Daily Development for Wednesday, June 13, 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

PREPAYMENT; PREPAYMENT PENALTIES; BANKRUPTCY: A prepayment premium secured by a mortgage on the debtor's homestead should be considered when determining the amount of "all other liens on the property" for purposes of Sec. 522(f)(2)(A)(ii) of the Bankruptcy Code..

In re Barrett, 2007 WL 1544658  (Bkrtcy D. Me. May 29, 2007)

This case decides what  may be a case of first impression.  The court termed it a  "novel issue." The court concluded that the prepayment premium was a "cognizable component of the claim secured by an unavoidable mortgage," and since the judicial lien of another creditor, Precision, impaired the debtor's homestead exemption, it would be avoided

Sec. 522(f) of the Bankruptcy Code permits debtors -- with the objective of providing a "fresh start" for the debtor -- to avoid s judicial lien to the extent "it impairs an exeemption to which the debtor would otherwise be entitled.") The debtor in this case had a homestead exemption.  The value of CIT's "unavoidable lien" (i.e., the principal balance of the mortgage ($447,712 ) and the prepayment premium ($22,386)), combined with the claimed homestead exemption ($70,000)), according to the court, "was greater than the stated value of the property ($540,000)."  Therefore, the court totally avoided Precision's judicial lien ($12,595.74) because "it impaired the exemption to which the [debtor] would otherwise be entitled."

Reporters Comment 1:  But when all the figures (including the prepayment premium) are added up, the "impairment" of the debtor's exemption is exactly $98.04! This appears to be another results-oriented decision, with the court wanting to make as much money available as possible for distribution to unsecured creditors and preserve the debtor's homestead. (The court noted that "Without inclusion of the prepayment penalty in CIT's secured claim, Precision's judicial lien would not impair the [borrowers] homestead exemption."

Reporters Comment 2: Note that here the first-mortgage lender, CIT, had not declared a default or accelerated its loan prior to the debtors' bankruptcy. Especially if the language in the prepayment provision did not provide that acceleration of the debt or any voluntary or involuntary payment of the debt would trigger the prepayment premium, it is at least arguable that the prepayment premium provision would not be an enforceable (as opposed to hypothetical and unmatured) obligation on the date of the debtor's bankruptcy filing. See, e.g., In re Hidden Lake Ltd. Partnership, 247 B.R. 722 (Bankr. S.D. Ohio 2000),where the court addressed the issue, raised by the debtor, of whether the prepayment charge constituted a claim for unmatured interest, which is barred by 502(b)(2) of the Bankruptcy Code. The court ruled that because the claim for the prepayment premium arose as the result of acceleration of the indebtedness prior to the debtor's bankruptcy, the charge had matured at th

at time and therefore could not constitute a claim for unmatured interest. However, the court noted that "[h]ad Aetna's note contained an acceleration right exercisable upon the filing of a bankruptcy petition and had there been no prepetition acceleration, the result might be different." Id. at 730. (emphasis added.)     

In In re Ridgewood Apartments of DeKalb County, Ltd., 174 B.R. 712 (Bankr. S.D. Ohio 1994), where the borrower filed a voluntary petition under Chapter 11 of the Bankruptcy Code. The lender, Fannie Mae, had accelerated the entire debt prior to the filing of the bankruptcy petition and filed a claim in the bankruptcy proceeding that included a prepayment premium in the amount of $263,275, as established by a formula attached as an Addendum to the promissory note. Fannie Mae contended that the prepayment premium had been validly triggered by the acceleration of the debt. The prepayment provision provided that the premium would be due whether the prepayment was voluntary or involuntary. But the court held that actual "prepayment" of the loan was initially required, regardless of whether the payment was "voluntary" or "involuntary," in order to invoke the penalty in the first place, and because the borrower had not in fact prepaid the note and did not contemplate prepayment under its

bankruptcy plan under the original terms of the loan, no prepayment penalty was due and owing prior to or at the time of the bankruptcy filing. Therefore, the court ruled that the prepayment premium calculated by the lender was a "contingent liability" and not properly part of the lender's claim. The court also held that (after - rightfully - acknowledging that several bankruptcy decisions allow the lender to collect a prepayment premium when the provision specifically states, as in this case, that the premium is due upon acceleration of the debt) because the claim was for contingent interest which was not yet due and payable at the time of the borrower's bankruptcy filing, it would also be disallowed to the lender, an undersecured creditor, as unmatured interest under 502(b)(2) of the Bankruptcy Code. The court stated that, because it had found the prepayment provision unenforceable under 502(b)(2), it "need not . . . render a determination on the enforceability of the prepay

ment penalty based solely upon an acceleration by the lender." Id. at 721. See also Continental Securities Corp. v. Shenandoah Nursing Home Partnership, 188 B.R. 205, 213-214 (Bankr. W.D. Va. 1995) ("to the extent 502 would disallow a claim for unmatured interest, it is relevant here since that is essentially what [the lender] is seeking. Were the bankruptcy court to hold that that [the borrower] must pay [the lender] the full value of the Note through its maturity, it would essentially be allowing the payment of unmatured interest which is prohibited by 502.").

