Carlyle Apartments Joint Venture v. AIG Life Insurance

RODOWSKY, Judge. This is a certified question case. 1 A mortgagor, as part of a refinancing, voluntarily prepaid a commercial loan in accordance with its terms. The mortgagor now seeks to recover the agreed prepayment fee by arguing that (1) the mortgagor’s performance of the contract should be treated as a breach of contract, (2) the prepayment fee should be treated as liquidated damages, and (3) the prepayment fee is void as a penalty. We do not accept the first step in the mortgagor’s argument.

Consequently, we do not reach the remaining steps. Appellant, Carlyle Apartments Joint Venture (Carlyle), owns an apartment complex in Crofton, Anne Arundel County, Maryland. In January 1991, Carlyle borrowed $3,100,000 from the appellee, AIG Life Insurance Co. (AIG), evidenced by a note and secured by a first Deed of Trust on the property. The debt bore 10.25% per annum interest, was payable in monthly payments of $28,800, and would mature January 1, 1996, when a balloon payment would be due.

The loan documents permitted Carlyle to prepay the entire outstanding indebtedness at any time on or after February 1, 1992, for a fee. Section 9.1 of the note, in relevant part, provides: “The Borrower is granted the privilege to prepay this Note in whole but not in part at any time on or after, but not before, February 1, 1992, and not after October 1, 1995.... ²⁶⁷ Any such prepayment shall be made on a payment date, at a prepayment price equal to the then outstanding balance of the Principal Sum, together with unpaid interest thereon accrued to the date fixed for prepayment, plus any other sums then due and payable to the Holder and accompanied by a prepayment fee equal to the difference in yield between the Loan as defined in the Deed of Trust (as hereinafter defined) and a Treasury Note in the amount of the prepayment proceeds with a term equal to the remaining term of the Loan. Such method of computation as aforesaid is hereinafter referred to as the ‘Treasury Note Yield.’ If prepayment is made pursuant to this Section 9, then the remaining term of the Loan shall be the length of time between the prepayment date and the maturity date of the Loan____ If on the date of any prepayment, the Treasury Note Yield is equal to or greater than the interest rate then payable under this Note, no prepayment premium will be due and payable by the Borrower with respect to such prepayment. The calculation of the Treasury Note Yield will be determined by reference to the yield quoted in the Federal Reserve Weekly Release H.15 (519) of Selected Interest Rates (or any similar successor publication of the Federal Reserve) for the first week ending not less than two full weeks prior to the prepayment date.

If the remaining Loan term is less than one year, the Treasury Note Yield will equal the yield for 1-Year Treasury Constant Maturities. If the remaining Loan term is equal to one of the maturities of the Treasury Constant Maturities (e.g., 1-year, 2-year, etc.), then the Treasury Note Yield will equal the yield for the Treasury Constant Maturity with a maturity equalling the remaining Loan term. If the remaining Loan term is longer than one year but does not equal one of the maturities of the Treasury Constant Maturities, then the Treasury Note Yield will be based on an interpolation of the yield on Treasury Notes having the next longer and the next shorter term.” Five other paragraphs of § 9 also address prepayment. If acceleration of maturity of the note, after an event of default, ²⁶⁸ occurred prior to February 1, 1992, Carlyle agreed in § 9.2 to pay a prepayment premium of one percent of the outstanding balance of principal plus the “Treasury Note Yield.” Section 9.3 provides that the prepayment fee “shall be due and payable whether such prepayment is voluntary or involuntary, including but not limited to repayment resulting from a default and the acceleration of the indebtedness....” No prepayment premium, however, would be due “to the extent the Holder applies the proceeds from a Condemnation or Casualty ... to repayment,” per § 9.4.

Under § 9.6 there would be no prepayment premium if, upon thirty days’ prior written notice, Carlyle prepaid in full within ninety days preceding the maturity date of the loan. This action commenced on January 28, 1993, when Carlyle, in anticipation of prepaying, filed a state court complaint seeking a declaration voiding the prepayment fee provision. AIG removed the case to federal court. Subsequently AIG moved for judgment on the pleadings.

AIG’s threshold position was that there is no right under Maryland law to prepay a mortgage, absent a statute or contract term so providing. As a matter of bargaining Carlyle had obtained an option to prepay, for the exercise of which it had promised to pay the prepayment fee. AIG simply refused to relinquish its contractual rights. Carlyle agreed that there is no prepayment right as a matter of Maryland common law.

