The Fifth Circuit Takes On the Issue of Prepayment Premiums

In a recent decision by the United States Court of Appeals for the Fifth Circuit in In re Denver Merchandise Mart, Inc., the court held that a lender's pre-bankruptcy acceleration of a promissory note arising from a borrower's nonpayment default did not trigger provision for a prepayment premium in the absence of an actual loan prepayment. Bank of N.Y. Mellon v. GC Merch. Mart, L.L.C. (In re Denver Merch. Mart, Inc.), 740 F.3d 1052 (5th Cir. 2014). The decision was the latest in a line of cases addressing whether certain clauses in loan instruments permitting borrowers to repay debts prior to maturity for an additional fee may be allowed as part of a lender's claim against a Chapter 11 debtor. Such clauses are typically referred to as a prepayment premiums, make-whole premiums, prepayment penalties, or in this case “Prepayment Consideration.” The Fifth Circuit's decision stresses the importance of precise drafting of prepayment premium provisions so that there is no ambiguity that the borrower agreed to pay a prepayment premium following not only a borrower's exercise of its rights to prepay, but as well a lender's acceleration of the note upon default thereof.

Factual Background

In Denver Merchandise, in September 2007, one of the debtors, GC Merchandise Mart, LLC (“GCMM”), executed a promissory note (the “Note”) in favor of a predecessor in interest to Bank of New York Mellon (the “Lender”) in exchange for a $30 million loan. Id. at 1054. The relevant provisions of the Note were included in Articles 4 and 6 thereof. Article 4 of the Note contained an acceleration provision stating that “if any payment required in this Note is not paid prior to the tenth (10th) day after the date when due or on the Maturity Date or on the happening of any other default,” certain sums become immediately due and payable, including the principal balance, interest, default interest, “other sums, as provided in this Note,” and, among other things, “all other moneys agreed or provided to be paid by Borrower in this Note, the Security Instrument or the Other Security Documents.” Id.

Article 6(A)(1) of the Note granted GCMM the “right or privilege to prepay all (but not less than all) of the unpaid principal balance of [the] Note” as well as all interest, and the payment of other sums including “Prepayment Consideration.” Id. at 1054, 1057. Article 6(A)(1) of the Note also provided that if a “Default Prepayment” occurred, GCMM would be required to pay the Lender the entire debt owed, including the prepayment premium. Id . at 1057. The Note defined “Default Prepayment” as “a prepayment of the principal amount of this Note made during the continuance of any Event of Default or after an acceleration of the Maturity Date under any circumstances, ' .” Id' In addition, Article 6(A)(3) of the Note provided that “Borrower shall pay the Prepayment Consideration due hereunder whether the prepayment is voluntary or involuntary (including without limitation in connection with Lender's acceleration of the unpaid principal balance of the Note) ' .” Id. at 1058.

GCMM stopped making payments on the Note by October 2010 and thereby defaulted on its terms. The Lender issued a notice of default and obtained an ex parte order appointing a receiver. At that point, GCMM and its debtor affiliates filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code. 11 U.S.C. ' 101, et seq.

At the time of the Chapter 11 filings, GCMM owed the Lender approximately $24 million. In addition to that amount, the Lender argued that, notwithstanding GCMM's failure to pay the Note prior to maturity, GCMM owed the Lender a $1.8 million prepayment premium pursuant to Articles 4 and 6 of the Note. The bankruptcy court disagreed with the Lender and found that: 1) some payment, whether voluntary or involuntary, must actually be made to trigger the Prepayment Consideration; 2) the rationale for requiring a prepayment premium did not apply; 3) the cases cited by the Lender were inapposite because in each of those cases the acceleration clause specifically provided that acceleration would trigger the prepayment consideration obligation; and 4) it would have been easy to expressly articulate in the Note a prepayment premium in the event of acceleration. Id. at 1054-1055.

As a result, the bankruptcy court disallowed the Lender's $1.8 million claim for the “Prepayment Consideration.” Id. at 1055. The district court affirmed the bankruptcy court's decision, and the Lender appealed the issue of whether GCMM was liable for the prepayment premium upon the pre-bankruptcy acceleration of the Note.

