Loans: Prepayment Penalty Upheld
By Alvin Arnold
The Colorado Court of Appeals ruled that a large loan prepayment penalty was enforceable and not unconscionable in the case of Planned Pethood Plus v. Keycorp, Inc., 2010 WL 185414 (Colo. App.). Pethood is a veterinary clinic owned by two veterinarians. It obtained a commercial loan of $389,000 from Keybank at a fixed interest rate of 8.3 percent for a term of 10 years. The promissory note contained a clause, prominently displayed on the first page, allowing Pethood to prepay the loan in whole or part by paying the lender a penalty equal to (1) prepayment amount, (2) times the number of years remaining on the loan, (3) times 1-1/4 percent. After 16 months, Pethood prepaid the loan together with a prepayment penalty of $40,500. This represented a penalty of 10.7 percent of the principal balance. Pethood then began this suit. The trial court entered judgment in favor of Keybank and Pethood appealed.
Not Liquidated Damages
Whether a prepayment penalty can be upheld as a form of liquidated damages was an issue of first impression in Colorado. The general rule is that when a breach of a loan contract occurs, a liquidated damages provision must be reasonable in light of the anticipated or actual loss caused by the breach. A liquidated damages provision must not be unreasonably large for the expected loss from a breach of contract. Said the court, “Even if Pethood is correct that the prepayment is unreasonable, it is not an unenforceable penalty under the law of liquidated damages because there was no breach of contract. Pethood exercised its right to prepay the loan, thereby triggering the prepayment penalty."
Where a borrower exercises an alternative form of performance by invoking a prepayment privilege the law of liquidated damages is inapplicable. Prepayment penalties are generally considered valid provisions for alternative performance rather than penalties or liquidated damages. Said the court, “Prepayment provisions simply grant borrowers the right to prepay the loan in exchange for paying the lender a fee.… Because the borrower retains control over the manner of performance, prepayment with a penalty is an alternative manner of performance, not liquidated damages."
Unconscionability
Pethood then argued that the prepayment penalty is nevertheless void on equitable grounds because it is unconscionable. The court disagreed. The court said that a penalty might be so large as to render its enforcement unconscionable and in such case a court has the equitable power to refuse to enforce it. However, the prepayment amount here was not unconscionable. In addition to being relatively small, the penalty clause was prominently displayed on the first page of the note, which the borrowers signed. In addition, the borrowers had previously negotiated for other commercial loans, two of which contained prepayment penalty clauses. The appellate court confirmed the ruling of the trial court.
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