Prepayment Premiums and Make-Whole Payments

Clear and Unambiguous Contract Language

To determine whether a creditor has an enforceable right to collect a prepayment premium in bankruptcy, courts first consider the text of the loan documents. A prepayment premium clause typically governs the situation in which a borrower voluntarily elects to prepay its debt and represents the price of the option exercisable by the borrower to repay the loan in advance of its maturity. See, e.g., In re S. Side House, LLC, 451 B.R. 248, 268 (Bankr. E.D.N.Y. 2011). Upon a default and acceleration of the borrower's loan, the acceleration advances the maturity date, and any subsequent payment is no longer considered a voluntary prepayment. See In re Madison 92nd St. Assocs. LLC, 472 B.R. 189, 195 (Bankr. S.D.N.Y. 2012) (citing In re LHD Realty Corp., 726 F.2d 327, 330-31 (7th Cir. 1984)). The lender forfeits the collection of a prepayment premium in such a scenario unless the parties' agreement contains a 'clear and unambiguous' clause requiring payment of the prepayment premium upon default and acceleration. See In re Madison 92nd St. Assocs. LLC, 472 B.R. at 195-96. Several courts have prohibited creditors from recovering prepayment premiums in bankruptcy where the loan document language is not clear and unambiguous.

In In re S. Side House, LLC, the language of the note and mortgage dictated that the debtor was liable for the prepayment premium in a default and acceleration situation only if full payment of the debt was deemed an 'evasion of the'[d]ebtor's obligation to pay prepayment consideration. ' ' 451 B.R. at 272. The court reasoned that the prepayment premium was not due because the debtor did not tender the full amount of the loan after default, and the loan documents did not make the prepayment premium due upon default and acceleration alone. Id.

For the creditor to recover, the contract would have had to have given the lender an unambiguous right to prepayment consideration upon default and acceleration without requiring the debtor's intentional evasion of the premium. Id.; see also In re S. Side House, LLC, 2012 WL 273119, at *5 (quoting Northwestern Mut. Life Ins. Co., 816 N.Y.S.2d at 836). Compare U.S. Bank Trust Nat'l Ass'n v. AMR Corp. (In re AMR Corp.), 2013 WL 4840474, at *6 (2d Cir. Sept. 12, 2013) (declining to enforce premium in light of following language in debt documents: 'if an Event of Default [defined to include Debtors' voluntary filing of bankruptcy petition that automatically results in acceleration without any action by Loan Trustee] ' shall have occurred and be continuing, then ' the unpaid principal amount ' (but for the avoidance of doubt, without Make-Whole Amount), shall immediately and without further act become due ' ' and '[n]o Make-Whole Amount shall be payable on the ' Equipment Notes as a consequence of or in connection with an Event of Default or the acceleration of the Equipment Notes.'), with In re CP Holdings, Inc., 332 B.R. 380, 382, 385 (W.D. Mo. 2005) (holding that language 'if the holder of this Note accelerates the whole or any part of the principal sum ' the undersigned waives any right to prepay said principal sum in whole or in part without premium and agrees to pay a prepayment premium' clearly gives creditor right to collect premium upon acceleration of debt).

Liquidated Damages or 'Unmatured Interests'

A majority of courts have determined that prepayment premium clauses should be scrutinized as liquidated damages provisions, and the amounts should not be considered unmatured interest under ' 502(b)(2) of the Bankruptcy Code, which provides that allowed claims may not include claims for 'unmatured interest.' See In re Trico Marine Servs., Inc., 450 B.R. 474, 480 (Bankr. D. Del. 2011) (citing Noonan v. Fremont Fin. (In re Lappin Elec. Co., Inc.), 245 B.R. 326, 330 (Bankr. E.D. Wis. 2000)). But see In re Ridgewood Apartments, 174 B.R. 712, 720-21 (Bankr. S.D. Ohio 1994) (deciding that prepayment premiums are not allowable claims in bankruptcy because they compensate lender for lost interest payments and therefore constitute unmatured interest).

A clause providing for liquidated damages is evaluated under state law standards to determine whether such damages are valid or constitute an unenforceable penalty. See In re Madison 92nd St. Assocs. LLC, 472 B.R. at 195-96 (citing U.S. Bank Nat'l Ass'n v. S. Side House, LLC, 2012 WL 273119, at *5 (E.D.N.Y. Jan. 30, 2012); and Northwestern Mut. Life Ins. Co. v. Uniondale Realty Assocs., 816 N.Y.S.2d 831, 836 (Sup. Ct. 2006)).

The standard for determining whether liquidated damages are valid under New York law is whether actual damages are difficult to determine, and whether the amount of damages are not 'plainly disproportionate' to the potential loss. See In re Sch. Specialty, Inc., 2013 WL 1838513, at *2 (Bankr. D. Del. Apr. 22, 2013) (citing In re S. Side House, LLC, 451 B.R. at 270). Many courts have used tests similar to New York's standard for determining whether liquidated damages are enforceable. But see 400 Walnut Assocs., L.P. v. 4th Walnut Assocs., L.P. (In re 400 Walnut Assocs., L.P.), 461 B.R. 308, 321 (Bankr. E.D. Pa. 2011) (internal citations omitted) (stating that standard for evaluating enforceability of liquidated damages in Pennsylvania is whether they are reasonable).

