On January 27, 2014, the US Court of Appeals for the Fifth Circuit, in Bank of New York Mellon v. GC Merchandise Mart, LLC (In re Denver Merchandise Mart, Inc.), held that a prepayment premium was not triggered upon the mere acceleration of a note without actual prepayment in the absence of a clear and unambiguous contractual provision providing for such payment (No. 13-10461, (5th Cir. Jan. 27, 2014)).

On September 30, 1997, GC Merchandise Mart (GCMM) signed a $30 million promissory note (Note) in favor of Dynex Commercial, Inc., who was later succeeded by Bank of New York Mellon (Mellon). In October 2010 GCMM stopped making payments to Mellon and defaulted, which accelerated certain sums due under the Note. After defaulting, GCMM made two more partial payments, but ceased making payments after December 2010. GCMM filed for bankruptcy in March 2011, at which time $24 million remained outstanding on the Note.

Mellon filed a proof of claim seeking a $25 million secured claim under the Note and a $1.8 million prepayment premium. Mellon argued that under certain provisions of the Note it was entitled to recover the prepayment premium, including:

Mellon argued that Article 4's acceleration clause triggered payment of the prepayment premium, despite the fact that GCMM stopped making payments under the Note after December 2010 and never paid the Note before its maturity date. The bankruptcy court disagreed, allowing Mellon to recover a $25 million secured claim under the Note, but disallowing the $1.8 million prepayment premium, reasoning that:

The district court affirmed the bankruptcy court's decision in full. Mellon appealed to the Fifth Circuit, asking it only to determine whether or not GCMM became liable for the prepayment premium upon the pre-bankruptcy acceleration of the Note.

The Fifth Circuit began by noting that under Colorado law:

The Fifth Circuit noted that parties are free to contract around these general rules if they do so clearly. It then examined the terms of the Note to determine whether the acceleration of the Note due to GCMM's default by nonpayment under Article 4 triggered the payment of the prepayment premium under Article 6.

First, the Court explained that because the plain language of Article 4 did not explicitly list the prepayment premium as a sum that would be accelerated upon default, it could only be due if it qualified as "other sums" provided in the Note or as "other moneys" that GCMM agreed to pay under the Note.

Next, the Fifth Circuit looked to Article 6 to determine whether the prepayment premium was agreed or provided to be paid by GCMM under the Note. After examining the plain language of each condition that might trigger payment of the prepayment premium, the Court concluded that none required GCMM to pay the prepayment premium absent an actual prepayment, which did not occur in this case. Further, the Court reasoned that the Note did not contain language which would deem the prepayment to have been made in the event of acceleration, stating that this goal is "not difficult to achieve."

Therefore, by applying Colorado law, which entitles a lender to a prepayment premium in the event of mere acceleration only where the contract clearly provides for it (or where there is evidence of the borrower's bad faith), and finding no such a provision in the Note, the Fifth Circuit held that Mellon was not entitled to the prepayment premium. In fact, the Fifth Circuit noted that the plain language of the Note provides that no prepayment premium is owed unless there is an actual prepayment, whether voluntary or involuntary.

Finally, because the Fifth Circuit held that no prepayment premium was due, it did not have to address whether prepayment premiums are proxies for unmatured interest or represent liquidated damages, which fully mature once triggered by the prepayment. Although the Fifth Circuit stated, in dicta, that prepayment premiums are not liquidated damages, this is the minority view on the issue.

Consistent with previous decisions on the enforceability of prepayment premiums, the Fifth Circuit's decision in Denver Merchandise Mart was determined by the specific language in the note (see Legal Updates, In re AMR: Second Circuit Affirms Rejection of Make-whole Claim for Repayment of Accelerated Debt and In re School Specialty: Delaware Bankruptcy Court Enforces 37% Make-whole Premium). The outcome again highlights the importance of careful drafting and serves as another reminder that courts will enforce prepayment premiums only where they are clearly and unambiguously provided for in the governing documents. The Fifth Circuit implied that it would have enforced the prepayment premium had the Note contained a provision explicitly stating that it would be due following acceleration, even in the absence of any actual prepayment.

However, the question as to whether prepayment premiums are generally enforceable in bankruptcy has not been answered in this case because the Fifth Circuit's decision was based only on its interpretation of the specific contractual provisions before it. Therefore, the issue still remains unresolved.

For more information on prepayment premiums, see Practice Note, Treatment of Make-whole and No-call Provisions in Bankruptcy and Chemtura Roadmap: Analysis of Make-whole and No-call Provisions in Bankruptcy.