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The Enforceability of Prepayment Premium Provisions
Lessors and lenders need to be aware of a recently issued U.S. District Court decision addressing the enforceability of a prepayment premium in a mortgage loan context. The decision in River East Plaza, LLC v. The Variable Annuity Life Company (Slip Copy, 2006 WL 2787483 (N. D. Ill.)) was rendered on Sept. 22, 2006, by the U.S. District Court for the Northern District of Illinois (Eastern Division), construing Illinois law.
In its decision, the court found that the particular prepayment premium required to be paid in connection with prepayment of a mortgage loan was an unenforceable penalty. The type of prepayment provision at issue in the case is generally referred to as a 'yield maintenance clause,' which compensates the lender for possible lost interest by making the lender whole on a similar investment. The borrower is required to pay the interest spread between the actual loan to be prepaid and a hypothetical alternative investment. In this particular transaction, the yield maintenance provision required discounting the outstanding principal and in-terest which would be due over the term of the original transaction to present value at the reinvestment rate, and the reinvestment rate used was the yield to maturity on a U.S. Treasury bond or note having a similar maturity as the unexpired term of the mortgage loan.
The court's conclusion that the particular prepayment premium was a penalty was based on the disparity between the high credit risk presented in the actual transaction and the lack of credit risk presented by an investment in a Treasury security. The rate negotiated between the parties for the actual mortgage transaction took into account the higher risk of default and impairment to collateral, justifying a premium interest rate. The yield to maturity on U.S. Treasury notes or bonds is virtually risk free (since it is backed by the U.S. government). The court's position was that the reinvestment rate should have been calculated with respect to comparable risk investments, and the court indicated that the parties could still use U.S. Treasury bonds or notes, but would have to include a spread to adjust for the risk differential.
The River East Plaza decision is important not only with respect to secured lending transactions, but also with respect to personal property leasing transactions. In the context of typical middle-market leasing of personal property, the decision could be applicable to any options offered to the lessee pursuant to which it could voluntarily cause the lease to be terminated early, such as an early purchase option or an early termination option. It could also be applicable to an involuntary early termination, such as would result from a casualty suffered by the equipment, and to liquidated damages after a default.
In the context of an early purchase option, the lessor receives payment of any rents then outstanding together with the purchase price for the equipment (typically fair market value or a fixed price based on anticipated fair market value), and the formula does not include any portion of future rents whether or not discounted to present value. Accordingly, the River East Plaza decision would not be applicable.
However, in the context of an early termination option or a casualty, the lessee is typically required to pay (or to cover) the Stipulated Loss Value ('SLV') or the Termination Value ('TV') of the equipment. In these two situations, the formula used to calculate the SLV and/or the TV does include the future rents discounted to present value. Accordingly, the discount rate used in calculating that amount is impacted by the River East Plaza decision.
Many leases include a liquidated damages provision that would be applicable after the occurrence of default, and many of those liquidated damages formulas are based on the SLV of the equipment. Since the formula used to calculate the SLV includes the future rents discounted to present value, the discount rate used in calculating that amount is impacted by this decision. This decision's conclusion in the context of liquidated damages is also supported by the well-known decision by the U.S. Court of Appeals for the Third Circuit in In re Montgomery Ward Holding Corp., 326 F.3d 383 (3rd Cir. 2003). In the Montgomery Ward case, which also considered Illinois law, the court upheld the majority view that a liquidated damages provision should only put the lessor in the same position it would have been in had the lease been fully performed. This is also supported by '2A-504 of the Uniform Commercial Code, which states that damages 'may be liquidated in the lease agreement but only at an amount or by a formula that is reasonable in light of the then anticipated harm caused by the default or other act or omission.'
