Daily Development for Thursday, August 5, 2004
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri dirt@umkc.edu

Jack Murray reported this case to me as a new case, so I’ll take him at his word, despite the 2001 date. Sometimes cases are slow to report. In any event, it deals with several significant current issues in a relatively unusual way. This is his work, with my edits. In keeping with the DIRT tradition of discussing only one major issue per case, I’ve divided Jack’s report into two DD’s. The second one will run tomorrow. Ed.

MORTGAGES; PREPAYMENT; PREPAYMENT PREMIUMS; ACCELERATION TRIGGER: A "defeasance fee" may be imposed on a mortgagor in default when the mortgagee accelerates the payment of the debt and the mortgagor did not "voluntarily" prepay the mortgage before the maturity date, even where the loan documents do not expressly provide for a defeasance fee in the event of acceleration and foreclosure following default..

LaSalle Bank v. Mobile Home Properties, LLC, 2004 U.S. Dist. LEXIS 14401 (D. La., July 27, 2001), discussed further under the heading: “Mortgages; Non-recourse; “Carve Outs;” “Bad Boy” Clauses.”

LaSalle, acting as a trustee for a securitized loan, accelerated the loan and foreclosed on the property as a consequence of a variety of defaults by the borrower. LaSalle completed its foreclosure of the hotel - with the express consent of MHP and Columbus - with a winning credit bid of $6.9 million, and gave MHP a credit for this amount. (LaSalle eventually resold the hotel for $2.1 million.) LaSalle then demanded payment of a deficiency of approximately $3.1 million, which included "a yield maintenance premium and defeasance fee totaling $2,161,484.00." (The remaining amount included late fees, default interest, attorney's fees, and other costs and expenses.)

MHP then commenced a declaratory action, claiming inter alia that it did not owe the yield-maintenance fee and prepayment premium because there was no "voluntary" payment.

MHP argued that the yield-maintenance/prepayment fee was only payable, under the clause in the mortgage note, if it "voluntarily" prepaid the note and not if it defaulted (leading to an acceleration and prepayment through foreclosure). The court didn't buy this argument, noting that while the note provided that the borrower could repay the note (or release the property from the mortgage lien) prior to the "defeasance option" date set forth in the mortgage, the mortgage stated explicitly the terms and conditions for the release of the property prior to such date "if no default exists." Moreover, the court noted, the note itself further provided that if MHP tendered prepayment of the mortgage loan prior to the defeasance option date, and following the occurrence of any Event of Default," such tender would be deemed voluntary and would require payment of "the yield maintenance premium, if any, that would be required under the Defeasance Option."

The court acknowledged that the loan documents were silent regarding the specific issue of whether payment of the prepayment/defeasance fee would be due if MHP simply defaulted and made no attempt to pay the fee prior to foreclosure. But the court noted that Alabama follows the "majority rule," i.e., "even if the loan documents are silent regarding prepayment, the borrower has no right to repay the mortgage note without payment of unearned interest." The court noted that the imposition of a yield maintenance premium is intended to provide an uninterrupted stream of income of replacement income to lenders equal to the lost interest payments occurring as the result of the borrower's prepayment of the loan, thereby protecting mortgage lenders against the loss of a favorable interest yield. According to the court, the yield-maintenance/defeasance premium "is in effect a payment of the unearned interest due to the lender," and that "to conclude otherwise would be to reward a borrower who defaults and makes no effort to pay its debt by relieving the borrower of its additional obligations under the loan documents." The court also noted that both MHP and Columbus had consented to LaSalle's foreclosure of the hotel, and that it "construes that consent as a voluntary transfer of a payment of the debt in the form of the mortgaged property in satisfaction of the lien, although not an amount sufficient to pay the debt in full." The court also found to be reasonable the amounts imposed on MHP with respect to late fees, default interest, attorney's fees, and other costs and expenses.

Reporter’s Comment 1: This case is not surprising with respect to the prepayment issue. But it does highlight the need for lenders to draft their prepayment provisions carefully to "cover all the bases" and not let the borrower slip through on a technicality. The court helped the lender out a little in this case, noting the absurdity and unfairness that would result if the borrower could avoid paying the prepayment premium simply by deliberately defaulting on the loan for the sole purpose of avoiding payment of the prepayment premium. More careful drafting of the clause probably would have eliminated any argument whatsoever by the borrower with respect to enforceability of the clause where the loan had been accelerated.

Reporter’s Comment 2: But what about the situation where the prepayment provision does not expressly state that acceleration of the loan will also trigger the obligation of the borrower to pay a prepayment premium?

