Today, almost every commercial loan note contains or incorporates some kind of provision that conditions the borrower's right to pre-pay the loan balance upon payment of compensation known as a "pre-payment premium." Absent such a provision, a borrower generally has no right to pay off the loan before the stated maturity date.¹ This general prohibition is based on several factors, most notably, that it would be unfair to allow borrowers to pre-pay without penalty when lenders cannot force early payment of a loan over a borrower's resistance without being in breach of the loan documents. Additionally, every commercial loan entails certain fixed administrative costs that are amortized over the entire term of the loan. Commercial lenders would forfeit repayment of such administrative costs if compelled to accept an early pre-payment without compensation from the borrower.²

Pre-payment provisions, therefore, are intended to protect the lender against a downturn in interest rates, which can result in wholesale refinancing by borrowers seeking the benefits of lower interest rates. Stated another way, such provisions ensure that the lender will receive its contractual rate of return over the life of the loan. A lender's damages in the event of pre-payment include, among other things, the loss of interest to which the lender would have been entitled, and the expense and attendant risk of procuring a substitute borrower (i.e., the new loan's applicable rate of return, its duration and the risks involved in each specific transaction, such as the extent and reliability of the collateral).³

Judicial Deference Outside of Bankruptcy

Courts traditionally have upheld pre-payment charges, affording respect to the contractual provisions negotiated by lenders and borrowers because of the sophistication of the parties and the arms-length nature of the transaction.⁴ Courts most frequently scrutinize such provisions using a liquidated damages analysis, which evaluates the reasonableness of the provision, without the benefit of hindsight, at the time the parties originally entered into the loan. The courts' deference to such provisions is manifested by several decisions that refuse to even apply a liquidated damages analysis, holding that pre-payment is not a breach of the contract because the pre-payment provision gives the borrower the election to render either one of two alternative performances—payment over the full term of the loan or early payment.⁵ A few courts even have imposed pre-payment premiums without supporting the language in the loan documents.⁶

Heightened Scrutiny in Bankruptcy

The lender, however, will encounter a more hostile attitude toward the recovery of such fees when the pre-paying borrower is in bankruptcy. The lender is likely to face challenges from other secured and unsecured creditors, in addition to the reticent borrower, in the cases of those seeking to maximize their own recoveries. Understandably, there is a certain amount of tension between unsecured creditors who expect to receive some cents on the dollar and the secured lender who has already received full payment of the principal balance of the loan (albeit prematurely).

Additionally, bankruptcy courts have been less apt to award such fees despite the clear intent of the contracting parties, relying upon §506(b),⁷ which expressly requires that such fees be "reasonable."⁸ The courts have taken two differing approaches to evaluating the reasonableness of pre-payment premiums. In what appears to be the majority approach, the court determines the lender's "actual damages," if any, and awards the lender a pre-payment premium in this amount.⁹ These courts disregard the contractual pre-payment provision (or rewrite the provision to make it reasonable under §506(b)). A case illustrating this approach is Imperial Coronado,¹⁰ wherein the contractual pre-payment premium was six months of interest on the pre-paid amount, which amounted to $54,000 on a principal pre-payment of $815,000. Acknowledging that the full amount of the contractual pre-payment premium might be enforceable under applicable state law, the Imperial Coronado court nevertheless awarded the lender a pre-payment premium equal to "the difference between (1) the market rate of interest on the pre-payment date, and (2) the contract rate, for the remaining term of the loan."¹¹ The court concluded that this approach was the most appropriate in light of the purpose behind pre-payment premiums, which is to protect lenders from a drop in interest rates between the date a loan is made and the pre-payment date.¹² Implicit in the court's analysis was the assumption that actual damages are easily calculable and measured by the difference between the market rate of interest at the time of pre-payment and the contract rate for the duration of the loan, discounted to present value.¹³ Courts adopting the "actual damages" approach to pre-payment premiums frequently justify their rejection of the contractual formula because it either presumes damages regardless of any change in interest rates, or makes no effort to discount the gross amount of lost interest to present value.¹⁴

However, other courts reject this "actual damages" approach as too formulaic and simplistic.¹⁵ These cases apply a liquidated damages analysis, which honors and upholds the contractual premium so long as the premium represents a reasonable estimation of the lender's damages viewed at the time the parties first contracted. These courts do not view §506(b) as authorizing a disregard of the contractual language, but rather as a safety valve to avoid a windfall to the lender. For example, in In re Financial Center Associates of East Meadow L.P.,¹⁶ the U.S. Bankruptcy Court for the Eastern District of New York held that such fees would be sustained where actual damages were difficult to determine and that the stipulated sum was not plainly disproportionate to the possible loss.¹⁷ The court rejected the debtor's argument that the provision bore no relation to the lender's actual damages, explaining:

