Daily Development for Monday, May 15, 2000

By: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
randolphp@umkc.edu

The text of the report is mainly by Jack Murray. The comments, however, are the editor's.

MORTGAGES PREPAYMENT; LIQUIDATED DAMAGES: Ohio Bankruptcy Court upholds lender's prepayment charge claim as a valid liquidated damages clause, even where mortgage contains no liquidated damages language.

In re Hidden Lake Limited Partnership, 2000 WL 518201 (Bankr. S.D. Ohio)

Hidden Lakes Limited Partnership (the "Debtor") executed a mortgage note in 1988 in connection with permanent loan financing provided by Aetna Insurance Company for a 258unit apartment complex. The note contained a "yield maintenance" prepayment provision, which specifically provided that acceleration of the debt would constitute an event triggering the right of Aetna to collect the prepayment premium. Prior to executing the loan documents, the Debtor's managing general partner, Investment Resources, Inc. ("IRI"), had been singularly unsuccessful in its attempt to negotiate a modification of the prepayment provision, although Aetna had honored IRI's request to supply it with hypothetical calculations showing the method of determining the amount of the premium under different scenarios and assumptions. As the court noted, "IRI understood both that the prepayment charge could effectively preclude the Debtor from any refinancing of the loan and that Aetna would not make the loan without the prepayment charge provision."

In 1994, the loan was restructured and the parties entered into an Amended Note. IRI again attempted to revise the prepaymentpremium provision, which again was rejected by Aetna. The maturity date of the Amended Note was May 1, 2004. In 1997, with the property unable to generate sufficient income to service the payments required under the Amended Note, IRI sought out another lender to refinance the Aetna mortgage. Although HUD financing was available at a lower rate, the large prepayment premium that would have to be paid to Aetna made such financing prohibitively expensive and therefore unobtainable. In late 1997, the debtor defaulted on its loan payments and Aetna accelerated. Aetna commenced a mortgage foreclosure proceeding and obtained a receiver to collect the rents and profits from the property. The Debtor subsequently filed a Chapter 11 bankruptcy petition in July 1998. Aetna then filed a proof of claim in the amount of $15,669,347, which included a prepayment charge in the amount of $2,699,487. The Debtor did not discover that Aetna had included the prepayment premium in its calculation of the amount owing to it until after the bankruptcy filing. However, the Debtor stipulated that Aetna had correctly calculated the prepayment charge in accordance with the prepayment clause in the Amended Note.

The Debtor then proposed a reorganization plan that would apply a discount factor of 7.75% to Aetna's allowed secured claim (which the Debtor claimed was the current market rate for comparable mortgage loans, as opposed to the Treasury note rate of 5.8% that would be applicable under the mortgage prepayment provision). Aetna argued that it was entitled "to a prepayment charge calculated to provide an amount which could be reinvested in an alternate investment and still maintain the return to Aetna promised in the Amended Note." Aetna also noted that the amount required to be paid under the formula was discounted to present value. The court stated that "Aetna has committed the yield it is to receive from this and other loans it has made to long term investment contracts it has with institutional investors."

The court further noted that there are several variables that make the exact calculation of the prepayment premium difficult and impractical, including the loan amount, the remaining term, the interest rate environment at the time of prepayment, and the possibility that the lender may not even be making mortgage loans at the time of prepayment. The court also stated that "[f]or a similar loan secured by commercial real estate, Aetna would expect a minimum return of 250 basis points over the comparable Treasury obligation."

Somewhat surprisingly, although the prepayment clause did not contain any language stating that it was to be construed as a "liquidated damages" provision, the court stated that "Aetna regards the prepayment charge as a liquidated damages provision which seeks to capture all of the interest that would have been paid if no prepayment had occurred and any administrative costs of doing business attributable to this loan." The court also noted that "Aetna has no policy which would require prepaid funds specifically to be reinvested in Treasury obligations . . . Nor is there any requirement imposed by the contract with an institutional investor for which this loan is targeted that requires Aetna to keep this investment with the Debtor in place." In discussing the applicable legal issues in this case, the court first found that the question of whether a contractual liquidated damages provision is in fact a penalty is governed by state law, although "there are certain bankruptcy considerations which may come into play." The court found that the particular circumstances of this case i.e., the treatment of acceleration of the debt as an event triggering payment of the prepayment premium even though no actual voluntary prepayment had occurred and the fact that the Debtor did not propose early prepayment as part of its bankruptcy plan were probably not what the parties had contemplated when the loan transaction was entered into. The court also acknowledged that allowance of Aetna's claim for the full amount of the contractual prepayment ($2,699,487) would likely prevent the Debtor from being able to file a confirmable plan of reorganization and would actually "overcompensate" Aetna over the life of the plan. Nonetheless, the court stated that it was not free to impose its own view on this issue and held that the provision was a valid and enforceable liquidated damages provision under Ohio law because it was a reasonable estimate of the damages that were most likely to occur. The court also found that the parties, who were "sufficiently sophisticated and experienced to be aware of the import of their agreement", entered into the prepayment provision knowingly and willingly

The court then addressed the issue of the starting date for calculation of the prepayment premium, which date had been disputed by the parties. The court determined that, although the language in the provision was not a model of clarity, Aetna's interpretation that the date of acceleration of the debt acted as the "prepayment" date was reasonable. Aetna had actually selected the date that was the first day of the month following the Debtor's default, which, the court found, benefitted the Debtor.

Finally, the court turned to 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 that 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."

Comment 1: Note that many cases that uphold prepayment clauses as valid do so because they view the prepayment as the exercise of an optional form of payment for which the lender may impose a separate charge. That is a harder argument when the prepayment fee is levied upon acceleration for default.

Comment 2: Perhaps because we were in a bankruptcy court, which frequently pay little attention to niceties such as legal rules, the lender was able to get away with a failure to characterize the prepayment fee as a liquidated damages clause. Obviously there is some argument that lenders might want to start doing so, at least as to prepayments attached to accelerations. In prepayments that are optional, perhaps the lender may want to continue to stylize the fee as a charge for an option. So there would be two separate prepayment provisions.

Comment 3: Note that in many jurisdictions liquidated damages clauses must replace other forms of damages for the identified default another point that just happened to slip by the bankruptcy court here. Lenders who seek to characterize prepayment fees on default as liquidated damages might take into account that they then might forfeit default interest and possibly even late payment charges. In bankruptcy, this might be a good trade.

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