Excerpts from Article on Prepayment
By Jack Murray

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The Comptroller of the Currency, which exercises regulatory and supervisory control over national banks, has issued an interpretive rule regarding the imposition of late charges and prepayment penalties by member banks. See Comptroller of the Currency (National Banks), Interpretive Letter No. 744 (published in Interpretations and Actions, October 1996), which takes the position that both late charges and prepayment penalties are "interest" for purposes of the "most favored lender" provisions of the National Banking Act, 12 U.S.C. § 85, thus allowing a national bank that is based in a state that has no restrictions on late charges or prepayment penalties to "export" its home-based freedom from such restrictions to other states in which it does business. As a result of this opinion by the Comptroller of the Currency, which is the regulatory authority for all national banks, such banks are permitted to "shop" for "friendly" interest-rate and prepayment-payment jurisdictions with respect to commercial loans.

See also Marquette Nat’l Bank of Minneapolis v. First of Omaha Service Corp., 439 U.S. 299, 314-315, 99 S.Ct. 540, 549 (1978) (holding that a national bank can "export" the interest rate provisions applicable in its home state to other states); 61 F.R. 50951-50984 (Sept. 30, 1996) (setting forth proposed federal preemptive regulations regulating, among other things, late-payment penalties and prepayment penalties).

A frequently litigated issue involves whether the mortgagee may charge a prepayment premium if it accelerates the loan as the result of the mortgagor’s violation of the due-on-sale provision in the loan documents. The regulations that were issued in connection with the Garn-St Germain Act, P.L. 97-320 (October 15, 1982), 96 Stat. 1469, 12 U.S.C. 1701j-3 (which Act provides for the federal preemption of any limitations on the exercise of due-on-sale clauses imposed by state law) state that "[a] lender may not impose a prepayment penalty or equivalent fee when the lender of party acting on behalf of the lender . . . declares by written notice that the loan is due pursuant to a due-on-sale clause." 12 C.F.R. § 591.5(b)(2)(i); 48 F.R. 32160-32162.

Although the introductory comments to the regulations seem to make this language (regarding the enforceability of prepayment premiums in connection with the exercise of a due-on-sale clause) applicable to all loans, the revision was placed in the section of the regulations limiting the enforcement of due-on-sale clauses only "[w]ith respect to any loan on the security of a home occupied or to be occupied by the borrower." 12 C.F.R. § 591.5(b).

Although this federal prohibition with respect to prepayment penalties would not appear to apply with respect to commercial loans, mortgage lenders must still be careful to draft their prepayment-premium provisions to specifically state that the premium will be payable if the loan is accelerated by the mortgagee as a result of the mortgagor’s default under any of the provisions of the loan documents (including violation of the due-on-sale clause).

See Slevin Container Corp. v. Provident Fed. Sav. & Loan Ass’n, supra, 98 Ill. App 3d at 648-50, 424 N.E. 2d at 940-42 (holding, in the context of a commercial loan, that no prepayment penalty may be imposed when a loan is accelerated for violation of a due-on-sale clause); First National Bank of Springfield v. Equitable Life Assurance Society of the United States, 157 Ill. App. 3d 408, 413, 510 N.E. 2d 518, 522 (1987), cert. denied, 116 Ill. 2d 553, 515 N.E. 2d 107 (1987) (citing Slevin as the "relevant case law on the topic" and ruling that "[a] mortgagee is not entitled to a prepayment penalty in addition to full payment of the indebtedness where it exercises its contractual right under the due-on-sale clause"); McCausland v. Bankers Life Ins. Co., 757 P.2d 941, 946 (Wash. 1988) (holding, in a case involving acceleration of the debt as the result of the mortgagor’s violation of the due-on-sale clause, that "[i]t is only fair that the lender be prohibited from demanding prepayment fees upon acceleration of the debt since . . . it is the lender who is insisting on prepayment"); Crockett v. First Fed. Sav. & Loan Ass’n, 289 N.C. 620, 626-27, 224 S.E. 2d 580, 585 (1976) (upholding validity and enforceability of due-on-sale clause, but prohibiting prepayment charge); American Fed. Sav. & Loan Ass’n v. Mid-America Serv. Corp., 329 N.W.2d 124, 125-126 (S.D. 1983) (holding, in a case of first impression in South Dakota, that the mortgagee was not entitled to a charge equal to three months’ interest upon acceleration of the mortgage loan for violation of the due-on-sale clause because "the due-on-sale clause is a type of acceleration clause which is triggered at the mortgage holder’s option"); Terry v. Born, 24 Wash. App. 652, 655, 604 P.2d 504, 506 (1979) (in a case decided before enactment of the Garn-St Germain Act, the court held that "the provisions of the [real estate installment contract] which prohibit assignment or conveyance and do not permit prepayment constitute an unreasonable and unenforceable restraint on alienation unless [the real estate installment contract vendee] can show that enforcement of the restraint is necessary to protect his security").

