Prepayment Fee Provisions: Enforceable or Not?
A prepayment is a prepayment is a prepayment, right?
Not necessarily. In determining the enforceability of prepayment fee provisions, courts historically have drawn a distinction between the borrower’s voluntary prepayment of a loan (i.e., a refinancing) and so-called “involuntary” prepayments, such as application of collateral proceeds or funds received through enforcement actions after a lender’s acceleration of the loan due to borrower’s default, the application of insurance proceeds after damage to the property or the application of condemnation awards. The wording of the prepayment provision in your loan documents, as well as state law, affect whether you can collect the prepayment fee in connection with a voluntary prepayment or a so-called “involuntary” prepayment.
This article discusses the general enforceability of prepayment provisions under state law in connection with commercial real estate loans. For purposes of this article, a “commercial real estate loan” refers to a loan made to a borrower for commercial purposes, which is secured by a mortgage or deed of trust on commercial real estate or agricultural real estate. This article does not address state or federal law regulating consumer loan transactions or consumer loans secured by deeds of trust or mortgages on residential real estate.
Courts generally have enforced prepayment fee provisions in connection with the borrower refinancing a loan with another lender prior to the maturity date. Courts have been hesitant, however, to enforce a prepayment fee provision when the borrower defaulted on the loan, the lender accelerated the debt prior to maturity and the lender added the prepayment fee to the outstanding amount of the debt due for purposes of trying to collect the debt due from the borrower.
This distinction arose because:
[p]rior to the mid-1980s, it was rare for the prepayment clauses in commercial mortgages to deal specifically with prepayment incident to acceleration. Hence, lenders who claimed prepayment fees upon acceleration had only a slender contractual basis for doing so. They could argue that the loan was indeed being paid prior to its scheduled maturity and hence that the fee had been earned, but they could point to no contract language so stating. They usually lost these cases, typically on the grounds that the clause was not intended to cover “involuntary” prepayments; having been accelerated by the lender, the loan was now mature, and thus that payment was not “pre-” in the sense of being in advance of maturity, or that the lender’s acceleration constituted a waiver of the prepayment fee.¹
In response to this line of cases, lenders revised their loan documents to expressly provide for the collection of a prepayment fee in connection with “involuntary” prepayments. As a result of such revisions, a number of courts in recent years have enforced provisions in loan documents allowing a lender to collect a prepayment fee in connection with the acceleration of the loan after default. Many courts that have enforced the post-acceleration “prepayment” fees did so by interpreting the prepayment fee provision to be a liquidated damages clause that enabled the lender to collect the fee as a result of the borrower’s breach of contract.
The case law on the enforceability of prepayment fee provisions continues to vary from state to state, particularly when the controlling cases have been based on loan documents that do not expressly provide for a prepayment fee in connection with “involuntary” prepayments. Generally, a court will enforce a prepayment fee provision in loan documents when the borrower initiates the early prepayment of the loan, unless the prepayment fee violates a state statute prohibiting prepayment fees or the fee is unreasonably large or unconscionable. In addition, a “prepayment” fee in connection with an “involuntary” prepayment generally is not enforceable if the loan documents do not expressly provide for the fee in those circumstances. If, however, the loan documents expressly provide for the prepayment fee in connection with an “involuntary” prepayment and the fee does not violate a state statute prohibiting the fee, state courts are split on whether the lender can collect the prepayment fee and whether it can be collected in all “involuntary” prepayment situations. The state courts do agree, however, that even if the provision is enforceable, they will not enforce the payment of a fee that is unreasonably large or unconscionable.
So, what’s a lender to do? First, become familiar with your state law restrictions on collecting prepayment fees in connection with commercial real estate loans. If you make loans secured by real estate in other states, become familiar with those state laws too. should be aware of the fact that some state courts have not ruled on this issue for several years and the “old” line of cases prohibiting the collection of a prepayment fee in connection with so-called ‘involuntary” prepayments is still controlling law in those states.
Second, review the prepayment provision in your loan documents. If your bank expects to collect a prepayment fee in connection with both voluntary prepayments and “involuntary” prepayments, the loan documents should clearly and expressly state that. For example:
“Borrower will pay to Bank the prepayment fee in connection with any repayment of the unpaid principal sum of the Note in whole or in part prior to the date on which repayment is due under the terms and conditions of the Note, including without limitation any such repayment (a) following Bank’s exercise of its rights upon an event of default and acceleration of the maturity date, whether or not foreclosure proceedings were commenced or (b) resulting from the application of insurance proceeds or condemnation awards.”
Because state law varies on the collection of a prepayment fee in connection with “involuntary” prepayments, you may not be able to collect the prepayment fee in every situation. The key is to protect your bank’s ability to collect those fees by carefully drafting a prepayment fee provision so the borrower understands the prepayment situations in which you will seek to collect the prepayment fee.
1. Dale A. Whitman, Mortgage Prepayment Clauses: An Economic and Legal Analysis, 40 UCLA L. REV. 851, 908 (1992).