Daily Development for Wednesday, February 1, 2006
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

MORTGAGES; PREPAYMENT; BANKRUPTCY: Another case finds that bankruptcy courts will accept as ‘reasonable” a liquidated damages type yield maintenance clause predicated on borrower default and bankruptcy sale.

In re AE Hotel Venture, 321 B.R. 209, 2005 Bankr. LEXIS 166 (Bankr. N.D. Ill., 2005), aff’d sub nom:  AE Venture v. GMAC Commercial Mortgage Corp., 2006 U.S. Dist. LEXIS 2040 (Jan. 26, 2006)

AE Hotel Venture ("AE Hotel") owned and operated a suburban Chicago hotel property, and obtained a mortgage loan on the property in 1997 in the amount of $7.6 million from LaSalle National Bank ("LaSalle").  The bankruptcy court held that a prepayment-premium provision in the mortgage-loan documents was enforceable, in connection with a public-auction sale of the property in the mortgagor-debtor's Chapter  11 bankruptcy proceeding, where the contract provision provided that the premium would be due if it occurred after default and prior to a foreclosure sale of the property. 

The court held that in order to be deemed "reasonable" under ? 506(b) of the Bankruptcy Code, the prepayment-premium provision must pass a two-part test. First, the prepayment premium must be enforceable under applicable state law, and second, the premium must meet the tests under Sec. 506(b), i.e., it must be "provided for under the agreement" and must be "reasonable." In a footnote, the court stated that the bankruptcy courts "appear" to have adopted two different approaches to whether the provision is reasonable: either the prepayment premium must reflect the lender's actual damages or it must meet the criteria of a valid liquidated-damages provision.

The court had no problem finding that the prepayment premium clearly was provided for under the agreement, and noted that"[s]ensibly, AE Hotel does not deny that the Note provides for prepayment."

AE Hotel argued, however, that although the note provided for prepayment, by accelerating the debt GMACCM had waived its right to the prepayment premium. As the court succinctly stated, however, "AE Hotel is mistaken."  The court referred to the large body of case law holding that while a lender may lose its right to a prepayment premium if it elects to accelerate the debt, this is not the case where the provision specifically states that the premium is due after acceleration. In this case, the provision did not directly mention "acceleration," but instead stated that payment of the debt after default would be a "voluntary prepayment" as long as the payment occurred "before a foreclosure sale or some other sale resulting from GMACCM's remedies under the mortgage." The  court ruled that in this case there was no such sale because the property was sold pursuant to a court-approved auction sale and not pursuant to the foreclosure proceeding instituted in state court by GMAC, which ha

d been halted by AE Hotel's bankruptcy proceeding.

The bankruptcy court also ruled that the prepayment premium was enforceable under state law, noting that "no Illinois decision says prepayment premiums are per se unenforceable." Id. at 219-220. According to the court, enforceability of such clauses under Illinois law "depends on whether the premium is meant to liquidate damages or impose a penalty." Id. at 220.

The court (while acknowledging that the liquidated-damages analysis was somewhat flawed when the contract is negotiated by sophisticated parties) found that the provision in this case clearly was not a penalty and was enforceable under the criteria for the enforceability of liquidated damages clauses existing under Illinois case law. This was so, the court reasoned, because AE Hotel did not deny that the clause was an attempt by the parties to liquidate damages in the case of prepayment or that the contractual calculation of the premium precisely determined the securitization trust's loss and damages. AE Hotel argued that somehow the fact the mortgage loan was later securitized affected the reasonableness of the prepayment premium under a liquidated-damages analysis, but the court found that this fact was irrelevant to its determination -- and, in fact, securitization of the loan made timely payments during the term of the loan essential and "according to GMACCM an unidentified pr

ovision of the Internal Revenue Code restricts the trust's reinvestment of prepaid funds to low-yield U.S. Treasury securities." Id. at 220 n. 13.

AE Hotel also alleged that the amount of the prepayment premium calculated pursuant to the contractual formula, $1.8 million, was "quite large" and amounted to more than 18% of the loan balance. The court rejected this argument, holding that the size of the premium is irrelevant under Illinois law; the real issue is the relation between that amount and the lender's projected actual loss. The court again pointed out that in this case GMACCM had permissibly, and correctly, calculated its exact loss in accordance with the contractual provision.

