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The impact of a borrower's bankruptcy filing on the enforcement and application of prepayment clauses. Prepayment clauses come in various forms, including yield maintenance formulas and fixed fees. The article summarizes case law on the application of section 506(b) to prepayment fees and clauses, and concludes that courts have not recognized a meaningful distinction between clauses that effectively grant a borrower an option to prepay and liquidated damages clauses. The document also discusses the implications for unsecured creditors.
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Introduction ............................................................................................................ I. Varieties of Prepayment Clauses ....................................................................... A. No Calls ................................................................................................ B. Prepayment Fees ...................................................................................
INTRODUCTION
Provisions governing the repayment of debt prior to its scheduled maturity are a fixture of commercial loan agreements. Some of these provisions—referred to as "no calls"—simply prohibit such prepayment. Other provisions permit prepayment, but require the borrower to pay a "prepayment fee." Prepayment fees themselves
∗ (^) The authors are a partner and an associate respectively at the law firm of Wachtell, Lipton, Rosen & Katz. The views expressed are the authors' and do not necessarily represent the views of the firm. The authors thank Harold S. Novikoff, Adam J. Levitin and Laura A. McIntosh for their insightful comments. † The authors' clients include banks and other financial firms that hold commercial debt.
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take various forms: While some are based on "yield maintenance" formulas that estimate the damages to lenders resulting from prepayment, others are fixed at a percent of the amount being prepaid.^1 The purpose of prepayment clauses is to determine the parties' respective rights in the event that prepayment becomes economically efficient for a borrower. Absent any limitation on prepayment, a rational borrower will repay its debt as soon as the benefits of refinancing exceed the transaction costs of procuring a new loan. Such a borrower, therefore, will generally repay a fixed-rate loan when market interest rates decline, and will repay any loan (fixed or floating rate) when its creditworthiness improves relative to the market. Prepayment clauses change the borrower's incentives. Faced with a flat prohibition on prepayment, a rational borrower will repay its debt prior to maturity only if the economic benefits of prepayment—either in the form of lower borrowing costs or improved contract terms—exceed the damages resulting from breach of the loan agreement. Similarly, when faced with a prepayment fee, the borrower will repay its debt only when the benefits from prepayment are greater than the fee. Prepayment clauses, in sum, allow a lender to negotiate for yield protection and a borrower to negotiate for freedom of action.^2 This article explores the ramifications of a borrower's bankruptcy filing on the enforcement and application of prepayment clauses. The Bankruptcy Code, in section 502(b)(2),^3 disallows claims for unmatured interest, the expectancy of which is precisely what prepayment clauses, at least insofar as they approximate damages resulting from prepayment, are intended to protect. At the same time, section 506(b) provides that to the extent a secured creditor's collateral has a higher value than its claim, the creditor has a valid secured claim both for post-petition interest and for "any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose."^4 Notwithstanding section 502(b)(2), therefore, section 506(b) protects an oversecured creditor's entitlement to be compensated for prepayment if such compensation is properly described either as "interest" or as a reasonable "fee," "cost," or "charge" provided for in the loan agreement.
(^1) See River East Plaza, LLC v. Variable Annuity Life Ins. Co., No. 06-3856, 2007 WL 2377383, at *3 (7th Cir. Aug. 22, 2007) (distinguishing no calls from prepayment fees and fixed prepayment fees from yield maintenance formulas); Dale A. Whitman, Mortgage Prepayment Clauses: An Economic and Legal Analysis 2 , 40 UCLA L. REV. 851, 869–71 (1993) (offering a detailed "taxonomy of prepayment fee clauses"). See generally Whitman, supra note 1, at 871–81 (describing prepayment fees as a "a form of insurance" for lenders and analyzing the economic goals achieved by prepayment clauses); In re MarketXT Holdings Corp., No. 04-12078, 2007 WL 2967233, at *18 (Bankr. S.D.N.Y. Oct. 12, 2007) (describing prepayment clause as "a liquidated damages clause designed to compensate a lender for costs incurred in connection with early payment of a long-term loan, resulting from the possibility that interest rates will be lower when the repaid funds are relent, or that the lender will not be able to rely on a stable flow of funds over a known period"). 3 11 U.S.C. § 502(b)(2) (2006). Citations to the "Bankruptcy Code" refer to title 11 of the United States Code. 4 11 U.S.C. § 506(b).
