Arizona Court of Appeals Division One holds that a lender cannot recover liquidated damages of 5% on a balloon payment for a conventional loan with a fixed interest rate because such damages are unreasonable and punitive in nature.

A borrower signed a $28.6 million promissory note secured by a deed of trust.  The loan agreement provided that the borrower would make interest-only installment payments and a final balloon payment at maturity, and included a late-fee provision obligating the borrower to pay an additional 5% on any unpaid sums.

The borrower failed to timely make the final balloon payment.  The initial lender assigned the debt to another party, who then initiated foreclosure proceedings and demanded payment of the loan balance, interest, and a $1.4 million late fee equal to 5% of the balloon payment.  The borrower paid the outstanding loan balance, but disputed the late fee.  Litigation ensued, and the trial court granted the creditor partial summary judgment after concluding that the late fee was enforceable as liquidated damages.  The borrower appealed.

The Court of Appeals Division One reversed.  Applying the two-factor test from the Restatement (Second) of Contracts § 356 for evaluating the enforceability of a liquidated damages clause, the Court concluded that the 5% fee was unreasonable and unenforceable as a penalty.  First, the Court found that the late fee did not reasonably approximate the anticipated or actual damages suffered by the creditor (who had purchased the debt knowing it was in default) as a result of the borrower’s failure to timely pay the balloon payment.  The Court explained that given the nature of conventional, fixed-rate loans, a 5% late fee on a balloon payment for such a loan is strictly punitive.  Second, the Court found that the borrower’s breach presented no difficulties of proof, because the resulting damages were easily ascertainable.

On this analysis, the Court held not only that the late-fee provision in the loan agreement was unenforceable, but also that as a matter of law, the imposition of a 5% late fee on a balloon payment for a conventional fixed-rate loan will generally be unenforceable.

Judge Brown delivered the opinion; presiding Judge Swann and Judge Jones joined.