The magnitude of the loan transaction and quality and quantity of the loan documents leave little doubt that here we have an arms-length transaction between adequately represented sophisticated businessmen. Under these circumstances, we feel, as did the United Merchants and Heller courts, that it would be offensive to the basic notion of freedom of contract if the debtor's argument were to prevail. Were we to accept debtor's position we would be granting borrowers a license to gamble with lender's money regarding the discount rate applicable to pre-payment charges, a gamble that cannot fail. Should the yield on treasury bonds go up, the debtor honors the deal; if, however, the yield goes down, the debtor moves to invalidate the pre-payment charge. Such a result offends our sense of fair play. It is an attempt to soften the blow of bad business judgment. The purpose of chapter 11, whether under the old Act or under the Bankruptcy Code, has never been designed to absorb the consequences of risk-taking.

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We are willing to view the reasonable standard of §506(b) in the context of pre-payment clauses as a safety valve which must be used cautiously and sparingly as all discretionary powers that are not subject to close scrutiny and statutory standard.¹⁸

Significantly, the Financial Center court found the magnitude of the actual damages was not even relevant to a determination of the reasonableness of the premium, and there was no discussion or any showing by either of the parties of the lender's actual damages.¹⁹

Similarly, the U.S. Bankruptcy Court for the Northern District of Illinois explained:

In determining the validity of a pre-payment clause, the court must look to the damages that the parties could anticipate at the time the parties contracted. The parties are not required to make the best estimation of damages, just one that is reasonable. It is immaterial that the actual damages suffered are higher or lower than the amount specified in the clause. However, if the damages are easily calculable or the pre-payment premium greatly exceeds a reasonable estimate of damages, that premium will be disallowed."²⁰

The Shaumburg court upheld the contractual premium because it concluded that the lender's estimated damages were difficult to calculate at the time the parties negotiated the loan documents (i.e., the parties had no way of estimating the date of pre-payment and the rate of return at the time of contracting).²¹ In that case, the lender submitted proof showing that its actual pre-payment damages were almost $1 million greater than the 10-percent contractual pre-payment fee. The court therefore stated that the enforcement of the parties' agreement would not result in an unlawful windfall to the lender.²²

Common Problems Encountered by Lenders

As these cases evidence, to obtain this contractually bargained-for payment, the lender should be prepared to refute and overcome varying challenges presented by adverse parties in the bankruptcy case. First and foremost, the lender should be prepared to present evidence of actual damages. This is true regardless of whether the court is likely to adopt the "actual damages" or "liquidated damages" approach to analyzing pre-payment premiums. Even courts utilizing the "liquidated damages" approach are sensitive to preventing a windfall to the secured lender at the expense of the debtor and other unsecured creditors. The lender should therefore introduce evidence of lost opportunity costs associated with the pre-paid loan. Proving lost interest alone, however, may not be sufficient where the lending formula is floating rather than fixed, or when interest rates have increased significantly since the execution of the original loan documents. Therefore, the lender should offer evidence of its costs to procure a new loan, and detail amortized costs of the loan that were not recovered as a result of the pre-payment. Evidence, by affidavit or otherwise, of the lender's difficulty and costs associated with obtaining a substitute borrower can go a long way toward convincing the bankruptcy court that the lender has been harmed and should receive some form of compensation. The lender should also, if applicable, demonstrate that it has not fully utilized its own loan facility, thereby showing damage in the form of lost income irrespective of interest rate movements. In other words, having other available untapped funds for other loans will demonstrate that the lender's receipt of such monies back from the borrower did nothing to replace the profit the lender would have earned on the original loan. Such a showing is helpful when interest rates have gone up since execution of the original loan documents.

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...the lender seeking payment of this premium should carefully review the language of the loan agreement to ensure that all express conditions precedent to payment of the premium have been satisfied.

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The lender is also likely to face attack if the contractual pre-payment premium does not discount future lost interest to the present value. On its face, such discounting appears reasonable if the interest rate is fixed over the term of the loan and the principal amount of the obligations is calculable to a certainty. However, at least in the context of a line of credit or a loan with a floating rate, a strong argument can be made that it is not possible to estimate how much the borrower would have drawn on the line, or the applicable rate of interest, during the remaining term of the loan. Accordingly, discounting an arbitrary balance is anything but certain, and represents an imperfect method of calculating the lender's actual damages.

