Prepayment premiums recently received a big boost from Bankruptcy Judge Barbara Sellers in In re Hidden Lake Ltd. Partnership, 247 B.R. 722 (Bankr. S.D. Ohio 2000). The decision upholds a $2.7 million prepayment premium arising under the terms of a yield-maintenance provision contained in a real estate mortgage note held by Aetna Life Insurance Co. The decision is significant for several reasons.

First, the decision confirmed that, even though the amount of the prepayment premium constituted 23 percent of the outstanding principal balance of the mortgage note, the prepayment premium was reasonable in amount. Second, the Hidden Lake court found that the yield maintenance provision's use of comparably maturing U.S. Treasury obligations as the discount rate in calculating the present value of future installments of principal and interest was reasonable, even though the court acknowledged that such a discount rate would "overcompensate" Aetna. Finally, Aetna's prepayment premium claim arose upon acceleration of Aetna's note prior to bankruptcy, causing the court to conclude that the prepayment premium claim did not constitute a disallowable claim for unmatured interest under the Bankruptcy Code.

Overview of Prepayment Premiums

Mortgage loan prepayments cause economic injury to fixed-rate lenders in a declining interest rate environment by depriving them of an advantageous contract interest rate.² To protect their right to earn bargained-for yields, commercial lenders use prepayment charges to allocate to borrowers some of the risk that rates may decline in the future.

Traditionally, insurance companies have employed a "yield maintenance" clause to govern the calculation of the prepayment premium. A yield-maintenance clause typically assumes that the prepayment premium and the prepaid principal will be invested in U.S. Treasury securities (Treasuries) that will mature at the same time as the prepaid loan and that the dollars so invested will return to the insurance company at maturity the same yield that the insurance company would have realized had its loan not been prepaid. Treasuries are used as the reinvestment norm because there exists no standard commercial mortgage loan rate, given the uniqueness of each commercial loan and the inherent difficulty (if not impossibility) of identifying an identical or similar loan; in contrast, the market for treasuries is deep and highly liquid.

As was the case in Hidden Lake, yield-maintenance provisions typically are triggered not only by actual prepayment, but also by acceleration of the indebtedness upon default. As Judge Sellers observed, "[i]f such clauses did not apply to acceleration for default as well as to prepayment, a borrower could cause a loan to go into default in order to pay prior to maturity and thereby avoid the prepayment charge." Hidden Lake at 727.

Background of the Case

The facts in the Hidden Lake case are straightforward. The debtor, a single-purpose real estate limited partnership, owned a residential apartment complex. Aetna held a first-priority mortgage secured by the apartment complex and the related rents. In December 1997, the debtor defaulted under the mortgage note, and Aetna accelerated all obligations under the note. In July 1998, the debtor commenced a chapter 11 case. Aetna's mortgage note contained a yield-maintenance formula that provided for the calculation of a prepayment premium payable upon prepayment or acceleration of the loan. The formula required a present-value calculation of post-acceleration scheduled debt service payments, derived by discounting such payments at a rate equal to the "mortgage equivalent of the average (or interpolated) yield of Treasury obligations maturing at approximately the same time as the indebtedness due [under Aetna's note]"³

At the time of Aetna's acceleration, the applicable Treasury-based discount rate was approximately 5.7 percent. At the time of bankruptcy, Aetna had a claim of $15.7 million secured by an apartment project valued at $12 million. Aetna and the debtor filed competing plans of reorganization, and the debtor and a junior mortgagee objected to Aetna's claim, challenging, in particular, the prepayment premium.

Legal Issues Decided by the Court

Aetna contended that its yield-maintenance formula constituted a valid liquidated-damages provision under applicable Ohio law. The standard established by the Ohio Supreme Court for evaluating the enforceability of prepayment premiums requires, among other things, that (1) the contemplated damages must be uncertain as to amount and difficult to prove, and (2) the contract as a whole must not be so manifestly unconscionable, unreasonable and disproportionate in amount to justify the conclusion that it does not express the true intention of the parties. Samson Sales Inc. v. Honeywell Inc., 465 N.E. 2d 392, 394 (Ohio 1984).

