Daily Development for Wednesday, February 23, 2005
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

I  know that we’ve beaten this topic to death lately, but Jack Murray does an excellent job and this discussion includes analysis of the specifics of liquidate damages justifications for prepayment premiums on acceleration, so I’ve decided to go with it.  It is the same case as that reported for other issues in the Tuesday DD.

MORTGAGES; PREPAYMENT; PREPAYMENT PREMIUM; ACCELERATION: Prepayment-premium provision in mortgage loan documents was enforceable in connection with sale of property in mortgagor-debtor's Chapter 11 bankruptcy proceeding, where contract provision provided that premium would be due if it occurred after default and prior to a foreclosure sale of the property.

In re AE Hotel Venture, 2005 Bankr. LEXIS 166 (Bankr. N.D. Ill., Feb. 16, 2005).

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"). LaSalle was the trustee for a securitization trust, and the loan was subsequently securitized; i.e., pooled with other loans and sold to investors pursuant to the issuance of mortgage-backed pass-through certificates. LaSalle designated GMACCM Commercial Mortgage Corp. ("GMACCM") to act as special servicer of the trust; the court in this case discusses the claim of the mortgagee as if it belonged to GMACCM.

Several years later AE Hotel defaulted under the loan, and GMACCM accelerated the debt and filed a foreclosure action in Illinois State court. A few days later, AE Hotel filed a Chapter 11 bankruptcy proceeding, in order to gain time to sell the hotel.  The bankruptcy court subsequently approved a sale of the hotel property for $7.8 million. Prior to the sale, GMACCM filed its proof of claim, seeking (as set forth in the loan documents): (1) a late payment charge equal to 5% of the unpaid balance of the loan (2) default interest at the rate of 14.72% (a 5% increase over the contract rate of 9.72%); and (3) a prepayment premium based on a yield-maintenance prepayment formula, discounted to present value. AE Hotel objected to GMACCM's request for payment of the default interest and prepayment premium as part of its allowed claim (but not to payment of the late charge).

The bankruptcy court noted that no facts were in dispute and that AE Hotel had conceded, as a factual matter, that the yield-maintenance prepayment-premium provision in the loan documents (which the court "translated roughly into English") provided a "precise method" of determining GMACCM's loss and was "an exact calculation of the damage" that would result from prepayment of the loan.

On  the issue of the enforceability of the contractual prepayment premium, the court reasoned that in order to be deemed "reasonable" under Sec. 506(b) of the Bankruptcy Code, such a premium 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, wh!

 ich h
ad 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." 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." 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 ruled, 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 mor!

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 provision of the Internal Revenue Code restricts the trust's reinvestment of prepaid funds to low-yield U.S. Treasury securities."

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 the 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, t!

 hey d
id not contemplate a sale. GMACCM's loss is therefore the loss of the income stream."

Reporter's Comment 1:  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. 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; this case was the DIRT DD for Dec. 1, 2004), have held that a prepayment penalty provision in a mortgage loan agreement is unenforceable where the clause does not distinguish between voluntary and involuntary prepayments. But 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 specifically state in the prepayment provision in t he 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. In the Seventh Circuit decision, In re LHD Realty Corp., 726 F.2d 327 (7th Cir. 1984), cited and refe!

 rred t
o 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. Id. at 330.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. In the AE Hotel case, the court noted that the prepayment premium provision did not specifically mention acceleration of the debt, but reasoned that the language of the provision made acc eleration 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 specifically use 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.

Reporters' Comment 1:  The bankruptcy court in the AE Hotel case states that, under Illinois law, "[e]nforceability depends on whether the premium is meant to liquidate damages or impose a penalty." But this is less than clear. Lenders commonly argue that, in contrast to a liquidated damages provision, which is entered into in advance of a breach of contract to fix damages for a particular breach, a prepayment premium is simply "bargained for consideration" for the contractual option to prepay the loan. In a federal case cited by the court in the AE Hotel case for the proposition that under Illinois law prepayment premiums are subject to a liquidated damages analysis, Auto. Fin. Corp. v. Ridge Chrysler Plymouth, L.L.C., 219 F.Supp. 2d 945, 951 n.5 (D.

Ill. 2002), the court stated that "a traditional liquidated damages analysis [is] an imperfect tool for analyzing prepayment premiums." The court also contrasted typical prepayment penalties with liquidated-damages provisions, stating that "a prepayment penalty is simply 'bargained for consideration' for the contractual option to prepay the loan." Id. at 949. In the other decision cited by the bankruptcy court in the AE Hotel case for the proposition that the prepayment-premium provision should be subjected, under Illinois law, to a liquidated damages analysis, In re Schaumburg Hotel Owner Ltd. Partnership, 97 B.R. 943, 953 (Bankr. N.D. Ill. 1989), that court upheld, under Illinois law, a clause allowing the lender to accelerate the debt and collect the prepayment charge, stating that "it is immaterial that the actual damages suffered are higher or lower than the amount specified in the clause."

