Despite Santa Claus: Prepayment and Default Interest Clauses Upheld

penalty

In Kimbrell Realty, the court addressed the question of whether certain prepayment and default interest provisions contained within a lender’s loan documents were enforceable as a matter of Illinois law. [FN1] The court found that that Illinois law permits a lender to lawfully charge a post-acceleration prepayment premium and default interest when the promissory note so provides and the charges are reasonable.

Kimbrell Realty/Jeth Court LLC (“Debtor”) is a chapter 11 debtor-in-possession which operates a 45-unit apartment complex in Peoria, Illinois. Before filing its chapter 11 case, it obtained a loan from the Royal Bank of Canada in the principal amount of $2,264,000. The note was secured by a multifamily mortgage, assignment of rents and security agreement on the real estate owned by the Debtor. The mortgage loan was assigned to the Federal National Mortgage Association (“Fannie Mae”). Prior to bankruptcy, the debtor defaulted on its obligations under the mortgage loan and Fannie Mae exercised its right to accelerate the entire unpaid principal balance under the note.

In the bankruptcy case, Fannie Mae filed a proof of claim totaling $2,898,588.71, broken down as follows:

  • Principal Balance           $2,185,859.78
  • Yield Maintenance          $400,962.55
  • Interest Due                     $145,560.05
  • Default Interest Due       $81,362.56

Fannie Mae argued that the yield maintenance / prepayment premium and default interest were provided for by the underlying note and not prohibited by applicable law. The debtor conceded that Fannie Mae was oversecured, but challenged the amounts claimed on the following grounds:

1)      First, it argued that because the note had been accelerated the prepayment premium was not enforceable as a matter of Illinois law;

2)      Alternatively, the Debtor contended that if a prepayment premium was allowed, the additional interest due on account of default was not enforceable under Illinois law and was not a reasonable charge.

The Debtor based its arguments on Section 502(b)(1) and 506(b) of the Bankruptcy Code. Section 502(b)(1) provides for disallowance of a claim to the extent that “such claim is unenforceable against the debtor and property of the debtor, under any agreement or applicable law for a reason other than because such claim is contingent or unmatured.” Section 506(b) provides that an oversecured creditor shall be allowed “interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement” under which its claim arose.  The court noted that it followed clear majority rule, under which the allowability of prepetition interest, fees, costs and penalties as part of a secured creditor’s claim is not determined under section 506, but rather under section 502; section 506(b) applies only to postpetition interest, fees, costs and charges sought as part of an oversecured claim.  [FN2]

Prepayment Premium

There is no per se prohibition against prepayment premiums under Illinois law, and provisions allowing for prepayment penalties are routinely upheld and enforced where the mortgagor voluntarily elects to pay the loan prior to maturity. Illinois cases limiting the enforcement of prepayment premiums are scarce. [FN3]

The Debtor relied upon the Illinois Appellate Court’s decision in Slevin Container and Seventh Circuit’s decision in Matter of LHD Realty Corp. in support of its arguments that a lender could not collect a prepayment premium after a loan had been accelerated. [FN4]

The note at issue in Slevin Container provided a right of prepayment to the borrower and a corresponding option to the lender to charge up to six months’ worth of anticipated but unaccrued interest if annual prepayments exceeded a certain amount. The appellate court characterized this as an election of remedies – “whether the lender may both accelerate the maturity of the note upon a sale of the premises and also collect a premium or penalty for prepayment.”  The appellate court then held that the lender could not charge the prepayment premium after having voluntarily elected to accelerate the note as permitted by the due-on-sale provision. [FN5]

The court distinguished Slevin Container by noting that the appellate court was resolving an ambiguity in a promissory note as to the enforceability of alternative remedies in the context of a sale of the mortgaged property. It found that the court’s statement was better interpreted as a determination of the meaning of the concepts “maturity” and “prepayment” as they applied to the note at issue, limited to the particular circumstances before that court. It found that in the absence of any citation to the state constitution, a statute or long-standing case law, it could not be presumed that the court was making a broad declaration of public policy. [FN6]

In LHD Realty, the Seventh Circuit considered whether a prepayment premium and late charges were properly part of a mortgagee’s allowed secured claim as determined under section 506(b). The court found that, unlike in this case, the LHD Realty note did not define “prepayment” with respect to default or acceleration; so the Seventh Circuit was dealing with a circumstance not expressly addressed in the note when it determined that the lender “voluntarily waived the unpaid interest” by opting to exercise its right of acceleration. The court also distinguished the decision in LHD Realty as concerning a matter of Indiana law.  The Seventh Circuit made it clear that the “acceleration exception” to the ordinary right to collect a prepayment premium could be modified by the parties through appropriate contractual provisions. [FN7]

The court found that the Fannie Mae note at issue in this case was not ambiguous with respect to its ability to assess a prepayment penalty. Unlike the notes at issue in Slevin Container and LHD Realty, the court found that the note, by its unambiguous terms, specified that the term “prepayment” included payments made following default and acceleration, by providing as follows:

Upon Lender’s exercise of any right of acceleration under this Note, Borrower shall pay to Lender, in addition to the entire unpaid principal balance of this Note outstanding at the time of the acceleration, (i) all accrued interest and all other sums due Lender under this Note and the other Loan Documents, and (ii) the prepayment premium calculated pursuant to Schedule A.