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however, section 502(b)(2) arguably should be interpreted to preclude claims based on no calls or true liquidated damages clauses, which are fundamentally claims for lost yield. Finally, Part V discusses the status of prepayment clauses in solvent cases, and concludes that, in such cases, bankruptcy courts do not have equitable discretion to disallow claims that would be valid under state law. The issues discussed in this article have attracted significant attention in recent bankruptcy cases, including Northwest Airlines and Calpine. In those cases, chapter 11 debtors have taken advantage of favorable borrowing conditions to repay billions of dollars of secured debt outside of a plan of reorganization. The issues discussed below, however, are as likely to emerge within the plan context as outside it. Under section 1129(a)(7)(A)(ii) of the Bankruptcy Code, commonly described as the "best interests" test, a court cannot confirm a chapter 11 plan unless the plan gives dissenting members of an impaired class of claims at least what they would receive "if the debtor were liquidated under chapter 7 [of the Bankruptcy Code]" on the effective date of the plan.^5 A prepayment fee, if enforceable in bankruptcy against a debtor, would be payable to secured lenders if the debtor were liquidated. Consequently, if a debtor proposes to repay the principal amount of a lender's debt, its plan can be confirmed under the "best interests" test only if the lender's rights under a prepayment clause are enforced.^6 Furthermore, under section 1129(b)(2)(A)(ii) of the Bankruptcy Code, when a class of creditors objects to a plan, the plan cannot be confirmed unless it is "fair and equitable"— i.e. , consistent with the Code's "absolute priority rule." Thus, if the proponents of a plan propose to deprive senior creditors of an enforceable prepayment fee, but also distribute value to junior creditors, that plan too will not be confirmable.^7 Both inside and outside of the plan context, therefore, the validity and application of prepayment clauses will continue to be the source of bankruptcy litigation, especially in low interest rate environments.
I. VARIETIES OF PREPAYMENT CLAUSES
The ubiquity of prepayment clauses, as well as the case law questioning their enforceability by lenders, makes it easy to forget that they are not necessary under state law to protect a lender's yield. Under the "perfect tender in time" rule, a commercial borrower "has no right to pay off his obligation prior to its stated
(^5) 11 U.S.C. § 1129(a)(7)(A)(ii) (2006); see, e.g. , Granada Wines, Inc. v. New England Teamsters and Trucking Indus. Pension Fund, 748 F.2d 42, 44 (1st Cir. 1984) ("Under... section [1129(a)(7)(A) of the Bankruptcy Code], either all creditors must accept the plan, or each creditor must receive under the plan at least as much as it would receive under a Chapter 7 liquidation."). 6 For a detailed discussion of the interrelationship between prepayment fees and section 1129(a)(7)(A)(ii), see Ingrid Michelsen Hillinger, The Story of YMPs ("Yield Maintenance Premiums") in Bankruptcy , 3 DE 7 PAUL BUS. & COM. L.J. 449, 452–55 (2005). Similarly, if the proponents of a plan propose to pay senior creditors an unenforceable prepayment fee, junior stakeholders may object to confirmation on the basis that the plan distributes value to senior creditors that belongs to them. Cf. In re Granite Broad. Corp, 369 B.R. 120 (Bankr. S.D.N.Y. 2007) (resolving objection by preferred equityholders to plan that, in their view, overcompensated senior creditors).
maturity date in the absence of a prepayment clause."^8 That common law rule was adopted by an American state court as early as 1829,^9 and was universally accepted a century later.^10 Although the rule is no longer inviolate (it has been rejected in several states^11 and roundly criticized by scholars^12 ), it remains the law of New York and many other jurisdictions.^13 The default rule that a loan may not be prepaid invites a separate question: whether lenders can refuse prepayment or, alternatively, have to sue for damages in the event they are prepaid. This question too has divided state courts. Some cases, including the earliest cases to embrace the perfect tender in time rule, either assume or hold that prepayment absent consent is not just a breach but, rather, an impossibility.^14 Other cases effectively treat prepayment as a breach that can be remedied by paying the lender whatever interest would be payable through the original maturity of the loan.^15
A. No Calls
Against this common law backdrop, it is apparent that a contractual prohibition on prepayment— i.e. , a "no call"—does no more than memorialize the rule of
(^8) Arthur v. Burkich, 520 N.Y.S.2d 638, 639 (N.Y. App. Div. 1987). (^9) Abbe v. Goodwin, 7 Conn. 377 (1829), has been identified as the first American case to embrace the perfect tender in time rule. See, e.g. , Rebecca C. Dietz, Silence is Not Always Golden: Mortgage Prepayment in the Commercial Loan Context 10 , 22 UNIV. OF BALT. L. REV. 297, 307 (1993). For a thorough history of the perfect tender in time rule, see Frank S. Alexander, Mortgage Prepayment: The Trial of Common Sense 11 , 72 CORNELL L. REV. 288, 308–09 (1987). E.g. , Hatcher v. Rose, 407 S.E.2d 172, 177 (N.C. 1991) (departing from Burkich ; North Carolina statutes recognize prepayment right); Mahoney v. Furches, 468 A.2d 458 (Pa. 1983) (holding that default rule restricting prepayment would be unlawful restraint on alienation); Skyles v. Burge, 789 S.W.2d 116, 119 (Mo. Ct. App. 1990) (indicating that Missouri statutes reject perfect tender in time rule). The minority approach, under which prepayment by a borrower is presumed to be permissible, has sometimes been called the "civil law rule." See George A. Nation, III, Prepayment Fees In Commercial Promissory Notes: Applicability to Payments Made Because of Acceleration 12 , 72 TENN. L. REV. 613, 619 n.27 (2005). For example, Frank S. Alexander argues that the rule lacks any foundation in English common law, Alexander, supra note 10, at 298–308, and that the economic justifications for the rule, including the need for predictable returns on investment, have been used to grant lenders more than the benefit of their bargain (for example, in cases in which interest rates have risen). Id. at 310–18. Dale A. Whitman agrees with Alexander that "[w]ithout doubt the standard rule ought to be reversed," because a lender can easily restrict or limit prepayment to the extent desirable. Whitman, 13 supra note 1, at 858–59. See, e.g. , Friends Realty Assocs., LLC v. Wells Fargo Bank, N.A.P., 836 N.Y.S.2d 565, 565 (N.Y. App. Div. 2007); Nw. Mutual Life Ins. Co. v. Uniondale Realty Assocs., 816 N.Y.S.2d 831, 835 (N.Y. Sup. Ct.