Reporter's Comment 2: Other state and federal courts refuse to engage in a strict liquidated-damages analysis when construing the validity and enforceability of prepayment provisions, or find such clauses enforceable under a liquidated damages analysis, and hold that the parties should be free to contract for the payment of any premium that is not clearly inequitable or unconscionable, whether or not the calculation of the premium corresponds with the actual damages incurred by the secured party.  These courts have upheld yield-maintenance prepayment premium provisions in mortgage loan documents against challenges that they are unenforceable penalties. See, e.g., In re Anchor Resolution Corp., supra, 221 B.R. 330, 341 (Bankr. D. Del. 1998) (finding that the yield-maintenance prepayment provision was reasonable and not a penalty under state law or the Bankruptcy Code, in terms of both the formula used to calculate the premium and the amount owed as a percentage of the outstan!

 ding p
rincipal); West Raleigh Group v. Massachusetts Mutual Life Ins. Co., 809 F.Supp 384, 387 (E.D. N. Carolina 1995) (holding that North Carolina law supports the conclusion that  a prepayment provision contained in a commercial loan is valid and enforceable and is not subject to analysis as a liquidated-damages provision); Williams v. Fassler, 110 Cal. 3d 7, 12-13, 167 Cal. Rptr. 545, 551 (1980) ("We ... hold that in a transaction between private parties, an agreement specifying a 50 percent prepayment penalty is valid if the penalty is reasonably related to the obligee's anticipated risk of incurring increased tax liability upon the occurrence of the prepayment"); Eyde Bros. Development Co. v. Equitable Life Assurance Soc'y, 888 F. 2d 127, 138 (6th Cir. 1989) (holding that, in transactions between sophisticated business entities, the inclusion in the loan documents of carefully negotiated prepayment and due-on-sale provisions is a reasonable allocation of risks between the par!

 ties a
nd does not amount to a restraint on alienation); Lazzareschi Inv. Co. v. San Francisco Fed. Sav.  & Loan Assoc., 22 Cal. App. 3d 303, 307, 99 Cal. Rptr. 316 (1971) (rejecting a buyer's argument that the prepayment fee was excessive because it bore no reasonable relationship to any damage sustained by virtue of the prepayment); In re Direct Transit, Inc., 226 B.R. 198, 203 (8th Cir. 1998) (rejecting the debtor's argument that the stipulated liquidated-damages sum should not be enforced because the parties did not more accurately estimate actual damages; the court held that the charge was reasonable under § 506(b) even though the damages in this case were impossible to quantify); 1 Witkin, Summary of Cal. Law. (9th Ed. 1987), Contracts, § 512 ("A clause in a deed of trust providing a 'penalty' or reasonable charge for payment of the principal in whole or in part before maturity is neither a penalty nor a liquidated damage provision"). In In re Lappin Electric  West Co., Inc.,!

  245 B
.R. 326, 329-30 (Bankr. E.D. Wis. 2000) (cited by the bankruptcy court in the AE Hotel case), the court held that the prepayment charge in the debtor's loan agreement was properly viewed as liquidated damages and not as an alternative means of payment under the loan agreement. But the relevant clause in the loan agreement was drafted specifically as a liquidated damages provision, and stated that payment of the prepayment charge was deemed to be a "reasonable calculation" of the lender's lost profits and damages as the result of early termination and that the charge was agreed to "in view of the impracticality and extreme difficulty of ascertaining actual damages by mutual agreement of the parties."


Reporter's Comment 3: AE Hotel appeared to be really grasping at straws when it argued that the fact that the loan was securitized somehow negated the right of GMACCM to collect the contractual prepayment premium. The court appeared to be particularly irritated by this argument. According to the court, "It is beside the point in determining what actual damages resulted from the prepayment that GMACCM later decided to make a deal with someone else limiting its reinvestment options and so increasing its potential losses from a prepayment." AE Hotel complained that GMACCM had not produced the investor certificates held by the trust and therefore had not shown that the investors were in fact "guaranteed any rate of return." The court's reaction to this argument: So what? The court correctly noted that this had nothing to do with the loss to GMACCM caused by the prepayment, or the reasonableness of the charge. (Interestingly, the court refers to a Seventh Circuit case, F.D.I.C. v!

 . Erns
t & Young, 374 F.3d 579, 580, as containing an excellent explanation of "securitization.")

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

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