In re <i>Denver Merchandise Mart</i>—Fifth Circuit Emphasizes Need for Clear Contractual Language Regarding Prepayment Premiums

In re Denver Merchandise Mart—Fifth Circuit Emphasizes Need for Clear Contractual Language Regarding Prepayment Premiums

Prepayment premiums have recently been a source of controversy in bankruptcy and appellate courts.  One of the latest examples of this trend is the Fifth Circuit's ruling in In re Denver Merchandise Mart, Inc., 740 F.3d 1052 (5th Cir. 2014).  The decision in Merchandise Mart stands for the proposition that, in the absence of clear contractual language stating otherwise, a lender's voluntary decision to accelerate a loan generally acts as a waiver of any right to a prepayment premium.  The ruling underscores the importance of using unambiguous language in a loan agreement detailing the circumstances under which a borrower is obligated to pay a prepayment premium.

Enforceability of Prepayment Premiums in Bankruptcy

Restrictions on a borrower's ability to prepay secured debt are a common feature of bond indentures and credit agreements.  Lenders often incorporate "no-call" provisions to prevent borrowers from refinancing or retiring debt prior to maturity.  Alternatively, a loan agreement may allow prepayment at the borrower's option, but only upon payment of a "make-whole premium" (commonly referred to as a "prepayment penalty").  The purpose of these prepayment penalties is to compensate the lender for the loss of the remaining stream of interest payments it would otherwise have received had the borrower paid the debt through maturity.

Bankruptcy courts almost uniformly refuse to enforce no-call provisions against debtors and routinely allow the debtor to repay outstanding debt.  Also, courts sometimes disallow a lender's claim for payment of a make-whole premium for breach of a no-call provision because the premium is generally not due under the applicable loan documents during the no-call period.  The courts are also divided on the alternative argument sometimes made that a lender should be entitled to contract damages (apart from a make-whole premium) for "dashed expectations" when its outstanding debt has been paid prior to its original maturity.  See, e.g., U.S. Bank Trust Nat'l Assoc. v. Am. Airlines, Inc. (In re AMR Corp.), 730 F.3d 88 (2d Cir. 2013) (debtors not required to pay make-whole premium when prepaying secured debt where plain language of loan documents did not require any such payment where default event, a voluntary bankruptcy filing, triggered automatic acceleration of debt); HSBC Bank USA, Nat'l Ass'n v. Calpine Corp., 2010 WL 3835200 (S.D.N.Y. Sept. 15, 2010) (damage claim for breach of no-call provision disallowed under section 502(b)(2) of claim for unmatured interest); In re Trico Marine Services, Inc., 450 B.R. 474 (Bankr. D. Del. 2011) (make-whole premium is in nature of liquidated damages, not interest, so that lenders were entitled only to unsecured claim for make-whole premium); In re Solutia Inc., 379 B.R. 473 (Bankr. S.D.N.Y. 2007) (disallowing claim for make-whole premium and reasoning that, by incorporating provision for automatic acceleration upon bankruptcy in indenture, noteholders made decision to give up future income stream in favor of having immediate right to collect entire debt).  But see In re School Specialty, Inc., 2013 BL 107127 (Bankr. D. Del. Apr. 22, 2013) (allowing claim for make-whole premium under New York law where loan agreement specifically provided for make-whole premium in event of "either prepayment or acceleration" and make-whole premium not plainly disproportionate to lender's probable loss); Premier Entm't Biloxi, LLC v. U.S. Bank Nat'l Ass'n (In re Premier Entm't Biloxi, LLC), 445 B.R. 582 (Bankr. S.D. Miss. 2010) (lenders not entitled to secured claim for make-whole damages because indenture required prepayment penalties only if debtor repaid loan prior to maturity, and maturity was automatically accelerated due to bankruptcy filing; however, lenders were entitled to unsecured claim for dashed expectations).

The Fifth Circuit considered the enforceability of a  prepayment premium in Merchandise Mart.

Merchandise Mart

GC Merchandise Mart, LLC (the "debtor") owns the Denver Merchandise Mart, a large exposition center in Denver, Colorado.  In 1997, the debtor borrowed $30 million and executed a secured promissory note in favor of the lender.  The note provided that the debtor could prepay the loan under certain conditions, but that early repayment would trigger the debtor's obligation to pay a prepayment premium.  Furthermore, the note provided that any default would trigger acceleration of all outstanding principal, interest and "all other moneys agreed or provided to be paid by Borrower in this Note," as well as the accrual of default interest.  