See also N.Y. Real Property Law § 254-a (McKinney Supp. 1998) (prohibiting a prepayment fee upon the lender’s exercise of a due-on-sale clause in connection with a residential mortgage); Frank S. Alexander, Mortgage Prepayment: The Trial of Common Sense, 72 Cornell L.Rev. 288, 343 n. 187 (January 1987); Annotation, Construction and Effect as to Interest Due of Real Estate Mortgage Clause Authorizing Mortgagor to Prepay Principal Debt, 86 A.L.R. 3d 599, 605 (1978); Gavin L. Phillips, Validity and Construction of Provision of Mortgage or Other Real-Estate Financing Contract Prohibiting Prepayment for a Fixed Period of Time, 81 A.L.R. 4th 423 (1991).

But see Eyde v. Empire of America Fed. Sav. Bank, 701 F.Supp 126 (E.D. Mich. 1988), in which the mortgagors argued that the mortgagee had accelerated the debt not because of default in the payment of principal and interest, but as a result of the mortgagors’ alleged violation of the due-on-sale provision in the loan documents. The court held that it was immaterial whether the loan had been accelerated for either reason, because the "clear intent" of the parties, as expressed in the prepayment-premium provision in the mortgage note, was that the mortgagee had the right to collect a prepayment charge in the event the debt was accelerated for any reason. The court, in distinguishing cases such as Slevin, supra, found that the prepayment-premium provision was valid and enforceable because the parties had contractually agreed to allow the mortgagee to collect a prepayment penalty in the event of any acceleration of the debt upon default by the mortgagor.

See also Clover Square Associates v. Northwestern Mutual Life Ins. Co., 674 F.Supp 1137, 1138 (D.N.J. 1987) (upholding the validity and enforceability of both the due-on-sale and prepayment provisions contained in the mortgage documents, and rejecting the mortgagor’s claim that the exercise of the mortgaee’s rights under such clauses resulted in an "absolute restraint on alienation"; the court noted that under New Jersey law the mortgagee was permitted to "extract a fee from the mortgagor for allowing prepayment of the loan" for "surrendering the privilege of having its funds invested, and of collecting interest thereon for the term provided in the contract" (citing Bloomfield Sav. Bank v. Howard S. Stainton & Co., 60 N.J.Super. 524, 531-32, 159 A.2d 443 (App. Div. 1960)); Warrington 611 Associates v. Aetna Life Ins. Co., 705 F.Supp 229, 234 D.N.J. 1989) (holding that a commercial mortgage containing both a prepayment penalty and a due-on-sale clause was not an unreasonable restraint on alienation where the mortgagor was not actually prevented from selling the property; the court noted that the cases cited by the mortgagor to the contrary had been decided before enactment of the Garn-St Germain Act); McCausland v. Bankers Life Ins. Co., 110 Wash.2d 716, 721-25, 757 P.2d 941, 944-46 (1988) (ruling that the Garn-St Germain Act did not preempt state restrictions on prepayment penalties and that a combination of a due-on-sale clause and a provision prohibiting prepayment or providing for a prepayment fee is not an unreasonable restraint on alienation so long as the two clauses do not operate simultaneously; otherwise it is an unreasonable restraint).

Federal associations, in any event, may include prepayment penalty clauses in commercial-loan documents and enforce such clauses according to their terms regardless of any state law to the contrary (including equitable principles) because C.F.R. §§ 545.2 and 545.34(c), as amended at 49 F.R. 43044, authorize a Federal association to include a prepayment penalty clause in any loan it makes and to enforce such a clause in accordance with its terms regardless of any state law - including equitable principles in a foreclosure action - which purports to prohibit the collection of a prepayment penalty under certain circumstances.

The preemptive effect of these regulations applicable to Federal associations is subject only to the limitations with respect to loans secured by borrower-occupied homes found or referred to in 12 C.F.R. 545.34(c) (governing disclosure and the imposition of a prepayment penalty after notice of an adjustment of an adjustable-rate mortgage) and the final rule regarding prepayment penalties with respect to residential property set forth in 12 C.F.R. 501(b) (see B. 4.a. above). However, other federal legislation has limited or prohibited prepayment premiums or fees in connection with FHA loans (12 C.F.R. § 545.6-12(b); Veterans’ Administration loans (24 C.F.R. § 207.253(a)); certain "high cost loans" (12 C.F.R. § 226.32), certain manufactured home loans (12 C.F.R. 590); and loans made by lenders subject to Federal Home Loan Bank Board regulations (38 C.F.R. § 36.4310).

The Alternative Mortgage Transactions Parity Act of 1982 (12 U.S.C. 3801), which regulates residential loans made by "housing creditors," permits covered lenders to preempt state law 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. At the time of enactment, states were allowed to opt out of the preemption, but only six have done so: Arizona (in part); Maine, Massachusetts; New York; South Carolina; and Wisconsin (in part).

Lenders that are not subject to specific Federal regulations regarding prepayment premiums should consult applicable state statutory and case law with respect to the enforceability of a prepayment-premium provision in connection with the breach by the borrower of a due-on-sale clause. Under the Garn-St Germain Act, the lender should be able to impose a prepayment loan if the borrower violates the due-on-sale clause, unless it is clear that neither the contractual provision providing for a prepayment premium nor the due-on-sale provision in the loan documents can be construed to contemplate the payment of a premium in such an event. Federally regulated lenders should also enjoy similar protection with respect to commercial loans.