Daily Development for October 14, 2004
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

Another Jack Murray contribution:

BANKRUPTCY; MORTGAGES; PREPAYMENT: Prepayment penalty provision in mortgage note was unenforceable in connection with court-approved bankruptcy sale of debtor-mortgagor's property, where state foreclosure decree entered prior to debtor-mortgagor's bankruptcy filing did not specifically provide for collection of prepayment premium.

In re McClung, 2003 Bankr. LEXIS 2076 (Bankr. D. Kansas, Dec. 11, 2003)

The debtor-mortgagor defaulted on a mortgage and note held by Washington Mutual Bank ("WMB"), which then commenced a foreclosure action. The foreclosure decree entered by the Kansas state court, which was submitted and approved by the attorneys for WMB's predecessor, granted judgment for the amount of the principal balance of the loan, together with interest at the contract rate, title insurance expenses, and costs, including reasonable attorneys' fees, "together with all advances and expenditures properly chargeable under the terms of the Mortgage." The note contained a prepayment penalty provision, which provided that if the debtor-mortgagor prepaid the note within the first three years of the loan term, it would be required to pay a prepayment premium.

The debtor-mortgagor sought and obtained the bankruptcy court's approval to sell part of the property consisting of ten unimproved acres (of the 25-acre total), and WMB did not object to the sale. The debtor-mortgagor subsequently entered into a contract to sell the remaining 15 acres, which sale was authorized by the court and also not objected to by WMB. The net proceeds obtained from these sales (which were sufficient to pay the full amount of WMB's loan) were escrowed with the closing agent, pending the bankruptcy court's decision as to whether WMB was entitled to a prepayment premium in the amount of $5,915.69.

WMB argued that it was entitled to the prepayment premium because the debtor-mortgagor sold the property during the three-year "lockout" period which, pursuant to the prepayment provision in the loan documents, would trigger the payment of a prepayment premium by the debtor-mortgagor. WMB also asserted that the language in the foreclosure decree did in fact, include payment of the prepayment premium. WMB argued further that in any event the state court did not have the authority to refuse to allow the prepayment premium, and therefore the bankruptcy court should alter the state court's foreclosure judgment to allow it.

The debtor-mortgagor argued that WMB was prohibited from collecting a prepayment premium because the language in the foreclosure decree (which was submitted and approved by WMB's attorneys) did not provide for such a remedy. The court agreed with the debtor-mortgagor's position on this issue and summarily rejected WMB's argument that the foreclosure judgment allowed it to collect a prepayment premium. The court held that no reasonable person could conclude that the words "advances" or "expenditures" included a prepayment premium, because such terms contemplate an actual expenditure of funds.

The court also pointed out that the judgment was drafted by counsel for WMB's predecessor (the loan had been assigned to WMB by the original lender prior to the debtor-mortgagor's bankruptcy filing), and that WMB stood in the shoes of its predecessor. The court further ruled that even if there were an ambiguity in the language contained in the foreclosure judgment, it would construe the terms against the drafter under established law. The court further rejected WMB's argument that the bankruptcy court should set aside or "reform" the state-court foreclosure judgment, holding that the judgment had not been appealed by WMB and was final. Finally, the court rejected WMB's argument that federal law, specifically 12 C.F.R. § 560.2(b)(5) (affecting federal savings associations regulated by the Office of Thrift Supervision) preempted state law with respect to the charging of prepayment penalties, because WMB had failed to raise this argument before the date that the state court entered i ts foreclosure judgment; therefore, under applicable federal law, the bankruptcy court lacked subject matter jurisdiction to determine or review matters that had previously been determined by the state court.

The court also reasoned that "matters of preclusion" prevented it from relitigating this matter, stating that the full faith and credit statute "directs a federal court to refer to the preclusion law of the State in which judgment was rendered." According to the court, "If WMB wished to assert its right, under the note and mortgage that were the subject of the suit, to a prepayment penalty, it was required to raise the issue in the foreclosure proceeding it commenced in state court, or be forever barred." The court noted that WMB was required to litigate the issue before the entry of the final judgment by the state court, and stated that "there is no note left to enforce" because the note had merged into the foreclosure judgment issued by the state court.

