In commercial real estate loan transactions, as in all finance transactions, prepayment of a loan may result in unanticipated economic consequences to the lender, including loss of the bargained-for interest payment, increased tax liability and costs associated with reinvestment. New York’s common law “perfect tender in time” rule, which has been settled law since the 19th century, provides a certain level of comfort to lenders in the event the loan documents are silent as to prepayment. Under this rule, the borrower has no right to pay off its loan prior to the stated maturity date absent statutory authority or an express clause in the loan documents permitting prepayment.
Of course, to further protect against the consequences associated with prepayments by borrowers, lenders frequently include provisions in their loan documents either (i) expressly prohibiting payment of the loan prior to its maturity or (ii) permitting such prepayment, at particular times, provided the borrower pays to the lender a premium or fee. Prepayment clauses, however, must be carefully drafted in order to be enforceable at all times, including after a borrower default and acceleration of the loan and after commencement of a foreclosure action.
Lenders often grant borrowers the option to prepay the loan in exchange for a prepayment fee. Generally considered an “option for alternative performance” on the loan rather than liquidated damages if prepayment is made absent an event of default, prepayment fee clauses preserve the lenders’ income stream or yield and shift the risk of loss associated with loan prepayments from the lender to the borrower. A prepayment fee would be deemed liquidated damages and thereby questionably enforceable, however, if such fee becomes due on account of a borrower default. The fee may be based on a percentage of the amount prepaid or a formula that approximates the lender’s reinvestment loss. Clauses providing for prepayment premiums are generally enforceable and widely sustained by New York courts. Nevertheless, lack of precise drafting can result in disputes concerning the collectability of the prepayment fee when the prepayment results from the lender’s acceleration following a borrower default.
Under New York law, the standard rule is that once the lender accelerates the loan following a borrower default, the lender forfeits its right to a prepayment fee because the acceleration effectively advances the maturity date, and, by definition, any subsequent payment cannot be a prepayment as maturity is deemed to have occurred. New York courts recognize two exceptions to this rule: (1) when the borrower intentionally defaults in order to trigger acceleration and evade the prepayment fee and (2) when the parties agree in the loan documents pursuant to a clear and unambiguous clause imposing a prepayment fee after acceleration. In the event a court concludes that the borrower intentionally defaulted in order to trigger acceleration and thereby evade the prepayment fee, the prepayment fee may be collected by the lender, notwithstanding the aforementioned standard rule that collection of a prepayment premium after acceleration requires an express agreement.
Best practice, of course, would be to include in the loan documents a so-called “evasion clause” to preserve lender’s right to receive a prepayment fee even after default and acceleration of the loan. For example, such a clause provides that the borrower’s repayment of the debt after acceleration of the loan will be deemed an evasion of the prepayment restrictions, requiring the borrower to, nonetheless, pay a prepayment premium. However, if the lender intends to include within the scope of its evasion clause that a borrower cannot avoid a prepayment after a foreclosure proceeding has been initiated, whether by exercise of borrower’s equity of redemption or pursuant to a sale of the property, the language must clearly and unambiguously require enforcement in such cases.
Effects of Poor Drafting
In Northwestern Mutual Life Ins. v. Uniondale Realty Assoc., 11 Misc.3d 980 (N.Y. Sup 2006), a New York State Supreme Court analyzed the consequences of imprecisely drafted loan documents. At issue in that case was a prepayment clause that purported to require the borrower to pay a prepayment fee following acceleration of the loan. Plaintiff-lender sought payment of the applicable prepayment fee in the context of a foreclosure proceeding. The Northwestern court reasoned that because the loan was in default, the prepayment premium would constitute liquidated damages, not an option for alternative performance, and, under New York law, courts will not impose a judgment for liquidated damages unless such liquidated damages were agreed to by the parties. The court held that while the subject evasion clause identified only “default” and “acceleration,” there was no trigger “consistent with New York procedures of foreclosure.” Accordingly, the court concluded that the parties did not agree to enforcement of a prepayment fee in a foreclosure action, either in connection with a foreclosure sale or a redemption by borrower. If the lender had intended the term “prepayment” to include payments realized from a foreclosure sale or from redemption, the evasion clause should have expressly so stated. Therefore, the plaintiff lender could not recover the prepayment fee from borrower in the foreclosure action.
The Northwestern court referred to the following example of a prepayment clause as being sufficiently comprehensive to cover all situations (citing “Current Issues Concerning Mortgage Prepayment,” 478 PLI/Real 871, 923-924, Appendix D):
Any tender of payment by Borrower or any other person or entity of the Secured Indebtedness, other than as expressly provided in the Loan Documents, shall constitute a prohibited prepayment. If a prepayment of all or any part of the Secured Indebtedness is made following (i) an Event of Default and an acceleration of the Maturity Date, (ii) the application of money to the principal of the Loan after a casualty or condemnation, or (iii) in connection with a purchase of the property or a repayment of the secured Indebtedness at any time before, during or after, a judicial or non-judicial foreclosure or sale of the property….
In U.S. Bank Nat. Ass’n v. South Side House, WL 273119 (E.D.N.Y. 2012), the U.S. District Court distinguished the prepayment provision before the court from the model provision favored by the Northwestern court. The South Side court concluded that while the prepayment provision it reviewed covered the borrower’s payment after acceleration and after foreclosure, the provision was drafted as a personal option of borrower to prepay, not as a prohibition against prepayment of the loan more generally. The court focused on the language in the South Side prepayment provision stating that “if [b]orrower or anyone on [b]orrower’s behalf makes a tender of payment” at any time prior to a foreclosure or during any redemption period, then borrower would be liable for the prepayment fee; i.e., the tender of payment by the borrower was required to trigger payment of the premium. The South Side court focused on the fact that the Northwestern model provision contemplates prepayment “by anyone and at any time,” which would include third-party purchasers at foreclosure sales, and covers “every scenario subsequent to a default and acceleration—before, after or during foreclosure.” The South Side court stated, therefore, that the Northwestern model provision is not technically an “evasion” clause to protect the lender from an intentional borrower default, but rather a penalty provision providing for liquidated damages.
Counsel representing lenders must take care when drafting provisions designed to protect their clients against the risks associated with prepayments by borrowers. For the broadest protection, such provisions should clearly and unambiguously call for the payment of a prepayment fee upon borrower’s default and lender’s acceleration of the loan, whether prepayment occurs before, after or during a foreclosure action. A poorly drafted prepayment provision could result in lenders being denied its expected yield.