assumptions) that damages for breach are accurately calculated and fully compensatory. Where parties agree to a no call, therefore, the borrower is likely to prepay its debt only if, for idiosyncratic reasons, the lenders' damages from prepayment will be lower than the borrower's savings from refinancing (or their economic equivalent in the form of improved contract terms). In those circumstances, the borrower will either breach its contract and pay the resulting damages or, in order to avoid litigation, pay the lenders a share of the savings/damages spread in exchange for a waiver of the no call.
B. Prepayment Fees
While a no call memorializes the common law default rule that prepayment is not permitted absent lender consent, a prepayment fee effectively opts out of that default rule, as it permits prepayment as long as a fee is paid. Prepayment fees take two primary forms: fixed fees and so-called yield maintenance formulas.
A fixed prepayment fee permits a borrower to repay its debt prior to maturity in exchange for a fixed sum. The fee can be calculated in several ways. It can require payment of a specific dollar amount or, more typically, a percentage of the outstanding principal loan balance. If prepayment is allowed upon payment of a percentage of the loan balance, that percent can either (i) stay the same throughout the term of the loan or (ii) decline or disappear as the loan gets closer to maturity. A fixed prepayment fee can also be combined with a no call: for example, a loan with a fifteen-year term can be non-callable for its first ten years and then callable at 2% of the prepaid amount for the remainder of the loan's term. A fixed prepayment fee is beneficial to borrowers because, unlike a no call or a formula that seeks to approximate actual damages in some manner, a reasonable fixed fee has an upper limit. Thus, once a borrower's projected savings from prepayment exceed the fixed fee, the borrower alone captures all those savings (minus transaction costs). The downside of a fixed prepayment fee for borrowers is that, if the lenders' actual damages from prepayment are below the fixed fee, payment in full of those damages will not suffice to allow prepayment. As a result, even if the borrower's expected savings from refinancing are greater than the lenders' lost yield— e.g. , because the borrower's creditworthiness has improved for idiosyncratic reasons—the borrower will still be deterred from refinancing, unless those expected savings are also greater than the fixed fee.^18
(^18) If the borrower's expected savings are not greater than the fixed fee, but are greater than the lender's damages from prepayment, the lender may still permit prepayment, but only in exchange for a share of the difference between its expected damages and the borrower's expected savings. See Whitman, supra note 1, at 876–78. As applied to prepayment fees, the Coase Theorem suggests that, where a fixed fee will exceed the
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The other major category of prepayment fees is composed of fees based on so- called yield maintenance formulas ("YMFs"). YMFs, unlike fixed prepayment fees, are intended to estimate the actual damages to the lender resulting from prepayment. YMFs, which are sometimes described as "makewholes," come in various forms. One type of YMF is in substance indistinguishable from a no call. It would provide, for example, that the lender's makewhole is equal to "the difference between (a) the interest income [the lender] would have earned had the contract been performed, and (b) the interest income [the lender] would be deemed to have earned by timely mitigating its damages."^19 If enforced, such a YMF would effectively ensure that a court does not enjoin prepayment and applies the standard formula for determining expectation damages. Otherwise, it is functionally no different from a no call. Another type of YMF simplifies the calculation of actual damages by fixing the lender's reinvestment rate ex ante. In some cases, loan parties have fixed the reinvestment rate at the rate of interest that could be obtained through investment in a U.S. Treasury note of a maturity similar to that of the relevant loan.^20 Because the interest rates on commercial loans are invariably higher than treasury rates, the effect of using a treasury rate as a reference is that damages will be payable to lenders under such a formula even when interest rates on similar loans have not changed or have even gone up. As a result, when a lender is able to reinvest absent material transaction costs, use of a treasury rate as a reference overcompensates the lender for lost yield. An alternative approach, which reduces the risk of such overcompensation, is to use a reference other than treasuries—such as (i) average interest rates on loans with the same credit rating, (ii) a lender's internal index for loans within the same industry, or (iii) a fixed spread above treasuries. In practice, such YMFs are relatively rare, whereas YMFs that use a treasury reference are common.^21
