Collecting A Prepayment Premium: Plain Language May Not Be So Plain

Bank of New York Mellon v. GC Merchandise Mart, L.L.C. (In re Denver Merchandise Mart, Inc.), 740 F.3d 1052 (5th Cir. 2014)

A lender sought to recover a prepayment premium of $1.8 million after acceleration of a note due to the borrower’s payment default. After the bankruptcy court and district court disallowed the lender’s claim, it appealed to the 5th Circuit.

The note included a provision that stated that if any payment was not paid within 10 days after the due date, the loan, including principal and interest, became immediately due and payable. The note also contained a section on prepayment. During an initial lockout period, the borrower was prohibited from prepaying. After that, the borrower could prepay all (but not less than all) of the principal and interest on the condition that it paid “Prepayment Consideration.” The prepayment section also referenced the concept of “Default Prepayment,” which meant a prepayment made during a period of default or after an acceleration of the maturity date. In particular:

Borrower shall pay the Prepayment Consideration due hereunder whether the prepayment is voluntary or involuntary (including without limitation in connection with the Lender’s acceleration of the unpaid principal balance of the Note) or the Security Instrument is satisfied or reduced by foreclosure (whether by power of sale or judicial proceeding), deed in lieu of foreclosure or by any other means.

The court framed this matter as a question of contract interpretation under state law. Under applicable state law:

  • A lender may refuse early payment, but may waive this right by contract.
  • If a lender does not waive this right, the borrower may not prepay without paying all future interest as well.
  • However, if a lender does waive its right to refuse prepayment, then it is not entitled to any prepayment penalty unless expressly provided for in the contract.
  • Generally acceleration of a note constitutes a waiver of a prepayment penalty.
  • This is subject to the exception that a court may elect to impose a prepayment penalty if it appears that the borrower defaulted in order to avoid paying the additional interest.

The 5th Circuit noted that the prepayment premium was not a remedy for a breach of contract, but rather consideration for the privilege of prepaying. Consequently (1) payment was not subject to a liquidated damages analysis, and (2) thus was not subject to a rule of reasonableness, (3) which in turn meant that the payment should not trigger Section 506(b) of the Bankruptcy Code (which requires charges to be reasonable).

In this case, the bankruptcy court concluded that the prepayment penalty applied only to payments that were actually made. Since the borrower defaulted and did not pay, there was no prepayment. Further, there was nothing that would deem acceleration to be a prepayment.

The 5th Circuit found this analysis to be persuasive. It distinguished the language on this case from the following language from another case where a prepayment claim was upheld:

The undersigned [borrower] agrees that if the holder of this Note [lender] accelerates the sum or any part of the principal sum… the undersigned waives any right to prepaid said principal sum in whole or in part without premium and agrees to pay a prepayment premium. (emphasis added)

The court felt that this quoted language evidenced a clear intent that the prepayment premium would be applicable in the case of acceleration, and found no comparable expression of intent in this case. Instead, the note in this case “plainly provides” that nothing is owed “unless there is an actual prepayment, whether voluntary or involuntary.” Accordingly, the 5th Circuit affirmed the lower court decisions disallowing the lender’s prepayment claim.

It seems likely that the lender fully expected that it would be entitled to collect a prepayment premium even though it accelerated the note – otherwise, why specifically reference acceleration? In drafting documents, it is important to consider and address the possibility of an unexpected literal interpretation of the language, since there is no assurance that a court will interpret the language in context or as intended.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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