E-DIRT NEWSLETTER -- Winter, 2000

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Yield Maintanence Revisited:
Prepayment Provisions in Commercial Loan Documents

By John C. Murray, Vice President and Special Counsel with First American Title Insurance Company

I. Prepayment - Bankruptcy Court Decisions

1. A key issue in determining the treatment of secured creditors under the Bankruptcy Code, Pub. L. No. 95-598, 92 Stat. 2549 (1978) (codified as amended at 11 U.S.C. §§ 101-1328) (1994), is whether the creditor is less than fully secured or slightly more than fully secured. In many districts, the fully secured creditor is not entitled to adequate protection payments, but the secured claim will accrue interest up to the value of the collateral. Section 506(b) of the Bankruptcy Code permits a secured creditor, to the extent that its claim is oversecured, to collect interest on such claim and any reasonable fees (including attorneys’ fees, costs, and charges) that are provided for in the loan documents. See, e.g., In re Schriock Const., Inc., 104 F.3d 200, 203 (8^th Cir. 1997) (holding that attorney’s fees provisions in loan documents are enforceable in bankruptcy even though state law prohibits them); In re Foertsch, 167 B.R. 555, 562 (Bankr. D.N.D. 1994) (holding, in the context of a request for recovery of attorneys’ fees, that in order to recover "fees, costs and charges" under § 506(b), a creditor must establish: (1) that it is oversecured in excess of the amount requested; (2) that the amount requested is reasonable; and (3) that the agreement giving rise to the claim provides for recovery of the fee, cost or charge requested); In re 268 Ltd., 789 F.2d 674, 676-677 (9^th Cir. 1986) (applying a single federal standard of "reasonableness" with respect to the issue of whether an attorney’s fees provision was allowable under § 506(b)); In re Hudson Shipbuilders, 794 F.2d 1051, 1058 (5^th Cir. 1986) (holding that fees otherwise enforceable under state law were still subject to § 506(b)’s requirement that fees be "reasonable"); In re Bristol, 92 B.R. 276, 277 (Bankr. S.D. Ohio 1988) (holding that creditors can collect fees under § 506(b) pursuant to an agreement that would be void under otherwise applicable state law); In re American Metals Corp., 31 B.R. 229, 234 (Bankr. D. Kansas 1983) (same); In re Carr Mall Limited Partnership, 201 B.R. 415, 1996 Bankr. LEXIS 1311 at *14 (Bankr. M.D.N.C. 1996) ("Authority for the allowance of prepayment penalties under the Bankruptcy Code can be found at 11 U.S.C. §506(b). Under that Code Section, oversecured creditors are permitted to collect the amount of any ‘reasonable’ charge as part of their allowed secured claim"); In re Outdoor Sports Headquarters, Inc., 161 B.R. 414, 424 (Bankr. S.D. Ohio 1993) ("Prepayment charges are encompassed in the term ‘charges,’ as used in § 506(b)"). Thus, an oversecured lender should be entitled to include, as part of its claim, interest at the default rate on the debt as well as the amount calculated pursuant to its contractual prepayment provision. However, the bankruptcy courts in various jurisdictions have differed as to whether the lender with an oversecured claim should be entitled to a prepayment premium and whether the charge is reasonable under federal or state law.

2. A commercial borrower may seek, as part of a reorganization under Chapter 11 of the Bankruptcy Code, to sell property free and clear of liens and avoid payment of a prepayment premium set forth in the mortgage loan documents of the secured creditor. In In re Skyler Ridge, 80 B.R. 500 (Bankr. C.D. Cal. 1987), the creditor (The Travelers Insurance Company) held a secured claim constituting a first mortgage lien against an apartment project in Kansas, and brought an action asking for a determination of the amount of its secured claim, including the prepayment premium stated in the loan documents, which premium was tied to the yield on a certain maturity date of U.S. Treasury instruments, and which yield varied depending on when the prepayment occurred. The debtor had found a purchaser for the apartment project, and filed a plan providing for payment in full of Travelers’ secured claim, with the exception of interest at the default rate and the prepayment premium (which was approximately $2.5 million). The Bankruptcy judge characterized the prepayment provision as a liquidated damages clause, and held that it was invalid under Kansas law because it was not "reasonable." Because the formula used in computing the prepayment premium was determined by the applicable Treasury instrument rate and not by the market rate for comparable first mortgages, and was not discounted to a present value worth, the court found that the prepayment provision was unenforceable under § 506(b) of the Bankruptcy Code for the same reasons it was unenforceable under state law. Since Kansas law requires that an unreasonable liquidated damages clause must be disallowed in its entirety (i.e., no reduction in or reformation of the offending prepayment formula calculation would be permitted), the court declined to decide the issue of whether, or to what extent, a "reasonably" drafted prepayment provision might be allowed under § 506(b) as a valid liquidated damages approximation. The court conceded that the classification of the prepayment provision as a liquidated damages provision "is not altogether certain," but stated that "the parties have agreed on this characterization of the provision, and the Court accepts this characterization." Id. at 503. This statement of the court as to the parties’ agreement regarding the characterization of the prepayment provision is untrue; the author was significantly involved with this case while employed with The Travelers Insurance Company, and the fact is that the court specifically directed the parties to treat the provision as a liquidated damages provision and brief the matter based on that assumption.

3. In In re Kroh Brothers Development Co., 88 B.R. 997 (Bankr. W.D. Mo. 1988), the bankruptcy court, in construing a prepayment provision similar to the provision contained in the loan documents in Skyler Ridge, agreed with the reasoning of the court in Skyler Ridge and held that the prepayment formula was unenforceable. The court in Kroh Brothers seemed particularly concerned that the prepayment charge, when computed in accordance with the lender’s contractual formula, equaled 25% of the principal amount of the loan (which the court felt was an exorbitant "penalty"), and also expressed concern that if the lender recovered its contractual prepayment charge, none of the other creditors of the bankruptcy estate would receive any distribution. (The court in Skyler Ridge had the same concern). However, unlike the court in Skyler Ridge, which held that under Kansas law an unreasonable liquidated damages clause must be disallowed in its entirety, the court in Kroh Brothers noted that under Missouri law, "[when] the amount of liquidated damages is greatly disproportionate to the actual damages courts construe the clause as a penalty but allow recovery of damages actually incurred." Id. At 999 (emphasis supplied). It appears, however, that the lender in Kroh Brothers did not request that the court allow it its "actual" damages.

