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But lenders have become more sophisticated in recent years, and borrowers can expect that commercial lenders will include both application of insurance proceeds and application of eminent domain proceeds as events triggering application of the prepayment premium, as well as any other "involuntary event" the lender can conceive and describe. Generally speaking, if the parties say it clearly enough in the instruments, courts have had little difficulty accepting the fact that a premium can be charged in such instances, although, not surprisingly, the "reasonableness" of such charges comes under greater scrutiny now that the payment is not a voluntary act of the borrower.
A perhaps more difficult analytic problem arises when the prepayment is the result of an acceleration of the loan balance in response to a default. Here, of course, the prepayment still is involuntary on the part of the borrower, and there is the additional factor that the acceleration was a voluntary act on the part of the lender, and not brought about entirely by circumstances beyond the control of either party. The lender will argue strenuously, of course, that the borrower in fact did not suffer the acceleration involuntarily, but brought it on by the volitional act of defaulting on the mortgage. Whatever the merits of the parties’ arguments, the hard reality is that the vast majority of the decisions have not permitted collection of a prepayment penalty when the documents do not specifically so provide. Here are a few representative cases: Matter of LHD Realty Corp., 726 F.2d 327 (7th Cir.1984);General Mortg. Assoc. v. Campolo Realty & Mortg. Corp., 678 So.2d 431 (Fla.App.1996) ; In re Planvest Equity Income Partners IV, 94 B.R. 644 (Bkrtcy.Ariz.1988); 3C Associates v. IC & LP Realty Co., 137 A.D.2d 439, 524 N.Y.S.2d 701 (1988); Rodgers v. Rainier Natl. Bank, 111 Wash.2d 232, 757 P.2d 976 (1988); George H. Nutman, Inc. v. Aetna Business Credit, Inc., 115 Misc.2d 168, 453 N.Y.S.2d 586 (1982); Kilpatrick v. Germania Life Ins. Co., 183 N.Y. 163, 167, 75 N.E. 1124, 1125 (1905).
Note that if the court concludes that the borrower has defaulted expressly to trigger acceleration and avoid prepayment, it may foil that motive notwithstanding the substantial authority cited above. See, discussion in Eyde Bros. Devel. Co. v. Equitable Life Assur. Soc., 697 F.Supp. 1431 (W.D.Mich.1988); In re LHD Realty Corp., 726 F.2d 327, 331 (7th Cir.1984); Rodgers v. Rainier Nat'l. Bank, 111 Wash.2d 232, 757 P.2d 976 (1988).
Where, however, there was just a threat to accelerate, and the borrower paid off the loan, the prepayment penalty was upheld. Mutual Life Ins. Co. of New York v. Hilander, 403 S.W.2d 260 (Ky. 1966) Similarly, where the lender did accelerate, but rescinded the acceleration, but the borrower still prepaid, the premium was upheld. West Portland Development Co. v. Ward Cook, Inc., 246 Or. 67, 424 P.2d 212 (1967).
The courts have almost uniformly upheld prepayment premiums where the documents provided specifically that they could be enforced upon acceleration. Virginia Housing Devel. Authority v. Fox Run Limited Partnership, ___ Va. ___, 497 S.E.2d (1998); Biancalana v. Fleming, 53 Cal.Rptr.2d 47 (1996); Golden Forest Properties v. Columbia Sav. & Loan Ass'n, 202 Cal.App.3d 193, 248 Cal.Rptr. 316 (1988); Pacific Trust Co. TTEE v. Fidelity Fed. Sav. & Loan Assn., 184 Cal.App.3d 817, 229 Cal.Rptr. 269 (1986) (junior mortgagee must include prepayment fee in amount necessary to redeem senior mortgage). Contra, see Clinton Capital Corp. v. Straeb, 248 N.J.Super. 19, 589 A.2d 1363 (Ch. Div. 1990). See Stark, New Developments in Enforcing Prepayment Charges After an Acceleration of a Mortgage Loan, 26 Real Prop. Prob. & Tr. J. 213 (1991).
The most recent case to illustrate the willingness of the courts to uphold express language permitting charging a prepayment premium upon acceleration involves an interesting twist - the property had been the subject of a civil forfeiture proceeding due to the owner’s alleged use of the proceeds of a criminal enterprise to acquire the property. The lenders accelerated due to nonpayment of the monthly installments at about the same time the government filed its forfeiture claim. The government sold the property at auction, pursuant to federal statutes, and produced a surplus of about $2 million over the accrued principal and interest, but the prepayment penalties exceeded $1.8 million. The lenders were entitled to enforce their mortgages because they were bona fide purchasers of an interest in the property, innocent of any knowledge of the crimes, even though the crimes had occurred before they acquired their interest. The court held that this protection extended as well to prepayment premium provisions, and upheld the right to the premiums pursuant to express language in the instruments. U.S. v. Harris, No. 01a0096p.06, 2001 FED. App. 0096P (6th Cir. 4/4/01)
3.3. Prepayment Premiums in Bankruptcy
In bankruptcy, lenders have an additional concern. They are not only focused on the enforcability of their money claims, but whether the court will treat these claims as secured by the mortgage. Where the existing indebtedness eats up all the available security, and the lender is undersecured, the issue, of course is moot. But where the lender is oversecured, which is often the case with lenders with high priority, the lender will want to claim that if prepayment occurs during bankruptcy it will have a priority claim to collect the prepayment premium set forth in the instruments.
