Prepayment Premiums: Removing Doubt About Their Enforceability
Commercial loan documents routinely state that, if a borrower defaults, the lender may accelerate the loan's maturity date and immediately commence an action to recover "all amounts due thereunder". Recent New Jersey case law has set forth clear guidelines as to when a lender may recover a prepayment premium after accelerating a loan because of a borrower's default.
What Is a Prepayment Premium?
Prepayment provisions provide that if a borrower pre-pays the entire indebtedness under the loan before a specified date in the loan documents, the borrower must pay a premium, which is usually a percentage of the outstanding indebtedness. These provisions both insure the lender against the loss of its bargained for rate of return (if interest rates decline during the term of the loan) and alleviate the unexpected tax burden and reinvestment costs associated with prepayment. Therefore, the enforceability of prepayment provisions is critical for lenders.
Earlier New Jersey Case Law
Before 2003, there were no controlling New Jersey decisions on whether a lender could recover a prepayment charge after accelerating the loan as a result of the borrowers' default. There were two decisions, however, which discussed this issue. First, in Jala Corp. v. Berkeley Savings & Loan Ass'n, 104 N.J. Super. 394 (App. Div. 1969), the State of New Jersey took title to certain mortgaged property by means of eminent domain. Plaintiff Jala was the mortgagor on the property and defendant Berkeley, the mortgagee.
In distributing the state's payment for this property, Berkeley retained all monies owed under the mortgage, including the prepayment charge. Jala challenged Berkeley's entitlement to the prepayment charge.
The Appellate Division found that Berkeley was not entitled to recover the prepayment premium because the mortgage's prepayment clause did not "expressly provide" for the contingency of condemnation of the premises by the State for public use. The Appellate Division did state that if Berkeley had believed it was entitled to recover the prepayment premium under this circumstance, it "could easily and should have so provided" for such in the mortgage. Accordingly, the Appellate Division implied that a lender could recover a prepayment premium after accelerating the mortgage because of the borrower's default, if the mortgage expressly provided for as much.
Second, in Clinton Capital Corp. v. Straeb, 248 N.J. Super. 19 (Ch. Div. 1990), plaintiff Clinton accelerated certain debt, including a prepayment provision, after the defendant defaulted under a note and mortgage. Here, the note provided that that "[t]he [prepayment] premium shall be paid [even] ... after exercise of any acceleration provision contained in this Note. â€¦"
Notwithstanding that clear provision, the Chancery Division, using New York law, found that the prepayment penalty was not recoverable because "where the mortgagee accelerates the mortgage, the amount due [is the result of an] act of the mortgagee and, hence, payment of that amount would not amount to a prepayment within the meaning and purpose of [the] prepayment clause. . . ."
To reach its result, the Chancery Division simply ignored Jala's dicta that if parties intended the prepayment charge to be due in certain instances they were free to draft an agreement that memorializes their intent. As Clinton Capital was not controlling, did not interpret New Jersey law and was widely criticized, lenders were left to wonder whether they could in fact recover a prepayment premium after accelerating a loan because of the borrower's default even if they were contractually entitled to do so.
Lenders Can Recover a Prepayment Premium
In 2003, the United States District Court for the District of New Jersey and New Jersey's Appellate Division cleared up lenders' confusion by expressly addressing the issue of whether a lender may recover a "prepayment premium" after exercising its contractual right to accelerate a loan due to the borrower's default in three separate decisions -- (i) Norwest Bank Minnesota v. Blair Road Associates, L.P., 252 F.Supp.2d 86 (D.N.J. 2003); (ii) Westmark IV v. Teenform Associates, 362 N.J. Super. 336 (App. Div. 2003); and (iii) Mony Life Ins. v. Paramus Parkway, 364 N.J. Super. 92 (App. Div. 2003).
In Norwest, the loan documents stated that upon acceleration of the Note, the lender could recover a prepayment premium equal to "three percent (3%) of the amount of this Note being prepaid." After accelerating a $4,235,000 loan due to the defendant-borrower's default thereunder, the plaintiff-lender sought to recover, inter alia, a $337,871.37 prepayment premium.
Defendant-borrower and guarantor argued that plaintiff was not entitled to recover this amount because, according to their reading of MetLife v. Washington Avenue Associates, L.P., 159 N.J. 484 (1999), prepayment premiums and default interest seek to compensate a lender for the same loss and therefore constitute an unreasonable liquidated damages provision.
