The Court of Appeals for the First Circuit recently held that an oversecured lender holds at least an unsecured claim for contractual prepayment penalties against a solvent debtor. UPS Capital Business Credit v. Gencarelli (In re Gencarelli), 2007 BL 91656 (1st Cir., Aug. 30, 2007). As the court explained, "[t]his is a difficult question that has significant ramifications for the commercial lending industry." Id. at 16. It is irrelevant, the court explained, whether the prepayment penalty is unreasonable or entitled to secured lender priority status under § 506(b) of the Bankruptcy Code ("Code"), so long as the penalty is valid under applicable state law.

The court first reviewed Code § 502, which deals with allowance of claims, and § 506(b), which deals with whether a lender's costs can be given secured status, before finding that the enforceability of a prepayment penalty turns only on its validity under state law. Id. at 16. Although a "reasonable" prepayment penalty may be allowed under § 506(b) as part of the lender's secured claim, even an unreasonable penalty will still constitute an allowable unsecured claim under § 502 against a solvent debtor. In short, "regardless of reasonableness, an over-secured creditor may be entitled to collect bargained for prepayment penalties as the functional equivalent of unsecured debt." Id. at 17.


The individual Chapter 11 debtor and his wholly owned company had entered into two pre-bankruptcy loan agreements, each containing a prepayment penalty clause: Should repayment occur within the first five years of the loan term, the borrowers would pay a fee equal to a percentage of the amount repaid, depending on the date of prepayment. After the sole shareholder and his corporate entity filed Chapter 11 petitions, the corporate debtor sold all of its assets, resulting in proceeds sufficient to pay all creditors in full plus interest, with a multi-million dollar surplus for the sole shareholder debtor. Id. at 4.

Debtor's Argument: Penalty Must Be Reasonable

The lender asserted a secured claim against the corporate debtor for the full amount of its loan, plus the prepayment penalty called for in the loan agreement. Although the debtor conceded liability for the loan balance, including interest, it objected to the prepayment penalty as being unreasonable. According to the debtor, § 506(b) permits a secured creditor to recover its contractual charges only if they are reasonable. Id. at 5.

Lender's Argument: Reasonableness Irrelevant

The lender argued that § 502 governed allowance of the claim and that § 506(b) only dealt with the secured priority status of the claim once it was allowed. Because its claim was valid under Rhode Island state law, the prepayment penalty was allowable under § 502, and it was irrelevant whether it was reasonable or entitled to priority under § 506(b). Id. at 5.

Lower Courts: Reasonableness Required

The lower courts held that § 506(b) governed the issue, reasoning that an oversecured lender could only recover a prepayment penalty if it was reasonable. Id. at 5–6. The lender appealed.


The First Circuit reversed and remanded the case to the bankruptcy court for a determination of whether the lender's prepayment penalty was valid under applicable Rhode Island state law. According to the court, § 502 governed the issue of allowability of a claim, but § 506(b) only addressed the secured priority status of a lender's "reasonable fees, costs or charges…." Id. at 9–10. "Section 502, not section 506(b), affords the ultimate test for allowability, and any claim satisfying that test is, at the very worst, collectible as an unsecured claim." Id.

Code Favors Oversecured Creditors

"Policy" and "common sense" dictated this result, the court explained. Id. at 12–13. First, unsecured creditors may recover their attorneys' fees, costs and expenses from the estate of a solvent debtor so long as they are permitted to do so by the terms of their contract and applicable non-bankruptcy law. Id. at 12, citing In re Dow Corning Corp., 456 F.3d 668, 683 (6th Cir. 2006). It would thus be absurd to disallow the very same type of claim held by an oversecured creditor: " . . . [I]t does not make sense that over-secured creditors should be penalized by disallowing those fees . . . altogether—especially when unsecured creditors can collect them." Id. at 13. Second, Congress probably never intended that debtors be able to avoid otherwise valid contractual obligations (e.g., prepayment penalties) by filing bankruptcy petitions and invoking § 506(b)'s reasonableness requirement to penalize an oversecured creditor. "Creating that kind of uneven playing field would be antithetic to the general policy of the Code, which strongly favors over-secured creditors." Id. at 12.

Equities Turned on Debtor's Solvency

The court relied heavily on the debtor's solvency. "Let us be perfectly clear. This is a solvent debtor case and, as such, the equities strongly favor holding the debtor to his contractual obligations as long as those obligations are legally enforceable . . ." Id. at 13. In a solvent debtor case, the bankruptcy court's role is to enforce the lender's contractual rights. Id. at 14. This statutory interpretation is sound, and, as the court noted, is supported by cases in both the Eleventh Circuit (Welzel v. Advocate Realty, Inc. (In re Welzel), 275 F.3d 1308 (11th Cir. 2001) (en banc)) (held, oversecured lender's claim for legal fees, enforceable under state law, may still be reviewed for reasonableness under § 506(b); any unreasonable fees treated as unsecured debt) and the Ninth Circuit (Joseph F. Sanson Inv. Co. v. 268 Ltd. (In re 268 Ltd.), 789 F.2d 674 (9th Cir. 1986) (same).

Even Unreasonable Penalties May Be Allowable

If the bankruptcy court on remand finds the prepayment penalty to be valid under applicable Rhode Island law, § 502 mandates allowance of the oversecured lender's claim for prepayment penalties, at least as an unsecured claim. In short, "both precedent and policy militate in favor of allowing [the lender's] claims for prepayment penalties as unsecured claims, even if the penalties are deemed unreasonable, so long as they are valid under [Code §] 502," which turns on applicable state law. Id. at 14.

Practice Points

  •  Prepayment penalty provisions in a secured loan agreement should meet the enforceability requirements under governing state law.
  • Secured lenders should assert claims for prepayment penalties when they file claims, and should also assert priority under § 506(b). Even if the prepayment penalty claims are held to be unreasonable under § 506(b), they can still be allowed as unsecured claims under § 502

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