Depending upon the nature of the deal, a commercial lender’s promissory note may contain a yield maintenance provision (the descendant of a prepayment clause). The provisions come in all shapes and sizes, and, to my knowledge, there is no universally-followed form. But they all have one thing in common: in the event the note is paid before maturity, the borrower must pay fees over and above the standard payoff amount of principal and interest. The purpose of such provisions, in theory, is to compensate the lender for the interest it would have received had the borrower made all the payments called for under the note. The question is whether these kinds of contract terms are enforceable in Indiana and, if so, under what circumstances.
The case law. Because the Indiana Supreme Court has not ruled on the validity of prepayment premiums or yield maintenance fees, the law in Indiana stems from two Court of Appeals decisions (in 1990 and 1991) and one opinion from the United States Court of Appeals for the Seventh Circuit (in 1984).
1. LHD. The first case, In the Matter of: LHD Realty Corporation, 726 F.2d 327 (7th Cir. 1984), dealt with a promissory note and a mortgage on an office building and parking garage. The borrower was to repay the note in monthly installments over fifteen years. The note provided that, if the borrower paid the loan before maturity, then the lender received a prepayment premium. The borrower subsequently filed for Chapter 11 bankruptcy and stopped making payments. The lender sought relief from the bankruptcy stay in order to foreclose its lien. The Court denied the lender relief but instead permitted the borrower to sell the property. One of the issues in the case was whether the lender could receive a prepayment premium in the payoff from the sale.
According to the Seventh Circuit, the general rule is that reasonable prepayment premiums are enforceable. “Prepayment premiums serve a valid purpose in compensating at least in part for the anticipated interest a lender will not receive if a loan is paid off prematurely. Among other things, a prepayment premium insures the lender against the loss of his bargain if interest rates decline.” Id. at 330. One exception (there are a few) to the rule is that the lender loses its right to a premium when it elects to accelerate the debt. Here’s the logic – acceleration, by definition, “advances the maturity date of the debt so that payment thereafter is not prepayment but instead a payment made after maturity.” Id. at 331. The Seventh Circuit held that the LHD case fell within the acceleration exception. The lender abandoned (waived) its claim to interest payable over a period of years by requesting relief from the automatic stay in order to proceed with foreclosure. As such, “it is not appropriate, under these circumstances, for the lender to receive a prepayment premium in lieu of the interest foregone since it has voluntarily waived the unpaid interest in the expectation of accelerated payment of the remaining principal.” Id.
Interestingly, the lender argued that recognition of the acceleration exception may cause borrowers to default intentionally and “court” acceleration and foreclosure in order to avoid prepayment liability. The Seventh Circuit dismissed this, however, as “implausible given the ramifications of default for a borrower’s credit rating and the ability of the lender to sidestep the ploy by suing only for overdue payments as they mature, together with attorney’s fees.” Id. [I’m not sure I agree with the Court on this point. I’ve seen an intentional default, and in the Coca Cola Bottling case discussed below the borrower ostensibly took this approach.]
2. McCae. The next in the line of three cases, decided in 1990 by the Indiana Court of Appeals, is McCae Management v. Merchants National Bank, 553 N.E.2d 884 (Ind. Ct. App. 1990). The case surrounded a loan for the construction and operation of two nursing homes and involved two promissory notes secured by real estate mortgages. The notes provided that there was no right to prepayment. On the other hand, the notes did not have yield maintenance provisions. Id. at 886. Before maturity, however, the borrower sold the two healthcare facilities and requested payoff amounts from the lender. The lender demanded a “yield maintenance fee,” though that term appeared nowhere in any of the loan documents. The borrower paid a reduced yield maintenance fee under protest and then filed suit, arguing that the yield maintenance fee was not warranted since it was not mentioned in the notes of mortgages. The Indiana Court of Appeals upheld the fee assessment and cited with approval the general rule in LHD. Id. at 888. “When [borrower] sought to prepay, it was attempting to vary the terms of the previously existing agreement. In essence, it was negotiating a new contract which would deprive [lender] of the interest it was to receive as consideration for making the loans [borrower] sought at the time. Clearly, [lender] was entitled to negotiate for and receive a ‘yield maintenance fee’ in lieu of the interest it would lose by prepayment.” Id.
3. Coca Cola Bottling. The last Indiana case on point is Coca Cola Bottling Company v. Citizens Bank, 583 N.E.2d 184 (Ind. Ct. App. 1991). The very complicated dispute surrounded a loan to Coca Cola Bottling of Portland, Indiana that was secured by the bottling plant property. The relevant loan agreement prohibited any prepayment before a certain date. The borrower ultimately stopped its interest payments to the lender in the hope that the lender would accelerate the loan obligation (seemingly as predicted by the lender’s lawyers in LHD). The pertinent issue in Coca Cola Bottling was whether acceleration was an exclusive remedy. Without actually using the words “prepayment premium” or “yield maintenance fees,” the lender argued it was entitled to interest as agreed for the full term of the loan documents, even if the lender accelerated, on the theory that the lender should receive the benefit of its bargain. The Court concluded, however, that once the lender chose to accelerate the maturity date and render the borrower’s debt immediately due and payable, the lender could not pursue any other remedy because other remedies were not available. “Acceleration, when acted upon, by maturing the debt, precludes any other remedy; the parties are receiving the benefit of the bargain as contemplated by the specific terms of their agreement by acceleration.” Id. at 190. In other words, as a general proposition, lenders can’t recover both default and yield maintenance remedies.
Look for Part II on this subject next week in my blog’s Practical Pointers category.