On January 21, 2010, the Colorado Court of Appeals issued a decision upholding the right of lenders to charge a prepayment premium. Planned Pethood Plus, Inc. v. Keycorp, Inc., 228 P.3d 262 (Colo. App. 2010).
Keycorp loaned Planned Pethood, a veterinary clinic, $389,000 at a fixed interest rate for a term of 10 years. The loan was secured by real property owned by Planned Pethood. Prepayment of the loan was permitted with the payment of a prepayment premium, in an amount specified in the promissory note. Planned Pethood elected to prepay the loan eight years and eight months early and paid Keybank a prepayment premium of approximately $40,000. The prepayment premium was calculated based on a formula using the outstanding principal balance and the term remaining on the loan. Planned Pethood filed suit, alleging that the prepayment premium amounted to an unenforceable liquidated damages clause and that the amount of the prepayment premium was unconscionable.
Are Prepayment Premiums Liquidated Damages?
Prepayment premiums have seldom been the subject of litigation in Colorado. Whether they are viewed as a form of liquidated damages was an issue of first impression. The Colorado Court of Appeals stated that liquidated damages are a remedy for a breach of contract and reasoned that because Planned Pethood never breached the loan agreement or the terms of the promissory note, there was no breach of a contract and thus no liquidated damages. Citing Great Plains Real Estate Development L.L.C. v. Union Central Life Insurance Co., 536 F.3d 939 (8th Cir. 2008), the court found that because the borrower retains control over the manner of performance, a prepayment premium is simply an alternative manner of performance, not a liquidated damages provision. The court discussed the fact that prepayment premiums arise from the common law view that a borrower may not compel a lender to accept early payment unless there is a specific provision for prepayment in the contract. Colorado courts have long held that a debtor has no right to obtain a release of a deed of trust by tendering the principal balance before it is due unless the contract so provides. The court did iterate that prepayment premiums must be specifically set forth in the loan agreement or other contract.
Is a 10% Prepayment Premium Unconscionable?
Planned Pethood also asserted that, regardless of whether the prepayment premium qualified as liquidated damages, the amount of the prepayment premium (equaling about 10% of the principal) was unconscionable. In holding that the prepayment premium was not unconscionable, the court reasoned that prepayment premiums are generally permitted in Colorado, except in consumer loans and certain residential mortgages. The court discussed the possibility that a prepayment premium might be so large, or a lender's behavior so egregious, as to render the enforcement of a prepayment premium unconscionable. A prepayment premium could be unenforceable, for example, if it were so unconscionable that no decent, fair-minded person would view the ensuing result without being possessed with a profound sense of injustice. Colorado courts have upheld prepayment premiums as large as 50%. In addition, the court discussed the following additional factors that helped it conclude that the prepayment premium was not unconscionable: the prepayment premium was prominently displayed on the first page of the note, the borrowers were not novice borrowers and the borrowers acknowledged on the signature page of the note that they read and understood the terms of the note.
What does this mean for Colorado lenders?
This holding shows that the Colorado Court of Appeals is willing to enforce lender-friendly provisions such as prepayment premium clauses.