Fifth Circuit Decision

The Fifth Circuit considered the appeal to be “a relatively straightforward question of contract interpretation under Colorado law.” Id. at 1054. Citing several Colorado decisions where prepayment penalties were in dispute, the Fifth Circuit found that under Colorado law, if a lender expressly waives the right to refuse early payment, including by voluntarily accelerating the note, then the lender is not entitled to any prepayment penalty unless there is a clear contractual provision for such premium or evidence of the borrower's bad faith in defaulting to avoid penalty. Id' at 1056, 1059. The Fifth Circuit also stated that a prepayment premium is not liquidated damages, but rather consideration for the borrower's right to prepay, and is therefore not subject to the rules of reasonableness for liquidated damages provided for in 506(b) of the Bankruptcy Code. Id. at 1056.

Having established that parties are free to contract for a premium upon prepayment, the Fifth Circuit next looked at the express provisions of Articles 4 and 6 of the Note. The court first examined the plain language of Article 4, and found that it must look elsewhere within the Note to determine whether the “other sums” or “other moneys” required to be paid by GCMM after acceleration of the Note from nonpayment included the “Prepayment Consideration.” Id' at 1058. As a result, the court turned to Article 6 of the Note, and in reviewing same, acknowledged that while there were several conditions that might trigger the prepayment premium, “none requires the Borrower to pay the Prepayment Consideration, absent an actual prepayment, which did not occur here.” Id. The Fifth Circuit found that Article 6(A)(1) of the Note did not apply because the “plain language requires an actual prepayment to trigger the obligation to pay the Prepayment Consideration, and no prepayment occurred here.” Id. The court also found that the plain language of Article 6(A)(3) of the Note contemplated a voluntary or involuntary prepayment, which did not occur.

In addition, the Fifth Circuit compared the language in the Note with an analogous provision in a note at issue in the In re CP Holdings, Inc. case. Id. at 1059; In re CP Holdings, Inc., 332 B.R. 380, 382 (W.D. Mo. 2005). There, the borrower expressly waived the right to pepay the note without premium and explicitly agreed to pay a prepayment premium upon acceleration. The Fifth Circuit found that the GCMM Note lacked similar language, which could “deem” the prepayment to have been made upon acceleration, an outcome that would not have been difficult to achieve through artful and precise drafting. Id.

Therfore, the Fifth Circuit concluded that “the plain language of the contract does not require the payment of the Prepayment Consideration in the event of mere acceleration,” but instead “provides that no Prepayment Consideration is owed unless there is an actual prepayment, whether voluntary or involuntary.” Id. Accordingly, the Fifth Circuit affirmed the lower courts' decisions to disallow the Lender's claim for contractual Prepayment Consideration.

Related Case Law

As noted above, Denver Merchandise follows the decisions of a number of courts that have addressed the enforceability of prepayment premiums. Recently, in a 2013 decision in In re AMR Corp., the United States Court of Appeals for the Second Circuit held that based upon the plain language of the indentures, the bankruptcy filing triggered a default, which accelerated the debt but did not require payment of a make-whole amount. The Second Circuit found that language of the indentures “must clearly be read to exclude the payment of any Make-Whole Amount where an Event of Default has occurred, is continuing, and debt acceleration has taken place ' .” U.S. Bank Trust Nat'l Ass 'n v. AMR Corp. ( In re AMR Corp.), 730 F.3d 88, 105 (2d Cir. 2013). In contrast, in another 2013 decision in In re School Specialty , the United States Bankruptcy Court for the District of Delaware held that a lender was entitled to a $23.7 million make-whole payment pursuant to a credit agreement that expressly provided for such premium upon either prepayment or acceleration.

Other cases that have dealt with the validity of prepayment provisions have also offered guidance on the importance of careful drafting of such provisions. See Transcript of Proceedings, In re GMX Resources, Inc., No. 13-11456 (Bankr. W.D. Okl. Aug. 27, 2013) (holding that based on the unambiguous language of the governing credit agreement the lenders' claim properly included a make-whole premium); In re Chemtura Corp., 439 B.R. 561 (Bankr. S.D.N.Y. 2010) (relying on the plain meaning of separate definitions of the relevant notes in determining bondholders' entitlement to make-whole payment); In re Solutia Inc., 379 B.R. 473 (Bankr. S.D.N.Y. 2007) (denying claim for prepayment premium because payment after automatic acceleration was post-maturity date repayment and finding that while it is possible to contractually provide for post-acceleration “yield maintenance” the notes did not have the necessary explicitness).

