In re 1141 Realty Owner LLC, 598 B.R. 534 (Bankr. S.D. N.Y. 2019) –

A debtor objected to a proof of claim filed by a mortgagee that included a Yield Maintenance Default Premium. The debtor argued that the mortgagee had accelerated the loan so that any prepayment premium should be disallowed as unenforceable. The proof of claim totaled ~$32 million and included a “make whole” or yield maintenance premium of ~$3.1 million.

Prior to bankruptcy the mortgagee’s counsel sent the debtor a Notice of Default and Acceleration demanding immediate repayment in full of the principal sum of ~$24.2 million with interest because, among other things, the debtor failed to maintain valid liquor licenses permitting it to serve alcoholic beverages at its hotel. A month later the loan servicer sent a Notice of Additional Defaults. The debtor did not contest the defaults, although it insisted it did not intentionally default.

Instead the dispute centered on whether the mortgagee was entitled to collect a yield maintenance premium under the circumstances. The loan agreement defined the Yield Maintenance Default Premium as an amount equal to the greater of: (1) 3% of the principal amount being repaid and (2) the excess if any of (a) the present value of all scheduled payments of principal and interest with respect to the principal amount being paid (using a discount rate based on a Treasury Rate) over (b) the principal amount being paid.

Under the loan agreement, generally the debtor could not prepay the loan prior to maturity except in accordance with the agreement. The agreement further provided that any payment after an event of default was deemed a “voluntary prepayment” that required payment of the Yield Maintenance Default Premium. Accordingly, the mortgagee included the yield maintenance premium in its proof of claim.

The debtor argued that the premium was unenforceable under state law because the mortgagee had accelerated the debt, requiring disallowance of the prepayment premium. In response the mortgagee contended that charging a premium was allowable under the unambiguous terms of the loan agreement. The debtor’s further reply was that the court would uphold a premium after acceleration only if the loan agreement specifically referenced payment after acceleration, and the agreement did not mention acceleration.

After discussing contract interpretation rules relating to ambiguity, court proceeded to outline applicable state law (New York):

• Under the “perfect tender” rule a debtor has no right to prepay a mortgage loan prior to its stated maturity date unless the mortgage contains a prepayment clause (or there is other statutory authority).
• The reason for this rule is the mortgagee’s right to receive bargained for income over the life of the loan.
• A negotiated prepayment or “make whole” premium gives the debtor an option to prepay while still giving the mortgagee the benefit of its bargain. The mortgagee obtains yield protection while the debtor obtains freedom of action.
• Generally, acceleration of the debt after default causes the mortgagee to forfeit a prepayment premium, since by definition the maturity date has been advanced and there is no prepayment.
• However, courts recognize two exceptions: (1) a clear and unambiguous provision requiring payment of the prepayment premium even after default and acceleration will be enforceable, in which case the provision is analyzed as a liquidated damages clause, and (2) if the debtor intentionally defaults to trigger acceleration and evade the premium, the mortgagee will be able to enforce the premium.

In connection with the first exception, the court emphasized that the parties are free to determine the specific terms applicable in the case of a default or acceleration.

In this case, the loan agreement clearly imposed the yield maintenance premium in connection with any payment after a default which was deemed to be a voluntary prepayment. The provision did not specifically mention allowing the premium after acceleration, but the court found that was not necessary since it was clear the premium was payable regardless of acceleration.

Thus, the court examined whether the yield maintenance provision was a valid liquidated damages clause as opposed to an unenforceable penalty. In setting the stage for this determination, the court emphasized that this historical distinction “has become increasingly difficult to justify,” so courts should not interfere with the parties’ agreement “absent some persuasive justification.”

Liquidated damages are enforceable if (1) it was difficult to determine actual damages at the time of the agreement, and (2) the amount was not “plainly disproportionate.” So, the party challenging the liquidated damages provision must either prove that damages were readily ascertainable or the damages were disproportionate. In this case the debtor gave “short shrift” to the issue, so the court found it did not carry its burden of proof.

Accordingly, the court determined that the Yield Maintenance Default Premium was enforceable under New York law, and the debtor’s objection was overruled.

The theme of the decision was that “parties can provide for their rights with any language that plainly covers their intent.” This appears to give the parties carte blanche, at least under New York law. However, there is still the test of whether a provision survives as a valid liquidated damages clause. For example, if the debtor was making a regularly scheduled monthly or quarterly payment after default and was charged a yield maintenance premium based on the entire outstanding principal amount (as opposed to the principal amount of the payment), that would probably be disproportionate and thus an unenforceable penalty.

Vicki R Harding, Esq.