Daily Development for Thursday, February 9, 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; PREMIUM:. A borrower who knowingly triggers a loan default in order to achieve other financing goals has “voluntarily” caused a prepayment when the lender accelerates in response, and the analysis of whether the prepayment premium is legitimate should focus only on whether the premium is “reasonable,” and not whether it meets liquidated damages standards.

Clean Harbors, Inc. v. John Hancock Life Ins. Co., 833 N.E.2d 611 (Mass. App. Ct. 2005).

Clean Harbors, Inc. sought a judicial  declaration that the “make whole amount” upon prepayment provision in the loan it received from John Hancock Life Insurance Co. was not enforceable.  Clean Harbors asserted that its prepayment of the loan was involuntary, compelled by Hancock’s acceleration of the loan upon Clean Harbor’s default under the loan terms, and that the make whole provision constituted a prohibited penalty under liquidated damages analysis.

Clean Harbors had entered into this relatively short term (seven year) 16% mezzanine financing arrangement due to a downturn in profits as opportunities to sell its services contracted and competition increased.   Under the terms of the note, the prepayment premium clearly applied whether the prepayment was voluntary or was brought about through acceleration due to default.  The court doesn’t describe the premium calculation in great detail, but it appears to be somewhat typical “yield maintenance” computation based upon federal funds plus 250 basis points.  But the high initial interest rate led to a very high premium computation - an estimated $17 million on a loan amount of $35 million.  In fact, Clean Harbors financial advisor had been warned in advance that the prepayment premium would be that order of magnitude.

Subsequent to that loan, Clean Harbors got an opportunity to acquire a major competitor.  It was convinced that if it didn’t make the acquisition, another competitor would, and this would lead to the ruination of Clean Harbors’ business.  But the acquisition required a major financing - $255 million - that would put Clean Harbors in breach of many of the financial covenants in the Hancock loan.  The proposed lender would not accept that consequence, and required that Hancock be paid off.  Clean Harbors  contacted Hancock, explained the situation, and asked that it be permitted to pay off the Hancock loan without premium, and Hancock refused.

Subsequently, Clean Harbors, on advice of counsel, elected to trigger a breach of the Hancock loan, forcing an acceleration, in the hope that this would be regarded by Massachusetts courts as an “involuntary” acceleration, which, under that state’s decisions (consistent with those in most states) would require analysis of the premium as liquidated damages. 

The Superior Court ruled that the “make whole provision was enforceable, finding that Clean Harbors had voluntarily prepaid the loan and that the make whole amount was not a penalty.  Clean Harbors appealed. 

The Appeals Court agreed.  It also  found that liquidated damages analysis, which renders such damages unenforceable if they are grossly disproportionate to a reasonable estimate of actual damages at the time the loan was executed, was not applicable to this loan because it was voluntarily prepaid. 

The court’s statement as to the test that is applied in to voluntary prepayments is worth scrutiny.  It state that, when loans are voluntarily prepaid, a contractual provision providing a premium to the lender for early payment, should be reviewed only to assure that it bore a “rational relation to the lender’s actual damages upon prepayment, thus securing the benefit of the bargain for the lender.”

When reviewing such contractual premiums in voluntary prepayment cases, the Appeals Court stated that the “first look” approach used in liquidated damages analysis should be used, and so damage estimates at the time the loan was executed are appropriate, as opposed to such estimates at the time of the breach or the time of repayment.  Finding that the estimated make whole amount at the time the loan was entered into bore a rational relation to the anticipated losses that John Hancock would incur upon prepayment, the Appeals Court declared the make whole amount provisions enforceable. 

The Superior Court ruling was upheld, but the case was remanded on a related usury claim against other lenders involved in the transaction. 

Comment 1: What puzzles the editor is the court’s description of the “rational relationship.”  It sounds to the editor very much like a typical liquidated damages analysis.  The trial court had simply held that the premium was a bargained for price to exercise an early repayment option, and left it at that.  The trial court’s analysis is most consistent with the treatment of the issue in most jurisdictions (outside of bankruptcy courts.)

Some language in the opinion suggested that the appeals court is saying very little more than the traditional test. The emphasis on the notion of “benefit of the bargain” of course is valuable, but what does “rational relation” mean?  The court’s next statement is very helpful.  Describing a precedent case which it was following, it stated that “[w]e considered whether the contractual premium bore a rational relation to the lender’s damages only to ensure that the amount was not unconscionable.”

This suggestion that simple unconscionability is the test will be more comforting to lenders.  When one is talking about a major high risk loan between two sophisticated parties, in which Deutschebank was the loan broker, one in which the lender estimated the potential premium amount in advance and so informed the broker, it is hard to imagine any number that a court should find unconscionable. 

Comment 2: But the court goes on to say that the test it has in mind should look directly at the anticipated losses to be suffered by the lender, looked at as of the time of the initial loan.  Although this clearly steered the court away from a “second look” at the lender’s actual injury at time of prepayment, a test applied by some courts using true  liquidated damages analysis (but only a minority), it nevertheless requires some greater level of justification than that the deal was struck by sophisticated parties with full knowledge of its meaning. 

Ultimately in analyzing specifically the prepayment formula used here, the court stated that the index of 250 basis points over prime was “consisted with the anticipated yield on new investments made by John Hancock’s Bond Group overall during the preceding two years.   The borrower argued that this was not a reasonable estimate of Hancock’s loss upon prepayment because the loan in question was a “B” grade loan, not typical of the Hancock portfolio. 

The court concluded that the evidence submitted by borrower only served to show that other formulas were possible and could have been used.  It stated that “the evidence does not render [the formula used] irrational, particularly given the uncertainties surrounding the availability of high yield reinvestment opportunities at the time of any prepayment.”

Fair enough.  But what if the index had not satisfied that test?  Wasn’t it freely and fairly bargained?  Why is it different from any other option price?  The lender didn’t have to permit prepayment at all.  Hmmmm. 

Comment 3:  Note that we're only talking here about voluntary prepayment outside of bankruptcy.  Most of the cases are decided in bankruptcy courts, where an independent standard of reasonableness applies.

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