The District Court, however, rejected the defendants' characterization of MetLife for two reasons. First, MetLife did not address the enforceability of prepayment premiums; it merely held that a 5% late fee and a 12.55% default interest rate (which was 3% over the note interest rate) were reasonable "under the totality of the circumstances."
Second, and more importantly, MetLife found that prepayment premiums and default interest are not duplicative and that "a prepayment premium is not a charge for the use of the money but consideration for something that unless bargained for a borrower is not entitled to; namely, the right to prepay." 252 F.Supp.2d at 97 quoting MetLife, 159 N.J. at 503.
Following MetLife, the District Court held that (i) a lender can recover a prepayment premium that is "reasonable under the totality of the circumstances" (provided it is contractually entitled to do so), and (ii) the defendant has the burden of proving that a prepayment premium is unreasonable. Ultimately, the Norwest defendants failed to meet their burden because:
"They produced no evidence that they lacked an opportunity to bargain over this clause";
They were sophisticated, experienced businessmen;
There was no evidence that "the prepayment premium was anything other than a common practice in a competitive industry or outside commercially accepted rates"; and
- The amount of the default interest ($528,637.22) and the prepayment premium ($337,871.37) for which the defendants were responsible was not "unconscionable", as it was less than what the defendants would have paid if they had paid all of the principal and interest under the loan.
Westmark and Mony
In May 2003, the Appellate Division adopted Norwest in its entirety in Westmark. Here, the defendant-borrowers appealed the trial court's entry of final judgment in foreclosure in favor of the plaintiff-lender contending, inter alia, that the prepayment premium was an "unreasonable charge." Before evaluating the reasonableness of the prepayment premium, the Appellate Division first defined "prepayment premiums":
[They] are designed to protect a lender against potential losses it may incur if a loan is paid earlier than it contracted for. â€˜The primary purpose of these clauses is to protect the mortgagee against the loss of a favorable interest yield. Prepayment may also result in further losses, such as the administrative and legal costs of making a new loan . . . and in some cases additional tax liability.' 362 N.J. Super. at 344 quoting Restatement (Third) of Property: Mortgages Â§6.2 comment a (1997).
Citing MetLife and Norwest, the Appellate Division held that a lender could recover a prepayment premium that was "reasonable under the totality of the circumstances." In so holding, the Appellate Division expressly abrogated Clinton Capital and held that the prepayment premium at issue was a "reasonable charge":
[W]e can perceive no reason why the debtor should be relieved of the terms of the contract freely entered into. The terms were clear and unambiguous, the parties clearly experienced and sophisticated in loan transactions of this type. . . . If we deem the clause unenforceable, we would be providing defendants with a better contract than they were able to negotiate for themselves; we decline to do so. 362 N.J. Super. at 347.
Finally, in October 2003, the Appellate Division reiterated its Westmark holding in Mony. In this case, the loan documents set forth that the lender was entitled after acceleration to recover a prepayment premium which was "equal to three percent (3%) of the principal amount, declining one half of one percent per year."
Accordingly, the plaintiff-lender attempted to recover, inter alia, the prepayment premium ($27,380.53 or one-half of one percent of the principal amount) after accelerating the loan's maturity date as a result of the defendant-borrower's default. The defendant-borrower ignored Westmark and argued that the plaintiff-lender who accelerated the loan's maturity date could not recover a prepayment premium because it was "illegal."
Citing Westmark and Norwest, the Appellate Division held that (i) a prepayment premium is not interest at all, because it is not compensation for the use of money but a charge for the option or privilege of prepayment, and (ii) a lender who accelerates a loan can collect a prepayment premium where the terms of the contract are clear and unambiguous, there is no evidence of unreasonableness or sharp practices and the prepayment premium is "reasonable under the totality of the circumstances". Accordingly, the Appellate Division found that the prepayment premium at issue was valid and enforceable.
New Jersey Law Is Clear
The law in New Jersey is clear -- a lender can recover a prepayment premium after accelerating a commercial loan due to the borrower's default, if (i) it is contractually entitled to do so by clear language in its promissory note, and (ii) the prepayment premium is reasonable under the totality of the circumstances. At a minimum, a prepayment charge of 3 percent of the principal is reasonable under Norwest.