In addition, in determining the enforceability of prepayment premiums, courts generally address the issue of whether a prepayment premium should be properly characterized as unmatured interest or liquidated damages. For instance, in In re School Specialty, Inc., Judge Kevin J. Carey agreed with the precedent of his colleague Judge Brendan L. Shannon's opinion in In re Trico Marine Services, and concluded, “a claim for a make whole premium was akin to a claim for liquidated damages, not a claim for unmatured interest.” In re Sch. Specialty, Inc., No. 13-10125, 2013 Bankr. LEXIS 1897, * 19 (Bankr. D. Del. Apr. 22, 2013) (citing In re Trico Marin Servs., 450 B.R. 474, 480-81 (Bankr. D. Del 2011). As a result, in analyzing the premium, the School Specialty court applied New York law and determined that the make whole payment met the reasonableness standard of section 506(b) of the Bankruptcy Code and was not disallowable as unmatured interest under section 502(b)(2).

In Denver Merchandise, however, because the court determined that the prepayment premium was not triggered, the Fifth Circuit did not directly address this issue. While the Fifth Circuit stated that a “prepayment is not liquidated damages and is not subject to the rules of reasonableness for liquidated damages,” the court did not address whether the premium constituted unmatured interest. One could argue that the absence of any discussion on this point suggests that had the language in the Note appropriately provided for the premium, the Fifth Circuit would have allowed the Lender's claim and found the premium did not constitute disallowable unmatured interest.

Considerations Going Forward

The Denver Merchandise case serves as a strong reminder that lenders (and their counsel) who seek to have effective and complete prepayment fee entitlement should most carefully draft provisions into loan documents that unambiguously provide for prepayment premiums upon acceleration and are consistent with applicable state law. The Fifth Circuit's decision reiterates that courts are reluctant to go beyond the plain language of the note or credit agreement in determining the enforceability of prepayment premiums. Hence, absent specific and precise language in these instruments granting prepayment penalties to lenders, courts are likely to deny such premiums in the event of acceleration or otherwise.

Brett D. Goodman is an attorney in the Bankruptcy Practice Group of Troutman Sanders LLP in New York. He may be reached at'[email protected]. The author gratefully acknowledges the assistance of Mitchel H. Perkiel, a partner in the Bankruptcy Practice Group of the firm, in the preparation of this article.

In a recent decision by the United States Court of Appeals for the Fifth Circuit in In re Denver Merchandise Mart, Inc., the court held that a lender's pre-bankruptcy acceleration of a promissory note arising from a borrower's nonpayment default did not trigger provision for a prepayment premium in the absence of an actual loan prepayment. Bank of N.Y. Mellon v. GC Merch. Mart, L.L.C. (In re Denver Merch. Mart, Inc.), 740 F.3d 1052 (5th Cir. 2014). The decision was the latest in a line of cases addressing whether certain clauses in loan instruments permitting borrowers to repay debts prior to maturity for an additional fee may be allowed as part of a lender's claim against a Chapter 11 debtor. Such clauses are typically referred to as a prepayment premiums, make-whole premiums, prepayment penalties, or in this case “Prepayment Consideration.” The Fifth Circuit's decision stresses the importance of precise drafting of prepayment premium provisions so that there is no ambiguity that the borrower agreed to pay a prepayment premium following not only a borrower's exercise of its rights to prepay, but as well a lender's acceleration of the note upon default thereof.

Factual Background

In Denver Merchandise, in September 2007, one of the debtors, GC Merchandise Mart, LLC (“GCMM”), executed a promissory note (the “Note”) in favor of a predecessor in interest to Bank of New York Mellon (the “Lender”) in exchange for a $30 million loan. Id. at 1054. The relevant provisions of the Note were included in Articles 4 and 6 thereof. Article 4 of the Note contained an acceleration provision stating that “if any payment required in this Note is not paid prior to the tenth (10th) day after the date when due or on the Maturity Date or on the happening of any other default,” certain sums become immediately due and payable, including the principal balance, interest, default interest, “other sums, as provided in this Note,” and, among other things, “all other moneys agreed or provided to be paid by Borrower in this Note, the Security Instrument or the Other Security Documents.” Id.