In Westmark Commercial Mortgage Fund IV v. Teenform Associates, L.P., 2003 WL 21692731 (N.J. Super. Ct. App. Div.) (the DIRT DD for Nov. 20, 2003) a New Jersey state appellate court ruled that the state would adopt the view espoused in the Restatement of Mortgages - permitting a mortgagee to impose a prepayment penalty on a mortgagor in default even when the mortgagee accelerates the payment of the debt.

The note in question included a prepayment premium, explaining, in set-off, emphasized language, that the "prepayment premium represents a reasonable and fair estimate of compensation for the loss that holder may sustain from the prepayment of this note. The borrower acknowledges and agrees that it has no right to prepay this note in whole or in part without the prepayment penalty[.]" As the note demanded, the mortgagor acknowledged this language by initialing a space below it.

The court noted that New Jersey law does not permit a borrower to prepay a commercial loan absent a document permitting prepayment and that, while the right to impose a prepayment penalty is not unlimited, that penalty serves to protect mortgagees against the loss of a favorable interest yield. The court went on to distinguish the two views on whether a lender may impose a prepayment penalty when the lender accelerates the debt.

Citing the Seventh Circuit Court of Appeals in In re LHD Realty Corp ,726 F.2d 327., the court explained that one view states that prepayment after a lender accelerates the maturity date is not prepayment but instead is payment made after the maturity. Thus, no prepayment penalty may be imposed. Furthermore, in the case of a lender-accelerated maturity, the lender has established by its act "that it prefers accelerated payment to the opportunity to earn interest over a period[,]" and therefore may not impose a prepayment penalty on this involuntary prepayment. Id. at 331.

The Westmark court, however, then noted that other courts have found to the contrary, allowing lenders to collect prepayment penalties even when those lenders initiate the early payment. The court quoted the Restatement (Third) of Property: "The [mortgagor's early] payment may be 'involuntary' in the sense that the mortgagor would prefer that the debt not be accelerated, but it is still the mortgagor's action in defaulting that triggers the acceleration." Mortgages 6.2 comment c (1997).

Citing the deference to parties' agreements shown in Metlife v. Washington Avenue Associates, L.P., 159 N.J. 484 (1999), the court then declared the Restatement more persuasive and held that the sophisticated debtor should not be "relieved of the terms of the contract freely entered into." Not to enforce the penalty, the court said, would be to provide the mortgagor "with a better contract [it] [was] able to negotiate for [itself]." In so holding, the court abrogated Clinton Capital Corp. v. Straeb, 589 A.2d 1363 (N.J. Super. Ct. Ch. Div. 1990), which had followed the holding in LHD, supra.

[The editor, reporting on the Westmark case, commented that it was difficult to be sure that this really was a holding that prepayment premiums may always be charged on acceleration or whether it is simply a holding that in this case the parties' contract should be interpreted in that way.]

Reporter’s Comment 3: Prepayment provisions, both yield-maintenance and otherwise, have often been challenged by borrowers on the basis that the prepayment was "involuntary" and therefore not covered by the provision. A lender would be well advised, from a drafting standpoint, to specifically state, in the prepayment provision contained in the loan documents, that the lender will be entitled to collect the contracted-for prepayment premium in the event of an acceleration of the loan upon default by the borrower.

