Contributed by Dana Hall
Prepayment premium litigation is all the rage these days. Lenders’ degree of success enforcing payment of such premiums – also commonly referred to as “make-whole” premiums – in the bankruptcy context has generally been dependent on state law contract interpretation and courts’ legal determinations of whether such premiums should be properly characterized as disallowable “unmatured interest” under section 502(b)(2) of the Bankruptcy Code or, alternatively, as liquidated damages. This past week, the United States Court of Appeals for the Fifth Circuit weighed in with an opinion denying a lender’s claim for a prepayment premium because (i) no payment was actually made prior to the accelerated maturity date of the applicable note and (ii) the note did not expressly provide for payment of the prepayment premium in the event of acceleration alone. The Fifth Circuit’s decision in In re Denver Merchandise Mart, Inc. is the latest in a string of notable decisions on prepayment premium-related issues, including decisions issued by the Second Circuit in In re AMR Corporation this past September (holding that the governing indenture in that case precluded the indenture trustee’s recovery on its claim for a make-whole premium) and the United States Bankruptcy Court for the District of Delaware in In re School Specialty this past April (allowing a lender’s claim for a make-whole premium after finding that the credit agreement clearly provided for payment of the premium). We’ve also previously discussed a number of other, older decisions here, here, here, and here.
If you haven’t been tracking this issue, you may be asking yourself – “what, exactly, is a prepayment premium anyway?” Although the precise terms of prepayment premiums vary greatly (part of the reason for all the recent sturm und drang), prepayment premium provisions (usually included in an indenture, note, or credit agreement) generally provide that in the event a borrower pays the loan or note balance, in whole or in part, in advance of the date on which payment is due, the borrower is required to pay the lender an additional amount to compensate the lender for its anticipated interest on the prepaid amounts. Lenders reason that such provisions protect them in the event that a borrower refinances to a lower interest rate and the lender, likely facing less favorable market conditions, is unable to re-lend funds at the same interest rate and obtain the benefit of its bargain. The word “prepayment” can be somewhat misleading, however, as in some cases the premium may become payable even in the absence of a payment prior to the maturity date. For instance, in Denver Merchandise, the lender and borrower both agreed that no prepayment had actually occurred. Rather, the lender argued that the note provided for payment of a premium in the event of acceleration of the note, regardless of whether or not the borrower actually made payment prior to the accelerated maturity date.
In Denver Merchandise, the borrower defaulted on a note and, following the lender’s acceleration of the outstanding amounts owed under the note, the borrower commenced a chapter 11 case. The prepayment premium dispute in that case centered on two key note provisions. The first provision, contained in Article 6 (“Prepayment”), provided as follows:
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) . . . .
The second provision, contained in Article 4 (“Default and Acceleration”), provided as follows:
(a) The whole of the principal sum of this Note, (b) interest, default interest, late charges and other sums, as provided in this Note . . . [and] (c) all other moneys agreed or provided to be paid by Borrower in this Note . . . shall without notice become immediately due and payable at the option of Lender 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 . . . .
The lender in Denver Merchandise included the prepayment premium amount (approximately $1.8 million) in its proof of claim filed in the debtor-borrower’s chapter 11 case. The debtor objected to the lender’s claim and the lender responded, arguing that it was entitled to payment of the premium because the language in Articles 6 and 4, taken collectively, provided for payment of the premium in the event of acceleration. The debtor argued, on the other hand, that Article 6 dealt only with voluntary or involuntary “prepayments” and that the language pertaining to acceleration merely provided an example of a situation in which an involuntary prepayment might be made. Similarly, Article 4 did not explicitly provide for payment of a premium in the event of acceleration, but rather just permitted the lender to accelerate “all other moneys agreed or provided to be paid” by the debtor pursuant to the note. Because neither provision explicitly provided the lender with a right to the prepayment premium in the absence of an actual prepayment, the lender was not entitled to a claim for the asserted premium amount. The United States Bankruptcy Court for the Northern District of Texas agreed with the debtor and issued a short order granting the debtor’s claim objection. The United States District Court for the Northern District of Texas affirmed, and, on de novo review (Colorado law provides that interpretation of a contract is a matter of law and is reviewed de novo), the Fifth Circuit affirmed the District Court’s ruling.
The Fifth Circuit noted as an initial matter that, absent a clear contractual provision to the contrary or evidence of a borrower’s bad faith in defaulting to avoid a penalty, a lender’s decision to accelerate acts as a waiver of a prepayment penalty. Other courts have stated this differently, noting that because acceleration necessarily “accelerates” the maturity date, any subsequent payment is, per se, not a “pre”-payment. Regardless of whether you look at the issue as one of mechanics or one of waiver, the Denver Merchandise court was clear that absent express language providing for payment of a premium in the event of acceleration alone, a prepayment premium would not be enforceable absent prepayment.
The court determined that there was no language in the note at issue that “would deem the prepayment to have been made in the event of acceleration” and that although “[t]here are several conditions that might trigger the obligation to pay the Prepayment Consideration . . . none requires the Borrower to pay the Prepayment Consideration absent an actual prepayment.” The court also noted that if the lender had desired to ensure payment of the premium in the event of acceleration, it could have easily achieved that result by including unambiguous language in the note to that effect. As an example of the type of unambiguous language that would have supported enforcement of the premium, the Fifth Circuit cited to a case in the United States District Court for the Western District of Missouri, in which the note provided, in part, that “[t]he [borrower] agrees that 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.”
Because the Fifth Circuit determined that no premium was due and owing under the terms of the note, the court did not need to determine the issue of whether the premium was properly characterized as unmatured interest or liquidated damages; an issue that a number of other courts, including the School Specialty court, have wrestled with. The Fifth Circuit stated, in dicta, and in contrast to the majority opinion on this issue, that a “prepayment penalty is not liquidated damages and is not subject to the rules of reasonableness for liquidated damages.” The court, however, also appears to have assumed that the prepayment premium did not constitute disallowable unmatured interest under section 502(b)(2) of the Bankruptcy Code because the court’s opinion suggests that the premium would have been allowed if it had been properly provided for in the note. The Fifth Circuit’s opinion implies that, at least in the Fifth Circuit, prepayment premiums do not constitute liquidated damages or unmatured interest.
As with the AMR Corporation and School Specialty decisions, the outcome in Denver Merchandise hinged on the governing language in the note. Although the law regarding enforceability of prepayment premiums is still rapidly developing, one thing is clear – if a lender intends to obtain a prepayment premium in the event of acceleration and regardless of any actual prepayment, the lender should be sure to include tight, unambiguous language to that effect in the governing documents.
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