1. See In re Imperial Coronado Partners, Ltd., 96 B.R. 997, 1001 (9^th Cir. B.A.P. 1989), in which the court held that state law validated the prepayment penalty at issue and that, under § 506 of the Bankruptcy Code, the amount of the premium should be limited to the actual damages suffered by the lender as the result of the early prepayment, to be determined by subtracting the market rate of interest from the contract rate from the date of prepayment until the scheduled maturity date of the loan. The court also held that because the borrower in this case was a federally chartered savings and loan association, federal regulations preempted California law, and the reasonableness requirement under § 506(b) was therefore a question of federal law and not state law. See also In re Outdoor Sports Headquarters, Inc., 161 B.R. 414, 424 (Bankr. S.D. Ohio 1993) ("In light of the economic rationale underlying prepayment charges, the court finds that ‘reasonable’ charges under § 506(b) are those that compensate the lender for the harm caused by the prepayment, the amount of actual damages which result from the prepayment"); Evergreen Community Development Assoc. v. Columbia Associates, 996 F. 2d 1224, 1225 (9^th Cir. 1993) (unpublished disposition) (holding that the prepayment provision was not an unreasonable liquidated damages clause because the premium assessed by the lender represented the actual cost to the lender of prepayment); In re Morse Tool, Inc., 87 B.R. 745, 750 (Bankr. D. Mass. 1988) (disallowing the "unreasonable" portion of the prepayment premium charge, rather than disallowing the entire amount); West Raleigh Group v. Massachusetts Mutual Life Ins. Co., 809 F.Supp 384, 387 (E.D. N. Carolina 1995) (holding that North Carolina law supports the conclusion that a prepayment provision contained in a commercial loan is valid and enforceable and is not subject to analysis as a liquidated damages provision); Williams v. Fassler, 110 Cal. 3d 7, 12-13, 167 Cal. Rptr. 545, 551 (1980) ("We … hold that in a transaction between private parties, an agreement specifying a 50 percent prepayment penalty is valid if the penalty is reasonably related to the obligee’s anticipated risk of incurring increased tax liability upon the occurrence of the prepayment"); Eyde Brothers Development Bros. v. Equitable Life Assurance Society of the United States, 888 F. 2d 127, 138 (6^th Cir. 1989) (holding that, in transactions between sophisticated business entities, the inclusion in the loan documents of carefully negotiated prepayment and due-on-sale provisions is a reasonable allocation of risks between the parties and does not amount to a restraint on alienation); Lazzareschi Inv. Co. v. San Francisco Fed. Sav. & Loan Assoc., 22 Cal. App. 3d 303, 307, 99 Cal. Rptr. 316 (1971) (rejecting a buyer’s argument that the prepayment fee was excessive because it bore no reasonable relationship to any damage sustained by virtue of the prepayment); 1 Witkin, Summary of Cal. Law. (9^th Ed. 1987), Contracts, § 512 ("A clause in a deed of trust providing a ‘penalty’ or reasonable charge for payment of the principal in whole or in part before maturity is neither a penalty nor a liquidated damage provision").

4. The decisions in Skyler Ridge and Kroh Brothers have been criticized as result-oriented decisions in which the court sought to preserve value for junior creditors when the debtor’s assets would otherwise have been insufficient to do so. See Debra P. Stark, Prepayment Charges in Jeopardy: The Unhappy and Uncertain Legacy of In re Skyler Ridge, 24 Real Prop. Prob. & Tr. J. 191, 193 (1989); Debra P. Stark, New Developments in Enforcing Prepayment Charges After an Acceleration of a Mortgage Loan, 26 Real Prop. Prob. & Tr. J. 213, 214 (1991) ("[B]oth bankruptcy courts and nonbankruptcy courts have recently repudiated the Skyler Ridge analysis, which in essence required a perfect estimate of the lender’s damages rather than a reasonable one."); John C. Murray, The Lender’s Guide to Single Asset Real Estate Bankruptcies, 31 Real Prop. Prob. & Tr. J. 393, 430-431 (Fall 1996).

5. In In re A.J. Lane & Co., 113 B.R. 821 (Bankr. D. Mass. 1990), the court disallowed the mortgage lender’s prepayment charge, which provided for a prepayment "penalty" equal to "the amount so prepaid times one percent times the number of years or portions thereof expressed as a fraction remaining on the term of the loan." This decision is noteworthy for the following reasons:

1. The court held that federal law, as opposed to state law, exclusively governs the determination of whether a prepayment provision is "reasonable" under § 506(b) of the Bankruptcy Code, thereby ignoring numerous other decisions (including Skyler Ridge and Kroh Brothers) that have applied both federal and state law in determining the reasonableness of prepayment charges. See, e.g., In re Morse Tool, Inc., 87 B.R. 745, 748 (Bankr. D. Mass. 1988); In re LHD Realty Corp., 20 B.R. 722, 725 (Bankr. S.D. Ind. 1982); In re Banks, 31 B.R. 173, 175 (Bankr. N.D. Ala. 1982).

2. The court determined (again, against the weight of existing case law - not to mention logic) that even a voluntary prepayment permitted as an alternative method of performance under the loan documents (with payment of the prepayment premium) should be treated as a breach of contract, and thus be subjected to a liquidated damages analysis.

3. Under the court’s view of liquidated damages, based on § 2-718 of the Uniform Commercial Code and § 356(1) of the Restatement of Contracts, the "actual loss" of the lender must be determined (as opposed to the damages that could reasonably be anticipated at the date of execution of the contract). Using this somewhat unique rationale, the court held that the formula for calculation of the prepayment penalty in this case "bears even less of a rational relationship to loss than does a formula comparing the loan’s projected interest yield to the projected yield from treasury notes that could be purchased at the time of prepayment; this type of formula has been properly rejected both for its failure to compare the contract rate to the current interest rate on comparable loans and for its failure to discount the lost interest rate to present value." Id. at 829.

4. According to the court, the formula to be utilized to determine the lender’s actual damages is "simple and well established." It is "the difference in the interest yield between the contract rate and market rate at the time of prepayment, projected over the term of the loan and then discounted to arrive at present value." Id. at 829. (If only all of life’s tribulations were susceptible of such facile resolution!). The court never mentioned the difficulty of determining the "market rate" for a comparable loan, let alone whether the lender might even be making new mortgage loans at the time of prepayment.

5. Because the court found the lender’s prepayment charge to be "unreasonable" under its version of the "federal" standard (unencumbered by state law definitions of reasonableness or liquidated damages), the court - surprise! - totally disallowed the prepayment charge under § 506(b) of the Bankruptcy Code.

6. The court fashioned a method of relief for borrowers that goes far beyond Skyler Ridge and Kroh Brothers; it established an amorphous yet exclusive federal standard of reasonableness to apply to the enforceability of prepayment provisions, the validity of which must in all circumstances (whether prepayment is voluntary or involuntary) be determined under the court’s "rule" on liquidated damages - i.e., determination of the lender’s actual loss - and if the prepayment clause is found under such an analysis by the bankruptcy court be unreasonable (which will always be the case, in the view of the court in A.J. Lane, with respect to a yield-maintenance provision that is matched to treasury instruments instead of "current mortgage rates" and/or is not discounted to present value), it will be declared void and the entire prepayment charge will be disallowed.

6. Numerous bankruptcy court decisions, both before and after the rulings in Skyler Ridge, Kroh Brothers and A.J. Lane, have rejected the reasoning of the courts in these cases and have held that a lender can collect its contracted-for prepayment premium when the prepayment provision is enforceable under applicable state law. See, e.g., In re LHD Realty Co., 726 F.2d 327 (7^th Cir. 1984); Continental Securities v. Shenandoah Nursing Home Partnership, 193 B.R. 769, 775 (W.D. Va. 1996); In re Duralite Truck Body & Container Co., 153 B.R. 708, 713 (Bankr. Md. 1993); In re United Merchants & Mftrs., Inc., 674 F.2d 134, 143-144 (2d Cir. 1982); In re Financial Ctr. Assocs., 140 B.R. 829, 835-838 (Bankr. E.D.N.Y. 1992) (holding that whether a contractual prepayment premium clause constitutes an unenforceable penalty is a question of state law, and stating that "Skyler Ridge appears to limit the freedom of contract of the parties by replacing the parties’ judgment regarding the appropriate discount rate with the court’s"); Travelers Ins. Co. v. 100 LaSalle Assoc., No. 90-C-4778, 1991 U.S. Dist. LEXIS 1903 at *8 -*9 (Bankr. N.D. Ill. Feb. 15, 1991); Lazzareschi Investment Co. v. San Francisco Federal Savings and Loan Association, 22 Cal App. 3d 303, 309 (1971) (upholding a prepayment premium provision in a commercial loan, and stating that "a prepayment clause does not fall into a simple calculation at any one point of time of the difference between the interest rate on the repaid loan and that which might be available to the lending institution on a new loan of about the same size made to a new borrower"); In re 433 South Beverly Drive, 117 B.R. 564, 568 (Bankr. C.D. Cal. 1990) (holding that the prepayment premium clause was enforceable under non-bankruptcy law, but concluding that "reasonableness" under § 506(b) is to be determined by a federal law analysis, which entitles the lender to collect only the difference between the market rate of interest on the prepayment date and contract rate for the remaining term of the loan; the court did not require that the resulting premium be discounted to present value); In re Schaumburg Hotel Owner Ltd. Partnership, 97 B.R. 943, 953 (Bankr. N.D. Ill. 1989) (upholding, under state law, a clause allowing the lender to accelerate the debt and collect the prepayment charge, and stating that "it is immaterial that the actual damages suffered are higher or lower than the amount specified in the clause").