If the right to collect a prepayment premium upon acceleration of the loan is not stated in the loan documents, courts generally will not permit the lender to collect it. See, e.g., In re LHD Realty Corp., supra, 726 F. 2d at 330 (refusing to permit the lender to collect a prepayment premium after the borrower's default because the prepayment clause did not clearly provide that the premium could be collected upon acceleration after default); Tan v. California Fed. Sav. & Loan Assoc., 140 Cal. App. 3d 800, 824, 189 Cal Rptr. 775, 809 (1983) (concluding that the terms of the prepayment penalty provision applied only when the borrower voluntarily exercised the prepayment option, and stating that "[t]he language of the 'prepayment privilege' provision rather clearly makes a prepayment penalty payable only upon the debtor's exercise of the reserved privilege to prepay"); Rogers v. Rainier Nat'l Bank, 111 Wash. 2d, 232, 238, 757 P. 2d 976, 979 (1988) (holding that because the promissor y note did not provide for any specific penalty as the result of acceleration upon default as the result of acceleration upon default, the court "cannot supply a provision which the parties omitted"); Slevin Container Corp. v. Provident Federal Sav. & Loan Ass'n, 98 Ill. App. 646, 648, 424 N.E. 2d 939, 940 (1981) (holding that acceleration, by definition, advances the maturity date of the debt so that payment thereafter is not prepayment but instead is payment made after maturity); Baybank Middlesex v. 1200 Beacon Properties, Inc., 760 F. Supp. 957, 966 (1991) (same; but noting that the parties "could have expressly provided for such a contingency [involuntary prepayment] in their agreement" and "the inclusion of such a provision in the Indenture would have entitled the [mortgagee] to the damages they now seek"); Kilpatrick v. Germania Life Ins. Co., 183 N.Y. 163, 168-169, 75 N.E. 1124, 1125-26 (1905) (ruling that by accelerating the debt and commencing foreclosure proceedings, th e mortgagee had made an irrevocable election to treat the entire debt as due and payable and could not thereafter, upon tender of the entire amount owing by the mortgagor, terminate the foreclosure but only accept payment accompanied by a prepayment "bonus" or penalty); Coca-Cola Bottling Co. of Portland, Indiana, Inc. v. Citizens Bank of Portland, 583 N.E.2d 184, 190-91 (1991) (holding that "[a]n election to accelerate a debt may become irrevocable if the election reasonably causes the defaulting party to rely and act upon the acceleration to its detriment; the court noted that the parties could presumably have waived the protection provided by detrimental reliance by "clear and unequivocal language to that effect," but the loan documents did not contain such language); Zwayer v. Ford Motor Credit Co., 279 Ill. App. 3d 906, 909-10, 665 N.E.2d 843, 845-46 (1996) ("[t]here is no provision specifying that the [prepayment-premium provision] will be applied . . . upon acceleration. S ince payment upon [the mortgagee's] choice to accelerate the loan is not prepayment, [the mortgagee] is not entitled to assess a prepayment penalty"); In re Maywood, Inc., 210 B.R. 91, 94 (N.D. Texas 1997) ("[w]hen acceleration of the loan is triggered by the lender, Illinois law does not enforce termination fees"); cf. 22 Gifford Associates v. Citicorp Mortgage, Inc., A-5381-96T3 (N.J. Super. App. Div. 1998) (unreported decision) (holding that language requiring the payment of a prepayment fee "whether or not the payment is voluntary or involuntary" was not sufficient to permit the mortgagee to collect the fee where the loan had been accelerated by the mortgagee, because no "prepayment" had occurred; the court noted that if the mortgagee expected to enforce the prepayment-penalty provision in the event of its own action (accelerating the loan), the provision should have specifically so stated); Eyde v. Empire of America Fed. Sav. Bank, 701 F.Supp. 126, 128-29 (E.D. Mich 1988) ("a lender may lose its right to a premium when it elects to accelerate a debt. This is so because acceleration, by definition, enhances the maturity date of the debt so the payment made thereafter is not made a prepayment but instead is payment after maturity"); Eyde Bros. Dev. Co. v. Equitable Life Assurance Society, 888 F.2d 127, 1989 WL 130632, at **3-**4 (unpublished per curiam) (rejecting lender's claim to prepayment premium because load documents did not expressly provide for such a charge in the event of acceleration).

But see Mutual Life Ins. Co. of New York v. Hilander, 403 N.W.2d 260, 264 (Ky. App. 1966) (upholding right of mortgagee to collect prepayment premium where mortgagor paid off mortgage, including prepayment premium under protest, in response to mortgagee's threat to accelerate defaulted loan, even though prepayment provision did not specifically mention involuntary prepayments); West Portland Dev. Co. v. Ward Cook, Inc., 246 Ore. 67, 71, 424 P.2d 212, 214 (Or. 1967) (rejecting mortgagor's argument that once mortgagee elected to accelerate the debt its election was irrevocable and no prepayment was due when mortgagee subsequently rescinded its election, and ruling that because there was no evidence that mortgagor changed its position or was prejudiced the mortgage payoff must included the prepayment penalty).

As noted above, courts have generally upheld the enforceability of a prepayment provision where the clause clearly states that it applies if the loan is accelerated as the result of the mortgagor's default under any of the terms and conditions of the loan documents. See, e.g., Parker Plaza West Partners v. UNUM Pension and Ins. Co., 941 F.2d 349 (5th Cir. 1991). In Parker Plaza,, the court reversed the holding of the District Court, which had denied enforcement of a contractual yield-maintenance prepayment provision based solely on the fact that the prepayment by the borrower was "involuntary," i.e., that the provision provided for collection of the premium upon acceleration by the lender, rather than upon the borrower voluntarily making the payment. The borrower had sued the lender to recover payment of the premium, alleging that it was a penalty under Texas law. The court noted that it could find no Texas case law holding that prepayment provisions are only valid when a volunt
ary prepayment is made by the borrower, and stated that parties to a contract have the right to contract for any provisions they wish, so long as the contract does not violate public policy and is not illegal. The court also found that the prepayment provision, which was "unambiguous, clear and unequivocal," did not constitute a usurious contract or an illegal restraint on alienation, was not "unreasonable or oppressive," and did not violate public policy.