borrower's expected savings by x and the lender's actual damages by x+y, the parties will negotiate to split y so that the prepayment can go forward, at least in a world without transaction costs. Id. The alternative, which is less beneficial to each party, is that no prepayment takes place. 19 This is the formula used in one of the Teachers cases to determine the damages resulting from breach of a no call. 20 See 799 F. Supp. at 19. E.g. , River East Plaza, LLC v. Variable Annuity Life Ins. Co., No. 06-3856, 2007 WL 2377383, at * (7th Cir. Aug. 22, 2007); 21 In re Skyler Ridge, 80 B.R. 500, 502 (Bankr. C.D. Cal. 1987). Commentators have disagreed as to whether it is practicable to use a reference other than treasuries to determine a lender's projected reinvestment rate. Some commentators have suggested that treasury rates are properly used, at least in the mortgage context, "because there exists no standard commercial mortgage loan rate, given the uniqueness of each commercial loan and the inherent difficulty (if not impossibility) of identifying an identical or similar loan." Richard F. Casher, Prepayment Premiums: Hidden Lake is a Hidden Gem , 19 AM. BANKR. INST. J., Nov. 2000, at 32. See Debra P. Stark, Prepayment Charges in Jeopardy: The Unhappy and Uncertain Legacy of In re Skyler Ridge , 24 REAL PROP., PROB. & TRAN. J. 191, 196 (1989) (noting that there is no "standard" index of commercial mortgage loan rates and that it may be
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Based on section 502(b)(1), courts have concluded that bankruptcy "operates as the acceleration of the principal amount of all claims against the debtor."^23 Many loan agreements compel the same result, as they provide that the borrower's bankruptcy filing is an event of default upon which the loans accelerate automatically without further action by the lenders. The question that has arisen in various bankruptcy cases, and which is discussed here, is whether contractual provisions governing the voluntary prepayment or redemption of debt have any further application once a loan's maturities have accelerated automatically, such that repayment is not necessarily "voluntary" and arguably may not be a " pre payment" at all. If such provisions are no longer operative in bankruptcy, their enforceability under sections 502(b) and 506(b) of the Bankruptcy Code is academic. At the outset, it is crucial to emphasize that any rule under which acceleration precludes enforcement of a prepayment clause is no more than a default rule. If parties to a loan agreement expressly agree that a prepayment fee will be payable upon or after acceleration, that agreement will be respected by courts inside and outside of bankruptcy.^24 To a large extent, therefore, a lender controls its destiny. If a lender and borrower agree to include a provision in their loan documents under which a prepayment fee is payable as long as the loan's original maturity dates have not passed, any possible tension between the fee and acceleration evaporates. The lender is then assured that it will be compensated for prepayment (to the extent permitted by bankruptcy law) if the borrower files. This discussion, therefore, is necessarily limited to a subset of cases, i.e. , those in which a loan agreement does not address the effect of acceleration on the agreement's prepayment clause.
(^23) E.g. , In re Tonyan Constr. Co., 28 B.R. 714, 727 (Bankr. N.D. Ill. 1983) (citing legislative history of section 502(b)); accord In re Manville Forest Prods. Corp., 43 B.R. 293, 297 (Bankr. S.D.N.Y. 1984) (citing numerous cases), 24 aff'd in part, rev'd in part on other grounds , 60 B.R. 403 (S.D.N.Y. 1986). See In re CP Holdings, Inc., 206 Fed. Appx. 629, 630 (8th Cir. 2006) (enforcing prepayment fee triggered by acceleration); In re AE Hotel Venture, 321 B.R. 209, 218 (Bankr. N.D. Ill. 2005) ("Parties to loan agreements may... agree that prepayment premiums are due even after acceleration."); In re Hidden Lake Ltd. P'ship, 247 B.R. 722, 728–30 (Bankr. S.D. Ohio 2000) (enforcing prepayment fee triggered by acceleration); In re Fin. Ctr. Assocs., 140 B.R. 829, 834–35 (Bankr. E.D.N.Y. 1992) (rejecting argument that acceleration waived prepayment charge where agreement provided for charge even after acceleration); In re Schaumburg Hotel Owner Ltd. P'ship, 97 B.R. 943, 953 (Bankr. N.D. Ill. 1989) (declaring prepayment fee enforceable upon acceleration where creditor bargained for clause allowing both acceleration and collection of prepayment fee upon default); see also Randall D. Crocker & Anne F.B. Weissmueller, Prepayment Provisions in Bankruptcy: Premiums or Penalties? , AM. BANKR. INST. J., Feb. 2007, at 26 (noting trend in favor of enforcing prepayment provisions upon acceleration where parties' agreement provides for prepayment fee in that circumstance); Nation, supra note 11, at 641 (arguing prepayment fees should be enforced upon acceleration if parties' agreement so provides) ("[T]he lender and the borrower have agreed to allocate the lender's risk from early payment.... caused by any events that are defined as events of default, including those that may be beyond the borrower's control.").
