Daily Development for Friday, December 1, 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

MORTGAGES; PREPAYMENT; PREPAYMENT PREMIUMS; ACCELERATION: Prepayment penalty provision in mortgage loan agreement was unenforceable where clause did not distinguish between voluntary and involuntary prepayment and bank's decision to accelerate debt and file foreclosure action resulted in involuntary prepayment.

Broadway Bank v. Star Hospitality, Inc., et al., 2004 Iowa App. LEXIS 1294 (Nov. 24, 2004).

In a case with confusing and sketchy facts, certain of the defendants executed a mortgage for $3,494,000 to Broadway Bank in 2001 on a hotel property in Davenport, Iowa. An individual, Syed Quadri, subsequently assumed the existing mortgage. According to the court, as collateral for the loan Quadri granted the bank a "first interest and assignment of rents against the hotel." Additional collateral, in the form of "CDs held in the name of the debtors and guarantors" (including a CD from Quadri in the amount of $532,229) as well as assignments of rents and second mortgages on Quadri's residential properties in Illinois, was also obtained by the bank. The aggregate value of this collateral was approximately $20 million.

The prepayment provision in the loan documents provided that if the principal amount of the loan was reduced by twenty percent in a one-year period, the prepayment penalty would be assessed equal to six months' interest. The loan documents also provided for a late charge of five percent and default interest of "ten points over the index upon default," and for the collection of attorney's fees if collection was necessary.

As a result of the occurrence of flood damage at the hotel and the terrorist attacks of September 11, 2001, the revenue from the hotel plunged and the bank granted Quadri a delay of three to four months to make payment on the loan. Quadri asked the bank to apply his CD to bring the past-due balance current and make future loan payments (the loan called for monthly payments of $33,014.99). The bank refused to do so, apparently believing that it would be left with insufficient collateral, and no payments were made on the loan. Quadri subsequently contacted the bank and inquired whether he could use the CD as collateral to secure a new loan at another bank and refinance the debt. The bank informed him that it had in fact converted his CD to a non-interest bearing account and had applied $192,574 to the outstanding loan balance, which brought the loan current within 30 days (but not completely current). The bank continued to charge default interest on the unpaid principal.

In March 2002, the bank filed a foreclosure action. The parties negotiated a settlement agreement providing for a "settlement sum" of $3,250,000 to be paid by the defendants. But the agreement also acknowledged that the defendants continued to owe an unpaid principal balance on the loan of $259,672, interest thereafter at 10.5%, mortgage release fees, and legal fees. The issues of the late fees, default interest, attorney's fees and, the prepayment penalty were preserved for later resolution, and were to be submitted by the defendants to arbitration, mediation or litigation within sixty days - but the defendants failed to do so.

The bank then filed a declaratory action, seeking the amount of $524,479, which included the outstanding principal due as well as late charges, default interest, attorney's fees, and the prepayment premium. After an evidentiary hearing, the trial court awarded the bank only $80,661, which included the principal owed of $70,493, interest on that amount from September 9, 2002 until the time of the ruling in the amount of $5168, and $5000 in attorney's fees. The court subsequently modified this ruling to allow a one-time late fee of five percent of the unpaid principal balance and increased the award of attorney's fees to $50,000 (increasing the total award to $129,186). The trial court made no award for the prepayment penalty, finding that the payment was "involuntary" and that to award the prepayment penalty would constitute unjust enrichment. The trial court reasoned that because the bank chose to accelerate the debt and commence a foreclosure proceeding, the defendants had !
not vo
luntarily "prepaid" the loan and the bank was not entitled to collect the prepayment penalty.

The appellate court reversed the holding of the trial court with respect to default interest, rejecting the trial court's finding that the bank had not acted in good faith in deeming itself insecure because the defendants were not in default due to Quadri's attempts to make payment on the loan by applying his CD. According to the appellate court, "The language of the promissory note regarding late charges, and default interest are [sic] clear and unambiguous. The settlement agreement between the parties did not extinguish [the bank's] ability to collect late charges and default interest. Rather, the agreement reserved defendants' right to adjudicate the issues at a later time. The availability of collateral to be used as a set-off is irrelevant to the issue of whether defendants were in default." The court further noted that even though Quadri was allowed to delay his loan payments for three or four months, he had failed to make any payments beyond that time.

With respect to the prepayment penalty, the appellate court concurred with the trial court's analysis and refused to permit the bank to collect the penalty, stating that "[t]he language of the promissory note does not distinguish between voluntary and involuntary prepayment." The court cited a Seventh Circuit bankruptcy decision, In re LHD Realty Co., 726 F.2d 327, 330 (7th Cir. 1984) for the proposition that "where a lender accelerates a debt, the right to prepayment is lost." The court also found that "under the Illinois law governing the action [the bank] is not entitled to the prepayment penalty."

