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Yield Maintenance Premium Upheld In Bankruptcy
Lending & Restructuring Alert
February 2004
Authors: Paul A. Rubin

A New York bankruptcy court recently held that an oversecured lender could assert its claim for a yield maintenance premium of over $8 million in its borrower's Chapter 11 case. The Court found the yield maintenance provision was a valid liquidated damages provision under New York Law, and the claim was allowable under the Bankruptcy Code. This decision, an important victory for lenders whose loan documents are governed by New York law, provides a roadmap for lenders seeking to enforce yield maintenance provisions in bankruptcy and state court.

The Facts

A major investment bank loaned $65 million to a debtor, secured by the debtor's only asset, a 2,500 unit apartment complex. After the debtor defaulted, the lender commenced a foreclosure action. In response, the debtor filed for Chapter 11 protection.

In the bankruptcy case, the lender filed an amended proof of claim for more than $75 million, consisting of unpaid principal, interest at the default rate, legal fees, servicing fees and costs, and the yield maintenance premium. The debtor objected to the lender's claim for the yield maintenance premium, arguing that (a) the lender had not suffered any damages because it could reloan the funds at a rate similar to that contained in the loan documents; and (b) its allowance would provide the lender with a "windfall."

The New York State Law Liquidated Damages Approach

The lender argued that the yield maintenance provision in the loan documents was a valid liquidated damages provision enforceable under New York law and that actual damages were irrelevant. Other New York courts have consistently held that yield maintenance provisions are enforceable as liquidated damages where (a) actual damages the lender may suffer are difficult to determine when the loan is made; and (b) the stipulated sum is not plainly disproportionate to the loss. Courts adopting this approach reason that possible losses resulting from prepayment of large commercial loans are not easily calculable at the time the loan is made. They hold that because the parties to the loan transaction are typically sophisticated entities who are represented by counsel, and because the damages are difficult to assess, the terms of the loan documents and intent of the parties at the time the loan was made should not be disturbed. In this case, the Bankruptcy Court observed that when the loan was made, potential damages were difficult to assess. Estimating the damages would have required predictions regarding the loss of interest to the lender, and the rate of return, duration and risk, and the extent and reliability of collateral for any substitute loan(s).

Another condition to enforcement of a yield maintenance provision is that it not be plainly disproportionate to the loss suffered by the lender. Here, the yield maintenance provision attempted to compensate the lender for the actual yield loss incurred upon prepayment by basing the calculation on treasury bond yields prevailing at the time of prepayment. Thus, it was not plainly disproportionate to the lender's possible loss.

Reasonableness under the Bankruptcy Code

Having found that the yield maintenance provision was enforceable under New York law, the Court then determined whether it was allowable under the Bankruptcy Code, which states that a secured creditors' fees, costs, expenses and charges are allowable if they are "reasonable."

The debtor argued that the Court should ignore the parties' contractual provision and find that only actual damages are reasonable--an approach some bankruptcy courts have adopted. This would have required the Court to determine the difference between the market rate of interest on the prepayment date and the contract rate for the remaining term of the loan multiplied by the amount of the loan, discounted to present value. The Court rejected this approach, finding that the yield maintenance formula at issue was an attempt to compensate the lender for its actual yield loss upon prepayment, and there was no presumption of damages.

Conclusion

Importantly, the Court deferred to the parties contractual choices and indicated it would only interfere with the bargained for agreements where the pre-payment charge was unjust. The Court concluded that a yield maintenance premium should be allowed as a reasonable charge under the Bankruptcy Code if it represents a reasonable estimation of the lender's damages at the time the agreement was made. Thus, the Court first assessed whether the yield maintenance provision was allowed as liquidated damages under applicable state law, and then applied the Bankruptcy Code only as a "safeguard" check on reasonableness, not as a basis to disregard summarily the parties' contractual agreement.

This decision properly reflects that, where liquidated damages clauses are reasonable and actual damages are hard to predict, lenders should receive the "benefit of their bargain," even against bankrupt borrowers.

For more information on these or other bankruptcy or restructuring issues, please contact Paul Rubin at prubin@herrick.com or (212) 592-1448. The editors wish to note that Herrick, Feinstein represented the lender in this case.

Copyright ©2004 Herrick, Feinstein LLP. Lender's Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.