A. Purposeful Acceleration
The first scenario in which the relationship between acceleration and prepayment has been tested, both inside and outside of bankruptcy, is that in which a lender elects to accelerate a debt in response to a default. In such situations, courts have generally held that the lender forfeits any contractual right it might have to a prepayment fee.^25 This result follows from the language of most prepayment provisions, under which a fee is payable or debt is non-callable only if a repayment is "voluntary" or "optional." Once a lender opts to accelerate a loan's maturities after a default, repayment of the loan is neither "voluntary" nor "optional" and arguably is not a " pre payment" at all, but rather a payment of debt that has matured.^26 In bankruptcy, the result is no different: If a lender attempts to coerce immediate repayment of a debt notwithstanding the automatic stay (for example, by seeking relief from the stay), there is a strong argument that the lender has waived whatever entitlement it may have had to collect a fee or damages on account of a voluntary prepayment.^27 A second scenario in which the relationship between prepayment clauses and acceleration has been tested is that in which a borrower purposely defaults under a loan agreement in order to avoid the effect of the agreement's prepayment clause. The Second Circuit considered the problem of a borrower's purposeful default in Sharon Steel Corp. v. Chase Manhattan Bank, N.A.^28 In that case, a borrower sold less than "all or substantially all" of its assets to a third party, triggering a provision in its indentures under which all debts became immediately due and payable. However, rather than redeeming the debts in full, and paying the indentures' fixed prepayment fee, the debtor defaulted on its redemption obligation. The debtor then asserted that, because the default permitted the bondholders to accelerate the debt,
(^25) See, e.g. , 3C Assocs. v. IC & LP Realty Co., 524 N.Y.S.2d 701, 702 (App. Div. 1988) (holding lender that brought foreclosure action could not collect prepayment fee); Nw. Mut. Life Ins. Co. v. Uniondale Realty Assocs., 816 N.Y.S.2d 831, 835–36 (N.Y. Sup. Ct. 2006); see also In re Duralite Truck Body & Container Corp., 153 B.R. 708, 715 (Bankr. D. Md. 1993) ("Where the lender has exercised its option to accelerate upon default, the economic justification for a prepayment premium as alternative performance of the bargained loan is negated."); In re Pub. Serv. Co. of N.H., 114 B.R. 813, 818 (Bankr. D.N.H. 1990) ("It is uniformly recognized that prepayment premiums are generally not enforceable when 'waived' by acceleration demands or other conduct indicating immediate cash payment is desired."); In re Planvest Equity Income Partners IV, 94 B.R. 644, 645 (Bankr. D. Ariz. 1988) ("Acceleration of a note is recognized as preventing the mortgagee from seeking to enforce a prepayment penalty clause."). 26 See In re LHD Realty Corp., 726 F.2d 327, 330–31 (7th Cir. 1984) ("[A]cceleration, by definition, advances the maturity date of the debt so that payment thereafter is not prepayment but instead is payment made after maturity." (citation omitted)); Slevin Container Corp. v. Provident Federal Savings & Loan Ass'n, 424 N.E.2d 939, 941 (Ill. App. Ct. 1981) ("[T]he election [to accelerate] renders the payment made pursuant to the election one made after maturity and by definition not prepayment."). 27 For bankruptcy cases recognizing that a lender's election to accelerate or other conduct aimed at collecting immediate payment amounts to a waiver of any right to a "voluntary prepayment" fee, see, for example, Duralite Truck Body & Container Corp. , 153 B.R. at 715; and Pub. Serv. Co. of N.H. , 114 B.R. at 818; 28 Planvest Equity Income Partners IV , 94 B.R. at 645. 691 F.2d 1039 (2d Cir. 1982).
The universe of cases addressing the effect of a bankruptcy filing on prepayment fees is surprisingly small. The cases that do exist have generally concluded that, as stated in In re Skyler Ridge , "[t]he automatic acceleration of a debt upon the filing of a bankruptcy case is not the kind of acceleration that eliminates the right to a prepayment premium."^31 But they have done so for different reasons. In Skyler Ridge , the court refused to find that the automatic acceleration resulting by operation of law from a bankruptcy filing defeats enforcement of a prepayment fee clause because, if that were the law, a debtor could "avoid the effect of [such a] clause by filing a bankruptcy case"—a result that the court believed was "drastic" and unfair to lenders.^32 In In re Imperial Coronado Partners, Ltd. , the Bankruptcy Appellate Panel for the Ninth Circuit reached the same conclusion as the Skyler Ridge court—that a chapter 11 debtor may not escape a contractual prepayment fee simply by filing for bankruptcy protection—but on different grounds.^33 In Coronado Partners , a lender initiated foreclosure proceedings against its borrower by declaring the borrower's debt to be due and owing after the borrower missed an interest installment. In response, the borrower filed a voluntary chapter 11 petition, successfully opposed the lender's motion for relief from the automatic stay to continue the foreclosure, and subsequently obtained court approval for a property sale that allowed the lender's debt to be paid in full. The borrower objected, however, to the payment of a prepayment fee equal to six months interest on the prepaid amount.^34 Rejecting the contention that the lender's acceleration of the note meant that the borrower could no longer "prepay" the note, the bankruptcy court concluded that the prepayment fee clause in the loan agreement should be enforced. The court focused on the borrower's legal authority to "deaccelerate" its debt:
Many courts have held that where a mortgagee accelerates the amount due under a note, a prepayment penalty may not be collected. In those cases, however, it appears that the borrower had no choice but to pay the accelerated amount or lose the property...