Comment 1: This is a decision that should serve as a cautionary tale for lenders' lawyers: If you screw up in state court and don't specifically include the right to a contractual prepayment premium as part of the amount claimed in the foreclosure decree, don't expect a bankruptcy court to bail you out. Or, alternatively, if you think the state court should have awarded a prepayment premium but failed or refused to do so (whether based on federal preemption or another argument), make sure to specifically raise the issue at the trial court level and appeal an adverse ruling immediately. Unfortunately, there may be a malpractice action lurking in the woods based on the facts of this case. It is hard to understand why WMB pursued this litigation, given the shaky foundation for its claim; it undoubtedly paid far more than the disputed $5900 prepayment premium in legal fees to contest the matter.

Comment 2: As the bankruptcy court noted in its opinion, 12 CFR sec. 560.2(b)(5) provides, pursuant to certain provisions of the Home Owners Loan Act (HOLA), that the OTS is authorized to promulgate regulations that preempt state laws affecting federal savings associations with respect to "loan- related fees," including "initial charges, late charges, prepayment penalties, servicing fees, and overlimit fees." On September 26, 2002, the OTS published a final rule identifying the OTS regulations that apply under the Parity Act. See 12 C.F.R. Parts 560, 590, and 591 (67 F.R. 60542, 60554). (The Parity Act permits covered lenders to preempt state law prohibitions and restrictions on prepayment penalties and provides for the insertion and enforcement of prepayment penalties in "alternative mortgage" instruments such as adjustable-rate and balloon mortgages - and virtually any other type of loan other than a fixed-rate level-debt-service loan). The Parity Act expressly preempts state laws that prohibit alternative mortgage transactions, and provides that state-chartered lenders may make variable-interest home mortgage loans and other alternative mortgage transactions on the same terms as federally chartered lenders, "notwithstanding any State constitution, law, or regulation." 12 U.S.C. §§ 3803(c) and 3804.) The OTS revised and amended 12 C.F.R. § 560.220 -- primarily in response to arguments from consumer groups that the federal preemption encouraged predatory-lending practices by lenders in the form of excess charges and fees -- and stated that it would no longer enforce its regulations governing prepayment penalties (C.F.R. § 560.33) and late charges (12 C.F.R. § 560.34) for state-chartered housing creditors (which includes most state-licensed mortgage lenders and state-chartered insured depositories). 67 F.R. 76, 304. The OTS delayed the effective date of the amended rule ("Amended Rule") until July 1, 2003, when it officially removed the federal exe mpti on for state-chartered lenders. 67 F.R. 76,304.

Non-federal lenders now are bound by applicable state-law restrictions on prepayment charges and fees when making alternative mortgages, such as adjustable-rate loans. The Amended Rule sets forth a number of arguments by the OTS supporting its conclusion that in adopting original 12 C.F.R. § 560.220, it had acted arbitrarily and capriciously and exceeded the authority granted to it by Congress. The OTS reasoned that prepayment-penalty and late- fee restrictions apply to traditional real estate lending transactions in general and are not peculiar to alternative mortgage transactions, and therefore there was no reason to distinguish those particular provisions from other general lending rules that were not identified as applicable to state housing creditors. By virtue of the revised rule, the OTS has eliminated the authority of state-chartered savings associations and mortgage companies to charge prepayment fees and late-payment fe es irrespective of state laws. Residential mortgage loans originated by state-chartered institutions qualifying as alternative mortgage transactions are now subject to state limits on prepayment fees and late-payment charges.

Comment 3: Can a mortgagee obtain interest on an unpaid prepayment claim in bankruptcy? Maybe.

A key issue in determining the treatment of secured creditors under the Bankruptcy Code is whether the creditor is less than fully secured or more than fully secured. In many districts, the fully secured creditor is not entitled to adequate protection payments, but the secured claim will accrue interest up to the value of the collateral. Section 506(b) of the Bankruptcy Code permits a secured creditor, to the extent that its claim is oversecured, to collect interest on such claim and any reasonable fees (including attorneys' fees, costs, and charges) that are provided for in the loan documents. An oversecured lender should be entitled to -- and should make certain to -- include, as part of its claim, interest at the default rate on the debt as well as the amount calculated pursuant to its contractual prepayment provision [assuming that it has a right to claim a premium upon acceleration for default - Ed.].

But the bankruptcy courts in various jurisdictions have differed as to whether the lender with an oversecured claim should be entitled to a prepayment premium and whether the charge is reasonable under federal or state law. Some bankruptcy courts (albeit the minority) find that, under the facts of a particular case, a "make whole" (or other form of) prepayment premium is an unenforceable penalty or an unreasonable fee that is not allowed under § 506(b).

The reporter for this item was Jack Murray of First American Title Insurance Company - Chicago.

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