Section 506(b) of the Bankruptcy Code provides that "fees, costs, or charges" are secured by the mortgage only if they are "reasonable." This question of "reasonableness" likely will be treated as a bankruptcy issue independent of whether the fee is collectible as a matter of state law. Some cases have treated the question of "reasonableness" as an independent state law question. See In re Financial Center Associates, 140 B.R. 829 (Bkrtcy.N.Y.1992); In re Skyler Ridge, 80 B.R. 500 (Bkrtcy.Cal.1987); In re Kroh Bros. Development Co., 88 B.R. 997 (Bkrtcy.Mo.1988); In re Morse Tool, Inc., 87 B.R. 745 (Bkrtcy.Mass.1988). (Interestingly, Skyler Ridge and In Re Kroh Bros. which are cases commonly cited for the "reasonableness analyis," have been repudiated specifically by the courts of Kansas, the state whose law they purported to apply. TMG Life Ins. Co. v. Ashner, 898 P.2d 1145, 1159, held that the rulings in these cases that the prepayment premiums were unreasonable "appears to limit the freedom of contract of the parties by replacing the parties' judgment regarding the appropriate discount rate with the court's. . . .") Perhaps it is worth noting specially that one New York case upheld a fee that other cases have found problematic. In re Financial Center Associates, 140 B.R. 829 (Bkrtcy.N.Y.1992). Here, the "defeasance style" prepayment premium provision employed a Treasury security reference rate, but state that the lender's lost interest stream would be discounted to present value. In context, this produced a fee of nearly 25% of the principal being prepaid. The court held that even though the formula might overestimate the lender's loss, it was good enough to satisfy the reasonableness test for liquidated damages under New York law. The court also described § 506(b) as a "safety valve" to be used sparingly, and made no serious effort to apply it to the clause before it.
A few recent cases have determined that Section 506(b) states an independent federal bankruptcy question of the reasonableness of the fee. See In re Wiston XXIV Ltd. Partnership, 170 B.R. 453 (D.Kan.1994), refusing to enforce a fixed prepayment fee of $1.2 million in the 4th year of a 10-year loan with an original balance of $10.8 million; In re A.J. Lane & Co., 113 B.R. 821 (Bkrtcy.Mass.1990); In re Imperial Coronado Partners, Ltd., 96 B.R. 997 (9th Cir. BAP 1989) (state law preempted, but fee not allowable under § 506 (b)).
It could be argued, in fact, that the bankruptcy courts that have purported to rely upon state law as the measure of "reasonableness" have done so only for convenience of reference, and that they in fact view the question as a federal bankruptcy law question. The Bankruptcy Code does not compel reference to state law in this case; the word appears in the federal statute. Thus, although Skyler Ridge and Kroh Bros., for instance, have been repudiated in Kansas, they continue to be embraced by federal cases and scholars evaluating prepayment penalties in bankruptcy.
In the latest draft of their treatise on Real Estate Finance Law, as yet unpublished, Nelson and Whitman see a different policy affecting bankruptcy treatment of prepayment provisions. Although they tend to support the enforceability of contracted for prepayment premiums outside of bankruptcy, with only minimal judicial oversight, they believe that public policy requires greater scrutiny of these arrangements in bankruptcy:
"The stricter scrutiny given to prepayment fees in bankruptcy is arguably quite justified, both by the language of § 506(b) and by the fact that in bankruptcy a large prepayment fee, one exceeding the lender's actual damages, accomplishes not merely a transfer of wealth from the borrower to the lender, but rather a transfer from the subordinate and unsecured creditors of the bankrupt mortgagor. Since they had no practical opportunity to examine or negotiate the mortgage, they ought to be protected against the effects of an improvident or overreaching prepayment clause that seriously overcompensates the lender."
Notwithstanding this suggestion that bankruptcy cases are different, the bankruptcy decisions are likely to affect the thinking of state courts over time. If state law courts are confronted with a continuing succession of bankruptcy court decisions finding prepayment premiums "unreasonable," and if they accept the notion, advocated by Nelson and Whitman, that prepayment premium agreements generally should be evaluated by the standard applicable to liquidated damages clauses, we can anticipate, as stated above, that state courts will find suspect many of the more traditional prepayment arrangements.
3.4. State Statutory Regulation of Prepayment Premiums
It virtually goes without saying that prepayment premiums in housing finance are not "politically correct," and have been heavily regulated by state legislatures over the years. A detailed recitation of the statutes and their various provisions is beyond the scope of this work. Suffice it to say that the vast majority of such legislation affects only residential real estate, and a great deal of that applies only to "consumer finance" transactions - residential loans that are not first lien purchase money mortgages.
One reason that I will not discuss these statutes in any detail is that, as explained in the next section, they have been preempted in the vast majority of significant loan transactions by Federal statute and regulations.
3.5. Federal Preemption of Prepayment Practices
Although federal policy generally is to protect lenders from state limitations on collection of prepayment premiums, there is a small amount of federal regulation that limits prepayment practices.