. The situation in the case at bar is different because [the borrower] had the right to reinstate the loan under California law or to
(^31) In re Skyler Ridge, 80 B.R. 500, 507 (Bankr. C.D. Cal. 1987). (^32) Id. at 507. The loan agreement at issue in Skyler Ridge contained a no call that prohibited prepayment for the first two years of the loan. However, the lenders, rather than seeking enforcement of the no call, sought only to collect the prepayment fee that would be payable after the first two years. 80 B.R. at 502. Before dealing with acceleration, the court concluded that the formula used by the parties to calculate the fee was not "reasonable" under state law or section 506(b) of the Bankruptcy Code. Id. at 507. The discussion of acceleration, therefore, is dicta. 33
34 96 B.R. 997 (B.A.P. 9th Cir. 1989). Id. at 998–99.
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deaccelerate the loan under bankruptcy law.... Under the Bankruptcy Code, [the borrower] had the right to deaccelerate the due date of the loan as part of a plan of reorganization. See 11 U.S.C. § 1124(2).^35
In response to the debtor's argument that it had not exercised its "deacceleration" right under the Bankruptcy Code, the court explained:
With respect to deacceleration, [the borrower] assessed its situation and decided that selling the property under § 363 was a better business decision than attempting to refinance the property and deaccelerate the loan as a part of a reorganization plan. As [the borrower] admits, this was a conscious decision on its part. In our view, the decision to sell the property and pay off the loan was voluntary, and the prepayment premium is therefore enforceable.^36
Thus, whereas the Skyler Ridge court emphasized that a borrower should not be able to avoid a prepayment fee at its option, the Coronado Partners court concluded that repayment of a debt the maturities of which could be deaccelerated was necessarily "voluntary."^37 Recently, the Bankruptcy Court for the Southern District of New York, in a decision arising out of the Calpine bankruptcy, apparently agreed with Skyler Ridge and Coronado Partners that the automatic acceleration of a debt does not preclude its "voluntary prepayment" in breach of a loan agreement.^38 Calpine involved various loan agreements under which the borrower's bankruptcy filing constituted an event of default that automatically accelerated the loans. Some of the same agreements, however, prohibited any voluntary prepayment.^39 The Court agreed with the debtor that, as a result of the Calpine bankruptcy filings, the debts at issue
(^35) Id. at 1000 (citations omitted). Section 1124(2) of the Bankruptcy Code provides that, notwithstanding an acceleration clause in a loan agreement, a creditor's claim is not impaired if, in a plan of reorganization, the debtor cures any defaults under the loan agreement, reinstates the loan's original maturities, compensates the creditor for any damages incurred as a result of "reasonable reliance" on an acceleration clause, and does not otherwise alter the creditor's rights. See 11 U.S.C. § 1124(2) (2006). Where loans have not yet reached their original maturity date, courts have held that a borrower is legally entitled to "deaccelerate" those maturities under section 1124(2). E.g., In re Liberty Warehouse Assoc. Ltd., 220 B.R. 546, 549 (Bankr. S.D.N.Y. 1998); 36 In re Ace-Texas, Inc., 217 B.R. 719, 727 (Bankr. D. Del. 1998).
37 Coronado Partners , 96 B.R. at 1000. Id. at 999–1000. At least one other court has adopted the reasoning of Coronado Partners. In In re 433 S. Beverly Drive , the Bankruptcy Court for the Central District of California compelled a debtor to pay a prepayment fee even though the lender had accelerated the loan the day before the borrower filed. 117 B.R. 563, 568 (Bankr. C.D. Cal. 1990). The Court emphasized, as in Coronado Partners , that the debtor's filing freed the debtor to reinstate its loans under section 1124(2) of the Bankruptcy Code. 38 Id. In re Calpine Corp., 365 B.R. 392 (Bankr. S.D.N.Y. 2007) (Lifland, J.). As of this writing, both the debtor and the lenders have appealed the Bankruptcy Court's decision, the debtor on the basis that no damages should have been awarded to lenders and the lenders on the basis that the damages awarded were not fully compensatory and should have been treated as a secured claim. 39 Id. at 397.