The lender should also be prepared to face aggressive attacks in cases where it has accelerated the loan before or upon the bankruptcy filing, or compelled a sale, the proceeds of which satisfy its principal balance. In this context, the lender is likely to encounter the argument that its own actions precipitated the pre-payment; therefore, it is highly inequitable to award such fees to the lender. In cases involving acceleration, courts have ruled that the lender waived the pre-payment premium on the theory either that the lender elected to receive its principal and interest immediately rather than receive the bargained-for interest over the remaining term of the loan, or that a payment following acceleration is a payment after maturity, and therefore not a "pre-payment."²³ A lender's motion for relief from stay has also been held to constitute an acceleration, thus precluding the lender from obtaining a pre-payment premium.²⁴ The best defense to this argument is contractual language, which requires the pre-payment premium even in the event of acceleration. Because this right may be specifically bargained for and agreed to by the debtor and the lender, courts generally will enforce such a provision.²⁵ Additionally, there is authority that authorizes payment of the premium notwithstanding acceleration because the borrower had the right to reinstate the loan after acceleration by paying arrearages, or the right under bankruptcy law to decelerate the due date upon filing for bankruptcy or as part of a plan of reorganization.²⁶

Finally, the lender seeking payment of this premium should carefully review the language of the loan agreement to ensure that all express conditions precedent to payment of the premium have been satisfied. Many commercial loans require prior termination of the loan agreement by the lender or borrower. Such a showing will be difficult if the post-petition financing order expressly states that the loan agreement and pre-petition documents "remain in full force and effect" during the bankruptcy. Accordingly, the lender confident of receiving payment in full should make certain that any financing orders or relief from stay orders do not abrogate this important contractual right.

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Footnotes

¹ Arthur v. Burkich, 131 A.D.2d 105, 520 N.Y.S.2d 638 (1987); Carpenter v. Winn, 566 P.2d 370 (Colo. App. 1977). Return to article

² Chestnut Corp. v. Bankers Bond & Mortgage Co., 395 P. 153, 149 A.2d 48 (1959). Return to article

³ United Merchants & Manufacturing Inc. v. Equitable Life Assurance Society of the United States, 674 F. 2d 143 (2d Cir. 1982). Return to article

⁴ Note, "Pre-payment Penalties and Due-on-Sale Clauses and Commercial Mortgages: What Next?" 20 Ind. L.R. Rev. 735, 749-75 (1987); Note, "Pre-payment Penalties: A Survey and Suggestion," 40 Vand. L. Rev. 409, 422-423 (1987). See, also, Renda v. Gouchberg, 4 Mass.App.Ct. 786, 343 NE 2d 159 (1976) (court upheld pre-payment penalties making no attempt to assess lender's actual damages or to calculate what damages could have been reasonably anticipated at the note's execution); Tyler v. Equitable Life Assurance Society of the United States, 512 SO 2d 55 (Ala. 1987); First National Bank of Equitable Life Assurance Society of the United States, 157 Ill. App. 3d 408, 510 NE 2d 518 (1987); First Ind. Fed. Sav. Bank v. Marilyn Dev. Co., 509 NE 2d 253 (Ind. App. 1987). Return to article

⁵ See, e.g., William Fassler v. Financial Fed., 110 Cal. App.3d 7, 167 Cal. Rptr. 545 (1980); Lazzareschi Inv. Co. v. San Francisco Fed. Sav. & Loan Ass'n., 22 Cal. App. 3d 303, 99 Cal. Rptr. 417 (1971). Return to article

⁶ See, e.g., Houston N. Hospital Properties v. Telco Leasing Inc., 680 F.2d 19, 22-33 (5th Cir. 1982). Return to article

⁷ 11 U.S.C. §101-1330 (1994). Return to article

⁸ 11 U.S.C. §506(b). This section expressly allows the holder of a secured claim, to the extent such claim is oversecured, "any reasonable fees, costs or charges provided for under the agreement under which such claim arose." Courts have uniformly rejected the argument that the pre-payment premium constitutes unmatured interest disallowed by 11 U.S.C. §502(b)(2). See In re Skyler Ridge, 80 B.R. 500, 508 (Bankr. C.D. Cal. 1987); In re 360 Inns. Ltd., 76 B.R. 573, 576 (Bankr. N.D. Tex. 1987). These courts properly reasoned that, although often computed as interest that would have been received through the life of a loan, pre-payment premiums do not constitute unmatured interest because they fully mature pursuant to the provisions of the contract. Return to article