Reporter’s Comment 1: Prepayment provisions, both yield-maintenance and otherwise, have been challenged by borrowers on the basis that the prepayment was "involuntary" and therefore not covered by the provision. A lender is always well advised, from a drafting standpoint, to specifically state in the prepayment provision in the loan documents that the lender will be entitled to collect the contracted-for prepayment premium if it subsequently accelerates the loan upon default by the borrower. The prepayment provision in the loan documents in the Broadway Bank case is one of the goofier clauses encountered by the reporter. The prepayment provision provided that if the principal amount of the loan was reduced by twenty percent in a one-year period, the prepayment penalty would be assessed equal to six months' interest. This is, frankly, a poorly drafted clause. It is not related in any manner to the lender's actual costs or damages and therefore is even less justifiable than !
a yiel
d-maintenance formula (if the court chooses to apply a liquidated-damages analysis or "reasonableness" standard). The use of this type of provision is not recommended, because (as with a "sliding percentage" clause, which was common before the advent of yield-maintenance prepayment provisions in the 1980s) it invites this argument by the borrower.

[The editor notes that, although this clause is “goofy” from the standpoint of modern commercial mortgage law, the “six months interest” penalty is a pretty standard formulation based upon residential mortgages, and in fact is a “safe harbor” penalty in some state statutes limiting prepayment premiums in residential loans. Further, the definition of prepayment as a reduction of more than 20% also is not unusual. The combination of the two might be seen as unusual, but not to a drafter who was not sensitive to the new thinking that emerged in the mid-80's concerning judicial restrictions on prepayment clauses.]
Comment 2: The LHD case (referred to by the court in the Broadway Bank case) was decided by the Seventh Circuit in 1984, and all (rational) institutional lenders quickly learned to include language specifically stating that the lender was entitled to the prepayment premium if it accelerated the loan. It is inexcusable that any institutional lender (such as the bank in the Broadway Bank case) would fail to include this additional language. [“Inexcusable,” perhaps, but not impossible. The editor has seen other examples, in and out of litigation.] 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. But the appellate court in the Broadway Bank case mischaracterizes the holding of the Seventh Circuit in the LHD case. The court in that case did not make a blanket statement that "where a lender accelerates a debt, the right to prepayment is lost." Rather, the !
in the LHD case refused 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. See In re LHD Realty Co., 726 F.2d at 330.

See also 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 promissory 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").

The appellate court in the Broadway Bank case also stated that "under the Illinois law governing the action [the bank] is not entitled to the prepayment penalty." The court likely is referring to Slevin Container Corp. v. Provident Federal Sav. & Loan Ass'n, 98 Ill. App. 646, 648, 424 N.E. 2d 939, 940 (1981), which held 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, and perhaps In re Maywood, Inc., I210 B.R. 91, 94 (Bankr. N.D. Tex. 1991) ("[w]hen acceleration of the loan is triggered by the lender, Illinois law does not enforce termination fees"). But these cases involved prepayment provisions that did not provide for collection of the prepayment premium upon acceleration of the debt. See Baybank Middlesex v. 1200 Beacon Properties, Inc., 760 F. Supp. 947, 966 (D.Mass. 1991) (same; but noting that the parties "could have expressly provided for such a conting!
ency [
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"); Coca-Cola Bottling Co. of Portland, Indiana, Inc. v. Citizens Bank of Portland, 583 N.E.2d 184, 190-91 (1991) ( "[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. Since payment upon [the mortgagee's] choice to accelerate the loan is not prepayment, [the mortgagee] is not e!
ed to assess a prepayment penalty"); 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).

See also 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 include the prepayment penalty).

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. In Parker Plaza West Partners v. UNUM Pension and Ins. Co., 941 F.2d 349 (5th Cir. 1991). In this case, 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 voluntary prepayment is made !
by th
e 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.

Comment 3: For other cases permitting the imposition of a prepayment premium where the loan documents provided that was due upon acceleration of the loan, see 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"); LaSalle Bank Nat'l Ass'n v. Sleutel, 289 F.3d 837, 842 (5th Cir. 2002) (ruling that under the language in the loan documents, the prepayment consideration could be accele!
along with the debt upon an event of default); 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 Thrift & 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")!
; Cit
icorp 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!
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. App. 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) ("we can perceive no reason why the debtor should be relieved of the terms of the contract freely entered into," and overruling Clinton Capital Corp. v. Straeb, 248 N.J. Super. 19, 32-33, 589 A.2d 1363, 1371 (1990), which prohibited, on equitable grounds, enforcement of prepayment penalty of 10% upon mortgagee's acceleration of defaulted lo!
an, ev
en though mortgage prepayment provision stated that "[t]he premium shall be paid whether prepayment is voluntary or involuntary, including any prepayment made after any exercise of any acceleration provision . . ."; the court in Clinton Capital stated that "the court construes the word 'involuntary' to mean actions taken by third parties which force the payment of the mortgage prematurely"); MONY Life Ins. Co. v. Paramus Parkway Bldg., Ltd., 364 N.J. Super. 92, 104 (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").

Reporter’s Comment 4: See also Restatement (Third) of Property: Mortgages § 6.2 comment c (1997) (permitting collection of prepayment premium upon acceleration of the loan unless found to be "unconscionable or to violate the duty of good faith and fair dealing").

Comment 1: Note that here we had a substantial default interest charge as well as a late payment penalty.

The Reporter for this item was Jack Murray of First American Title Insurance, Chicago office.

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