Indiana Court of Appeals Concludes That Prepayment Premium Enforceable In Foreclosure Case

The opinion in Weinreb v. Fannie Mae, 993 N.E.2d 223 (Ind. Ct. App. 2013) is full of Indiana commercial law tidbits, and I intend to write more about the case later this week.  Today, I’d like to highlight quickly one of the important, stand-alone holdings by the Court related to “yield maintenance fees” a/k/a “prepayment premiums.”  To my knowledge, Weinreb is the first Indiana state court opinion since 1991 commenting on a lender’s right to recover these damages. 

Education.  For background and context, please click on my 2007 posts:  Yield Maintenance Fees, Part I:  Indiana Law and Yield Maintenance Fees, Part II:  Applying Indiana Law.  Weinreb does not change Indiana law.  Rather, the case officially extends it.  The Weinreb decision for first time upholds prepayment premium damages in a foreclosure (debt acceleration) action, as opposed to a mere pre-maturity payoff scenario. 

Recovery of lost interest.  The Court in Weinreb first determined that the subject clause constituted a liquidated damages provision.  The promissory note stated that, upon a default, the borrower was liable for repayment of “all of the Indebtedness,” which specifically included a recovery of the prepayment premium.  (The details of the language used will matter in your particular case.)  When a loan is prepaid, the lender is deprived “of interest it was to receive as consideration for making the loan.”  It follows that prepayment premiums “insure the lender against the loss of his bargain if interest rates decline.”    For a handful of reasons, the Court viewed the subject language as an enforceable liquidated damages clause as opposed to an unenforceable penalty provision. 

Amount okay.  The defendant guarantor in Weinreb contended that the premium could not be enforced in his case because it was too high.  Generally, a lender will need to demonstrate “some proportionality between the loss and the sum established as liquidated damages.”  Under the specific facts of Weinreb, which involved a $6MM loan payable over ten years at 6.37%, the 25% of unpaid principle premium was not grossly disproportionate to the lender’s losses, especially considering that the default occurred about two years after closing.  

Re-lent at higher rate?  The guarantor’s second argument was that the lender could have re-lent at a higher interest rate and thus may not have lost any money as a result of the default.  The Court rejected this point.  “All that is required is that the prepayment premium be reasonable and bear a relation to [the lender’s] loss.”  In Weinreb, the note articulated this idea, and prior Indiana precedent established that such provisions generally are enforceable.  The Court held that the prepayment premium fairly compensated the lender for the interest lost. 

The Court’s opinion sets out the yield maintenance provision in the Weinreb promissory note.  Since the language held up, lenders -  both on the front end of transactions and during post-default workout negotiations - might want to compare their clauses to the one in Weinreb.      

Seventh Circuit Remands Prepayment Premiums Case For Trial

I previously blogged about yield maintenance provisions, also known as prepayment premium clauses, on 1-25-07 and 2-2-07.  My prior posts addressed whether Indiana law permitted lenders to pursue yield maintenance remedies and the rules that may apply.  Then, on 9-11-08, I discussed BKCAP, LLC v. CAPTEC, a decision from the Northern District of Indiana that tacitly recognized the validity of prepayment premiums/yield maintenance provisions.   

Reversed.  On 7-13-09, the Seventh Circuit issued its opinion in the appeal of the BKCAP case.  Here’s the cite:  BKCAP, LLC v. CAPTEC, 2009 U.S. App. LEXIS 15369 (7th Cir. 2009, amended Aug. 5, 2009).  The decision reversed the District Court’s holding and remanded the case “for a trial on the question of the parties’ intended meaning of the prepayment premium.”  Click here to review the opinion.

The lesson of the latest BKCAP opinion is that the contract language should be simple and clear.  Note Judge Tinder’s opening remarks:

This case demonstrates that even experienced, sophisticated business entities can encounter difficulty when drafting carefully negotiated loan documents.  Since July 2007, the plaintiffs and the defendant have been at loggerheads over the meaning of just a handful of lines out of several hundred in their five-page, single-spaced Note.  Unfortunately, this appeal cannot bring their stalemate to an end, and more litigation lies ahead. 

Judge Tinder ultimately concluded that “the meaning of the prepayment premium is a question of fact that requires an examination of relevant extrinsic evidence.”  Since trials translate to further delays and expense for lenders, as a practical matter Judge Tinder’s holding is a bad result.  For more on how the Seventh Circuit reached its conclusion and how a court might analyze the meaning of a yield maintenance provision/prepayment clause, please review the opinion. 

Still fine.  Despite the remand, the Seventh Circuit did not in any way, shape or form question the validity of yield maintenance fees.  As such, it would appear that my prior conclusions remain true as they related to Indiana’s view of the legitimacy of prepayment premiums under certain circumstances. 

Court Recognizes Prepayment Premiums

In early 2007, I wrote two articles discussing in detail yield maintenance provisions (prepayment clauses) in promissory notes and the applicable Indiana law:  Part I and Part II.  By way of follow-up, I thought it might be worthwhile to write very briefly on the August 12, 2008 decision from the Northern District of Indiana in BKCAP v. CAPTEC, 2008 U.S. Dist. LEXIS 61984 (N.D. Ind.) (BKCAP.pdf), which analyzed a series of promissory notes with prepayment provisions.  This was not a foreclosure case, but rather a contract dispute about how to calculate the prepayment premium called for under several promissory notes involved in the refinancing of a significant portion of the borrower's $110 million bank debt. 

There is no need for me to discuss the case in detail because the prepayment provisions were unique and because the facts were so case specific.  The reason why I'm posting about BKCAP is because Judge Nuechterlein really didn't question the enforceability of prepayment premiums under Indiana law.  Evidently, he presumed such provisions can be valid.  The Judge's recognition of the premiums, or perhaps the borrower's concession of their legitimacy, is good for Indiana lenders.  All the Judge did was interpret the contract and draw a conclusion regarding the amount of the premium.

