Prepayment Premiums and Make-Whole Payments

Last month, we discussed' “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.'

We pointed out that 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. The discussion continues herein.

Is the Prepayment Premium Plainly Disproportionate?

In considering whether a prepayment premium is “plainly disproportionate” to the lender's potential loss, courts look at the damages foreseeable at the time of contracting and not the actual damages at the time of prepayment or acceleration of the debt. See In re Sch. Specialty, Inc., 2013 WL 183513, at *2 (citing Walter E. Heller & Co., Inc. v. Am. Flyers Airline Corp., 459 F.2d 896, 898-99 (2d. Cir. 1972)). Furthermore, courts consider whether the prepayment premium clause is the result of arm's-length negotiations between represented sophisticated parties. See In re Sch. Specialty, Inc., 2013 WL 183513, at *3 (internal citations omitted). A number of courts have held that prepayment consideration calculated on the basis of U.S. Treasury Bond interest rates is not plainly disproportionate to the lender's possible loss. Id. at *4 (internal citations omitted); In re S. Side House, LLC, 451 B.R. at 271; but see In re Skyler Ridge, 80 B.R. 500, 505 (Bankr. C.D. Cal. 1987) (stating that using U.S. Treasury notes would have been acceptable provided that appropriate adjustment were included to bring rate up to then-existing comparable mortgage rate).'

In In re Vanderveer Estates Holdings, Inc., the court held that the prepayment premium was not plainly disproportionate to the creditor's possible loss. 283 B.R. at 130 (citing United Merchs. & Mfrs., Inc. v. Equitable Life Assurance Soc'y of the U.S. (In re United Merchs. & Mfrs., Inc.), 674 F.2d 134, 143 (2d Cir. 1982)). The prepayment premium was the result of arm's-length negotiations and was calculated based on prevailing Treasury Bond yields at or about the time of prepayment and was structured to allow the creditor to collect its bargained-for yield if the prepaid funds were reinvested in a Treasury Bill of comparable maturity. In re Vanderveer Estates Holdings, Inc., 283 B.R. at 130.' The court reasoned that the prepayment premium clause did not result in an automatic premium upon prepayment.' Id. If interest rates increased such that the Treasury Bond yield would exceed the interest rate under the loan documents, then the creditor could still obtain the bargained-for interest, and the prepayment premium would be zero. Id.

Does the Reasonableness Standard Apply?

In addition to evaluating the enforceability of a prepayment premium clause as liquidated damages, many courts have held that the prepayment premium must satisfy the reasonableness standard set forth in Section 506(b) of the Bankruptcy Code. Courts have taken different approaches as to how reasonableness under Section 506(b) is evaluated. Some courts have held that if the prepayment premium passed muster under the liquidated damages standard, then it should similarly be enforceable under Section 506(b). See In re Sch. Specialty, Inc., 2013 WL 183513, at *5. Other courts have evaluated liquidated damages and reasonableness under Section 506(b) as two distinct issues. See In re Vanderveer Estates Holdings, Inc., 283 B.R. at 131-34.'

Section 506(b) allows an oversecured creditor to recover “reasonable [post-petition] fees, costs, or charges provided for under the [relevant] agreement ' .” 11 U.S.C. ' 506(b) (2005); see also In re Vanderveer Estates Holdings, Inc., 283 B.R. at 131. At least one court has held that prepayment premium clauses are not subject to Section 506(b) where the premium became due before the debtor filed for bankruptcy and therefore was included as part of the creditor's claim. In re CP Holdings, Inc., 332 B.R. at 392.

If a court determines that Section 506(b) applies to a prepayment premium, typically its initial inquiry in evaluating reasonableness is the purpose of the premium. See, e.g., In re Duralite Truck Body & Container Corp., 153 B.R. at 713.

Generally, prepayment premiums protect lenders against falling interest rates. Without a prepayment premium, a borrower would have an incentive to refinance the debt, thus depriving the lender of the benefit of its bargain, namely, the unearned interest at above current market rates over the unexpired term of the loan. On the other hand, if the loan was involuntarily prepaid when market interest rates were higher than the contractual rate, the lender could reinvest the funds at the higher rate, resulting in a windfall to the lender.

Id. at 713-14 (internal citations omitted).

The majority of courts have held that to qualify as “reasonable” under Section 506(b), prepayment premiums must reflect the creditor's actual damages. See, e.g., In re Schwegmann Giant Supermarkets P'ship, 264 B.R. 823, 828 (Bankr. E.D. La. 2001) (citations omitted). But see Noonan, 245 B.R. at 330 (declining to use actual damages to determine reasonableness due to fact that actual damages were hard to calculate in line of credit situation). Actual damages are calculated as “the difference between the market rate of interest at the time of prepayment and the contract rate for the duration of the loan, discounted to present value.” In re Schwegmann Giant Supermarkets P'ship, 264 B.R. at 828 (quoting In re Duralite Truck Body & Container Corp., 153 B.R. at 714).