1. In an interesting decision by the Court of Appeals of Maryland, Carlyle Apartments Joint Venture v. AIG Life Insurance, 333 Md. 265, 635 A.2d 366 (Md. 1994), in which the issue of the enforcement of a prepayment premium under applicable state law was certified and referred to the Maryland state court for determination by the U.S. District Court for the District of Maryland, the court specifically discussed and rejected the holding in A.J. Lane and upheld the validity and enforceability of a yield-maintenance prepayment provision. The court reasoned that an offer to prepay a mortgage loan, while the borrower is current in all of its loan obligations, does not constitute a breach of the loan, and that absent a breach of the loan it would be inappropriate to apply a liquidated-damages analysis to the prepayment. The court construed the prepayment provision as offering the borrower an alternative method of performance, or an option to prepay (which would otherwise not be available) on terms agreed upon by the parties. The court stated that "[a]bsent any breach by the borrower, there is no occasion to consider damages or to look for a liquidated damages clause in disguise, much less to alter the contract to accord with a theory of a lender’s primary economic desires." Id. at 279, 635 A.2d at 373. See also In re Financial Center Assocs., 140 B.R. 829, 835 (Bankr. E.D. N.Y. 1992) (holding that whether a contractual prepayment premium clause is an unenforceable penalty is a question of state law, and refusing to follow the test set forth by the court in A.J. Lane for calculating the lender’s damages).

2. In another interesting decision, TMG Life Ins. Co. v. Ashner, 21 Kan. App. 2d 234, 898 P.2d 1145 (1995), the Court of Appeals of Kansas specifically discussed and rejected the holding of the court in Skyler Ridge, which the Court of Appeals found to be an incorrect interpretation of Kansas prepayment law by the bankruptcy court in California that decided Skyler Ridge. This case arose in the context of a claim against the guarantors of a loan that had defaulted and become the subject of a Chapter 11 bankruptcy filing by the borrower. The mortgage note contained a yield-maintenance prepayment provision, which the guarantors claimed was invalid under Kansas law. The court first rejected the guarantors’ claim that a tender of the entire indebtedness was required to trigger the prepayment penalty, because the prepayment provision prohibited the borrower from defaulting intentionally and tendering the unpaid balance without also including the amount of the applicable premium. The court, after noting that the parties had agreed that the prepayment provision should be interpreted according to the rules applicable to liquidated damages provisions, then held that under Kansas law a yield-maintenance prepayment provision that provided for payment of the premium in the event of an acceleration of the loan upon default is enforceable and does not violate public policy. The guarantors had relied upon Skyler Ridge, which the court noted "purport[s] to apply Kansas law." Id. at 251, 898 P. 2d at 1159. The court cited with approval the holding of the court in In re Financial Ctr. Assocs., 140 B.R. 829, 835 (Bankr. E.D.N.Y. 1992), which specifically rejected the holding in Skyler Ridge and found that it restricted the freedom of contract of the parties by substituting the court’s judgment for that of the parties. The court noted that "[t]his reasoning is more consistent with Kansas law than the California Bankruptcy court’s decision in Skyler Ridge." Id. at 252, 898 P.2d at 1160. The court also stated, relying on a recent Kansas Supreme Court decision, Metropolitan Life Ins. Co. v. Strnad, 255 Kan. 657, 670-671, 876 P.2d 1362 (1994), that because of the freedom of the parties to contract for the specific terms of the prepayment formula and the reasonable investment requirements and goals of the lender, the lender was not required to tie the formula to investments of the same type as the original mortgage or even to discount the interest recovered through the prepayment formula to present value. Finally, the court held that a prepayment provision that provides for payment of the premium in the event of acceleration of the debt upon default by the borrower does not violate Kansas public policy and is enforceable.

7. In a recent (and disturbing) case of first impression, In re Carr Mill Mall Ltd. Partnership, 201 B.R. 415, 1996 Bankr. LEXIS 1311 (Bankr. M.D.N.C. 1996), the bankruptcy court held that a yield-maintenance prepayment provision contained in a mortgage note was unenforceable en toto where the loan matured prior to bankruptcy but was extended as part of a confirmed Chapter 11 plan agreed to by the creditor, and no specific mention of the prepayment provision contained in the original loan documents was made in the plan or in the amended loan documents memorializing and implementing the plan. Under the terms of the plan, the maturity dates of the three debt obligations of the borrower were extended for a period of seven years after the effective date of the plan. All three of the notes had matured prior to the borrower’s bankruptcy filing. The plan contained a provision stating that "[e]xcept as expressly modified by the terms and conditions of this Plan or any other order of the Bankruptcy Court, all terms and conditions of the [lender’s] loan documents shall remain unaltered and in full force and effect." Id. at *11. In order to implement the plan, the lender and the borrower entered into three modification agreements to memorialize the modifications made to the loans as the result of the confirmed plan. However, the modification agreements made no mention of the prepayment penalty provisions contained in the original notes, although the modification agreements each contained a provision stating that, except as expressly modified, "all other terms and conditions of the original loan documents remained unaltered and in full force and effect" Id. at *8. Subsequently, the borrower located an entity willing to refinance the loans and requested payoff statements from the lender, which the lender provided. The payoff letters included a prepayment calculation for each note. The court found that the plan and the modification agreements were ambiguous as to the post-confirmation effect of the prepayment provisions in the notes, because although all unaltered terms of the loan documents were retained, the parties would be required, under the approved bankruptcy plan, to be returned to their post-maturity/pre-bankruptcy status, a period when "the prepayment provisions could not possibly have been enforced." Id. at *19. The court found, on the basis of its own factual determination, that the parties did not actually intend to require the borrower to pay a prepayment penalty in the event that the loan was prepaid prior to the extended maturity date. The court reasoned that once the original maturity dates of the notes had passed, prepayment was no longer an option for the borrower; therefore, the rights created by the original prepayment provisions had disappeared and the borrower could pay the debt obligations free of any prepayment premium. The court stated that the lender could have "revived" the prepayment premium provisions by insisting that the plan specifically so provide, but had failed to do so. The court’s decision was also influenced by the fact that the prepayment penalty provision contained in the original notes could not be accurately calculated during the extended term, i.e., the provisions in the notes referenced a Treasury Note due on February 15, 1993, which Treasury Note had already matured prior to the plan confirmation and the execution of the modification agreements.

1. The lesson of this case is clear for lenders: Take nothing for granted and specifically address the prepayment rights of the lender in both the confirmed bankruptcy plan and any modification, supplemental or restated documents intended to acknowledge and implement the terms of the plan, and make certain that the maturity date or dates of any Treasury Note (or Notes) or other instruments utilized in the calculation of the prepayment premium are accurate and applicable with respect to any extension of the maturity date of the loan as authorized by the plan and set forth in the documents memorializing the terms of the plan.

