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C Mortgage ., 847 F.2d 564 (9th Cir.1988). In Tyler v. Equitable Life Assur. Soc., 512 So.2d 55 (Ala. 1987), the court held that a lender may exact a fee in exchange for waiving the "lock in" period, but some bankruptcy decisions have held otherwise, since the lender did not provide specifically for a fee in the documents themselves. See, e.g., In re Vest Associates, 217 B.R. 696 (Bankr.S.D.N.Y.1998); Continental Securities Corp. v. Shenandoah Nursing Home Partnership, 188 B.R. 205 (W.D.Va.1995).
Some legal scholars, who also have argued against the "perfect tender in time" rule, also argue that courts should set aside these "lock in provisions" when prepayment would be economically efficient. Alexander, Mortgage Prepayment: The Trial of Common Sense, 72 Corn.L.Rev. 288 (1987). But the Restatement of Mortgages would honor "lock in" provisions because in this case the parties have expressly agreed upon the issue, and the business deal should be honored, even though the Restatement would view the situation differently if the parties had not addressed prepayment at all.
Note that a "lock in" clause combined with a prohibition on transfer may amount to an unlawful restraint on alienation. See Terry v. Born, 24 Wash.App. 652, 604 P.2d 504 (1979). A covenant not to transfer (as opposed to a due on sale clause) is rare in mortgages, but does appear in alternative instruments, such as installment land contracts. A number of cases have acknowledged the argument that such clauses constitute unlawful restraints, but have found it inapplicable because the lender had a duty to consent reasonably to a proposed transfer. Carey v. Lincoln Loan Co., 165 Or.App. 657, 998 P.2d 724 (2000). But compare East Bay Limited Partnership v. American Gen. Life & Acc. Ins. Co., 744 F.Supp. 1118 (M.D.Fla. 1990) (combination of prohibitions on transfer and prepayment upheld, but with no discussion of restraint on alienation).
Professor Lefcoe has argued, however, that courts will honor "lock in" provisions, but only by an award of damages, not by specific performance. G. Lefcoe, Prepayment Disincentives in Securitized Commercial Loans, 449 PLI/Real 237, 246 (1999), although he cites as authority only a 1993 law review article by Professor Whitman. (Lefcoe, by the way, refers to the provision as a "lockout," although Nelson and Whitman refer to the same concept as "lock in."
Professor Lefcoe argues that lock in clauses are potentially disastrous for borrowers, and, in light of the fact that lenders, arguably, will be compensated only by damages, probably are less preferable than defeasance provisions (discussed below) or yield maintenance clauses that might be upheld (at least outside of bankruptcy) as liquidated damages clauses even when favorable to the lender.
3. The Prepayment Premium
3.1. Validity of the Premium as an "Optional Performance."
Lenders and borrowers generally are not content with abiding by the concept of "perfect payment in time," and the vast majority of long term loan arrangements, of course, do permit prepayment, but in many cases the documents provide that the borrower must pay a premium fee in connection with such prepayment (borrowers call such fee a "penalty").
Again, until recently, most courts have viewed the contractual provisions for prepayment with a premium the statement of an option right, with a price. At least where the prepayment is a voluntary act on the part of the borrower, most common law courts have accepted the notion that such a provision is neither a contractual penalty nor a liquidated damages provision nor an interest charge (which could lead to usury problems. It is nothing more or less than an optional form of performance. See. E.g. Boyd v. Life Ins. Co. of Southwest, 546 S.W.2d 132 (Tex. Civ. App. 1977) (no usury issue - simply an optional payment provision); Meyers v. Home Savings & Loan Assoc., 113 Cal. Rptr. 358 (Cal. App. 1974) (no liquidated damages analysis required because an optional form of payment).
But, increasingly, common law courts are evaluating the reasonableness of the charge before deciding whether to uphold it. This indicates that these courts are not accepting its characterization as a simple cost for alternative performance. In a leading case, Lazzereschi Investment Co., v. San Francisco Federal S&L Assoc., 99 Cal. Rptr. 417 (Cal. App. 1971), the court first characterized the prepayment fee as a charge for an alternative method of payment, and therefore found it not to be a penalty. In evaluating the question of whether the charge amounted to a restraint on alienation, however, the court resorted to the now famous approach of California courts of measuring the "reasonableness of the restriction" against the "degree of restraint." It found that the prepayment charge in the case was reasonable, but the injecting of the reasonableness analysis into the issue at all makes the case a watershed opinion.
