Commercial Lenders: Is Your Default Interest Provision Enforceable?

Many commercial loans contain what are called default interest provisions. When the borrower defaults, the interest rate on the loan increases from the agreed upon basic rate of say 5% to a much higher default rate of usually 18%. The provisions call for the default rate to apply upon any default by the Borrower under the loan agreement. A default can include a monetary default for failing to make required loan payments or a non-monetary default such as breaches of a promise to maintain a particular loan to value ratio, a promise not to transfer or encumber the loan collateral without consent of the lender, and similar promises in the loan documents.

The theory behind default interest provisions is quite obvious: to promote compliance with the payment terms and to discourage any actions or inactions that would increase the lender’s risk on the loan. Sounds reasonable, right? But it is possible courts in Washington may not enforce default interest provisions.

The problem is not that an 18% default interest violates the usury laws. Usury laws do not apply to commercial loans. Instead, the problem lies in courts’ equitable powers to “do equity”, or do what is fair. Under this power, courts take a hard look at any contractual remedy that sets a specific sum of money as damages for the breach of the contract. These are generally known as “liquidated damages” clauses. Such clauses are only enforced by a court if they are not a “penalty”. If the damages bear no reasonable relationship to the actual damages incurred by the non-breaching party, the damages will be held to be an unenforceable penalty. Courts also take into account the parties’ sophistication and level of expertise in determining enforceability, and are more likely to enforce the provision in the event both parties are sophisticated in commercial transactions.

There are no reported court decisions in Washington that specifically apply this sort of “penalty” or “reasonableness” analysis to default interest provisions in commercial loans. But courts in other states have. For example, the Supreme Court of New Jersey held a 15% default interest provision was unenforceable but ruled a default rate of 3% above the primary loan rate was reasonable based upon the increase in the lender’s risk upon default. While this decision is not binding on Washington courts, it could be cited and considered by judges here.

Overall, a court in Washington is more likely than not to apply the “penalty” or “reasonableness” analysis if a Borrower formally challenges the default interest rate. This obviously introduces an unwanted element of uncertainty for the lender. However, most lenders include default interest rate provisions in their notes not because they want or intend to collect default interest, but because they want to entice the borrower to comply with the loan agreements. In this respect, while default interest rates may not be legally enforceable depending on the situation, they continue to remain of value to lenders in making sure borrowers comply with their loan agreements.