Damages

In the prepayment premium context, courts look at a number of factors to determine whether actual damages are difficult to determine: 'the loss of interest to the lender, the rate of return on any substitute loan or loans, the duration of that loan ' , the risk of the substitute loan or loans, and the extent and realizability of the collateral for the substitute loan or loans.' In re Vanderveer Estates Holdings, Inc., 283 B.R. 122, 130 (Bankr. E.D.N.Y. 2002). The evaluation of whether damages are difficult to determine is evaluated as of the time the agreement was made. See In re Duralite Truck Body & Container Corp., 153 B.R. 708, 712 (Bankr. D. Md. 1993).

The court in In re Madison 92nd St. Assocs. LLC held that the prepayment premium satisfied the first prong of the liquidated damages evaluation. 472 B.R. at 197. The premium, due upon either the debtor's prepayment or default and acceleration, was intended to estimate the present value of the lender's lost future interest, which depended on future changes in interest rates not readily ascertainable at the time of contracting. Id. at 193, 197. Moreover, the creditor was seeking a prepayment premium based on the debtor's default, not actual prepayment, and therefore the creditor lost not only future income payments, but also the opportunity to reinvest its money. Id. at 197.

We continue this discussion in next month's issue.

Joel H. Levitin is a partner at Cahill Gordon & Reindel LLP in New York. Levitin is a member of this newsletter's Board of Editors and may be contacted at [email protected]. The author gratefully acknowledges Nicole Lindgren, a JD candidate at Syracuse University College of Law, for her assistance in the preparation of this article.

Many loan agreements include clauses that permit borrowers to repay debt prior to the maturity date only if they make additional payments that are typically referred to as 'prepayment premiums' or 'make-whole payments.' The purpose of such prepayment premiums is to compensate lenders for what would otherwise be the loss of their bargained-for yields for the scheduled lives of their loans. Prepayment premiums are usually either based on a fixed fee, such as a percentage of the principal balance at the time of prepayment, or a yield maintenance formula that approximates the lenders' damages in the event of prepayment.'

In the bankruptcy context, a prepayment premium will rarely be triggered by the debtor's voluntary prepayment of debt. Instead, usually the debtor will have defaulted and the debt will have been accelerated prior to bankruptcy, or the debt will have automatically accelerated due to the bankruptcy filing.

In these circumstances, to be enforceable, the loan documents must contain clear and unambiguous language requiring the prepayment premium upon acceleration. The majority of courts have held that prepayment premiums are not 'unmatured interest' and may constitute recoverable liquidated damages if they satisfy the applicable state law test for enforcement, including in many states if the prepayment premium bears a reasonable relationship to the creditor's actual damages caused by the debtor's early repayment of the debt. Many courts also consider whether the prepayment premium is 'reasonable' under ' 506(b) of the Bankruptcy Code.

Clear and Unambiguous Contract Language

To determine whether a creditor has an enforceable right to collect a prepayment premium in bankruptcy, courts first consider the text of the loan documents. A prepayment premium clause typically governs the situation in which a borrower voluntarily elects to prepay its debt and represents the price of the option exercisable by the borrower to repay the loan in advance of its maturity. See, e.g., In re S. Side House, LLC, 451 B.R. 248, 268 (Bankr. E.D.N.Y. 2011). Upon a default and acceleration of the borrower's loan, the acceleration advances the maturity date, and any subsequent payment is no longer considered a voluntary prepayment. See In re Madison 92nd St. Assocs. LLC, 472 B.R. 189, 195 (Bankr. S.D.N.Y. 2012) (citing In re LHD Realty Corp., 726 F.2d 327, 330-31 (7th Cir. 1984)). The lender forfeits the collection of a prepayment premium in such a scenario unless the parties' agreement contains a 'clear and unambiguous' clause requiring payment of the prepayment premium upon default and acceleration. See In re Madison 92nd St. Assocs. LLC, 472 B.R. at 195-96. Several courts have prohibited creditors from recovering prepayment premiums in bankruptcy where the loan document language is not clear and unambiguous.

In In re S. Side House, LLC, the language of the note and mortgage dictated that the debtor was liable for the prepayment premium in a default and acceleration situation only if full payment of the debt was deemed an 'evasion of the'[d]ebtor's obligation to pay prepayment consideration. ' ' 451 B.R. at 272. The court reasoned that the prepayment premium was not due because the debtor did not tender the full amount of the loan after default, and the loan documents did not make the prepayment premium due upon default and acceleration alone. Id.