In their fine treatise on Real Estate Finance Law 3d. Ed. (West 1994) (Practitioner’s Treatise) at 484 et seq. Grant Nelson and Dale Whitman conclude that prepayment charges ought to be evaluated as a form of damages for breach of a contractual agreement not to prepay. If the amount of the penalty can satisfy the test for liquidated damages, they conclude, it should be upheld. Also see Alexander, Mortgage Prepayment: The Trial of Common Sense, 72 Cornell L. Rev. 288, 306 (1987). Dale Whitman, however, believes that state courts should be quite generous in evaluating the validity of these liquidated damages provisions. At the time the prepayment premium is negotiated, the actual "damage" that will be suffered by the lender at the time of the hypothetical prepayment is impossible to gauge accurately, and consequently almost any attempt by the parties, engaged in head to head bargaining, ought to be accepted by the court as "reasonable." See Whitman, Mortgage Prepayment Clauses: An Economic and Legal Analysis, 40 U.C.L.A.L.Rev. 851 (1993).
Notwithstanding these comments, legal analysts should keep in mind that the fundamental approach reflected in a number of prepayment clause calculations is simply a price for an option, and not an attempt to liquidate damages. Any prepayment premium that consists of a fixed sum of money clearly is not an attempt to liquidate damages for prepayment of an amortizing loan, since the degree of injury to the lender is not fixed, but will decline as the principal amount declines over time.
A prepayment premium that is measured by a certain period of interest - say six month’s or one year’s interest - on the amount of the prepayment is considerably safer from attack, but still the argument is far from perfect. Such a computation does take into account any reductions brought about by amortization, but does not reflect the fact that the lender’s potential "loss" will be affected by market conditions at the time of the loan. When the prepayment occurs for the purpose of refinancing, of course the lender will suffer some loss since typically the market for money is lower than rate on the note, or the borrower would have no incentive to refinance. The extra interest "kicker" represented by the prepayment premium reflects the fact that the lender will have some time delay before being able to place that loan. But if the prepayment occurs in connection with some other event, such as the sale of the property or for some involuntary payment, as described below, then a court may conclude that the lender ought to be able to relend at the same or higher return, even taking the cost of replacing the loan into account. Therefore, the court could find that a formula which could produce such a windfall for the lender is not a reasonable attempt to liquidate damages.
As the following discussion indicates, lenders increasingly are phrasing prepayment premium clauses so that they will apply to involuntary payment situations. This not only increases the liklihood that courts will analyze the prepayment premium arrangements as liquidated damages clauses, but also decreases the liklihood that courts will conclude that the more traditional prepayment premium computations, described above, will satisfy the liquidated damages test. Such reasoning is perhaps what is driving lenders to move toward more sophisticated "yield maintenance" premium computations, as described below.
3.2. The Special Case of Involuntary Prepayment
In probably the majority of prepayment situations, the borrower is prepaying the loan because there will be a new mortgage loan replacing it, either in connection with the sale of the property to another or in connection with a refinancing by which the borrower increases the size or decreases the interest rate on the secured loan. These prepayments are voluntary acts on the part of the borrower, and the analysis set forth above, evaluating prepayment premiums as an alternative form of performance, makes some sense.
But one problem that has dogged the judicial analysis in this area is the insistence of many mortgage lenders to exact prepayment penalties when it is clear that the borrower is forced to prepay the loan due to circumstances that are not of the borrower’s choosing. In Lazzareschi, supra, the borrower claimed that the prepayment was made necessary by the liquidation of the real property security caused by a divorce settlement. The more common situation, however, are those where the borrower must prepay because of an insured injury to the property that cannot reasonably be repaired (or which the lender refuses to permit to be repaired with insurance proceeds) or because of a total or partial condemnation of the property by eminent domain (where, again the lender will not permit the property to be restored by use of condemnation proceeds.)