8. In In re Ridgewood Apartments of DeKalb County, Ltd., 174 B.R. 712 (Bankr. S.D. Ohio 1994), the borrower filed a voluntary petition under Chapter 11 of the Bankruptcy Code. The lender, Fannie Mae, had accelerated the entire debt prior to the filing of the bankruptcy petition and filed a claim in the bankruptcy proceeding that included a prepayment premium in the amount of $263,275, as established by a formula attached as an Addendum to the promissory note. Fannie Mae contended that the prepayment premium had been validly triggered by the acceleration of the debt. The prepayment provision provided that the premium would be due whether the prepayment was voluntary or involuntary. However, the court held that actual "prepayment" of the loan was initially required, regardless of whether the payment was "voluntary" or "involuntary," in order to invoke the penalty in the first place, and because the borrower had not in fact prepaid the note and did not contemplate prepayment under its bankruptcy plan under the original terms of the loan, no prepayment penalty was due and owing prior to the bankruptcy filing. Therefore, the court found, the prepayment premium calculated by the lender was a "contingent liability" and not properly part of the lender’s claim. The court also held that (after - rightfully - acknowledging that several bankruptcy decisions allow the lender to collect a prepayment premium when the provision specifically states, as in this case, that the premium is due upon acceleration of the debt), because the claim was for contingent interest which was not yet due and payable at the time of the borrower’s bankruptcy filing, it would also be disallowed to the lender, an undersecured creditor, as unmatured interest under § 502(b)(2) of the Bankruptcy Code. The court stated that, because it had found the prepayment provision unenforceable under § 502(b)(2), it "need not . . . render a determination on the enforceability of the prepayment penalty based solely upon an acceleration by the lender." Id. at 721. This appears to be something of a cop-out by the court, which had earlier in the opinion laboriously set forth its rationale for its "contingent liability" argument against the enforceability of the prepayment provision, only to decide that maybe it wasn’t such a great argument after all. This appears to be another results-oriented decision, with the court wanting to make as much money available as possible for distribution to other creditors (at the expense of the secured lender).

1. See also Continental Securities Corp. v. Shenandoah Nursing Home Partnership, 188 B.R. 205, 213-214 (Bankr. W.D. Va. 1995) ("to the extent § 502 would disallow a claim for unmatured interest, it is relevant here since that is essentially what [the lender] is seeking. Were the bankruptcy court to hold that that [the borrower] must pay [the lender] the full value of the Note through its maturity, it would essentially be allowing the payment of unmatured interest which is prohibited by § 502."); Comptroller of the Currency (National Banks), Interpretive Letter No. 744 (published in Interpretations and Actions, October 1996), which takes the position that both late charges and prepayment penalties are "interest" for purposes of the "most favored lender" provisions of the National Banking Act, 12 U.S.C. § 85, thus allowing a national bank that is based in a state that has no restrictions on late charges or prepayment penalties to "export" its home-based freedom from such restrictions to other states in which it does business. As a result of this opinion by the Comptroller of the Currency, which is the regulatory authority for all national banks, such banks are permitted to "shop" for "friendly" interest-rate and prepayment-payment jurisdictions with respect to commercial loans. See also Marquette Nat’l Bank of Minneapolis v. First of Omaha Service Corp., 439 U.S. 299, 314-315, 99 S.Ct. 540, 549 (1978) (holding that a national bank can "export" the interest rate provisions applicable in its home state to other states).

2. But see Continental Securities Corp. v. Shenandoah Nursing Home Partnership, 193 B.R. 769, 1996 U.S. Dist. LEXIS 3514 (U.S. Dist. Ct., W.D. Va. 1996) at *22 ("[the lender] cites several cases for the proposition that a prepayment penalty is not "unmatured interest" for purposes of § 502. The court acknowledges the force of [the lender’s] argument, but notes that it has no impact on the present analysis."); In re Outdoor Sports Headquarters, Inc., 161 B.R. 414, 424 (S.D. Ohio 1993) ("Prepayment amounts, although often computed as being interest that would have been received through the life of the loan, do not constitute unmatured interest because they fully mature pursuant to the provisions of the contract…. As a result of the parties’ contractual agreements, reflected in the terms of the Notes and mortgage, the [lender] has a right to receive this payment if payment of the entire amount due pursuant to the Note is made prior to the full term of the contract. Therefore, the Prepayment Amount does not constitute unmatured interest and will not be disallowed pursuant to § 502(b)(2)."); Boyd v. Life Ins. Co. of the Southwest, 546 S.W. 2d 132, 133 (Tex. Civ. App. 1977) (holding that "[a] prepayment charge on a promissory note is not compensation for the use of money. Rather, it is a charge to the borrower for the privilege of repaying the loan before maturity… ."); C.C. Port, Ltd. v. Davis-Penn Mortgage Co., 61 F.3d 288, 289 (5^th Cir. 1995) ("Where the contract grants the borrower the right to prepay, a prepayment premium is not compensation for the use, forbearance, or detention of money, rather it is a charge for the option or privilege of prepayment"); In re 360 Inns, Ltd., 76 B.R. 573, 576 (Bankr. N.D. Tex. 1987) ("the prepayment penalty was not unmatured interest as contemplated in § 502(b)(2), inasmuch as the prepayment penalty was activated and matured once the plan of reorganization proposed to pay [the lender’s] debt"); In re Skyler Ridge. 80 B.R. 500, 508 (Bankr. C.D. Cal. 1987) (finding that the prepayment premium did not represent unmatured (i.e., unearned) interest that would be disallowed under § 502(b)(2)).

9. In Continental Securities Corp. v. Shenandoah Nursing Home Partnership, 193 B.R. 769, 1996 U.S. Dist. LEXIS 3514, (U.S. Dist. Ct., W.D. Va. 1996), the court was asked to construe the rights of the parties in connection with a "lockout" provision in the mortgage note. The provision prohibited prepayment prior to December 1, 2001, but (unlike most commercial mortgage notes) did not contain a penalty or damages provision in the event the borrower violated the terms of the lockout provision. The bankruptcy plan approved by the court on July 1, 1995 provided for acceleration of the mortgage indebtedness and payment of the mortgage loan in full (with the exception of a prepayment penalty or premium) within ten days after the confirmation date, thus allowing for prepayment in violation of the lockout provision contained in the loan documents. The lender asked the court to revise the plan to allow it to collect a prepayment premium in lieu of enforcing the prepayment "lockout" provision. The court noted that a prepayment premium or penalty is a "charge" under § 506(b) of the Bankruptcy Code that is only available to oversecured creditors (the court acknowledged that the lender in this case was oversecured), but held that § 506(b) precludes a creditor from receiving, as part of its secured claim, a prepayment premium where one is not provided for within the loan documents. Unlike most other commercial mortgage notes, the lender’s note in this case contained "no formula, nor any specific figure, for calculating damages stemming from prepayment." Id. at 777. The lender appeared to be asking the court to either prohibit prepayment or fashion a penalty for prepayment even though no mechanism for doing so appeared in the lender’s own loan documents; this the court refused to do. This result, although borrower-oriented, is not surprising, and makes one wonder how a supposedly sophisticated lender could be so inattentive to such an important loan provision. But see McCae Management Corp. v. Merchants Natl. Bank and Trust Co. of Indianapolis, 553 N.E. 2d 884, 888 (Ind. Ct. App. 1990) (upholding the right of the lender to charge and collect a prepayment premium even though the mortgage loan documents specifically prohibited prepayment and contained no provision for the payment of a penalty in the event of prepayment by the borrower).

