The U.S. Court of Appeals for the Fourth Circuit recently held that a lender’s practice of charging late fees when the amount of the payment was insufficient to cover both the scheduled payment and earlier late fees violated Maryland’s Credit Grantor Closed End Credit Provisions (CLEC).

However, the Court also held that the lender’s practice of applying payments first to late charges, then to accrued interest, and then to principal, as well as the lender’s internal accounting practices, did not violate CLEC.

A copy of the opinion is available at:  Link to Opinion.

In 2009, the defendant lender extended a personal loan to the plaintiff borrower in the amount of $2,620.72 and the borrower executed a promissory note in favor of the lender.

In relevant part, the note required the borrower to make 36 monthly payments of $102.23 and provided that if the borrower did not pay each monthly installment by the first day of each month, plus a five-day grace period, she would owe a late charge of $25.  In addition, the note provided that all payments were “to be applied first to late charges, then to accrued interest, and finally to principal.”

Pursuant to the note, the borrower had three potential methods for making her monthly payments: (1) she could pay in person at one of the lender’s branch offices during normal business hours; (2) she could pay over the phone during the lender’s normal business hours; or (3) she could pay by mail.

Accordingly, per the terms of the note, “there were no means by which…[the lender] could receive a payment on a given day after the close of business.”  Thus, the lender’s practice was to post late charges on its internal accounting records after the close of business on the fifth day of a five-day grace period.

For the first three months that payments were due, the borrower made timely payments for slightly more than the $102.23 owed for each payment.  However, in the months that followed, she made four payments late and was charged a $25 late fee for each late payment.  In December 2010 and February 2011, she made a payment of $106 within the five-day grace period.  However, the lender still charged her a $25 late fee on each of those payments because “it applied that month’s payment first to prior late fees and then to interest and principal” therefore, according to the lender, “leaving only a partial payment of interest and principal” for the December 2010 payment.

Eventually, the borrower paid off the note (long after it matured) and after having been charged more than 40 late fees.

Subsequently, the borrower sued the lender alleging that the lender violated CLEC by (1) applying her payments first to late fees, then to interest, and then to principal; and (2) imposing a late fee on two timely payments.  The borrower also alleged that the lender’s accounting procedures purportedly violated the terms of CLEC and the note.

Following a motion to dismiss and later motion for summary judgment, the U.S. District Court for the District of Maryland dismissed all of the borrower’s claims.  She appealed.

On appeal, the Fourth Circuit affirmed judgment as to the dismissal of the borrower’s claim that the lender’s accounting practices somehow violated CLEC and the borrower’s claim that the lender’s practice was to apply payments first to late fees, then to interest, and then to principal.  In so holding, the Court explained that “CLEC expressly allows a creditor to impose late charges” as long as those charges are imposed consistently with the terms of the agreement between the parties (i.e. the note) and in accordance with any restrictions under the CLEC statute.

The Court examined the statute and noted two relevant restrictions on late fees: (1) that no “more than 1 late…charge may be imposed for any single payment or portion of payment, regardless of the period during which it remains in default;” and (2) that all payments “shall be applied to satisfaction of payments in the order in which they become due.”   The Court held that the borrower’s executed note did not run afoul of any CLEC provisions.

Nevertheless, the borrower argued that under the terms of the note and relevant CLEC provisions, the lender was permitted to apply each monthly payment “only to principal and interest” and not “late fees” because those fees were not part of the “scheduled payments” as defined in the note.

The Court rejected that argument.

It held that, per the terms of the note, the amount the borrower agreed “to pay each month is separate from how…[the lender] agreed to apply those payments.”

Moreover, the Court held that the borrower’s interpretation of the note was nonsensical because it “would require that each payment be applied to only interest and principal, leaving for some later unspecified date that payment of late charges” and that this interpretation was plainly “not supported by either the language of the note or by CLEC.”

Accordingly, the Court held that the lender’s practice of applying payments first to late charges and then to principal and interest was legal under CLEC and consistent with the note.

Likewise, the Court held that the lender’s practice of booking or assessing a “late charge on its internal accounting records is irrelevant to the issue of whether it properly charged the borrower with a late fee.” Moreover, the Court noted that the evidence showed that the borrower was only charged late fees when she did not pay within the grace period—except in two instances unrelated to the lender’s accounting practices (as discussed below), which were unrelated to the lender’s accounting practices.

Accordingly, the Court rejected the borrower’s contention that the lender “somehow violated the promissory note by ‘assessing’ late fees on its books” and held that its accounting practices did not violate CLEC.

However, the Court also held that by charging late fees on timely payments in December 2010 and February 2011, the lender violated CLEC and the terms of the note.  The lender argued that these two late fees were appropriate because, although the payments were timely and for slightly more than the required scheduled amount, the payments were insufficient to cover prior late fees, plus the $102.23 required amount, and therefore, not a timely payment of the full amount owed for that month.

The Court rejected this argument.

It held that the lender’s argument “confuses the note’s specification of the amount of payment with its authorization as how to apply each payment.  Nowhere in the note is the monthly payment defined to be more than $102.23.”  Accordingly, the Court held that although the lender was permitted to apply the borrower’s monthly payment “first” to any previous late charges, nothing in the note supports the lender’s contention that a timely payment for the scheduled amount “of $102.23 was insufficient.”

Moreover, the Court held that the lender’s interpretation of the December 2010 and February 2011 payments as only partial payments would result in “effectively compounding or pyramiding late charges” in violation of CLEC because it would result in more than one late charge being assessed for “any single payment.”

Therefore, the Court held that the lender was “not entitled to charge a late fee in December 2010 or February 2011, or in any month” in which the borrower “paid an installment timely and in full.”

Accordingly, the Fourth Circuit reversed and remanded the borrower’s claim regarding the December 2010 and February 2011 late fees, but affirmed dismissal of her other claims.