simply throwing a rate of 18% (which seems to be the most popular rate used in the small-ticket area) into the contract could create a risk, since it is probably at least double the rate needed to be made whole.
LEAN member Michael J. Witt is the Founder of Witt Law located in West Des Moines, IA. The practice is uniquely concentrated in the area of commercial equipment leasing and finance. Michael Witt has more than 25 years’ experience in the field.
Mike can be reached at:
4342 Oakwood Lane
West Des Moines, IA 50265