II. Prepayment Decisions by State and Federal Courts (Non-Bankruptcy)

1. In Parker Plaza West Partners v. UNUM Pension and Ins. Co., 941 F.2d 349 (5^th Cir. 1991), the court reversed the holding of the District Court, which had denied enforcement of a contractual yield-maintenance prepayment provision based solely on the fact that the prepayment by the borrower was "involuntary," i.e., that the provision provided for collection of the premium upon acceleration by the lender, rather than upon the borrower voluntarily making the payment. The borrower had sued the lender to recover payment of the premium, alleging that it was a penalty under Texas law. The court noted that it could find no Texas case law holding that prepayment provisions are only valid when a voluntary prepayment is made by the borrower, and stated that parties to a contract have the right to contract for any provisions they wish, so long as the contract does not violate public policy and is not illegal. The court also found that the prepayment provision, which was "unambiguous, clear and unequivocal," did not constitute a usurious contract or an illegal restraint on alienation, was not "unreasonable or oppressive," and did not violate public policy.

1. See also Citicorp Mortgage, Inc. v. Morrisville Hampton Village Realty Ltd. Partnership, 443 Pa. Super. 595, 599, 662 A. 2d 1120, 1122 (Pa. Super. Ct. 1995) (holding that, with respect to a prepayment provision that required payment of the contractual premium regardless of whether the prepayment was voluntary or involuntary, the matter was governed by contract law and the parties, as sophisticated participants in a commercial loan transaction, were bound by the provision.); Travelers Ins. Co. v. Corporex Properties, Inc., 798 F. Supp. 423, 428 (E.D. Ken. 1992) (holding that a prepayment premium providing for payment if the indebtedness is accelerated is enforceable as a means of insuring the lender against the loss of its bargain if interest rates decline).
2. A lender would be well advised, from a drafting standpoint, to specifically state, in the prepayment provision contained in the loan documents, that the lender will be entitled to collect the contracted-for prepayment premium in the event of an acceleration of the loan upon default by the borrower. See, e.g., In re LHD Realty Corp., 726 F. 2d 327, 330 (7^th Cir. 1984) (refusing to permit the lender to collect a prepayment premium after the borrower’s default because the prepayment clause did not clearly provide that the premium could be collected upon acceleration after default); Tan v. California Fed. Sav. & Loan Assoc., 140 Cal. App. 3d 800, 824, 189 Cal Rptr. 775, 809 (1983) (concluding that the terms of the prepayment penalty provision applied only when the borrower voluntarily exercised the prepayment option, and stating that "The language of the ‘prepayment privilege’ provision rather clearly makes a prepayment penalty payable only upon the debtor’s exercise of the reserved privilege to prepay"); Rogers v. Rainier Nat’l Bank, 111 Wash. 2d, 232, 238, 757 P. 2d 976, 979 (1988) (holding that because the promissory note did not provide for any specific penalty as the result of acceleration upon default as the result of acceleration upon default, the court "cannot supply a provision which the parties omitted"); Slevin Container Corp. v. Provident Federal Sav. & Loan Ass’n, 98 Ill. App. 646, 648, 424 N.E. 2d 939, 940-941 (1981) (holding that acceleration, by definition, advances the maturity date of the debt so that payment thereafter is not prepayment but instead is payment made after maturity); cf. Pacific Trust Co. v. Fidelity Sav. & Loan Assn., 184 Cal. App. 3d 817, 824, 229 Cal. Rptr. 269, 274 (1986) (permitting acceleration upon default by the borrower and acceleration of the debt by the lender where the prepayment clause by its terms applied to an acceleration by the lender after default); Biancalana v. Fleming, 53 Cal. Rptr. 2d 47, 50, 45 Cal. App. 4^th 698, 703 (1996) (upholding the enforceability of a prepayment charge after acceleration of the debt by the lender, and noting that "the note in this case indicates that the prepayment penalty is intended to apply when the lender accelerates"); Pacific Trust Co. TTEE v. Fidelity Fed. Sav. & Loan Assoc., 229 Cal. Rptr. 269, 274, 184 Cal. App. 3d 817, 824 (1986) ("The instant clause is intended to apply in the event the lender elects to accelerate and describes such a payment as an involuntary payment. . . . [T]here is no ambiguity which may be resolved against the lender who presumably drafted the note. … Thus, we find that the clause applicable to the facts of the instant case"); Ridgely v. Topa Thrift & Loan Ass’n., 54 Cal. App. 4^th 729, 738, 62 Cal. Rptr. 2d 309 (1997) ("The instant provision indicated the prepayment penalty was intended to apply when defendant accelerated the note").

2. In an interesting unreported Nebraska decision, R-D Investment Co. v. The Mutual Benefit Life Insurance Co., Doc. No. 880, Page 883 (Dist. Ct. of Douglas County, Neb. 1991), the court upheld the enforceability of the lender’s yield-maintenance prepayment premium provision, even though it did not provide for discounting the amount of the premium to present value. The borrower filed a declaratory judgment action against the lender, seeking the right to voluntarily prepay the loan without paying the prepayment premium. The court stated that where, as in the instant case, there had been no breach or default under the mortgage note and the prepayment was voluntary, a liquidated damages analysis would be inapplicable and noted that, even under a liquidated damages analysis, the provision was valid and enforceable and did not result in a penalty. The court specifically held that, under Nebraska law, "where the parties give due deliberation and careful thought to a stipulated sum as liquidated damages, the failure to include a ‘present worth’ adjustment does not render the amount a penalty." Id. at 16. The court was particularly impressed in this regard by the testimony of the lender’s accountants that the prepayment clause was in fact a reasonable estimation, at the time the loan was entered into, of the damages that the lender would likely incur in the event of early payment of the loan by the borrower, and by the fact that a commercial mortgage market might not continuously exist for the lender during the ten-year life of the loan (the lender had in fact been out of the commercial mortgage market for a few years prior to making the loan to the borrower). The court noted that the testimony of the lender’s accountants had demonstrated that the effect of the lack of a "present value" analysis was minimal, that the income generated from note was "match funded" to a guaranteed investment contract, and that the premium of $2 million was not "unconscionable," especially where the borrower’s own expert had testified that the lender’s damages approximated $1.5 million.

3. In Ridgely v. Topa Thrift & Loan Ass’n., 54 Cal. App. 4^th 729, 62 Cal. Rptr. 309 (1997), the prepayment provision in the note provided that so long as the borrower was not in default under the note or any of the other loan documents, no prepayment charge would be assessed if the loan was paid in full at any time after the date that was six months from the date of the loan. As set forth in the note, the prepayment charge consisted of a payment of six months’ interest at the rate in effect at the time of prepayment on the amount prepaid. More than two years later, the borrower failed to pay a monthly payment due under the loan. The borrower and the lender entered into an agreement to modify and extend the payments due under the loan, but no mention was made of the prepayment provision or the borrower’s failure to pay the missed monthly payment. The borrower then sold the property and paid off the note. The lender included the prepayment premium, in the amount of $113,000, as part of the payoff amount. The lender paid the premium as part of the payoff, then subsequently sued the lender for reimbursement of this amount, plus interest and other related costs. The trial court ruled in favor of the borrower, holding that the prepayment penalty provision was unenforceable because it was in fact a late charge and a penalty in the nature of an unreasonable forfeiture. The court of appeals reversed, holding that California law treats a prepayment penalty provision as an option granted to the borrower to pay off the loan early (which, absent such a provision, the borrower would have no right to do) and that such a provision is not subject to a liquidated damages, usury, or forfeiture analysis. The court agreed with the lender’s contention that no prepayment penalty would be imposed after six months only if the borrower made all required monthly payments up to that date in a timely manner, and concluded that because the note could have provided for the prepayment penalty to be imposed unconditionally, the provision was not rendered invalid by conditioning a waiver upon a lack of default by the borrower. The court also held that there were no factual issues relating to estoppel or waiver based on the conduct of the lender in connection with the modification of the loan, because the borrower knew that the loan payments were due on specific dates and mere silence by the lender did not constitute consent or the waiver or relinquishment of a known right by the lender.