The debtor asserted that, under the Samson Sales standard, the yield-maintenance formula failed to pass muster because, among other things, Aetna's damages as a result of prepayment were not sufficiently uncertain to warrant a liquidated-damages provision. The court rejected the debtor's contention, concluding that "there are significant variables which make the exact calculation of potential losses from prepayment difficult to calculate." The court observed:

Such variables include the loan amount and term remaining and the interest rate available at the time of a prepayment. It is also difficult to know if a suitable reinvestment vehicle will be available. In 1988 Aetna had a corporate policy prohibiting loans secured by commercial real estate, but that policy is no longer in effect. Although many of the factors which are difficult to ascertain at the time a loan is entered into would be more certain if evaluated at the time of default or prepayment, the pricing of any reinvestment loan would not be known until such a loan was closed.

Hidden Lake at 726-27.

The debtor also contended that the amount of Aetna's prepayment charge significantly exceeded Aetna's actual damages, such that the prepayment premium did not satisfy the second prong of the Samson Sales test recited above. The debtor argued that the yield-maintenance provision overcompensated Aetna because Aetna could have reinvested any prepaid funds in real estate investments at 200-250 basis points over the Treasuries rate. But the debtor never established at trial the availability to Aetna of such a high-yielding alternative reinvestment option that had a term that matched the remaining term of Aetna's note. Nor did the debtor establish at trial whether Aetna's investment policies and state and federal insurance regulations would have permitted Aetna to make such an investment, what the level of a so-called real estate "market rate" was at the time Aetna accelerated its note, or whether, in fact, a "market rate" for such a loan even existed.

In the same vein, the debtor complained that the yield-maintenance formula's reliance on the "naked" yield on risk-free Treasuries (i.e., a yield not adjusted upward by additional basis points) as the basis for discounting unpaid future installments under the mortgage note could not have constituted a reasonable forecast of Aetna's actual damages. Here again, the court rejected the debtor's challenge, holding that "[a]lthough the amount of damages calculation under the yield-maintenance formula generally would overcompensate Aetna, the amount of that overcompensation, given the uncertainties accompanying the prediction of probable actual damages, was not so great that this court could find, as a matter of law, that the prepayment clause was intended to punish the debtor rather than compensate Aetna." Hidden Lake at 729.⁴

It bears emphasis that the yield-maintenance formula endorsed by the court used a Treasuries rate without any upward basis point adjustment. Compare Anchor Resolution Corp. v. State St. Bank and Tr. Co. (In re Anchor Resolution Corp.), 221 B.R. 330 (Bankr. D. Del. 1998) (concluding that a make-whole premium calculated by using a discount rate equal to 0.50 percent over Treasuries was reasonable). In blessing the $2.7 million damage figure yielded by Aetna's yield-maintenance formula, the court was particularly influenced by the uncontested fact that "both parties were knowledgeable, had a reasonable chance to understand the terms of the agreement and were sufficiently sophisticated and experienced to be aware of the import of their agreement." Hidden Lake at 729.

Finally, the debtor contended that Aetna's claim for a prepayment premium should not be allowed because the charge constitutes a claim for unmatured interest, which is barred by 11 U.S.C. §502(b)(2). In support of its argument, the debtor cited Judge Sellers' own decision in In re Ridgewood Apartment of DeKalb County Ltd., 174 B.R. 712 (Bankr. S.D. Ohio 1994), where the court disallowed a claim for a prepayment premium, viewing the premium as "an attempt to compensate the lender for potential loss in interest income..." Id. at 721. Aetna, in turn, contended that the prepayment premium was not "unmatured" because, in accordance with the provisions of Aetna's mortgage note, the prepayment premium matured when Aetna accelerated the note more than seven months prior to bankruptcy.

Aetna also contended that the calculation yielded by the yield-maintenance provision did not constitute interest; rather, application of that formula yielded a calculation of damages, albeit damages that are designed, in part, to approximate the yield that Aetna could expect to receive had its loan run to maturity. At trial, Aetna argued that an analogy could be drawn to the damage claims to which landlords and employees are entitled under the Bankruptcy Code §§502(b)(6) and 502(b)(7), respectively. In the case of landlords, for example, the landlord's damages claim is calculated with reference to unpaid future rent, but the result yielded by application of the statutory formula is still "damages" and not rent. Similarly, in the case of Aetna's prepayment premium, although the yield-maintenance provision is intended to provide compensation for loss of the stream of future payments due under the mortgage note after prepayment or acceleration, application of the formula yields a calculation of "damages." "Interest," on the other hand, is "the compensation allowed by law, or fixed by the parties, for the use, detention or forbearance of money." Systems Data Inc. v. Visi Trak Corp., 655 N.E.2d 287, 288 (Ohio 1995); see Parker Plaza West Partners v. UNUM Pension and Ins. Co., 941 F.2d 349, 352 (5th Cir. 1991) (applying Texas law, noting that "...a prepayment premium is a charge for the option or privilege of prepayment, not 'compensation...for the use or forbearance or detention of money,' and as such, the charge is not 'interest'"). In contrast, a prepayment premium represents contractually fixed damages arising upon the prepayment or acceleration of a loan.

