Daily Development for
Wednesday, September 10, 1997

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law

MORTGAGES; PREPAYMENT: Provision in mortgage note stating that if borrower timely pays and does not default will be no penalty for prepayment establishes an enforceable prepayment penalty and is not subject to analysis as a late payment charge.

Ridgley v. Topa Thrift & Loan Ass'n, 62 Cal. Rptr. 2d 309 (Cal. App. 1997)

Specifically, the note provided that if there was no default and all payments were made on time there would be no penalty for prepayment six months from date.

Over a year after the loan was originated, borrower was in the process of selling the mortgaged property and paying off the loan (consistent with the original business plan). During this process, of which the lender was fully aware, the borrower did not make a monthly payment, apparently because the originally planned date for closing on the sale of the property was postponed. Thereafter, the parties agreed to modify and extend payments for the next three months, but there was no mention in this modification agreement of the prior missed payment. Then the property did sell and borrower paid off the note. The lender demanded a prepayment penalty of $114,000. The borrower paid the penalty and sued for reimbursement, interest, and related costs.

The trial court ruled that the prepayment penalty operated as a late payment penalty and therefore could not be enforced because it acted as an unreasonable forfeiture.

On appeal: held: Reversed. California jurisprudence regarding prepayment penalties treats such penalties as a charge for an option to pay early, and not subject to "forfeiture analysis." Since the mortgage could have provided for the prepayment penalty requirement unconditionally, there is no prohibition from providing for it subject to a condition that it will not arise if the borrower is not in default.

As to the interpretation of the clause itself, borrower argued that it required timely payment only during the first six months. But the court concluded that there could be only one logical reading - that the lender could charge the prepayment penalty if the borrower ever missed a payment.

Borrower also argued that the lender had waived the late payment by its cooperation in the ongoing planning for closing. Basically, in this case the court held that mere silence was not assent and did not give a basis for estoppel. Although lender had never mentioned the fact that the payment wasn't made, and did not declare a default, and was fully aware of the circumstances, it had never actually consented to the later payment either. Consequently, it still had the right to invoke the prepayment penalty.

There was a dissenter on the three judge panel. The dissent argued strongly that the prepayment charge operated as a penalty for default. The dissent pointed out that, although not relevant under the instant facts, the clause provided that a prepayment charge applied if there was a default on any loan agreement between borrower and lender, not just this one. The dissent concluded that the clear purpose of the prepayment language was to assess a punishment or penalty on the borrower as a consequence of a default.

Comment: This "no default" language is common in lending instruments, and the editor at first thought that the majority opinion was unassailable. But the dissent does give one pause. Where the "no default" requirement is imposed as a condition for benefits that have to do with the ongoing relationship of borrower and lender, such as application of insurance proceeds to rebuild, or reinstatement of an acceleration, it makes sense that the lender demand that there be no other defaults. Here, however, the loan will be paid off and the relationship will end as a consequence of the prepayment. (The language dealt only with full prepayments.) What purpose did the parties have in demanding that the borrower not be in default other than to provide incentive to the borrower to avoid default? If that was their purpose, how can this feature be anything but a penalty?

As to the argument that what can be imposed unconditionally can be made subject to conditions, the response is that if the conditions operate to establish a prohibited penalty, then they cannot be imposed. For instance, what if the instruments provide for a $50,000 "loan fee" that is not collectible unless and until the borrower defaults. The fact that the lender could have charged the loan fee up front would not prevent this fee from being analyzed as a default penalty.

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