Courts have considered prepayment premium clauses to be “unreasonable” for a variety of reasons. Prepayment premiums that allow a creditor to recover the same amount regardless of whether the market interest rates increase or decrease are said to “presume a loss” and are deemed unreasonable. Id. at 829 (quoting In re Duralite Truck Body & Container Corp., 153 B.R. at 714-15) (prepayment premium allowed creditor to receive 10% of prepaid principal regardless of market interest rates).

Additionally, prepayment premiums are likely to be found unreasonable and therefore unenforceable if they fail to discount the recovery to present value. See Schwegmann Giant Supermarkets P'ship, 264 B.R. at 829 (citing In re Duralite Truck Body & Container Corp., 153 B.R. at 714-15). The court in In re Kroh Bros. Dev. Co., 88 B.R. 997, 1002 (Bankr. W.D. Mo. 1988), struck down a prepayment premium that amounted to 25% of the loan's principal, and held that a reasonable prepayment premium is “at most” the equivalent of 10% of the loan's principal.

Many courts have followed this guideline. See, e.g., In re Schwegmann Giant Supermarkets P'ship, 264 B.R. at 829-30 (holding 18% premium unreasonable); Noonan, 245 B.R. at 331 (holding 5.9% premium reasonable); Anchor Resolution Corp. v. State St. Bank & Trust Co. (In re Anchor Resolution Corp.), 221 B.R. 330, 341 (Bankr. D. Del. 1998) (holding 6.9 % premium reasonable). But see Fin. Ctr. Assocs. of East Meadow, L.P. v. Funding Corp. (In re Fin. Ctr. Assocs. of East Meadow, L.P.), 140 B.R. 829, 839 (Bankr. E.D.N.Y. 1992) (disagreeing with Kroh Bros. Dev. and holding that although 25% premium was high, it was not unreasonable).

Conclusion

Prepayment premiums are important for creditors' ability to fully receive their anticipated benefit of lending money. In the context of debt acceleration in bankruptcy, loan documents must include clear and unambiguous language to enable creditors to have a chance of collecting prepayment premiums. Prepayment premiums are more likely to be enforceable if they meet state law standards permitting liquidated damages, typically that damages must be difficult to determine at the time of contracting, and if the contractual damages are not be plainly disproportionate to the creditors' potential damages. In courts that apply the reasonableness standard under Section 506(b) of the Bankruptcy Code, prepayment premiums are most likely to be enforced if the clauses are structured so that the amounts reflect the particular creditors' actual damages.

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.

Last month, we discussed' “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.'

We pointed out that 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. The discussion continues herein.

Is the Prepayment Premium Plainly Disproportionate?

In considering whether a prepayment premium is “plainly disproportionate” to the lender's potential loss, courts look at the damages foreseeable at the time of contracting and not the actual damages at the time of prepayment or acceleration of the debt. See In re Sch. Specialty, Inc. , 2013 WL 183513, at *2 (citing Walter E. Heller & Co., Inc. v. Am. Flyers Airline Corp. , 459 F.2d 896, 898-99 (2d. Cir. 1972)). Furthermore, courts consider whether the prepayment premium clause is the result of arm's-length negotiations between represented sophisticated parties. See In re Sch. Specialty, Inc., 2013 WL 183513, at *3 (internal citations omitted). A number of courts have held that prepayment consideration calculated on the basis of U.S. Treasury Bond interest rates is not plainly disproportionate to the lender's possible loss. Id. at *4 (internal citations omitted); In re S. Side House, LLC, 451 B.R. at 271; but see In re Skyler Ridge, 80 B.R. 500, 505 (Bankr. C.D. Cal. 1987) (stating that using U.S. Treasury notes would have been acceptable provided that appropriate adjustment were included to bring rate up to then-existing comparable mortgage rate).'

In In re Vanderveer Estates Holdings, Inc., the court held that the prepayment premium was not plainly disproportionate to the creditor's possible loss. 283 B.R. at 130 (citing United Merchs. & Mfrs., Inc. v. Equitable Life Assurance Soc'y of the U.S. (In re United Merchs. & Mfrs., Inc.), 674 F.2d 134, 143 (2d Cir. 1982)). The prepayment premium was the result of arm's-length negotiations and was calculated based on prevailing Treasury Bond yields at or about the time of prepayment and was structured to allow the creditor to collect its bargained-for yield if the prepaid funds were reinvested in a Treasury Bill of comparable maturity. In re Vanderveer Estates Holdings, Inc., 283 B.R. at 130.' The court reasoned that the prepayment premium clause did not result in an automatic premium upon prepayment.' Id. If interest rates increased such that the Treasury Bond yield would exceed the interest rate under the loan documents, then the creditor could still obtain the bargained-for interest, and the prepayment premium would be zero. Id.

Does the Reasonableness Standard Apply?