The debtor stopped making payments on the note in October 2010, and the lender issued a notice of default.  As permitted by its security agreement, the lender then appointed a receiver for the merchandise mart.  The debtor and certain affiliates filed for chapter 11 protection in the Northern District of Texas shortly afterward.

The lender argued that payment of the $1.8 million prepayment premium was required under the acceleration clause in the note, even though the debtor stopped making payments under the note before filing for bankruptcy and never repaid the debt prior to maturity.  The bankruptcy court disagreed.  It concluded that some prepayment, whether voluntary or involuntary, was required to trigger the obligation to pay the prepayment premium.  The court also emphasized that the note could have expressly provided for payment of the premium in the event of acceleration, but did not.  The lender appealed to the district court, which affirmed the ruling below.  The lender then appealed to the Fifth Circuit.

The Fifth Circuit's Ruling

A three-judge panel of the Fifth Circuit affirmed.  The court wrote that, under Colorado law (which governed the note), "unless specifically provided for by contract, a lender may not assess a prepayment premium when a note is accelerated at the lender's option."  Therefore, the court explained, a lender's decision to accelerate generally acts as a waiver of any right to a prepayment premium.  Even so, the Fifth Circuit stated, a court may enforce a prepayment penalty even when a lender accelerates the note at its option if the borrower defaulted to avoid additional interest.

In dicta, the Fifth Circuit panel noted that at least one Colorado court has held that a prepayment premium is consideration for a borrower's right or privilege to prepay and therefore not a remedy for breach of contract (discussing Planned Pethood Plus, Inc. v. KeyCorp, Inc., 228 P.3d 262 (Colo. App. 2010)).  As a consequence, the Fifth Circuit explained, prepayment premiums are not considered to be liquidated damages under Colorado law, and they are not subject to the rules of reasonableness applied in assessing whether a liquidated damages clause is enforceable.

In addition, the court noted that section 506(b) of the Bankruptcy Code provides that, to the extent the value of collateral exceeds the amount of a claim secured by it, the creditor's allowed secured claim includes "any reasonable fees, costs, or charges provided for under the agreement" (emphasis added).  According to the Fifth Circuit, a prepayment premium is not subject to section 506(b)'s reasonableness standard if the premium is deemed to be consideration for the borrower's privilege to prepay rather than a remedy for breach of contract.   

Turning to the language of the note, the Fifth Circuit focused on two points:  (i) the absence of any prepayment; and (ii) the principle that, when a lender voluntarily accelerates a note due to a default, no prepayment premium will be due unless the contract specifically provides that such acceleration triggers the lender's right to a prepayment premium.  The court examined three separate sections of the note to determine whether the debtor was expressly required to pay a prepayment premium.  Although the note gave the debtor the "right or privilege" to prepay, it did not require the debtor to prepay.  In addition, even though the note required the payment of a premium if the debtor prepaid the debt in the event of default or acceleration, no prepayment had actually been made.  Similarly, although the note provided that a prepayment premium was payable regardless of whether a prepayment was "voluntary or involuntary," no prepayment actually occurred.

The Fifth Circuit panel noted that language could easily have been included in the note making a prepayment premium due upon acceleration, even in the absence of an actual prepayment.  However, the court wrote, the note in the case before it evidenced "no such clear intent."


The central message of the Fifth Circuit's ruling in Merchandise Mart is that lenders should bargain for specific and unambiguous language stating that a prepayment premium is due in the event of an acceleration of a note by a lender.  In the absence of such language, lenders run the risk that a court will rule that acceleration of a note does not trigger an automatic right to a prepayment premium.

Notably, in Merchandise Mart, the Fifth Circuit's analysis extended no further than the question of whether acceleration triggered the right to a prepayment premium.  Having concluded that it did not, the court did not undertake—nor was it asked—to determine:  (i) whether an otherwise enforceable prepayment premium claim should be disallowed under section 502(b)(2) as "unmatured interest"; or (ii) whether any such claim, if allowed, should be treated as secured or unsecured under section 506(b).

The court's discussion in dicta regarding whether prepayment premiums should be treated as liquidated damages may be confusing.  As noted above, citing Planned Pethood, the Fifth Circuit observed that a prepayment premium should not be deemed liquidated damages if the premium is not payable as a consequence of default or acceleration, but rather is payable solely because the borrower simply chose to prepay.  As a result, the Merchandise Mart panel did not provide any clear direction with respect to the situation where a prepayment premium is contractually due as a result of a default or acceleration.