Finally, AE Hotel argued (somewhat half-heartedly) that GMACCM had no compensable loss because it had received an amount in excess of the value of the property from the bankruptcy sale.

The court summarily rejected this argument, stating that "GMACC made the loan, not to gain the benefits from some eventual sale of the property, but to obtain the income stream from AE Hotel's loan payments. The loan documents contemplated payments, they did not contemplate a sale. GMACCM's loss is therefore the loss of the income stream." Id. at *30.

The appeals court reasoned that because the foreclosure proceeding was halted by the bankruptcy proceeding and never concluded or reinstated, the prepayment therefore did not result from foreclosure and the sale (via subsequent auction) was therefore "voluntary" and subject to the prepayment provision under the terms of the loan agreement. The Federal District Court also agreed with the bankruptcy court that, when read in its entirety, the loan agreement provided for a prepayment penalty even in the event of acceleration, and ruled that AE Hotel "failed to present evidence supporting the unreasonableness of the prepayment premium, let alone the formula they now take issue with, to the bankruptcy court." Id. at *13.

Reporter’s Comment:  It is amazing that the borrower, AE Hotel, even bothered contesting the validity and enforceability of the prepayment premium provision, given the facts of this case.

It is true that numerous cases, including recent cases such as Broadway Bank v. Star Hospitality, Inc., 2004 Iowa App. LEXIS 1294 (Nov. 24, 2004), (a decision based on Illinois law), have held that a prepayment penalty provision in a mortgage loan agreement is unenforceable when there is a default driven acceleration where the clause does not distinguish between voluntary and involuntary prepayments. In a Seventh Circuit decision, In re LHD Realty Corp., 726 F.2d 327, 329-30 (7th Cir. 1984), cited and referred to by the bankruptcy court in the AE Hotel case, the Seventh Circuit 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.

But the LHD 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. case law, both bankruptcy and non-bankruptcy, also has consistently 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.  A lender is always well advised, from a drafting standpoint, to state specifically  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.

Editor’s comment: As Jack suggests, but is too nice to come out and say, this prepayment premium language was really awful by modern standards.  Possibly the lender apparently was trying to skate around collecting the prepayment premium following prepayment through an acceleration and foreclosure.  But, as indicated in the above cited cases, this is really not necessary.  It is perfectly all right (most places) to demand a prepayment premium as part of the foreclosure claim following acceleration.  The acceleration, in essence, is the prepayment event.  That’s when it is clear that the lender is no longer being paid at all (much less as originally scheduled) and the lender must face the consequences of the loss of its loan. 

Perhaps the odd wording was dictated by bargaining environment of the parties.  Perhaps the borrower was insisting that it should not be charged a prepayment premium in the event of an “involuntary” prepayment.  If that is the case, then perhaps the borrower didn’t get the benefit of its bargain.  But one assumes it attempted to present evidence of the true intent of the parties at the trial, and wasn’t convincing. 

Here is some further commentary from Jack on his report of the original bankruptcy court decision, almost one year ago exactly:

“The court noted [here] that the prepayment premium provision did not specifically mention acceleration of the debt, but reasoned that the language of the provision made acceleration of the debt "irrelevant," because the provision provided that any tender of payment before a sale or other exercise of GMACCM's remedies under the loan documents (which would exclude a bankruptcy sale), would be deemed a "voluntary prepayment." Nonetheless, it may be a good idea to use specifically the word "acceleration" in a loan prepayment-premium provision, to avoid any issue as to the actual meaning and intent of the language. The following is suggested language excerpted from a current securitized-mortgage-loan note:

“Additional Charge. If this Note is prepaid on any day other than a Due Date, whether such prepayment is voluntary, involuntary or upon full acceleration of the principal amount of this Note by Lender following a Default, Borrower shall pay to Lender on the prepayment date (in addition to the basic prepayment charge described in Section ___ above and all other sums then due and owing to Lender under this Note and the other Loan Documents) an additional prepayment charge equal to the interest which would otherwise have accrued on the amount prepaid (had such prepayment not occurred) during the period from and including the prepayment date to and including the last day of the month in which the prepayment occurred.”

The Reporter for this item was Jack Murray of the Chicago office of First American Title Insurance.  The editor has edited substantially Jack’s submission, and is responsible for any glitches.

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