The borrower asserted that “in the absence of a clause permitting prepayment, prepayment has traditionally been regarded as a breach of the loan agreement.” Record Extract at 46-47. From this Carlyle concluded that, to the extent that a loan agreement does not freely permit prepayment, but instead provides for a prepayment fee, the fee must be evaluated under liquidated damages standards. While AIG’s motion was pending, Carlyle, on May 28, 1993, prepaid the full amount owing under the note and paid the full prepayment fee, calculated according to the formula in § 9.1 of the note. Carlyle paid the fee “under protest and with full reservation of all rights.... ” Brief of Appellant at 5 n. 3. ²⁶⁹ This prepayment was part of a refinancing of the indebtedness on the apartment property. 2 In response to AIG’s motion for judgment, the federal court concluded that “no Maryland court has spoken ... concerning the substantive issues involved in this case” and certified the following questions to this Court: “[1] Are the prepayment provisions of the note involved in this case valid and enforceable, per se? “[2] Or, are the said provisions of the said note valid and enforceable only if they meet standards such as those which prevail under Maryland law in connection with the enforcement of liquidated damage clauses? “[3] If such prepayment provisions are valid and enforceable only if they meet standards of the type described in Question 2, what are the standards which are prescribed under Maryland law?” The certification also disclaims restricting this Court’s consideration by the phraseology of the questions.

The first and second questions raise one basic issue and may be merged. That issue is whether this prepayment fee provision is subject to the legal rules governing the validity of liquidated damages clauses in contracts. Our analysis begins with the rule that “under Maryland common law, a mortgagor or grantor under a deed of trust payable at a fixed date or dates in the future, does not have a right to prepay, absent provision for prepayment in the loan contract. Phrased another way, there is no presumption of prepayment which must be negated by express contract provision in order to prevent prepayment.” ²⁷⁰ Promenade Towers Mutual Housing Corp. v. Metropolitan Life Ins.

Co., 324 Md. 588, 603-04 , 597 A.2d 1377, 1384 (1991). That is the majority rule in this country. Id. at 592-94 , 597 A.2d at 1379-80 . The loan contract in the case before us creates a borrower’s prepayment privilege, but it is not unlimited.

Prepayment must be of the entire principal balance, accompanied by the calculable prepayment fee under § 9.1 of the note. The only legal theory advanced by Carlyle to support judicial invalidation of the prepayment provision and a judgment for refund to Carlyle of the prepayment premium is that, under the Maryland law of liquidated damages, the prepayment fee is a penalty and is invalid. But the loan contract between Carlyle and AIG permits prepayment under circumstances with which Carlyle complied. Carlyle did not breach the contract— Carlyle performed in accordance with its terms.

These facts do not engage the gears of the Maryland law relating to liquidated damages. West Raleigh Group v. Massachusetts Mutual Life Ins. Co., 809 F.Supp. 384 (E.D.N.C.1992), is on point. Seven years into the fifteen year term of a mortgage loan carrying interest at 13.375% per annum, the borrower sought voluntarily to prepay without paying the prepayment premium, the calculation of which used as a factor the difference between the loan contract rate of interest and specified yields on United States Treasury obligations.

The borrower brought a declaratory judgment action contending that the prepayment provision created an unenforceable penalty because it would compensate the lender “in an amount ‘wholly disproportionate’ to probable losses arising from the prepayment.” Id. at 386 . The court rejected this contention on a number of independent grounds. One ground invoked a very basic analysis with which we are in complete accord. The court said: “More fundamentally, [the borrower’s] claims depend on its unstated premise that the prepayment provision is intended to be a liquidated damages provision, and thus is subject to challenge as an illegal ‘penalty.’ [The borrower’s] implicit premise, however, ignores the fact that there has ²⁷¹ been no breach of contract in this case; rather, [the borrower] is attempting to voluntarily invoke a contract term — the privilege and option of prepayment.

Therefore, to invoke that option it must abide by the terms of its agreement. The prepayment penalty or premium is the bargained — for consideration for the option to prepay, and as such it is enforceable as a matter of contract law and not as a measure of damages.” Id. at 391 . Carlyle would have us distinguish West Raleigh Group from the instant matter because the court in that case also analyzed the issue in relation to certain North Carolina statutes. The opinion in West Raleigh Group , however, on its face defeats Carlyle’s attempt to distinguish.

