In a win for lenders, on March 18, the U.S. Bankruptcy Court for the Southern District of New York held that an unambiguous make-whole provision in a loan contract was enforceable under New York law, despite the fact that the lender had accelerated the loan. In re 1141 Realty Owner LLC, 2019 WL 1270818 (Bankr. S.D.N.Y. Mar. 18, 2019).
1141 Realty Owner LLC is the owner of the Flatiron Hotel, a boutique hotel located in New York City’s iconic Flatiron Building. Rialto Mortgage Finance LLC lent $25 million to 1141 Realty, then assigned the loan documents to Wilmington Trust, N.A.
1141 Realty defaulted on the debt for failing to maintain its liquor license, among other defaults. Wilmington Trust sent 1141 Realty a notice of default and elected to accelerate the principal amount of the loan, together with accrued interest and all other sums due.
The following year, 1141 Realty filed for Chapter 11 bankruptcy in the Southern District of New York. Wilmington Trust filed a claim three months later for $32 million, which included more than $3.1 million in prepayment premium.
1141 Realty objected to the claim, arguing that Wilmington Trust’s acceleration of the loan negated the possibility of any demand for the make-whole payment as a matter of New York law. Wilmington Trust countered that, by the terms of the contract, any post-default payments were deemed prepayments that triggered the premium.
In response, 1141 Realty contended that the courts will only uphold make-whole payments after acceleration if the agreement expressly provides that the premium is due following acceleration by using the word “acceleration” or another variant in the loan agreement.
The language at issue is the following:
If, following an Event of Default which occurs prior to Free Window Date, payment of all or any part of the Debt is tendered by Borrower or otherwise recovered by Lender, such tender or recovery shall be deemed a voluntary prepayment by Borrower in violation of the prohibition against prepayment set forth in Section 2.3.1 and Borrower shall pay, in addition to the Debt, (i) an amount equal to the Yield Maintenance Default Premium.
The court began its analysis by describing the “perfect tender” rule: A borrower “has no right to pay off his obligation prior to its stated maturity date in the absence of a prepayment clause.” The rationale for the rule is that a lender has a right to receive the bargained-for income stream over the life of the loan. To offset this rule, a prepayment or make-whole premium gives the borrower the flexibility to prepay the loan while reducing the lender’s losses.
A lender that accelerates a loan forfeits the right to a prepayment premium because, by advancing the maturity date, the lender has terminated the borrower’s ability to prepay the loan. There are two exceptions:
- First, if a clear and unambiguous provision requires a prepayment premium even after acceleration, then the clause may be analyzed as a liquidated damages clause.
- Second, if the borrower intentionally defaults to trigger the acceleration and “evade” payment of the prepayment premium.
In the 1141 Realty case, the second exception was not applicable because the court found that 1141 Realty did not intentionally default. Under the first exception, the court found the language was clear and unambiguous that any post-default payment, whenever and however made, was deemed to be a voluntary prepayment for the purpose of the premium.
The court then turned to whether the provision was valid as a liquidated damages clause. Liquidated damages clauses are valid if:
- The actual damages are difficult to determine.
- The agreed sum is not plainly disproportionate to the potential loss.
1141 Realty argued that the prepayment premium should be deemed invalid because the premium was disproportionate to its final payment. The court found that the proper comparison was to the debt as a whole when the parties entered into the loan agreement, and that the damages were not disproportionate to the loan amount at that time.
Finally, the court circled back to the question of ambiguity. The court firmly rejected 1141 Realty’s argument that the language of the agreement must expressly provide that the premium is due following acceleration by using the word “acceleration” or another variant. The court acknowledged that parties can use any language that plainly conveys their intent, for example by saying explicitly that a make-whole premium is payable even after acceleration. However, to ensure that a prepayment premium is payable after acceleration, parties may render acceleration irrelevant, such as here, where Wilmington Trust made the premium contingent on any post-default payment.
While the court did not require the lender to expressly provide for acceleration in the prepayment provision, it did suggest that doing so would plainly convey the parties' intent. Lenders whose contracts are governed by New York law may want to choose the path of least resistance and follow the below best practices:
- Make-whole provisions should be clear and unambiguous that payment is required even after default and acceleration.
- Make-whole provisions should plainly convey intent by explicitly providing for payment and collection after acceleration.
- Alternatively, make-whole provisions should render acceleration irrelevant by making the premium contingent on any post-default payment.