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The court's reasoning in Coronado Partners has more force, at least in cases in which the debtor is simply seeking to refinance its debt on more favorable terms. As a general matter, a chapter 11 debtor that has the capacity to refinance secured debt on better terms also has the wherewithal to deaccelerate that debt and, if the loans have not reached their original maturities, unimpair the creditors that hold it. Under the protection of the automatic stay, such a debtor is in the same position within bankruptcy as it would be outside bankruptcy, and cannot reasonably assert that its repayment of debt is not "voluntary." If redemption in such circumstances were considered involuntary, the debtor would effectively have an option for which it did not bargain: It could deaccelerate if interest rates go up, thus depriving a lender of the opportunity to reinvest at higher interest rates, but it could repay without penalty if interest rates go down, thus forcing the lender to reinvest at lower interest rates without receiving a prepayment fee. The insight of Coronado Partners is that, because the Bankruptcy Code gives a debtor the power to maintain its capital structure notwithstanding curable defaults, any decision to alter that capital structure is not "compelled" by the acceleration attendant to bankruptcy. Given its emphasis on voluntariness, Coronado Partners is less persuasive as applied to cases in which deacceleration is infeasible or lenders seek to coerce immediate payment. It is unclear, for example, why the power to deaccelerate should render a repayment "voluntary" when deacceleration is not a practical possibility. It is also unclear why a lender's pre-bankruptcy election to accelerate should not be treated as a waiver of the lender's right to collect a prepayment fee; although the automatic stay may protect the borrower from foreclosure in that circumstance, that does not change the fact that the lender had sought to compel repayment prior to maturity.^44 The logic of Coronado Partners , in sum, is most persuasive as applied to situations in which the "voluntariness" of the decision not to deaccelerate is not subject to question based on either the debtor's options or the lender's actions. Coronado Partners and the other cases cited are open to scrutiny not only for their broad conception of "voluntariness" but also for failing to grapple with the literal meaning of the word "prepayment." Where a contractual provision imposes a fee for voluntary " redemption ," it is hard to dispute that the provision should apply to a mid-case refinancing aimed at exploiting better borrowing conditions. In that situation, since the borrower has the option to deaccelerate and enjoys the protection of the automatic stay, such a "redemption" would indisputably be "voluntary." However, altering the language of a provision to apply to "voluntary prepayments ," as opposed to "voluntary redemptions ," arguably complicates the analysis. Under one potential view, a repayment of a debt that is technically
(^44) These are among the arguments made by Judge Mooreman in his dissent from the majority opinion in Coronado Partners. See 96 B.R. at 1001–02 (Mooreman, J., dissenting). Judge Mooreman questioned the majority's conclusion that the power to deaccelerate necessarily makes a payment "voluntary" even when deacceleration is implausible. Id. at 1001. He likewise questioned the majority's conclusion that the lenders had not waived their right to a "voluntary" prepayment by seeking relief from the stay to foreclose. Id. at
accelerated cannot, by definition, be a pre payment.^45 The strength of this contention depends in part on whether "prepayment" is interpreted to mean payment before a loan's original maturity date or payment before its accelerated maturity date. Although the Skyler Ridge and Coronado Partners courts did not expressly address this issue, each of those courts apparently adopted the former interpretation. The fact that many loan agreements will assess a "prepayment" fee even after acceleration supports these courts' position, as it suggests that sophisticated parties view "prepayment" as a term of art meaning payment before an original maturity date.^46 The fact that payments voluntarily made during a chapter 11 case are necessarily made prior to the date on which they are "due" as a matter of bankruptcy law—at the earliest, the date that a plan of reorganization goes into effect—further supports these courts' position. On the other hand, interpreting "prepayment" to mean payment before a loan's original maturity date is difficult to reconcile with the case law stating that a lender's election to accelerate necessarily precludes a prepayment fee. If a contract provision requires a "voluntary prepayment," the "voluntariness" requirement is enough to ensure that a lender waives any prepayment fee by attempting to coerce prepayment. If a provision merely refers to "prepayment," however, and if "prepayment" is interpreted to mean payment before a loan's original maturity date, a lender's election to accelerate would not necessarily prevent collection of a prepayment fee—a result that does not comport with some precedents.^47
The courts have not focused on two additional issues that bear on the relationship between acceleration and prepayment—(1) the distinction between acceleration by law and acceleration by contract, and (2) the possibility that
(^45) See In re LHD Realty Corp., 726 F.2d 327, 330–31 (7th Cir. 1984) ("[A]cceleration, by definition, advances the maturity date of the debt so payment thereafter is not prepayment but instead is payment made after maturity."); Nw. Mut. Life Ins. Co. v. Uniondale Realty Assocs., 816 N.Y.S.2d 831, 834 (N.Y. Sup. Ct.
to file a claim for unmatured principal. The tension between acceleration and prepayment, therefore, is strongest when the lender has agreed by contract that debts mature upon a bankruptcy filing.