With respect to secured lending, any yield maintenance provisions must be carefully analyzed to make sure that they do not constitute an unenforceable penalty by yielding a windfall to the lender. In addition to the hypothetical alternative investment approach associated with the yield maintenance provision, many lenders alternatively use a percentage formula in connection with voluntary prepayment of secured loans (e.g., 3%, 2%, 1%), which fee typically varies with the timing of the voluntary prepayment over the scheduled term of the loan. In the River East Plaza case, the prepayment premium formula included a fall-back base premium calculated as 1% of the outstanding principal balance. The court upheld the application of that fixed percentage premium, without discussion as to whether the specific percentage was calculated appropriately to fully compensate the lender for the loss of the loan, but not to produce a windfall. Notwithstanding the absence of that analysis in this decision, lenders and lessors would be well advised to take into account the court's overriding concern that any prepayment premium should be calculated in such a manner as to compensate the lender for loss of the transaction, but not to produce a windfall.
This concern is supported by another recent federal court decision. On Nov. 3, 2006, the U.S. District Court for the District of Rhode Island entered its Memorandum and Order affirming the Bankruptcy Court's determination that certain prepayment premiums were not 'reasonable fees, costs, or charges' within the meaning of 11 U.S.C. '506(b). UPS Capital Business Credit v. Louis A. Gencarelli, Sr., et al., C.A. No. 05-39T. This case involved the appeal of an order of the Bankruptcy Court denying the claim of UPS Capital Business Credit for prepayment premiums in connection with two commercial loans. The prepayment provisions used a percentage formula calling for a prepayment premium of 5% in year one, 4% in year two, 3% in year three, 2% in year four, and 1% in year five. In the context of this case, the court focused on whether the prepayment premium constituted a 'reasonable' charge within the meaning of 11 U.S.C. '506(b) and concluded that the creditor had failed to carry its burden of showing that the prepayment premiums amounted to a reasonable estimate of the loss. Accordingly, when a lender sets the fixed percentages for voluntary prepayment of a loan, it should consider whether those fixed percentages will merely compensate for the loss of the transaction or would produce a windfall. If the latter, then the provision is questionable as to its enforceability.
The lesson to be taken from the River East Plaza decision is that the discount rate used in a yield maintenance provision must be calculated in such a manner as to fully compensate the lessor/lender for the lost investment, but not to produce a windfall. If the discount rate is roughly equivalent to the implicit rate in the transaction, that should not present an issue. If the discount rate is unreasonably low, then it is possible that the lessor/lender would receive a windfall that would not be supported by the decision in this case.
Alan J. Mogol is a principal of Ober|Kaler in Baltimore. He has more than 35 years of experience in structuring and documenting equipment finance transactions and co-chairs the firm's Lending & Leasing Practice Group. He may be reached at [email protected].
Lessors and lenders need to be aware of a recently issued U.S. District Court decision addressing the enforceability of a prepayment premium in a mortgage loan context. The decision in River East Plaza, LLC v. The Variable Annuity Life Company (Slip Copy, 2006 WL 2787483 (N. D. Ill.)) was rendered on Sept. 22, 2006, by the U.S. District Court for the Northern District of Illinois (Eastern Division), construing Illinois law.
In its decision, the court found that the particular prepayment premium required to be paid in connection with prepayment of a mortgage loan was an unenforceable penalty. The type of prepayment provision at issue in the case is generally referred to as a 'yield maintenance clause,' which compensates the lender for possible lost interest by making the lender whole on a similar investment. The borrower is required to pay the interest spread between the actual loan to be prepaid and a hypothetical alternative investment. In this particular transaction, the yield maintenance provision required discounting the outstanding principal and in-terest which would be due over the term of the original transaction to present value at the reinvestment rate, and the reinvestment rate used was the yield to maturity on a U.S. Treasury bond or note having a similar maturity as the unexpired term of the mortgage loan.
The court's conclusion that the particular prepayment premium was a penalty was based on the disparity between the high credit risk presented in the actual transaction and the lack of credit risk presented by an investment in a Treasury security. The rate negotiated between the parties for the actual mortgage transaction took into account the higher risk of default and impairment to collateral, justifying a premium interest rate. The yield to maturity on U.S. Treasury notes or bonds is virtually risk free (since it is backed by the U.S. government). The court's position was that the reinvestment rate should have been calculated with respect to comparable risk investments, and the court indicated that the parties could still use U.S. Treasury bonds or notes, but would have to include a spread to adjust for the risk differential.