For the creditor to recover, the contract would have had to have given the lender an unambiguous right to prepayment consideration upon default and acceleration without requiring the debtor's intentional evasion of the premium. Id.; see also In re S. Side House, LLC, 2012 WL 273119, at *5 (quoting Northwestern Mut. Life Ins. Co., 816 N.Y.S.2d at 836). Compare U.S. Bank Trust Nat'l Ass'n v. AMR Corp. (In re AMR Corp.), 2013 WL 4840474, at *6 (2d Cir. Sept. 12, 2013) (declining to enforce premium in light of following language in debt documents: 'if an Event of Default [defined to include Debtors' voluntary filing of bankruptcy petition that automatically results in acceleration without any action by Loan Trustee] ' shall have occurred and be continuing, then ' the unpaid principal amount ' (but for the avoidance of doubt, without Make-Whole Amount), shall immediately and without further act become due ' ' and '[n]o Make-Whole Amount shall be payable on the ' Equipment Notes as a consequence of or in connection with an Event of Default or the acceleration of the Equipment Notes.'), with In re CP Holdings, Inc., 332 B.R. 380, 382, 385 (W.D. Mo. 2005) (holding that language 'if the holder of this Note accelerates the whole or any part of the principal sum ' the undersigned waives any right to prepay said principal sum in whole or in part without premium and agrees to pay a prepayment premium' clearly gives creditor right to collect premium upon acceleration of debt).

Liquidated Damages or 'Unmatured Interests'

A majority of courts have determined that prepayment premium clauses should be scrutinized as liquidated damages provisions, and the amounts should not be considered unmatured interest under ' 502(b)(2) of the Bankruptcy Code, which provides that allowed claims may not include claims for 'unmatured interest.' See In re Trico Marine Servs., Inc., 450 B.R. 474, 480 (Bankr. D. Del. 2011) (citing Noonan v. Fremont Fin. (In re Lappin Elec. Co., Inc.), 245 B.R. 326, 330 (Bankr. E.D. Wis. 2000)). But see In re Ridgewood Apartments, 174 B.R. 712, 720-21 (Bankr. S.D. Ohio 1994) (deciding that prepayment premiums are not allowable claims in bankruptcy because they compensate lender for lost interest payments and therefore constitute unmatured interest).

A clause providing for liquidated damages is evaluated under state law standards to determine whether such damages are valid or constitute an unenforceable penalty. See In re Madison 92nd St. Assocs. LLC, 472 B.R. at 195-96 (citing U.S. Bank Nat'l Ass'n v. S. Side House, LLC, 2012 WL 273119, at *5 (E.D.N.Y. Jan. 30, 2012); and Northwestern Mut. Life Ins. Co. v. Uniondale Realty Assocs. , 816 N.Y.S.2d 831, 836 (Sup. Ct. 2006)).

The standard for determining whether liquidated damages are valid under New York law is whether actual damages are difficult to determine, and whether the amount of damages are not 'plainly disproportionate' to the potential loss. See In re Sch. Specialty, Inc., 2013 WL 1838513, at *2 (Bankr. D. Del. Apr. 22, 2013) (citing In re S. Side House, LLC, 451 B.R. at 270). Many courts have used tests similar to New York's standard for determining whether liquidated damages are enforceable. But see 400 Walnut Assocs., L.P. v. 4th Walnut Assocs., L.P. (In re 400 Walnut Assocs., L.P.), 461 B.R. 308, 321 (Bankr. E.D. Pa. 2011) (internal citations omitted) (stating that standard for evaluating enforceability of liquidated damages in Pennsylvania is whether they are reasonable).

Damages

In the prepayment premium context, courts look at a number of factors to determine whether actual damages are difficult to determine: 'the loss of interest to the lender, the rate of return on any substitute loan or loans, the duration of that loan ' , the risk of the substitute loan or loans, and the extent and realizability of the collateral for the substitute loan or loans.' In re Vanderveer Estates Holdings, Inc., 283 B.R. 122, 130 (Bankr. E.D.N.Y. 2002). The evaluation of whether damages are difficult to determine is evaluated as of the time the agreement was made. See In re Duralite Truck Body & Container Corp., 153 B.R. 708, 712 (Bankr. D. Md. 1993).

The court in In re Madison 92nd St. Assocs. LLC held that the prepayment premium satisfied the first prong of the liquidated damages evaluation. 472 B.R. at 197. The premium, due upon either the debtor's prepayment or default and acceleration, was intended to estimate the present value of the lender's lost future interest, which depended on future changes in interest rates not readily ascertainable at the time of contracting. Id. at 193, 197. Moreover, the creditor was seeking a prepayment premium based on the debtor's default, not actual prepayment, and therefore the creditor lost not only future income payments, but also the opportunity to reinvest its money. Id. at 197.

We continue this discussion in next month's issue.

Joel H. Levitin is a partner at Cahill Gordon & Reindel LLP in New York. Levitin is a member of this newsletter's Board of Editors and may be contacted at [email protected]. The author gratefully acknowledges Nicole Lindgren, a JD candidate at Syracuse University College of Law, for her assistance in the preparation of this article.