Of course, the first question to be addressed in such cases is whether the parties contemplated that the prepayment premium be payable when the prepayment was not due to a voluntary decision by the borrower. Where the language of the prepayment clause does not specifically address the situation of an insured casualty or an eminent domain award, the usual approach is to conclude that the parties did not intend that the prepayment premium requirement would attach. Chestnut Corp. v. Bankers Bond & Mortgage Col, 149 A.2d 48 (Pa. 1959) (insured damage to property); DeKalb County v. United Family Ins. Co., 219 S.E.2d 7078 (Ga. 1975) (eminent domain); Silverman v. State, 370 N.Y.S. 2d 234 (App. Div. 1976) (semble).
But lenders have become more sophisticated in recent years, and borrowers can expect that commercial lenders will include both application of insurance proceeds and application of eminent domain proceeds as events triggering application of the prepayment premium, as well as any other "involuntary event" the lender can conceive and describe. Generally speaking, if the parties say it clearly enough in the instruments, courts have had little difficulty accepting the fact that a premium can be charged in such instances, although, not surprisingly, the "reasonableness" of such charges comes under greater scrutiny now that the payment is not a voluntary act of the borrower.
A perhaps more difficult analytic problem arises when the prepayment is the result of an acceleration of the loan balance in response to a default. Here, of course, the prepayment still is involuntary on the part of the borrower, and there is the additional factor that the acceleration was a voluntary act on the part of the lender, and not brought about entirely by circumstances beyond the control of either party. The lender will argue strenuously, of course, that the borrower in fact did not suffer the acceleration involuntarily, but brought it on by the volitional act of defaulting on the mortgage. Whatever the merits of the parties’ arguments, the hard reality is that the vast majority of the decisions have not permitted collection of a prepayment penalty when the documents do not specifically so provide. Here are a few representative cases: Matter of LHD Realty Corp., 726 F.2d 327 (7th Cir.1984);General Mortg. Assoc. v. Campolo Realty & Mortg. Corp., 678 So.2d 431 (Fla.App.1996) ; In re Planvest Equity Income Partners IV, 94 B.R. 644 (Bkrtcy.Ariz.1988); 3C Associates v. IC & LP Realty Co., 137 A.D.2d 439, 524 N.Y.S.2d 701 (1988); Rodgers v. Rainier Natl. Bank, 111 Wash.2d 232, 757 P.2d 976 (1988); George H. Nutman, Inc. v. Aetna Business Credit, Inc., 115 Misc.2d 168, 453 N.Y.S.2d 586 (1982); Kilpatrick v. Germania Life Ins. Co., 183 N.Y. 163, 167, 75 N.E. 1124, 1125 (1905).
Note that if the court concludes that the borrower has defaulted expressly to trigger acceleration and avoid prepayment, it may foil that motive notwithstanding the substantial authority cited above. See, discussion in Eyde Bros. Devel. Co. v. Equitable Life Assur. Soc., 697 F.Supp. 1431 (W.D.Mich.1988); In re LHD Realty Corp., 726 F.2d 327, 331 (7th Cir.1984); Rodgers v. Rainier Nat'l. Bank, 111 Wash.2d 232, 757 P.2d 976 (1988).
Where, however, there was just a threat to accelerate, and the borrower paid off the loan, the prepayment penalty was upheld. Mutual Life Ins. Co. of New York v. Hilander, 403 S.W.2d 260 (Ky. 1966) Similarly, where the lender did accelerate, but rescinded the acceleration, but the borrower still prepaid, the premium was upheld. West Portland Development Co. v. Ward Cook, Inc., 246 Or. 67, 424 P.2d 212 (1967).
The courts have almost uniformly upheld prepayment premiums where the documents provided specifically that they could be enforced upon acceleration. Virginia Housing Devel. Authority v. Fox Run Limited Partnership, ___ Va. ___, 497 S.E.2d (1998); Biancalana v. Fleming, 53 Cal.Rptr.2d 47 (1996); Golden Forest Properties v. Columbia Sav. & Loan Ass'n, 202 Cal.App.3d 193, 248 Cal.Rptr. 316 (1988);