Reporters Comment 3: But the majority view is that a prepayment premium does not constitute unmatured interest under 502. See, e.g., In re Tri-State Ethanol Co., LLC, 354 B.R. 913, 918 ("the prepayment charge was fully due and owing on the date Debtor filed its petition. Thus, it cannot represent unmatured interest" [under 502(b)(2)]); In re Outdoor Sports Headquarters, Inc., 161 B.R. 414, 424 (Bankr. S.D. Ohio 1993) ("Prepayment amounts, although often computed as being interest that would have been received through the life of the loan, do not constitute unmatured interest because they fully mature pursuant to the provisions of the contract. As a result of the parties' contractual agreements, reflected in the terms of the Notes and mortgage, the [lender] has a right to receive this payment if payment of the entire amount due pursuant to the Note is made prior to the full term of the contract. Therefore, the Prepayment Amount does not constitute unmatured interest and will

not be disallowed pursuant to 502(b)(2)"); In re Skyler Ridge, 80 B.R. 500, 508 (Bankr. C.D. Cal. 1987) ("[l]iquidated damages, including prepayment premiums, fully mature at the time of breach, and do not represent unmatured interest" under 502(b)(2)); Boyd v. Life Ins. Co. of the Southwest, 546 S.W. 2d 132, 133 (Tex. Civ. App. 1977) (holding that "[a] prepayment charge on a promissory note is not compensation for the use of money. Rather, it is a charge to the borrower for the privilege of repaying the loan before maturity ."); C.C. Port, Ltd. v. Davis-Penn Mortgage Co., 61 F.3d 288, 289 (5th Cir. 1995) ("Where the contract grants the borrower the right to prepay, a prepayment premium is not compensation for the use, forbearance, or detention of money, rather it is a charge for the option or privilege of prepayment"); In re 360 Inns, Ltd., 76 B.R. 573, 576 (Bankr. N.D. Tex. 1987) ("the prepayment penalty was not unmatured interest as contemplated in 502(b)(2), inasmuch as

 the prepayment penalty was activated and matured once the plan of reorganization proposed to pay [the lender's] debt"); In re Hidden Lake Ltd. Partnership, 247 B.R. 722, 730 (Bankr. S.D. Ohio 2000) (finding that because the claim for the prepayment premium arose as the result of acceleration of the debt prior to the debtor's bankruptcy, the charge had matured at that time and therefore could not constitute a claim for unmatured interest); In re Lappin Electric Co., Inc., 245 B.R. 326, 329-30 (Bankr. E.D. Wis. 2000) ("this court is in agreement with a majority of courts that view a prepayment charge as liquidated damages, not as unmatured interest or an alternative means of paying under the contract [citations omitted]. In this case, the charge is independent of the amount owed at termination, thus negating any characterization as interest"); In re Tri-State Ethanol Co. LLC, 354 B.R. 918, 918 (Bankr. D. S. Dak. 2006) ("the prepayment charge was fully due and owing on the date Debt

or filed its petition. Thus, it cannot represent unmatured interest").

Reporters Comment 4: In any event, this case involves a very unusual fact situation of apparently first impression, with the prepayment issue being only tangential to the court's ruling. It also involves a residential loan, thereby invoking Sec. 522(f) of the Bankruptcy Code, which enables the debtor or trustee to avoid a judicial lien to the extent "it impairs an exemption to which the debtor would otherwise be entitled." Many statess severely restrict or even prohibit prepayment premiums in connection with residential (but not commercial) loans. Federal associations may include prepayment penalty clauses in commercial loan documents and enforce such clauses according to their terms regardless of any state law to the contrary (including equitable principles) because C.F.R. 545.2 and 545.34(c), as amended at 49 F.R. 43044, authorize a Federal association to include a prepayment penalty clause in any loan it makes and to enforce such a clause in accordance with its terms regardl

ess of any state law - including equitable principles in a foreclosure action - which purports to prohibit the collection of a prepayment penalty under certain circumstances. The preemptive effect of these regulations applicable to Federal associations is subject only to the limitations with respect to loans secured by borrower-occupied homes found or referred to in 12 C.F.R. 545.34(c) (governing disclosure and the imposition of a prepayment penalty after notice of an adjustment of an adjustable-rate mortgage) and the final rule regarding prepayment penalties with respect to residential property set forth in 12 C.F.R. 591.5(b). However, other federal legislation has limited or prohibited prepayment premiums or fees in connection with FHA loans (12 C.F.R.545.6-12(b); Veterans' Administration loans (24 C.F.R. 207.253(a)); certain "high cost loans" (12 C.F.R.226.32), certain manufactured home loans (12 C.F.R. 590); and loans made by lenders subject to Federal Home Loan Bank

 Board regulations (38 C.F.R. 36.4310).

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


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