Article 6(A)(1) of the Note granted GCMM the “right or privilege to prepay all (but not less than all) of the unpaid principal balance of [the] Note” as well as all interest, and the payment of other sums including “Prepayment Consideration.” Id. at 1054, 1057. Article 6(A)(1) of the Note also provided that if a “Default Prepayment” occurred, GCMM would be required to pay the Lender the entire debt owed, including the prepayment premium. Id . at 1057. The Note defined “Default Prepayment” as “a prepayment of the principal amount of this Note made during the continuance of any Event of Default or after an acceleration of the Maturity Date under any circumstances, ' .” Id' In addition, Article 6(A)(3) of the Note provided that “Borrower shall pay the Prepayment Consideration due hereunder whether the prepayment is voluntary or involuntary (including without limitation in connection with Lender's acceleration of the unpaid principal balance of the Note) ' .” Id. at 1058.

GCMM stopped making payments on the Note by October 2010 and thereby defaulted on its terms. The Lender issued a notice of default and obtained an ex parte order appointing a receiver. At that point, GCMM and its debtor affiliates filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code. 11 U.S.C. ' 101, et seq.

At the time of the Chapter 11 filings, GCMM owed the Lender approximately $24 million. In addition to that amount, the Lender argued that, notwithstanding GCMM's failure to pay the Note prior to maturity, GCMM owed the Lender a $1.8 million prepayment premium pursuant to Articles 4 and 6 of the Note. The bankruptcy court disagreed with the Lender and found that: 1) some payment, whether voluntary or involuntary, must actually be made to trigger the Prepayment Consideration; 2) the rationale for requiring a prepayment premium did not apply; 3) the cases cited by the Lender were inapposite because in each of those cases the acceleration clause specifically provided that acceleration would trigger the prepayment consideration obligation; and 4) it would have been easy to expressly articulate in the Note a prepayment premium in the event of acceleration. Id. at 1054-1055.

As a result, the bankruptcy court disallowed the Lender's $1.8 million claim for the “Prepayment Consideration.” Id. at 1055. The district court affirmed the bankruptcy court's decision, and the Lender appealed the issue of whether GCMM was liable for the prepayment premium upon the pre-bankruptcy acceleration of the Note.

Fifth Circuit Decision

The Fifth Circuit considered the appeal to be “a relatively straightforward question of contract interpretation under Colorado law.” Id. at 1054. Citing several Colorado decisions where prepayment penalties were in dispute, the Fifth Circuit found that under Colorado law, if a lender expressly waives the right to refuse early payment, including by voluntarily accelerating the note, then the lender is not entitled to any prepayment penalty unless there is a clear contractual provision for such premium or evidence of the borrower's bad faith in defaulting to avoid penalty. Id' at 1056, 1059. The Fifth Circuit also stated that a prepayment premium is not liquidated damages, but rather consideration for the borrower's right to prepay, and is therefore not subject to the rules of reasonableness for liquidated damages provided for in 506(b) of the Bankruptcy Code. Id. at 1056.

Having established that parties are free to contract for a premium upon prepayment, the Fifth Circuit next looked at the express provisions of Articles 4 and 6 of the Note. The court first examined the plain language of Article 4, and found that it must look elsewhere within the Note to determine whether the “other sums” or “other moneys” required to be paid by GCMM after acceleration of the Note from nonpayment included the “Prepayment Consideration.” Id' at 1058. As a result, the court turned to Article 6 of the Note, and in reviewing same, acknowledged that while there were several conditions that might trigger the prepayment premium, “none requires the Borrower to pay the Prepayment Consideration, absent an actual prepayment, which did not occur here.” Id. The Fifth Circuit found that Article 6(A)(1) of the Note did not apply because the “plain language requires an actual prepayment to trigger the obligation to pay the Prepayment Consideration, and no prepayment occurred here.” Id. The court also found that the plain language of Article 6(A)(3) of the Note contemplated a voluntary or involuntary prepayment, which did not occur.

In addition, the Fifth Circuit compared the language in the Note with an analogous provision in a note at issue in the In re CP Holdings, Inc. case. Id. at 1059; In re CP Holdings, Inc., 332 B.R. 380, 382 (W.D. Mo. 2005). There, the borrower expressly waived the right to pepay the note without premium and explicitly agreed to pay a prepayment premium upon acceleration. The Fifth Circuit found that the GCMM Note lacked similar language, which could “deem” the prepayment to have been made upon acceleration, an outcome that would not have been difficult to achieve through artful and precise drafting. Id.