Like the bankruptcy court in AE Hotel and the District Court in 100 LaSalle Associates, the court agreed that Illinois law permitted a lender to lawfully charge a post-acceleration prepayment premium when the promissory note so provides, as in this case. [FN8]

Default Interest

To the extent the prepayment provision was upheld, the Debtor alternatively challenged the default interest provision in the note. It asserted that allowance of default interest on top of the prepayment premium would amount to an unreasonable and impermissible double recovery, since the charges were imposed over the same post-default time period. [FN9]

Fannie Mae maintained that a default interest rate bump of 4% was reasonable and was freely agreed to by the Debtor. It relied upon the general proposition that interest, fees, costs and other contractual charges arising prepetition are part of the secured creditor’s claim in the first instance determined by section 502(b) and not by section 506(b). [FN10]

First, the court noted that under Illinois law, default interest provisions are generally valid and enforceable so long as the higher rate is reasonable in light of the anticipated or actual loss caused by the breach and the difficulty of proving the loss. [FN11] There is no statutory ceiling on the rate of interest that may be charged on mortgage loans or a general prohibition on default interest in Illinois. [FN12] A borrower can agree to a higher rate of interest after default and the additional amount will be treated as liquidated damages, not as a penalty.  [FN13]  A liquidated damages clause is enforceable if the damages are reasonable in light of the anticipated loss and if the actual damages would be uncertain in amount and difficult to prove. [FN14]

The court then noted that the Illinois Supreme Court has considered the following factors in determining that a default interest bump of 1% was reasonable:

(1) the additional amount was not for a fixed sum;

(2) the default interest was computed only from the date of the breach and not before;

(3) the default interest was charged only for the duration of the default; and

(4) actual damages would be uncertain and difficult to ascertain or prove. [FN15]

In this case, the court found that the Baker factors were met. The default interest rate in the note was not for a fixed sum, but rather decreased as the principal balance decreased. It also was computed only from the date of breach and charged only while the note was in default. It would be difficult and uncertain to prove actual damages. [FN16]

It then found that the 4% interest rate increase upon default was in the range of increases historically approved by Illinois courts. There was no redundancy between the default rate and prepayment premium as, at least according to the note, the provisions were designed to address different types of loss – the prepayment penalty for the loss of future income, and the default interest for the increased expense and cost in servicing the loan and increased risk of nonpayment of the loan. As a result, the court concluded that the charges were not duplicative of each other. [FN17]

The court concluded by noting the the principle that it is settled in the Seventh Circuit that there is a presumption that an oversecured creditor is entitled to postpetition interest at the contractual default rate, if applicable under the circumstances, provided that there are no equitable considerations that would compel a different result.  [FN18] It found that the presumption was not rebutted in this case.

Conclusion

Illinois adheres to the general rules of contract interpretation and the primary objective in construing a contract is to give effect to the intent of the parties. As illustrated by this case and cases discussed, parties to a contract should specify whether both prepayment and default interest penalties will apply, as Illinois courts will uphold freely bargained for provisions and they can be difficult to challenge.

[FN1] Kimbrell Realty/Jeth Court LLC v. Federal National Mortgage Association (In re Kimbrell Realty/Jeth Court LLC), 483 B.R., 679, Bankr. No. 12-81454, Adv. No. 12-8047 (Bankr. C.D. Ill. December 7, 2012).

[FN2] 11 U.S.C. §§ 502(b)(1), 506(b); Kimbrell at 5-6, citing In re Wesley, 455 B.R. 383, 386 (Bankr.D.N.J. 2011) (citing cases).

[FN3] Kimbrell at 7, citing First Nat. Bank of Springfield  v. Equitable Life Assur. Soc., 157 Ill.App.3d 408, 414-15, 510 N.E.2d 518 (Ill.App. 4 Dist. 1987).

[FN4] Slevin Container Corp. v. Provident Federal Sav. & Loan Ass’n, 98 Ill.App.3d 646, 424 N.E.2d 939 (Ill.App. 3 Dist. 1981); Matter of LHD Realty Corp., 726 F.2d 327 (7th Cir. 1984).

[FN5} Kimbrell at 8-9, citing Slevin Container , 98 Ill.App.3d at 648.

[FN6] Id. at 11.

[FN7] Id. at 12, citing In re AE Hotel Venture, 321 B.R. 209, 218 (Bankr.N.D.Ill. 2005).

[FN8] Id. at 13, citing AE Hotel Venture, 321 B.R. at 218 and Travelers Ins. Co. v. 100 LaSalle Associates,  1991 WL 23692 (N.D.Ill. 1991)(finding prepayment obligation enforceable where note provision was clear and unambiguous even after default and acceleration).

[FN9] Id. at 14.

[FN10] Id. at 15, citing In re Vanderveer Estates Holdings, Inc., 283 B.R. 122 (Bankr.E.D.N.Y. 2002).

[FN11] Id. at 14, citing Inland Bank & Trust v. Knight, 399 Ill.App.3d 378, 927 N.E.2d 777 (Ill.App. 1 Dist. 2010).

[FN12] Id. at 15-16, citing U.S. Bank Nat. Ass’n v. Clark, 216 Ill.2d 334, 347, 837 N.E.2d 74 (2005).

[FN13] Id. at 16, citing Baker v. Loves Park Sav. & Loan Ass’n, 61 Ill.2d 119, 127-28, 333 N.E.2d 1 (1975).

[FN14] Id., citing Karimi v. 401 North Wabash Venture, LLC, 2011 IL App. (1st) 102670, 952 N.E.2d 1278, 1285.

[FN15] Id. at 16-17, citing Baker, 61 Ill.2d at 128.

[FN16] Id. at 17.

[FN17] Id. at 17-20.

[FN18] Id. at 20, citing Matter of Terry Ltd. Partnership, 27 F.3d 241, 243 (7th Cir. 1994); accord Matter of Southland Corp., 160 F.3d 1054, 1059-60 (5th Cir. 1998); General Elec. Capital Corp. v. Future Media Productions, Inc., 547 F.3d 956, 961 (9th Cir. 2008).

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