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 Section 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.

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 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 Section 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 Section 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.

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 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.