Therfore, the Fifth Circuit concluded that “the plain language of the contract does not require the payment of the Prepayment Consideration in the event of mere acceleration,” but instead “provides that no Prepayment Consideration is owed unless there is an actual prepayment, whether voluntary or involuntary.” Id. Accordingly, the Fifth Circuit affirmed the lower courts' decisions to disallow the Lender's claim for contractual Prepayment Consideration.

Related Case Law

As noted above, Denver Merchandise follows the decisions of a number of courts that have addressed the enforceability of prepayment premiums. Recently, in a 2013 decision in In re AMR Corp., the United States Court of Appeals for the Second Circuit held that based upon the plain language of the indentures, the bankruptcy filing triggered a default, which accelerated the debt but did not require payment of a make-whole amount. The Second Circuit found that language of the indentures “must clearly be read to exclude the payment of any Make-Whole Amount where an Event of Default has occurred, is continuing, and debt acceleration has taken place ' .” U.S. Bank Trust Nat'l Ass 'n v. AMR Corp. ( In re AMR Corp.), 730 F.3d 88, 105 (2d Cir. 2013). In contrast, in another 2013 decision in In re School Specialty , the United States Bankruptcy Court for the District of Delaware held that a lender was entitled to a $23.7 million make-whole payment pursuant to a credit agreement that expressly provided for such premium upon either prepayment or acceleration.

Other cases that have dealt with the validity of prepayment provisions have also offered guidance on the importance of careful drafting of such provisions. See Transcript of Proceedings, In re GMX Resources, Inc., No. 13-11456 (Bankr. W.D. Okl. Aug. 27, 2013) (holding that based on the unambiguous language of the governing credit agreement the lenders' claim properly included a make-whole premium); In re Chemtura Corp., 439 B.R. 561 (Bankr. S.D.N.Y. 2010) (relying on the plain meaning of separate definitions of the relevant notes in determining bondholders' entitlement to make-whole payment); In re Solutia Inc., 379 B.R. 473 (Bankr. S.D.N.Y. 2007) (denying claim for prepayment premium because payment after automatic acceleration was post-maturity date repayment and finding that while it is possible to contractually provide for post-acceleration “yield maintenance” the notes did not have the necessary explicitness).

In addition, in determining the enforceability of prepayment premiums, courts generally address the issue of whether a prepayment premium should be properly characterized as unmatured interest or liquidated damages. For instance, in In re School Specialty, Inc., Judge Kevin J. Carey agreed with the precedent of his colleague Judge Brendan L. Shannon's opinion in In re Trico Marine Services, and concluded, “a claim for a make whole premium was akin to a claim for liquidated damages, not a claim for unmatured interest.” In re Sch. Specialty, Inc., No. 13-10125, 2013 Bankr. LEXIS 1897, * 19 (Bankr. D. Del. Apr. 22, 2013) (citing In re Trico Marin Servs., 450 B.R. 474, 480-81 (Bankr. D. Del 2011). As a result, in analyzing the premium, the School Specialty court applied New York law and determined that the make whole payment met the reasonableness standard of section 506(b) of the Bankruptcy Code and was not disallowable as unmatured interest under section 502(b)(2).

In Denver Merchandise, however, because the court determined that the prepayment premium was not triggered, the Fifth Circuit did not directly address this issue. While the Fifth Circuit stated that a “prepayment is not liquidated damages and is not subject to the rules of reasonableness for liquidated damages,” the court did not address whether the premium constituted unmatured interest. One could argue that the absence of any discussion on this point suggests that had the language in the Note appropriately provided for the premium, the Fifth Circuit would have allowed the Lender's claim and found the premium did not constitute disallowable unmatured interest.

Considerations Going Forward

The Denver Merchandise case serves as a strong reminder that lenders (and their counsel) who seek to have effective and complete prepayment fee entitlement should most carefully draft provisions into loan documents that unambiguously provide for prepayment premiums upon acceleration and are consistent with applicable state law. The Fifth Circuit's decision reiterates that courts are reluctant to go beyond the plain language of the note or credit agreement in determining the enforceability of prepayment premiums. Hence, absent specific and precise language in these instruments granting prepayment penalties to lenders, courts are likely to deny such premiums in the event of acceleration or otherwise.

Brett D. Goodman is an attorney in the Bankruptcy Practice Group of Troutman Sanders LLP in New York. He may be reached at'[email protected]. The author gratefully acknowledges the assistance of Mitchel H. Perkiel, a partner in the Bankruptcy Practice Group of the firm, in the preparation of this article.