⁹ See In re Imperial Coronado Partners Ltd., 96 B.R. 997, 1001 (9th Cir. B.A.P. 1989); In re Outdoor Sports Headquarters Inc., 161 B.R. 414 (Bankr. S.D. Ohio 1993); In re 433 S. Beverly, 117 B.R. 563 (Bankr. C.D. Cal. 1990); In re Kroh Brothers Development Co., 88 B.R. 1001 (Bankr. W.D. Mo. 1988); In re Morse Tool Inc., 87 B.R. 745, 750 (Bankr. D. Mass. 1988); In re American Metals Corp., 31 B.R. 229, 237 (Bankr. D. Kan. 1983). Return to article

¹⁰ 96 B.R. 997, 1001 (Bankr. 9th Cir. 1989). Return to article

¹¹ Id. Return to article

¹² Id. It's important, however, that the court did not invalidate the pre-payment clause on the grounds that it led to an unreasonable charge. Rather, because there was no evidence submitted regarding the market rate at the time of the pre-payment, the court remanded the case to the trial court to determine that figure and allow the secured claim accordingly. Interestingly, the court noted that the entire amount of the lender's actual damages constituted an allowed claim that, if there were sufficient assets, would be paid. Id. To the extent the contractual premium exceeded such "actual damages," the difference would be treated as an allowed unsecured claim. Id. Return to article

¹³ In re Outdoor Sports Headquarters Inc., 161 B.R. 414 (Bankr. S.D. Ohio 1993); In re Duralite Truck Body & Container Corp., 153 B.R. 708, 712 (Bankr. D. Md. 1993); In re A.J. Lane & Co. Inc., 113 B.R. 829 (Bankr. D. Mass. 1990); In re Kroh Brothers, 88 B.R. 1000-01 (Bankr. W.D. Mo. 1988); In re Skyler Ridge, 80 B.R. at 505 (Bankr. C.D. Cal. 1987). Return to article

¹⁴ In re Kroh Bros. Dev. Co., 88 B.R. at 1001-2 (Bankr. W.D. Mo. 1988); In re Skyler Ridge, 80 B.R. at 505-07 (Bankr. C.D. Cal. 1987). Return to article

¹⁵ Anchor Resolution Corp. v. State Street Bank and Trust Co. of Connecticut, 221 B.R. 330 (Bankr. D. Del. 1998); In re Financial Center Associates of East Meadow L.P., 140 B.R. 829 (Bankr. E.D.N.Y. 1992); In re Shaumburg Hotel Owner Ltd. Partnership, 97 B.R. 943 (Bankr. N.D. Ill. 1989). Return to article

¹⁶ 140 B.R. 829 (Bankr. E.D.N.Y. 1992). Return to article

¹⁷ Id. at 836. Return to article

¹⁸ Id. at 838. Return to article

¹⁹ The premium in Financial Center represented 24.9 percent of the principal amount due and 20.9 percent of the total balance consisting of principal, interest and late charges. Id. at 839. Return to article

²⁰ In re Shaumburg Hotel Owner Ltd. Partnership, 97 B.R. at 953 (Bankr. N.D. Ill. 1989). Return to article

²¹ Id. Return to article

²² Id. Return to article

²³ In re A.J. Lane & Co. Inc., 113 B.R. at 826-27 (Bankr. D. Mass. 1990); In re Planvest Equity Income Partners, 94 B.R. 644 (Bankr. D. Ariz. 1988); In re LHD Realty Corp., 726 F.2d 327 (7th Cir. 1984). Return to article

²⁴ In re LHD Realty Corp., 726 F.2d 327 (7th Cir. 1984). Return to article

²⁵ In re Financial Center Associates of East Meadow L.P., 140 B.R. 829 (Bankr. E.D.N.Y. 1992); In re 433 South Beverly Drive, 117 B.R. 563 (Bankr. C.D. Cal. 1990); In re Schaumburg Hotel Owner Ltd. Partnership, 97 Bankr. 943 (Bankr. N.D. Ill. 1989). The court in Eyde v. Empire of America Fed. Sav. Bank, 701 F. Supp. 126 (E.D. Mich. 1988), recognized that there may be situations in which the collection of the pre-payment penalty after acceleration by the lender would be appropriate, regardless of the language in the pre-payment provision, where the borrower intentionally defaults on the note in an attempt to force the lender to accelerate payment. The above scenario seems implausible given the ramifications of a default on the borrower's credit rating. However, a borrower with sufficient funds may be adamant in its desire not to pay such a penalty to a lender. Return to article

²⁶ In re Imperial Coronado Partners Ltd., 96 B.R. 997 (Bankr. 9th Cir. 1989). Return to article