by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
randolphp@umkc.edu

MORTGAGES; PREPAYMENT: California court upholds prepayment penalty assessed upon acceleration after default; and upholds "sliding scale" penalty tied to tax impact on mortgagee.

Biancalana v. Fleming, 53 Cal. Rptr. 2d 47 (Cal. App. 1996).

The note in question was a million dollar commercial purchase money note. The seller/mortgagee had agreed to the arrangement in order to have an income during retirement. The note specifically provided protection against adverse tax consequence if the borrower prepaid:

"If more than 15% above the yearly total payments are made during any one calendar year, the payor agrees to pay the additional income tax created by all excessive monies so paid."

The borrower argued that there was no "additional income tax created" by the prepayment because the amount of tax the mortgagee would have to pay on its gain was fixed at the time of sale. Prepayment might affect the timing of the payment of the tax, but not the amount of tax per se. The court read this provision to reflect its reading of the parties' intent, and concluded that the mortgagor would have to pay all of the tax payable in a given year upon mortgagee's receipt of a prepayment of more than 15% above the yearly total payments. Note that in the case of acceleration upon default, this means that borrower will pay the bulk of mortgagee's taxes (assuming there is sufficient equity in the property to cover that amount).

The borrower next based upon a "due on sale/prepayment" case, decided in the heat of the due on sale hysteria of the early 1980's. Tan v. California Fed. Sav. & L. Assoc., 189 Cal. Rptr. 775 (Cal. App. 1983). Tan had held that there could be no prepayment charge where the acceleration resulted from a voluntary election by the lender, such as in the case of a due on sale clause. Borrower in the instant case argued that lender here also had the option to accelerate, and that therefore the Tan principle ought to apply. The court rejectd borrower's argument, but it is important to note that the court did so only because of its interpretation of the wording of the default/acceleration clause in the note, which provided that if default were made in the payment of principal, interest "or any other sums due" under the note, then lender at its option could accelerate "the whole of the sum of principal, interest and all other sums due . . . hereunder."

Comment 1: There are a number of decisions that have held that mortgagee cannot collect a prepayment penalty following acceleration absent quite specific language in the prepayment clause. See, generally, Nelson & Whitman, Real Estate Finance Law 418-419 (3rd Ed.) (West 1994). These decisions probably do not constitute a recognizable "majority view," but clearly there are enough so that lender's lawyers drafting prepayment clauses should be certain that the event of acceleration is included as a triggering event.

Comment 2: As most real estate professionals know, the Tan principle was later picked up in federal regulations implementing the Garn-St. Germaine Act "due on sale preemption" language. In owner occupied one to four family mortgage loans, the lender cannot exact a prepayment penalty when the property is sold and the lender invokes the due on sale clause or refuses to accept a qualified assumption, thus forcing a payoff. 12 C.F.R. Sec. 591.5.

Comment 3: It is difficult for the author to perceive the basis for the court's differentiation of the Tan concept on the basis of the language contained in this deed of trust. The acceleration still was at the lender's option. The borrower had defaulted in payments of principal and interest, not in payment of a prepayment penalty. Consequently the situation seems parallel to the Tan reasoning as this court described that reasoning. Nevertheless, the editor agrees with the court's conclusion. It is refreshing to see a court actually look through the arguments to identify the real business purpose of the parties and enforce it.

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