1. In a vigorous dissent, Judge Johnson argued that the prepayment charge was clearly a penalty for default by the borrower and had absolutely no relationship to the amount of damage suffered by the lender in the event of a prepayment by the borrower (i.e., that there was no logical relationship between the borrower’s late payment of one of the monthly interest payments and the rationale for charging prepayment penalties), and could only be imposed in the event the borrower defaulted on other terms of the contract. Judge Johnson expressed the concern that virtually any sanction or penalty could be rephrased in the language of waiver in order to escape the legal sanctions otherwise imposed in California on penalty and forfeiture provisions in loan documents.

III. The "Perfect Tender in Time" Rule.

1. A current "hot" issue with respect to the prepayment of mortgage loans involves consideration of the "perfect tender in time" rule. This is an old common law rule that establishes the right of a lender to receive payment on a mortgage loan in exact accordance with the loan documents and prohibits early payment of a loan when the loan documents are silent regarding prepayment. See Debra P. Stark, New Developments in Enforcing Prepayment Charges After an Acceleration of a Mortgage Loan, Prepayment and Yield Maintenance in Bankruptcy, American Bar Association, Section of Real Property, Probate and Trust Law, Atlanta, Georgia, August 12, 1991, pp. 5-7; Alexander, Mortgage Prepayment: The Trial of Common Sense, 72 Cornell L. Rev. 288, 306 (1987); Abbe v. Goodwin, 7 Conn. 377 (1829) (holding that the mortgagee was not required to accept in advance a payment of principal, accrued interest, and interest that would accrue in the future during the stated term of the loan); Brown v. Cole, 14 L.J.- Ch. 167 (1845); 59 C.J.S. Mortgages § 447(a) (1949). Courts continue to enforce this rule today, although a strong minority view is evolving that holds that the rule is outdated and based on an inaccurate view of the common law and modern investment methods.

1. Typical of the cases following the majority view (i.e., that the borrower has no right to prepay a mortgage loan absent a provision in the loan documents permitting prepayment) are the following: Brannon v. McGowan, 683 So. 2d 994, 995-997 (Sup. Ct. Ala. 1996) (holding that, notwithstanding the trend to change the prevalent common law rule, both statutorily and judicially, the State has a strong preference for protecting contractual obligations and there exist "no compelling changes in institutions, customs, mores, or conditions," to justify changing the common law rule pertaining to prepayment); In re A.J. Lane & Co., Inc., 113 B.R. 821, 827 (Bankr. D. Mass. 1990) ("In the absence of a clause permitting prepayment, the courts of this country and England have regarded prepayment as a breach of contract… ."); Skyles v. Burge, 789 S.W. 2d 116, 119 (Mo. Ct. App. 1990) (reaffirming the validity of the rule as a method of preserving the lender’s right to receive a regular flow of income over a stipulated period of time at a specific rate of return); R-D Investment Co. v. Mutual Benefit Life Ins. Co., Doc. 880, Page 883 (Dist. Ct. of Douglas County, Neb. 1991) (unpublished decision) at 13 ("[u]nder Nebraska law, a mortgagor has no common law right to prepay a mortgage note"); Parker Plaza West Partners v. UNUM Pension and Ins. Co., 941 F. 2d 349, 352 (5^th Cir. 1991) (holding that, under Texas law, a borrower has no right to prepay a loan unless the contract otherwise permits it); Carlyle Apartments Joint Venture v. AIG Life Ins. Co., 333 Md. 265, 269-270, 635 A.2d 366, 368 (Md. Ct. of Appeals 1994) (holding that, under Maryland law, a mortgagor under a mortgage payable at a fixed date in the future does not have a right to prepay, absent a specific contract provision permitting prepayment); Poomipanit v. Sloan, 1 Neb. App. 1132, 1136 (1993) (adopting the "majority rule" and holding that where an installment real estate contract does not contain a provision permitting prepayment, the vendee-purchaser has no right to prepay the contract against the wishes of the vendor-seller); Young v. Sodaro, 193 W. Va. 304, 456 S.E. 2d 31, 35 (Sup. Ct. of Appeals of W. Va.1995) (finding the majority rule to be "more compelling," the court held that under the "perfect tender in time" rule, absent statutory authority or contractual language to the contrary, the borrower has no right to prepay prior to maturity); McCausland v. Bankers Life Ins. Co., 110 Wash. 2d 716, 723, 757 P.2d 941, 944-945 (1988) (holding that, in general, a borrower is not entitled to prepay a mortgage note absent a specific provision in the note permitting prepayment); Dugan v. Grzybowski, 165 Conn. 173, 332 A. 2d 97, 99 n.2 (1973) (ruling that a mortgage is an investment instrument designed to permit the lender to maintain a regular flow of income over a definite period of time); McCae Management Corp. v. Merchants National Bank, 553 N.E. 2d 884, 888 (Ind. Ct. of Appeals 1990) ("[T]he notes give [the lender] the contractual right to receive payments of principal and interest over the predetermined length of the loans. They do not provide the right to prepay"); Ridgley v. Topa Thrift & Loan Ass’n, 54 Cal. App. 4^th 729, 737, 62 Cal. Rptr. 2d 309 (1997) (citing Gutzi Associates v. Switzer, 215 Cal. App 3d 1636, 1644, 264 Cal. Rptr. 538 (1989) and other cases holding that, in California, it is firmly established that a lender may refuse to accept payment of a debt before the debt is due).

2. Typical of cases adhering to the minority view (i.e., that the borrower should be permitted to prepay the loan where the loan documents are silent as to prepayment) are the following: Citicorp Mortgage, Inc. v. Morrisville Hampton Village Realty Ltd. Partnership, 443 Pa. Super. 595, 599, 662 A. 2d 1120, 1122 (1995) (ruling that, generally, where a mortgage note is silent as to the right of prepayment, there is a presumption that the debt may be prepaid, although the presumption may be rebutted by evidence that a contrary result was intended by the parties); Mahoney v. Furches, 503 Pa. 60, 63, 468 A.2d 458, 461 (1983) (the Supreme Court of Pennsylvania changed the common law rule on the presumption regarding the right to prepay a mortgage obligation, finding that the majority rule restrains the free alienability of land); Hatcher v. Rose, 329 N.C. 626, 629, 407 S.E. 2d 172, 177 (1991) (finding, based on several statutes, a State treatise on real property, and a form deed of trust promulgated by the State bar association, that the mortgagor had the right to prepay the loan absent any provision specifically permitting prepayment); Skyles v. Burge, 789 S.W. 2d 116, 119-120 (Mo. App. 1990) (holding that a State statute on prepayment penalties in connection with residential loans established a maximum penalty and granted the right to prepay without penalty after five years from the origination date, thereby restricting the application of the "perfect tender in time" rule to residential mortgages, but reaffirming the general validity of the majority rule as an investment instrument designed to enable the lender to maintain a level flow of anticipated income over the term of the loan at a predictable rate of interest and prevent the avoidance by the borrower of future payment of interest due under the note).
3. A mortgage note that specifies a payment by the borrower "on or before" a date certain, "if not sooner paid" before a specified date,
   "not later than" a specified date, or "in" or "within" a certain period of time, creates special problems for a lender, and will likely be construed by a court to permit payment by the borrower prior to the stated maturity date of the loan. See, e.g., Latimer v. Grundy County National Bank, 239 Ill. App. 3d 1000, 1002 (Ill. App. Ct. 1993) (in a case of first impression, the court held that "[p]hilosophical justifications of mutuality and freedom of contract support the majority rule," but concluded that the parties in fact contemplated payment of the principal before the maturity date of the loan because of the phrase "if not sooner paid" contained in the contract); Garner v. Sisson Properties, 198 Ga. 203, 31 S.E. 2d 400 (1944) (permitting prepayment where the contract provided for payment "on or before" a date certain); Schotte v. Meredith, 138 Pa. 165, 20 A. 936 (1890) (permitting prepayment where the contract provided for payment "within" a certain period of time).