The Judge adopted the lender's position, so the lender got what it wanted.  As such, lenders drafting or enforcing prepayment provisions can learn from some of the contract language utilized in the promissory notes outlined in BKCAP.  As always, clarity is key.  The Judge seemingly had no choice but to recognize the validity of the prepayment premiums in BKCAP:

The parties specifically included the prepayment premium as a specific bartering tool that provided a benefit to both parties.  The Stated Rate of the notes was at approximately 9% when the parties entered into the contracts in 1999.  Borrowers foresaw that if interest rates dropped, they may want to re-finance their debt under the notes.  Lender would lose funds and possibly even suffer a loss if Borrowers re-financed too early.  Therefore, the parties created a prepayment premium, which allowed Borrowers the freedom to re-finance if they paid a sum of money to the Lender to cover its losses.  A portion of paragraph three memorializes this intent....   

See page 10 of the opinion for the referenced paragraph three.         

The rules, reasoning and conclusion found in the BKCAP opinion may be helpful for anyone struggling with how to draft or enforce loan documents calling for the recovery of fees/premiums in the event a business borrower prepays a loan.

YIELD MAINTENANCE FEES, PART II: APPLYING INDIANA LAW

This is the second of a two-part article dealing with yield maintenance fees in the context of Indiana commercial foreclosure law.  In Part I, posted under the Court Commentary category, I summarized the only three Indiana cases on point.  I’ll now apply that case law and, given the rules, explore some of the decisions commercial lenders may face.

The rules.  The law from the Seventh Circuit and the Indiana Court of Appeals is definitive as to a few issues.  The general rule is that reasonable prepayment provisions are enforceable.  Thus yield maintenance fees (a/k/a prepayment premiums) can be recovered.  But there is an exception if a lender accelerates the debt (forecloses).  In that instance, the lender waives its claim to yield maintenance fees.  In other words, an election to accelerate generally is an exclusive remedy that will preclude the recovery of yield maintenance fees. 

Payoff vs. acceleration.  Assuming a reasonable yield maintenance fee provision is in the note, a pure payoff by the borrower (an election to prepay the note) generally will permit the assessment of reasonable yield maintenance fees designed primarily to compensate the lender for its lost interest.  On the other hand, a pure foreclosure by the lender (an election to accelerate the note payments) probably will defeat a claim for such fees.  When lenders hire my firm to foreclose on loan collateral, therefore, we advise that it will be difficult to recover yield maintenance fees.  Usually, the lender’s only remedy will be what is articulated in the default/acceleration clause of the note, typically the recovery of the unpaid principal balance, accrued interest, late fees and litigation expenses.  Of course, not all cases are the same, and there are exceptions to every rule.  As a foreclosing lender, don’t give up on yield maintenance fees until you or your lawyer fully evaluate the issue.

The junior lender’s dilemma.  Recently, a lender hired my firm to protect its interests, many but not all of which were subordinate to a senior lender’s.  Although our junior lender client was getting paid, the senior lender was not.  So, our client got dragged into the senior lender’s foreclosure case.  Our note had a yield maintenance provision.  Of course the client wanted yield maintenance fees as part of its damages.  But, for several reasons, our client’s best interests dictated acceleration and foreclosure, which weakened our argument for those fees.  The client understood and relented on its claim.

Decisions like these can be difficult for junior lenders involved in a foreclosure.  Typically, the junior lender could choose to declare a default (triggered by the default on the senior debt), accelerate the debt, file a cross-claim against the borrower and reduce its claims to a judgment, as we did in our recent case.  There are advantages to this approach, including the creation of a judgment lien.  This option, however, almost certainly will result in a waiver of yield maintenance fees.  On the other hand, the junior lender could elect to simply answer the complaint, protect its collateral position (priority) in the litigation and await a payoff request when the collateral is disposed of.  This scenario likely will result in a recovery of, or a strong argument for, yield maintenance fees.  In the final analysis, decisions depend upon an almost infinite number of factors, and there is no case law applicable to every situation.  The key is for junior lenders to remain mindful of the general rules and make strategic decisions accordingly. 

Demand a calculation.  As a competing lender, beware of other lenders improperly building in yield maintenance fees to their judgment amounts.  Borrowers and their counsel may not aggressively police the damages claimed by lenders, or they may not know the law.  As a party to a foreclosure case, it’s in a lien holder’s best interests to force the plaintiff, and all competing lien holders for that matter, to provide a calculation, based upon admissible evidence, of the nature and extent of the claimed debt.  This is particularly true for junior lenders because the amount of a junior lender’s recovery, if any, will increase as the senior lender’s recovery decreases.  If a competing lender is not entitled to yield maintenance fees, a timely objection to the claim should be made.   

Uncharted waters.  Bear in mind that there has been no Indiana case on the topic of yield maintenance fees for over fifteen years, and there are gaps in the law.  So creative contract drafting may net positive results.  In the commercial setting, courts are disinclined to rewrite contracts and generally will lean toward enforcing what the parties clearly and unambiguously agreed to.  For instance, although it may not be a common contract term, it’s conceivable that reasonable yield maintenance fees built into an acceleration clause (to be paid upon foreclosure) could be upheld by an Indiana court.  “Reasonable” means, among other things, that the fees are tied to interest formulas in the note or based on present value calculations.  Arbitrary or purely penal computations are far less likely to be enforced.  As always, I will be keeping an eye out for any new Indiana case law on this issue and will log new posts accordingly.

YIELD MAINTENANCE FEES, PART I: INDIANA LAW

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.