In addition to evaluating the enforceability of a prepayment premium clause as liquidated damages, many courts have held that the prepayment premium must satisfy the reasonableness standard set forth in Section 506(b) of the Bankruptcy Code. Courts have taken different approaches as to how reasonableness under Section 506(b) is evaluated. Some courts have held that if the prepayment premium passed muster under the liquidated damages standard, then it should similarly be enforceable under Section 506(b). See In re Sch. Specialty, Inc., 2013 WL 183513, at *5. Other courts have evaluated liquidated damages and reasonableness under Section 506(b) as two distinct issues. See In re Vanderveer Estates Holdings, Inc., 283 B.R. at 131-34.'

Section 506(b) allows an oversecured creditor to recover “reasonable [post-petition] fees, costs, or charges provided for under the [relevant] agreement ' .” 11 U.S.C. ' 506(b) (2005); see also In re Vanderveer Estates Holdings, Inc., 283 B.R. at 131. At least one court has held that prepayment premium clauses are not subject to Section 506(b) where the premium became due before the debtor filed for bankruptcy and therefore was included as part of the creditor's claim. In re CP Holdings, Inc., 332 B.R. at 392.

If a court determines that Section 506(b) applies to a prepayment premium, typically its initial inquiry in evaluating reasonableness is the purpose of the premium. See, e.g., In re Duralite Truck Body & Container Corp., 153 B.R. at 713.

Generally, prepayment premiums protect lenders against falling interest rates. Without a prepayment premium, a borrower would have an incentive to refinance the debt, thus depriving the lender of the benefit of its bargain, namely, the unearned interest at above current market rates over the unexpired term of the loan. On the other hand, if the loan was involuntarily prepaid when market interest rates were higher than the contractual rate, the lender could reinvest the funds at the higher rate, resulting in a windfall to the lender.

Id. at 713-14 (internal citations omitted).

The majority of courts have held that to qualify as “reasonable” under Section 506(b), prepayment premiums must reflect the creditor's actual damages. See, e.g., In re Schwegmann Giant Supermarkets P'ship, 264 B.R. 823, 828 (Bankr. E.D. La. 2001) (citations omitted). But see Noonan, 245 B.R. at 330 (declining to use actual damages to determine reasonableness due to fact that actual damages were hard to calculate in line of credit situation). Actual damages are calculated as “the difference between the market rate of interest at the time of prepayment and the contract rate for the duration of the loan, discounted to present value.” In re Schwegmann Giant Supermarkets P'ship, 264 B.R. at 828 (quoting In re Duralite Truck Body & Container Corp., 153 B.R. at 714).

Courts have considered prepayment premium clauses to be “unreasonable” for a variety of reasons. Prepayment premiums that allow a creditor to recover the same amount regardless of whether the market interest rates increase or decrease are said to “presume a loss” and are deemed unreasonable. Id. at 829 (quoting In re Duralite Truck Body & Container Corp., 153 B.R. at 714-15) (prepayment premium allowed creditor to receive 10% of prepaid principal regardless of market interest rates).

Additionally, prepayment premiums are likely to be found unreasonable and therefore unenforceable if they fail to discount the recovery to present value. See Schwegmann Giant Supermarkets P'ship, 264 B.R. at 829 (citing In re Duralite Truck Body & Container Corp., 153 B.R. at 714-15). The court in In re Kroh Bros. Dev. Co., 88 B.R. 997, 1002 (Bankr. W.D. Mo. 1988), struck down a prepayment premium that amounted to 25% of the loan's principal, and held that a reasonable prepayment premium is “at most” the equivalent of 10% of the loan's principal.

Many courts have followed this guideline. See, e.g., In re Schwegmann Giant Supermarkets P'ship, 264 B.R. at 829-30 (holding 18% premium unreasonable); Noonan, 245 B.R. at 331 (holding 5.9% premium reasonable); Anchor Resolution Corp. v. State St. Bank & Trust Co. (In re Anchor Resolution Corp.), 221 B.R. 330, 341 (Bankr. D. Del. 1998) (holding 6.9 % premium reasonable). But see Fin. Ctr. Assocs. of East Meadow, L.P. v. Funding Corp. (In re Fin. Ctr. Assocs. of East Meadow, L.P.), 140 B.R. 829, 839 (Bankr. E.D.N.Y. 1992) (disagreeing with Kroh Bros. Dev. and holding that although 25% premium was high, it was not unreasonable).

Conclusion

Prepayment premiums are important for creditors' ability to fully receive their anticipated benefit of lending money. In the context of debt acceleration in bankruptcy, loan documents must include clear and unambiguous language to enable creditors to have a chance of collecting prepayment premiums. Prepayment premiums are more likely to be enforceable if they meet state law standards permitting liquidated damages, typically that damages must be difficult to determine at the time of contracting, and if the contractual damages are not be plainly disproportionate to the creditors' potential damages. In courts that apply the reasonableness standard under Section 506(b) of the Bankruptcy Code, prepayment premiums are most likely to be enforced if the clauses are structured so that the amounts reflect the particular creditors' actual damages.

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.