DIRT Development for Monday, January 12, 2009
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Husch Blackwell Sanders
Kansas City, Missouri

We have two Jack Murray prepayment updates.  Here is the first.  The editor has edited.

MORTGAGES; PREPAYMENT; RESIDENTIAL; “SIX MONTHS INTEREST:” Bankruptcy court concludes that standard “six months interest” in residential note will not be prioritized in bankruptcy over other lenders.

In In re Atrium View, LLC, 2008 WL 5378293 (Bankr. M.D. Pa., Dec. 24, 2008),

At an auction sale of the commercial property in bankruptcy.  The property was encumbered by three mortgage liens, and of course all three were to be taken into account in the bankruptcy sale.. There was enough money from the proceeds to pay off the first mortgagee (minus the prepayment premium) and partially pay the second mortgage.

The first lender's note contained a provision requiring the debtor to pay a "prepayment premium" if it prepaid all or part of the debt, voluntary or otherwise, within three years of the date of the note. The debtor filed its bankruptcy petition a little more than a year after the first mortgage note was executed by the debtor. The fee was a flat fee of six months interest. 

The court disallowed the first lender's prepayment premium as not meeting the bankruptcy test for being “reasonable” in order to be paid out of the security with priority.  The first mortgagee objected, arguing it should receive its contracted-for prepayment premium.
The court rejected the first lender's objection, and stated”

“In the instant case, [the lender] provided no evidence that the prepayment premium approximates predicted actual losses. A flat fee that is the same regardless of how many months interest is lost and that is unrelated to the market interest rate clearly is not based on a forecast of actual damages.”

The court further stated that "[The lender's] only justification in support of the [prepayment] provision is that '[i]n the current residential subprime mortgage industry, a typical prepayment premium is six months' interest." In sum, while a six-month prepayment penalty may be inserted routinely in mortgage notes, that does not mean this provision passes muster in the bankruptcy context. [The lender] has not shown that the prepayment premium is reasonable, and, therefore, it is disallowed under § 506(b).

The bankruptcy court therefore disallowed the amount of the premium claimed by the first lender and ordered distribution of that amount ($15,815), which was held in escrow, to the second lender because it had not been paid in full and such distribution would still not be enough to pay the second lender's claim in full; therefore there were no funds available for the third lender.

Reporter’s Comment 1: This case illustrates the affinity of bankruptcy courts to find a reason to "spread the proceeds around" to secured creditors (and unsecured creditors when possible) when there are not enough funds from a sale to pay them in full. The court stated that prepayment premium clauses are enforceable in Pennsylvania with respect to commercial loans, stating that "if the parties manifest an intent in the instrument to provide for a prepayment fee and the fee serves as measure of liquidated damages, payment of the fee will be enforced (citation omitted)." This again underscores the fact that many bankruptcy courts (and some state courts) have a basic misunderstanding of prepayment provisions, which should not be subjected to a liquidated damages analysis in connection with a commercial loan. This is certainly not a majority position. The bankruptcy court then looked to Sec. 506(b) of the Bankruptcy Code and, relying selectively on the distinct minority of courts that
 support its position, stated that "A prepayment charge formula must effectively estimate actual damages, otherwise, the charges may operate as either a penalty on the debtor or a windfall to a lender, at the expense of other creditors of the bankruptcy estate."

Reporter’s Comment 2: This case demonstrates the danger to lenders in not inserting a standard yield-maintenance prepayment provision in the loan documents, and instead using a non-standard "flat rate" or "sliding percentage scale" provision. These types of clauses (which are still used by some lenders, especially in connection with some subprime and securitized loans) are subject to rejection by both bankruptcy and state courts, even if (as argued by the lender), "In the current residential subprime mortgage industry, a typical prepayment premium is six months' interest." Bankruptcy courts (and state courts) generally see much more justification for enforcing a standard (and well-drafted) yield-maintenance prepayment provision in mortgage loan documents, because they have become standard in the industry and appear to truly attempt to quantify the lender's estimated damages.

Editor’s Comment: This was a contract claim, and the lender still can line up with other unsecured creditors for its prepayment amount.  The question is one of priority, not validity.  Frankly, the editor thinks that loading up a residential borrower with a yield maintenance penalty is overkill, and also likely violates many state consumer laws.  Many lenders do not enjoy the preemption protection that they once did.  The editor would leave well enough alone and not react to this case by beefing up the prepayment claim.

Some would argue that the lender shouldn’t have been getting that high subprime interest in the first place.   So it shouldn’t complain about losing it from an overloaded borrower.

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