DD 11/11/05 OK to use treasuries to compute prepayment premiums as liquidated damages for mortgage loan default

>Daily Development for Friday, November 11, 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
>dirt@umkc.edu
>
>PREPAYMENT; PREPAYMENT PREMIUMS; YIELD MAINTENANCE: Prepayment premium provision based upon treasury yields is a reasonable attempt to liquidate damages in the event of a default and acceleration, and satisfies Bankruptcy Code test for a “reasonable charge,” even when effect of application of formula is a premium of over $2 million. 

>
>In re CP Holdings, Inc., 2005 U.S. Dist. LEXIS 24461 (W.D. Mo.
>9/30/2005)
>
>This case involves a wretchedly written prepayment clause used in a 1989 loan.  Very fortunately for the editor, who served as an expert in this case, the court upheld the Bankruptcy Court’s determination that the clause ought to be read to apply both to acceleration as well as other prepayment events, notwithstanding that the borrower’s counsel was able to fake out the editor on the stand and interpret a segment of the note incorrectly.  Other aspects of the note, and the logic of the entire arrangement, made clear that the parties’ intent was to provide for a prepayment premium upon acceleration.

>
>More interesting and valuable for posterity, however, are other aspects of the opinion, in which the court concluded that it was not unreasonable for the lender to demand a prepayment premium based upon a hypothetical  yield maintenance requirement drawn from treasury yields, even though the lender, looking at the situation at the time of actual default and “prepayment,” might very possibly not invest in treasuries to replace the yield, but might instead invest in higher return investments, thus profiting much more than the interest lost as a consequence of the default.

>
>Here is the computation formula (admittedly not the greatest - but it worked):
>
>Said premium to be the greater of one percent (1%) of the principal amount to be prepaid or a premium which is calculated as follows:

>(a) Determine the "Reinvestment Yield." The Reinvestment Yield will be equal to the yield on the U.S. Treasury Issue described below ("primary issue")* published two weeks prior to the date of prepayment and converted to an equivalent monthly compounded nominal yield.

>
>(b) Calculate the "Present Value of the Mortgage." The Present Value of the Mortgage is the present value of the regularly scheduled payments to be made in accordance with the note (all regular debt service payments and/or any balloon payment) discounted at the Reinvestment Yield for the number of months remaining from the date of prepayment to loan maturity. In the event of a partial prepayment, the Present Value of the Mortgage shall be calculated in accordance with the preceding sentence multiplied by the fraction which results from dividing the amount of the prepaid proceeds by the principal balance of the loan immediately prior to prepayment.

>(c) Subtract the amount of the prepaid proceeds from the Present Value of the Mortgages as of the date of prepayment. The resulting differential shall be the "Premium."

>As a result of there being no U.S. Treasury Issue comparable to this
>Note on the date hereof, the holder of this Note shall choose a
>comparable Treasury Bond, Note or Bill which the holder of this Note
>deems to be similar to the primary issue's characteristics (i.e., rate,
>remaining time to maturity, yield) at the time of prepayment.)
>
>The editor testified, and the court accepted, that the reasonableness of liquidated damages clauses ought to be measured on the basis of facts and circumstances existing at the time of the making of the original loan, and not “reanalyzed” at the time that default actually occurs to determine whether the parties’ language remains a reasonable attempt to assess damages.  This is probably the majority approach to this question, but there is some authority that would take a “second” look before approving the reasonableness of a liquidated damages provision.

>
>Given that premise, the editor then testified, and the court again
>agreed, that the use of the treasury rate is a reasonable practice for
>assessing the lender’s probable injury, even though in virtually every
>case treasury yields will be lower than the yield on high grade
>commercial mortgages.  The editor testified that in general it is
>difficult for a  lender to find comparable real estate mortgage
>investments that exactly match all the risk and yield characteristics
>of another large loan.  This uncertainty is magnified when the parties
>were projecting in 1989 whether it would be possible, at any time over
>the life of the loan, to identify a comparable mortgage investment that
>would generate the same yield with the same risk as the original loan 
>Thus, he testified, it was reasonable for the parties to select a
>stable and easily verifiable index that would move roughly in
>accordance with the cost of money and would certainly be a reliable
>computational base, even though it was n
ot likely to correspond exactly to all the characterstics of the investment (the original mortgage) that the treasury note investment would replace. 

>
>Given the formula and the dramatic decrease in treasury yields since the making of the loan, the application of the formula in this case brought a prepayment premium of $2.6 million on a loan “prepayment” (acceleration) of $8.4 million.

>
>It is important to note that, in this case, default and acceleration occurred prior to bankruptcy, and the court concluded therefore that Bankruptcy Code Section 506(b), which requires that fees associated with default must be “reasonable” to be permitted in bankruptcy, did not apply.  Rather, the court viewed the fee from the perspective of state law on prepayment premiums as liquidated damages.

>
>Comment 1: The court quoted quite a lot from the editor’s testimony.  The editor doesn’t include those quotes here, because to him, at least, they were virtually unintelligible.  Most people are not happy reviewing the written report of what they say.  Without nuance and tone, it doesn’t always look like it sounded. But the editor confesses that he was not at the top of his game that day, having been up all night due to matters unrelated to the case.  Fortunately, the judges of the Western District were veterans at studying written accounts of verbal testimony, and were very forgiving, and found the nuggets it needed in the editor’s verbiage.

>
>Comment 2: Although defeasance techniques have replaced the prepayment formula used here, the question of whether it is appropriate to use treasury yields as a computation base for otherwise uncertain yield comparisons remains an important question in many contexts, and the editor does not believe there are many published opinions validating this very common business practice.  So, despite the editor’s garbled language, it is possible his words, and the better stated words of Judge Fenner here,  will ring through precedent.

>
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