Judge Sellers adopted Aetna's argument that the prepayment premium was not "unmatured". The court observed:

The problem with [the debtor's] argument in this circumstance, however, is that Aetna's entitlement to the prepayment charge arose upon acceleration of its debt. That event occurred many months before the debtor filed this bankruptcy case. The charge matured at the time the debt was accelerated for default under the terms of the amended note. Consequently, even though the purpose for the provision was to capture the return on Aetna's investment, which could be lost upon a default in payments, the charge is more than and different from an "unmatured interest" assessment. It may in reality represent estimated interest, but it is not unmatured after [the date when Aetna accelerated its note].

Hidden Lake at 730.

In so ruling, Judge Sellers noted her agreement with the universally aligned case law that holds that a prepayment premium imposed pre-petition is not a claim for unmatured interest within the purview of §502(b)(2). Although the Hidden Lake decision does not so note, Judge Sellers, in her Ridgewood decision, disallowed a claim for a prepayment premium on the basis that it constituted a claim for unmatured interest that is not allowable under §502(b)(2). However, the Ridgewood decision is distinguishable because the court found that the loan documents did not specifically state that the prepayment charge was payable upon acceleration. Therefore, no prepayment premium was due and payable prior to bankruptcy. As Judge Sellers noted in Hidden Lake, if Aetna's note permitted acceleration upon the filing of bankruptcy and there had been no pre-petition acceleration, "the result might be different. Under the facts of this case, however, the court agrees with the existing case law that a prepayment charge imposed pre-petition is not a claim for unmatured interest within the meaning of §502(b)(2)." Hidden Lake at 730. Judge Sellers' observation is distinguishable from Anchor Resolution Corp.'s approval of a make-whole premium triggered by the borrower's commencement of a bankruptcy case in that in Anchor Resolution Corp., the make-whole premium was not challenged as unmatured interest under §502(b)(2).

Lessons to be Drawn from Hidden Lake

The fundamental gripe in Hidden Lake (and other prepayment premium cases) was that the amount of Aetna's prepayment premium was disproportionately too large in relation to Aetna's claim and overcompensated Aetna for its damages. That argument fails (at least under Ohio law applied by the court) where the court discerns that the yield-maintenance provision reflects a compensatory intent, the contract as a whole is reasonable, legitimate uncertainties exist at the time of contract origination as to the extent of probable damages, and the parties had a reasonable chance to understand the terms of the agreement in light of their sophistication and experience.

Second, a yield-maintenance provision's use of a discount rate equal to a "naked" Treasuries rate does not yield an "unreasonable" estimate of prepayment damages where the damages calculation is subject to uncertainty and the parties had a reasonable chance to understand the terms of the agreement and were sufficiently sophisticated and experienced to appreciate the import of their agreement.

Third, where a prepayment premium becomes liquidated pre-petition as a result of acceleration of the governing promissory note, the claim for the prepayment premium arising in the obligor's subsequent bankruptcy case does not constitute a disallowable claim for unmatured interest under Bankruptcy Code §502(b)(2). However, where the claim for the prepayment premium arises upon the filing of the bankruptcy case as a result of an ipso facto default clause, at least one court may disallow the claim under §502(b)(2).

Hidden Lake demonstrates that Treasury-based yield-maintenance provisions and prepayment premiums are very much alive and well in bankruptcy court.

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Footnotes

¹ The author represented Aetna Life Insurance Co. in the Hidden Lake case. Return to article

² Because the interest rate on floating-rate notes automatically adjusts to current market conditions, such notes do not include yield-maintenance or similar provisions tied to early repayment. Return to article

³ Under Aetna's yield-maintenance formula, the prepayment premium was equal to the difference between (i) the present value of post-acceleration installments of scheduled debt service and (ii) the outstanding principal balance of the note at the time of prepayment. Return to article

⁴ Elsewhere in its opinion, the court reiterated its approval of the "naked" Treasuries rate used in Aetna's yield-maintenance formula, noting that "[u]se of the Treasury obligation as a reference point for the calculation, although generally overcompensating Aetna, is not an unreasonable estimate." Hidden Lake at 729. Return to article