See also Pacific Trust Co. TTEE v. Fidelity Sav. & Loan Assn., 184 Cal. App. 3d 817, 824, 229 Cal. Rptr. 269, 274 (1986) (permitting acceleration upon default by the borrower and acceleration of the debt by the lender where the prepayment clause by its terms applied to an acceleration by the lender after default; the court stated that "[t]he instant clause is intended to apply in the event the lender elects to accelerate and describes such a payment as an involuntary payment. . . . [T]here is no ambiguity which may be resolved against the lender who presumably drafted the note. ... Thus, we find that the clause applicable to the facts of the instant case")); Biancalana v. Fleming, 53 Cal. Rptr. 2d 47, 50, 45 Cal. App. 4th 698, 703 (1996) (upholding the enforceability of a prepayment charge after acceleration of the debt by the lender, and noting that "the note in this case indicates that the prepayment penalty is intended to apply when the lender accelerates"); Ridgely v. Topa Th rift & Loan Ass'n., 54 Cal. App. 4th 729, 738, 62 Cal. Rptr. 2d 309, 318 (1997) ("The instant provision indicated the prepayment penalty was intended to apply when defendant accelerated the note"); Virginia Housing Dev. Authority v. Fox Run Ltd. Partnership, 497 Va. 356, 365, 97 S.E.2d 747, 753 (1998) (holding that because the note provided that the mortgagee was entitled to a prepayment premium if it accelerated the debt as the result of a default, the mortgagee "was not required to include notice of its election to assess the prepayment fee as part of the debt owed upon acceleration of the principal debt"); Citicorp Mortgage, Inc. v. Morrisville Hampton Village Realty Ltd. Partnership, 443 Pa. Super. 595, 599, 662 A. 2d 1120, 1122 (Pa. Super. Ct. 1995) (holding that, with respect to a prepayment provision that required payment of the contractual premium regardless of whether the prepayment was voluntary or involuntary, the matter was governed by contract law and the parties, as sophisticated participants in a commercial loan transaction, were bound by the provision); Travelers Ins. Co. v. Corporex Properties, Inc., 798 F. Supp. 423, 428 (E.D. Ken. 1992) (holding that prepayment premium providing for payment if indebtedness is accelerated is enforceable as means of insuring the lender against loss of its bargain if interest rates decline); United States v. Harris, 246 F.3d 566, 573 (6th Cir. 2001)(rejecting government's argument that prepayment premium could not be collected because acceleration of the loan was "involuntary" as the result of a criminal forfeiture action; the court noted that the parties expressly provided for the payment of a prepayment premium in the event that the mortgagor lost ownership of the property through acceleration of the loan or foreclosure); MIE Md. Executive Park Gen. Partnership v. LaSalle Nat'l Bank, 2000 U.S. LEXIS 11558, No. 99-2066 (4th Cir. May 22, 2000) (unpublished per curiam) (finding that because the parties had bargained for the payment of a prepayment premium, the obligation survived the loan modification where the modification did not did not expressly address the prepayment premium); Westmark Commer. Mortg. Fund IV v. Teenform Asssocs., 362 N.J. Super. 336, 344 (2003) (discussed above); MONY Life Ins. Co. v. Paramus Parkway Bldg., Ltd., 364 N.J. Super. 92, 104 (N.J. Super. Ct. App. Div. 2003)("We can see no reason why the debtor should be relieved of the terms of the contract freely entered into. The terms were clear and unambiguous, the parties clearly experienced and sophisticated in loan transactions of this type"); Annotation, Construction and Effect as to Interest Due of Real Estate Mortgage Clause Authorizing Mortgagor to Prepay Principal Debt, 86 A.L.R. 3d 599 (2003).

Reporter’s Comment 4: In its finding that the defeasance fee should apply even when the documents did not specifically provide for such payment upon acceleration and foreclosure, the LaSalle case is an extraordinary win for the lender’s side. LaSalle case is a rare "threefer:" rulings on three separate issues, all of which holdings benefit the lender! The two aspects of the case other than the prepayment premium aspects are discussed in another entry, mentioned above.

Editor’s Comment: Many different considerations apply when a prepayment clause operates in the context of an acceleration and foreclosure as opposed to a true prepayment. It often is not enough simply to state that acceleration for default triggers a prepayment obligation. Thought must be given to the mechanics of how the clause actually works in each situation. Lenders (and borrowers as well) should “game” each of the different ways in which the clause might operate, so as to be sure that the language reflects their true intent.

The reporter for this item is Jack Murray of First American Title Insurance Company.

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