b. Acceleration Clauses as Ipso Facto Clauses
An additional question that has not been widely considered is whether section 365(e)(1) of the Bankruptcy Code,^51 which prevents enforcement of clauses in executory contracts that modify a borrower's rights based solely on a bankruptcy filing, might preclude the enforcement of provisions in loan agreements that provide for automatic acceleration upon a bankruptcy default. Based on a straightforward reading of the Bankruptcy Code, it would appear that section 365(e)(2)(B) settles the issue. That provision excludes from the scope of section 365(e)(1) any "contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor."^52 In several decisions, however, bankruptcy courts have concluded that section 365(e)(2)(B) applies only to agreements to extend future credit to a debtor, not to agreements under which credit has already been extended.^53 These cases rely on a statement in the legislative history of section 365(c)(2) of the Code, under which a trustee may not assume or assign a "contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor." With respect to section 365(c)(2), the House Judiciary Committee report states that "the purpose of this subsection, at least in part, is to prevent the trustee from requiring new advances of money or other property."^54 Based on this statement, courts have concluded that section 365(e)(2)(B) does not apply, and thus section 365(e)(1) applies, to loan agreements that do not require the extension of future credit.^55 The courts' reliance on the House Report is open to question. Although the Report suggests that Congress was concerned about the assumption of agreements under which future credit has to be extended, it is hard to understand how it proves that either section 365(c)(2) or section 365(e)(2)(B) applies only insofar as post- petition credit obligations are concerned. On their face, both provisions apply categorically to entire loan contracts, not just contracts or provisions under which future credit must be extended. Further, even if 365(e)(2)(B) applies only to executory commitments to extend future credit, as stated in Texaco , section 365(e)(1) still does not apply to contracts other than "executory contracts" and unexpired leases. In Texaco , the court concluded that a note indenture was executory under the "Countryman definition"
(^51) 11 U.S.C. § 365(e)(1) (2006). (^52) 11 U.S.C. § 365(e)(2)(B). (^53) In re Texaco, Inc., 73 B.R. 960, 965 (Bankr. S.D.N.Y. 1987); In re Peninsula Int'l Corp., 19 B.R. 762, 764 (Bankr. S.D. Fla. 1982). 54
55 H.R. REP. NO. 95–595, at 348 (1977),^ reprinted in^ 1978 U.S.C.C.A.N. 5963, 6304–05. In re Schewegmann Giant Supermarkets, 287 B.R. 649, 657 (E.D. La. 2002) (applying section 365(e)(1) to invalidate automatic acceleration clause in loan agreement); Texaco , 73 B.R. at 965.
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of an executory contract— i.e. , "a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete the performance would constitute a material breach excusing the performance of the other."^56 As evidence of the "executoriness" of the indenture, the Texaco court pointed to, among other things, the trustee's continuing obligation to tender notices of default to the debtor and to deliver status reports to noteholders.^57 The Texaco court did not consider, however, whether a breach of these particular obligations would be sufficiently material to justify non- performance by the debtor. The court also glossed over the fact that the obligations it identified were obligations of the indenture trustee to the noteholders rather than the debtor; thus, even if such obligations were material, it is unclear how their breach could excuse the debtor from meeting its obligations to the trustee. Although a full discussion of "executoriness" is beyond the scope of this article, there is clearly room for dispute as to whether the types of obligations identified by the Texaco court are sufficient to make a loan agreement executory.
Until the relationship between acceleration and prepayment clauses is resolved, or the loan agreements that do not explicitly address that problem pass out of existence, courts will continue to grapple with whether the acceleration attendant to bankruptcy filing precludes enforcement of a prepayment clause. For lenders seeking to protect their yield in bankruptcy, the optimal strategy is to negotiate a provision that requires the borrower to pay a prepayment fee whenever debt is repaid prior to its original maturity. Otherwise, although there is some precedent under which a lender that elects to accelerate a loan's maturities can still collect a prepayment fee in bankruptcy (on account of the debtor's power to deaccelerate), a lender seeking to preserve its right to collect such a fee is on the strongest ground if it takes no action to coerce payment of outstanding principal.
III. PREPAYMENT CLAUSES AND OVERSECURED CREDITORS
If a prepayment clause is operative notwithstanding acceleration, that does not necessarily mean that the right to payment arising from the clause must be included in a lender's allowed claim. To determine whether a prepayment clause gives rise to an allowed claim, a court needs to apply the claims allowance provisions of the Bankruptcy Code. The Code defines a "claim" as a "right to payment,"^58 and requires a bankruptcy court, upon objection, to disallow claims to the extent they
(^56) Texaco , 73 B.R. at 964 (relying on Vern Countryman, Executory Contracts in Bankruptcy: Part I , 57 M 57 INN. L. REV. 439, 460 (1973)).
58 Id. 11 U.S.C. § 101(5) (2006).