IV. Sample Prepayment Provisions in Commercial Mortgage Loan Documents.

1. Prepayment Privilege (Percentage of Amount Paid).

There shall be no right or privilege of prepayment during the first ___ years following commencement of amortization and then, in full only, on any installment payment date thereafter, upon 30 days’ prior written notice, with a premium of ____ % on the amount so prepaid during the ____ year following commencement of amortization, declining ½ of 1% per annum thereafter to a minimum premium of ____%, which minimum premium shall continue thereafter to maturity.

2. Prepayment Privilege (Yield Maintenance).

None during the first ____ years of the Loan Term and then you may prepay the Loan in whole, but not in part, provided that simultaneously with such prepayment you pay an amount which is equal to the greater of: (1) the excess, if any, of (i) the present value on the date of prepayment of all interest payments that would have been payable from the date of prepayment through the maturity date (the period from the date of prepayment through the maturity date being hereinafter referred to as the "calculation period") calculated by multiplying the original fixed interest rate payable on the Note by the outstanding balance of the Note on the date of prepayment by the outstanding balance of the Note on the date of prepayment, dividing this product by 12 and discounting such monthly payments at the "Discount Rate" over (ii) the present value on the date of prepayment of all hypothetical interest payments that would have been payable during the calculation period had the fixed interest rate on the Note been the "Assumed Reinvestment Rate" calculated by multiplying the Assumed Reinvestment Rate by the outstanding balance of the Note at the time of prepayment, dividing this product by 12 and discounting such monthly payments at the Discount Rate:* or (2) beginning in the ____ loan year ____ % of the outstanding balance of the Note with the required percentage of the outstanding balance declining ½ of 1% per annum thereafter to a minimum of 1% which minimum payment shall continue thereafter to maturity; provided, however, that in the event you prepay the Note during the last 90 days of the Loan Term, prepayment shall be made at par with no prepayment charges assessed or due.

* All present value calculations are made on a monthly basis.

"Discount Rate" shall mean the then treasury discount rate charged on loans to depository institutions by the __________ Federal Reserve Bank on the date of prepayment.

"Assumed Reinvestment Rate" shall mean the arithmetic mean of the yields under the respective headings "This Week" and "Last Week" published in the Statistical Release under the caption "Treasury Constant Maturities" for the maturity (rounded to the nearest month) corresponding to the remaining term of the Note being prepaid. If no maturity exactly corresponds to such remaining term of the Note, yields for the two published maturities most closely corresponding to such remaining term shall be calculated pursuant to the immediately preceding sentence and the Reinvestment Rate shall be interpolated or extrapolated from such yields on a straight-line basis, rounding in each such relevant periods to the nearest month. For the purposed of calculating the Assumed Reinvestment Rate, the most recent Statistical Release published prior to the date of determination of the premium hereunder shall be used.

"Statistical Release" shall mean the statistical release designated "H.15(519)" or any successor publication which is published weekly by the Federal Reserve System and which establishes yields on actively traded U.S. Government Securities adjusted to constant maturities or, if such statistical release is not published at the time of any determination hereunder, then such other reasonably comparable index as may be designated by __________.

The Loan Documents shall provide that the above described prepayment amounts are to be interpreted in the manner that will render them fully enforceable. It is the intent of the parties hereto that said prepayment amount provisions are to be interpreted so that they are fully enforceable. Any portion of any of the said prepayment amount provisions which are deemed to be unlawful or unenforceable by a court of competent jurisdiction shall be deemed stricken or otherwise changed, so as to cause the prepayment amount provisions, as revised, to be enforceable to the fullest extent permitted by law.

3. Prepayment Privilege (Yield Maintenance - Alternative).

Section ____. Prepayment.

1. Except as hereinafter set forth, no full or partial prepayments of principal shall be allowed under this Note.

2. At any time during the period from and including _______________ to but not including (insert date which is the second anniversary of the Distribution Date), upon giving Payee not less than thirty (30) days prior written notice (the "Prepayment Notice"), Borrower shall have the right to prepay all or a portion of the Outstanding Principal Balance, which shall be accompanied by payment of all accrued and unpaid interest hereunder and all additional sums, fees and charges due under the Loan Documents, together with a prepayment premium equal to the greater of:

1. an amount equal to one percent (1%) of the portion of the Outstanding Principal Balance being prepaid, multiplied by a fraction, the numerator of which shall be the number of full and partial months remaining to the scheduled Maturity Date, as determined as of the date of prepayment specified in the Prepayment Notice, and the denominator of which shall be the number of months comprising the term of this Note, i.e., _______________ months: or

2. an amount determined by:

1. calculating the sum of the present values of all unpaid principal and interest payments required under the Loan Documents by discounting such payments from their scheduled payment dates back to the date of prepayment, utilizing a discount rate equal to the Converted Treasury Yield;

2. subtracting from such sum the Outstanding Principal of the Loan as of the date of prepayment; and

3. multiplying the difference by a fraction, the numerator of which is an amount equal to the portion of the Outstanding Principal Balance being prepaid and the denominator of which is an amount equal to the entire Outstanding Principal Balance.

3. In no event shall Payee be obligated to accept any such prepayment of an amount less than $10,000.00, and the provisions of Sections ____ and ____ shall apply to each partial prepayment of the Outstanding Principal Indebtedness.

4. The Prepayment Notice shall be irrevocable and shall specify the intended date of prepayment, which shall be a Business Day not more than 60 days after the date of the Prepayment Notice. After delivery of the Prepayment Notice, the Outstanding Principal Balance or portion of the Outstanding Principal Balance being prepaid, together with the prepayment premium described above, shall be absolutely and unconditionally due and payable in full on the date specified in the Prepayment Notice, and failure to pay the same in full on such date shall, at Payee’s sole option, constitute an Event of Default, without notice or opportunity to cure. If the amounts necessary to prepay the Outstanding Principal Balance, or such portion thereof, in accordance with the terms and provisions hereof are received by Payee after 2:00 p.m., _______________ time, such prepayment shall be deemed to have been made on the next occurring Business Day and Payee shall be entitled to receive interest on the Outstanding Principal Balance, or the portion thereof which is to be prepaid (as the case may be), calculated at the Default Rate, through the date of such prepayment.

5. Notwithstanding any contrary provision of this Section ____, at any time within the six (6) months prior to the Maturity Date, upon not less than thirty (30) days’ prior written notice to Payee, Borrower shall have the right to prepay this Note, without premium of any kind, by paying the entire remaining Outstanding Principal Balance, all accrued and unpaid interest hereunder and all additional sums, fees and charges due under the Loan Documents.

