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Prepayment penalties in loan agreements

Loan agreements will often have fixed repayment terms. In some cases, it is in the lender's interest to delay the repayment of the loan, usually in order to take advantage of a high interest rate. In order to guarantee the payment of interest at the high rate for the whole of the projected term, the loan agreement may contain a prepayment provision. Under such provision, even though early payment may be allowed, the lender will be entitled to recover the amount of interest that would have otherwise been payable over the term of the loan.

An issue may arise where the borrower has made default under the terms of the loan agreement and the lender elects to demand payment of the loan prior to the stated due date. In such case, does the lender have the right to recover, as part of the amount demanded, the monies that would have been payable pursuant to a prepayment clause when the borrower makes payment in response to the demand? This issue arose in the recent decision of Cymax Stores Inc. v. Coleco Investments Inc., 2019 BCSC 492.

Cymax obtained a loan from Coleco and other company (the "Lenders"). The loan agreement provided for interest at the rate of 17% per annum calculated and payable monthly, if there was no event of default, and at 20.5% per annum, if there was a default. The agreement provided, in part, with respect to prepayment as follows:

... prepayment of the outstanding principal balance of the Loan by the Borrower in whole or part may be made only:

(a) if made at any time prior to and including the date that is eighteen (18) months from the Closing Date, upon repayment of (i) all unpaid fees and expenses and unpaid interest then owing to the Lenders, together with (ii) all unpaid accrued interest on the amount of outstanding principal being prepaid that would be payable from the Closing Date until and including the date that is eighteen (18) months from the date of Closing and (iii) the amount of outstanding principal being prepaid ... (emphasis added)

Following default within the 18 month period, the Lenders made demand for the full amount of the loan and the then outstanding interest. The demand did not include any reference to an additional amount related to prepayment of the loan (the "Prepayment Penalty"). The Lenders also gave notice of their intention to enforce their security. Demand was also made on guarantors without mention of the Prepayment Penalty. Correspondence from the lawyers for the Lenders about two weeks later confirmed the amount of the demand with no reference to the Prepayment Penalty.

It was not until a month later, when Cymax was about to make payment of the outstanding principal and interest, that the Lenders asserted a claim for the Prepayment Penalty. Cymax made payment based on the original demand and the Prepayment Penalty claimed, but the parties agreed that the amount claimed for the Prepayment Penalty ($550,083.33 U.S.) would be held in trust pending resolution of the issue. Cymax then applied to the court for a declaration that the Lenders were not entitled to the Prepayment Penalty.

Madam Justice Fitzpatrick addressed the issue in detail. She considered the applicable rules for contractual interpretation, the ordinary meaning of "prepayment", American and Canadian decisions on prepayment provisions, and the surrounding circumstances set out in the evidence. She ultimately concluded that the prepayment provision in the loan agreement should be given its plain and ordinary meaning and that in the circumstances the Prepayment Penalty was not recoverable by the Lenders. She left open the door for an appropriately drafted prepayment clause that would allow recovery of a Prepayment Penalty even in the event that the due date of the loan was accelerated by demand following default by the borrower.

The take away for lenders is that a prepayment clause must be clear and unequivocal as to the ability to recover a Prepayment Penalty in the event of demand following a default.

The take away for borrowers who default under a loan agreement with a prepayment clause and who are then subject to a demand is that the Prepayment Penalty may not be recoverably by the lender. However, borrowers should be cautious to not deliberately default on their obligations in order to avoid the rigours of a prepayment clause in the loan agreement. Such deliberate conduct may provide sufficient basis for a court to enforce a prepayment clause that might otherwise be unenforceable.

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