By: Tracy M. Evans, Esq., Associate, Saxon, Gilmore, Carraway & Gibbons, P.A.
On January 27, 2014, the U.S. Court of Appeals for the Fifth Circuit issued a decision in the case of In re Denver Merchandise Mart, Inc., 740 F.3d 1052 (5th Cir. 2014), weighing in on the enforceability of prepayment clauses in promissory notes upon acceleration of the note. The enforceability of prepayment clauses is often challenged in bankruptcy court, so this topic has been the subject of several decisions in recent years. However, unlike other decisions where the enforceability of the prepayment clause was determined based on state law or under the Bankruptcy code, Denver Merchandise was decided based on basic principles of contract interpretation.
A prepayment clause is a provision within a note, indenture, or credit agreement that requires the borrower to pay a premium in the event that the borrower pays the loan balance, either in part or in full, before the actual payment due date. These provisions are sometimes referred to as “make-whole” provisions because they compensate the lender for anticipated interest on the prepaid amounts that the lender would have otherwise received had the borrower not advanced the payment before the due date. However, there are some instances where prepayment is not actually required, and a prepayment clause may be triggered upon other occurrences specified in the contract.
In Denver Merchandise, the borrower defaulted on the terms of a note, and the lender accelerated the balance of the note. The borrower subsequently filed for Chapter 11 bankruptcy. The lender filed a proof of claim in the bankruptcy, which included a prepayment premium of approximately $1.8 million, even though no prepayment had actually occurred. The lender argued that certain provisions within the note should be interpreted to require a prepayment premium in the event of acceleration of the note, regardless of whether or not the borrower actually made a prepayment. The borrower objected to the lender’s claim, and both the bankruptcy court and the district court agreed with the borrower, finding that a premature payment was required in order to trigger the prepayment premium, absent specific language in the note to the contrary. The lower courts failed to find an express provision in the note providing for payment of the premium upon acceleration alone.
On appeal, the Fifth Circuit examined the two relevant provisions in the note, the first governing acceleration upon default, and the other governing prepayment. Applying basic principles of contract interpretation, the Court found that the express language of both provisions required actual prepayment in order to trigger the obligation to pay the prepayment premium. Therefore, the Court affirmed the lower court’s ruling, noting that if it was the lender’s intent to ensure payment of the prepayment premium in the event of default and acceleration, the lender could have easily included unambiguous language to that effect.
Denver Merchandise underscores the importance of careful drafting when preparing a note to ensure that if a prepayment premium is to be applied in the event of acceleration, unambiguous language to that effect is included. The use of clear and unambiguous language will bolster the lender’s position in the event that the enforceability of the provision is challenged, and help ensure recovery of the prepayment premium upon acceleration of the note.
The full text of the Denver Merchandise case is available at: http://www.ca5.uscourts.gov/opinions%5Cpub%5C13/13-10461-CV0.pdf
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