6. Borrower acknowledges that it has no right prepay the Loan, except as expressly provided herein. Borrower further acknowledges and agrees that if the Loan is prepaid prior to the Maturity Date for any reason, including, but not limited to, acceleration of the Maturity Date by reason of an Event of Default under the Loan Documents, any subsequent tender of payment of the Loan made by Borrower or by anyone on behalf of Borrower or otherwise, including any tender of payment at any time prior to or at foreclosure sale or proceedings or during any redemption period following foreclosure, or during any federal or state bankruptcy or insolvency proceedings, shall constitute an evasion of the restrictions on prepayment set forth herein, and shall be deemed a voluntary prepayment prior to the Maturity Date requiring payment of the prepayment premium provided for, if any, and Payee shall not be required to accept such payment if it does not include payment of the prepayment premium provided for, if any. Further, Payee’s acceptance of such prepayment without the requisite prepayment premium shall not constitute or be deemed to constitute a waiver by Payee of its right to seek payment of the required prepayment premium in accordance with the terms hereof or any rights and remedies Payee may have under this Note, the other Loan Documents, at law or in equity on account of Borrower’s failure to timely pay such prepayment premium as and when required hereunder. To the extent permitted by law, Payee may bid at any foreclosure sale, as part of the Indebtedness evidenced by the Loan Documents, the amount of the prepayment premium, if any, which is payable hereunder for prepayment of the Loan occurring on the date of such foreclosure.

7. The "Converted Treasury Yield" is the yield available, or if there is more than one yield available, the average yields, on U.S. Treasury non-callable bonds (excluding flower bonds) and notes having a maturity closest to (before, on or after) the Maturity Date, as reported in the Wall Street Journal, or in any other similar or comparable publication selected by payee, five (5) Business Days prior to the date of prepayment, as converted to [insert "a monthly equivalent yield" if interest on the Note is paid monthly; insert "a quarter-annual equivalent yield" if interest on the Note is paid quarterly; insert "a semi-annual equivalent yield" if interest on the Note is paid semi-annually; and insert "an annual equivalent yield" if interest on the note is paid annually], it being understood that the "Converted Treasury Yield" and the "____________ equivalent yield" are annualized rates which reflect the frequency of interest payments during a calendar year. The term "Business Day" shall mean any day upon which Payee and commercial banks are open for the transaction for business in the City of ____________. Payee shall deliver to Maker a statement setting forth the amount and basis of determination of the Prepayment Premium which is due in connection with a prepayment of the Principal Balance in accordance with the provisions of this paragraph, it being expressly understood that (i) Payee shall not be obligated or required to have actually reinvested the prepaid portion of the Principal Balance in any U.S. Treasury obligations as a condition precedent to Maker being obligated to pay a Prepayment Premium calculated in accordance with the provisions of this paragraph, and (ii) Maker shall not have the right to question the correctness of any such statement or the method of calculation set forth therein, which statement shall in all respects be conclusive and binding upon Maker absent manifest error.

8. Borrower and Payee have negotiated the Loan upon the understanding that if the Loan is paid or prepaid prior to the Maturity Date, for any reason (other than an application of insurance or condemnation proceeds, which applications shall not result in payment of a prepayment premium), including any prepayment made pursuant to Section ____ of the [Mortgage] [Deed of Trust] [FAILURE TO MEET MINIMUM DEBT SERVICE COVERAGE RATIO], Payee shall receive the prepayment premium provided for as partial compensation for: (i) the cost of reinvesting the prepayment proceeds and the loss of the contracted rate of return on the Loan; and (ii) the privilege of early payment of the Loan, which Borrower has expressly bargained for and which privilege Payee would not have granted to Borrower without a prepayment premium. Borrower agrees that the prepayment premium provided for herein is reasonable. Borrower agrees that Payee shall not be obligated, as a condition precedent to its receipt of the prepayment premium provided for, to actually reinvest all or any part of the amount prepaid in any United States Treasury instruments or obligations or otherwise.

Section ____. Failure to Meet Minimum Debt Service Coverage Ratio (Mortgage or Deed of Trust) [Event of Default]

If at any time during the term of the Loan the Debt Service Coverage Ratio shall be less than ____:1 and [Mortgagor] [Trustor] shall not, within three (3) Business Days of such default, either (x) pay to [Mortgagee] [Beneficiary] a portion of the Outstanding Principal Balance such that the Debt Service Coverage Ratio, when recalculated (in accordance with Section ____ of the Note) based on debt service on the Outstanding Principal Balance as reduced by the amount or value of such prepayment, would equal or exceed ____:1 or (y) deposit with [Mortgagee] [Beneficiary] cash or cash equivalents or other collateral acceptable to [Mortgagee] [Beneficiary] in its sole and absolute discretion, of value equal to an amount that, if applied to the Outstanding Principal Balance, would be sufficient to restore the Debt Service Coverage Ratio, when recalculated (in accordance with Section ____ of the Note) based on debt service on the Outstanding Principal Balance as reduced by the amount of such prepayment of the Note, to ____ :1 or greater. For purposes of clause (y) above, the value of collateral other than cash shall be determined by [Mortgagee] [Beneficiary] in its sole and absolute discretion, which determination shall be binding on [Mortgagor] [Trustor] for all purposes. Any partial prepayment of the Outstanding Principal Balance made pursuant to the provisions of this Section ____ shall be accompanied by payment of all accrued and unpaid interest under the Note and all additional sums, fees and charges due under the Loan Documents, together with a prepayment premium calculated in accordance with the provisions of Section ____ of the Note.

4. Prepayment Privilege (Yield Maintenance - Variable Rate Convertible Into Fixed Rate - Alternative).

Section ____. Prepayment.

This Note my be prepaid (a) in full, and (b) in part only to the extent required to meet the conversion requirements if the Fixed Rate Option is exercised, but not otherwise in part at any time, provided that any such permitted prepayment shall be: (i) accompanied by all accrued and unpaid interest and all fees and costs due Maker to Holder; (ii) made only upon Holder’s receipt of at least thirty (30) days’ prior written notice of Maker’s election to prepay; and (iii) accompanied by either (x) the "Yield Maintenance Amount" if the Fixed Contract Rate is in effect at the time of the prepayment, or (y) the "Prepayment Premium" if the Floating Rate is in effect at the time of the prepayment. If the Interest Rate Option has been exercised, the Loan may be prepaid without payment of a Yield Maintenance Amount during the last ninety (90) days of the Loan Term.

"Yield Maintenance Amount" means an amount, never less than zero, equal to the present value of a series of "Monthly Amounts," assumed to be paid at the end of each month remaining from the date of prepayment through the Maturity Date, discounted at the U.S. Securities Rate.

"Monthly Amount" shall mean the following:

1. The Contract Rate,

MINUS

2. The yield ("U.S. Securities Rate"), as of the date of such prepayment, as published by the Federal Reserve System in its "Statistical Release H.15(519), Selected Interest Rates" under the caption "U.S. Government Securities/Treasury Constant Maturities," for a U.S. Government Security with a term equal to that remaining on this Note on the date of such prepayment (which term may be obtained by interpolating between the yields published for specific whole years),

DIVIDED BY TWELVE (12) AND THE

QUOTIENT THEREOF THEN MULTIPLIED BY

3. The amount prepaid on the date of such prepayment.

All percentages shall be rounded to the nearest one hundred thousandth percent and dollar amounts to the nearest whole dollar. Maker acknowledges and agrees that any prepayment of this Note by virtue of the occurrence of an Event of Default hereunder shall be deemed a voluntary prepayment for purposes of determining the applicability of the Yield Maintenance Amount.

The "Prepayment Premium" shall be calculated as follows:

Loan Year During Which Prepayment Occurs	Prepayment Premiums
Loan Year 1	Five (5%) Percent of current outstanding balance
Loan Year 2	Four (4%) Percent of current outstanding balance
Loan Year 3	Three (3%) Percent of current outstanding balance
Loan Year 4	Two (2%) Percent of current outstanding balance
Loan Year 5	One (1%) Percent of current outstanding balance