The River East Plaza decision is important not only with respect to secured lending transactions, but also with respect to personal property leasing transactions. In the context of typical middle-market leasing of personal property, the decision could be applicable to any options offered to the lessee pursuant to which it could voluntarily cause the lease to be terminated early, such as an early purchase option or an early termination option. It could also be applicable to an involuntary early termination, such as would result from a casualty suffered by the equipment, and to liquidated damages after a default.
In the context of an early purchase option, the lessor receives payment of any rents then outstanding together with the purchase price for the equipment (typically fair market value or a fixed price based on anticipated fair market value), and the formula does not include any portion of future rents whether or not discounted to present value. Accordingly, the River East Plaza decision would not be applicable.
However, in the context of an early termination option or a casualty, the lessee is typically required to pay (or to cover) the Stipulated Loss Value ('SLV') or the Termination Value ('TV') of the equipment. In these two situations, the formula used to calculate the SLV and/or the TV does include the future rents discounted to present value. Accordingly, the discount rate used in calculating that amount is impacted by the River East Plaza decision.
Many leases include a liquidated damages provision that would be applicable after the occurrence of default, and many of those liquidated damages formulas are based on the SLV of the equipment. Since the formula used to calculate the SLV includes the future rents discounted to present value, the discount rate used in calculating that amount is impacted by this decision. This decision's conclusion in the context of liquidated damages is also supported by the well-known decision by the U.S. Court of Appeals for the Third Circuit in In re Montgomery Ward Holding Corp., 326 F.3d 383 (3rd Cir. 2003). In the Montgomery Ward case, which also considered Illinois law, the court upheld the majority view that a liquidated damages provision should only put the lessor in the same position it would have been in had the lease been fully performed. This is also supported by '2A-504 of the Uniform Commercial Code, which states that damages 'may be liquidated in the lease agreement but only at an amount or by a formula that is reasonable in light of the then anticipated harm caused by the default or other act or omission.'
With respect to secured lending, any yield maintenance provisions must be carefully analyzed to make sure that they do not constitute an unenforceable penalty by yielding a windfall to the lender. In addition to the hypothetical alternative investment approach associated with the yield maintenance provision, many lenders alternatively use a percentage formula in connection with voluntary prepayment of secured loans (e.g., 3%, 2%, 1%), which fee typically varies with the timing of the voluntary prepayment over the scheduled term of the loan. In the River East Plaza case, the prepayment premium formula included a fall-back base premium calculated as 1% of the outstanding principal balance. The court upheld the application of that fixed percentage premium, without discussion as to whether the specific percentage was calculated appropriately to fully compensate the lender for the loss of the loan, but not to produce a windfall. Notwithstanding the absence of that analysis in this decision, lenders and lessors would be well advised to take into account the court's overriding concern that any prepayment premium should be calculated in such a manner as to compensate the lender for loss of the transaction, but not to produce a windfall.
This concern is supported by another recent federal court decision. On Nov. 3, 2006, the U.S. District Court for the District of Rhode Island entered its Memorandum and Order affirming the Bankruptcy Court's determination that certain prepayment premiums were not 'reasonable fees, costs, or charges' within the meaning of 11 U.S.C. '506(b).
The lesson to be taken from the River East Plaza decision is that the discount rate used in a yield maintenance provision must be calculated in such a manner as to fully compensate the lessor/lender for the lost investment, but not to produce a windfall. If the discount rate is roughly equivalent to the implicit rate in the transaction, that should not present an issue. If the discount rate is unreasonably low, then it is possible that the lessor/lender would receive a windfall that would not be supported by the decision in this case.
Alan J. Mogol is a principal of Ober|Kaler in Baltimore. He has more than 35 years of experience in structuring and documenting equipment finance transactions and co-chairs the firm's Lending & Leasing Practice Group. He may be reached at [email protected].
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