The court, summarizing the above-stated reason for its conclusion, said: “North Carolina case law supports the conclusion that prepayment provisions of a large commercial loan such as the one in question here, are valid and enforceable and that such provisions, even in the absence of applicable statutes, are not liquidated damages provisions subject to analysis as such.” Id. at 387 . An analysis similar to that which we apply here and to that applied in West Raleigh Group is found in Lazzareschi Investment Co. v. San Francisco Fed. Savings & Loan Ass’n, 22 Cal.App.3d 303 , 99 Cal.Rptr. 417 (1971). The reported case grew out of a divorce action. In order to pay obligations due from husband to wife, the court appointed a receiver to sell commercial realty owned by the husband.

That realty was subject to a mortgage securing a $300,000 debt that was not in default. The loan contract permitted partial prepayment, but prepayment exceeding twenty percent of the original principal amount of the loan during any successive twelve month period triggered the borrower’s obligation to pay a fee equal to six months’ interest at the loan rate on the amount by which the prepayment exceeded the twenty percent limitation. In Lazzareschi this provision, apparently in conjunction with a “due ²⁷² on sale” clause, generated a fee of $9,130.02 when the receiver sold. The fee was paid to the lender by the purchaser who then sued to recover it.

The purchaser in Lazzareschi argued that the fee was an invalid penalty because interest rates had risen above the loan contract rate so that the mortgagee suffered no loss of interest income by virtue of the prepayment. The court, treating the purchaser as a subrogee of the mortgagor husband, rejected the purchaser’s penalty argument on the following rationale: “[The purchaser] cites Freedman v. The Rector, 37 Cal.2d 16 [ 230 P.2d 629 ], for the principle that damages imposed must bear a reasonable relationship to the injury caused. But the Freedman case and all of those which have been based on it are concerned with breach of a contract in some manner. In the instant case, there has been no breach.

The borrower had the option, clearly spelled out in the promissory note, of making one or more prepayments. He, by the action of the receiver, availed himself of the option. This is not a situation of liquidated damages. Although the word ‘penalty’ is used, and perhaps properly so in that a charge is made which is equivalent to unearned interest, there is no penalty in. the sense of retribution for breach of an agreement, nor is there provision for liquidated damages because of ascertaining what the damages for such breach may be.

Nor is the case one in which there is forfeiture for a default.... Indeed, in the case before us there is the opposite of default, that is, a payment made before the promisor was obligated to make it.” 22 Cal.App.3d at 307 , 99 Cal.Rptr. at 420 . Carlyle’s initial assault on the logic that performance is not breach is encapsulated in two sentences from its brief in chief. “[T]he legal principle [is] that, in the absence of a clause permitting prepayment, prepayment has traditionally been regarded as a breach of the loan agreement.” Brief of Appellant at 15. “It follows that where ... a note contains a clause which, instead of freely permitting prepayment, pro ²⁷³ vides for a ‘fee’ or ‘premium’ in the event of prepayment, the legal effect of that fee provision is to specify a sum as liquidated damages for the breach by prepayment.” Id. We have serious reservations concerning the validity of the premise.

In any event, we deny that the conclusion applies here. The only authority that Carlyle cites for the proposition that any prepayment is a breach of contract, absent a prepayment provision, is In re A.J. Lane & Co., 113 B.R. 821, 827 (Bankr.D.Mass.1990). Lane states that prepayment has been regarded as a breach “since the decisions in Abbe v. Goodwin, 7 Conn. 377 (1829) and Brown v. Cole, 14 L.J.-Ch. 167[, 14 Simons’ Reports 427] (1845).” Id. The cases are early recognitions of the rule of perfect tender, but neither illustrates a “breach” by prepayment.

Brown v. Cole reports the sustaining of a demurrer to a bill to decree redemption of mortgaged property, where the mortgagor had tendered prepayment, but the mortgagee refused to accept the money and would not execute a deed of reconveyance. 14 Simons’ Reports at 427. The court would not order redemption before the day appointed for that purpose had arrived. Id. at 428 . Abbe v. Goodwin was cited by this Court in Promenade Towers, 324 Md. at 594 , 597 A.2d at 1380 , as one among many cases denying a right to prepay absent statute or contract so providing.

In Abbe the lender refused tendered prepayment, prompting the borrower to seek an order of redemption. The court dismissed the bill with a ringing endorsement of freedom of contract, as follows: “Has the plaintiff any merits? What is the object of this bill? It is to compel the defendant to accept his money before it is due, and relinquish his security.

In other words, it is to substitute another contract for that which the parties have entered into. It will be in vain to search for authorities to that effect. None are shewn. It is opposed to the