Seventh Circuit Finds Ambiguity in Promissory Note Where Plain Language of Note Creates Commercially Unreasonable Result

The Seventh Circuit recently held that a prepayment penalty provision in a promissory note was ambiguous because under the calculation described in the provision, the borrowers could never be liable for a penalty. BKCAP, LLC v. Captec Franchise Trust 2000-1, 572 F.3d 353 (7th Cir. 2009).

The borrowers executed several promissory notes that contained prepayment penalty clauses. The borrowers negotiated a prepayment penalty that differed from the lender’s standard clause in that it permitted payment without penalty after ten years. The promissory notes, as negotiated by the parties, defined the prepayment penalty as:

[E]qual to the positive difference between the present value (computed at the Reinvestment Rate) of the stream of monthly payments of principal and interest under this Note from the date of the prepayment through the tenth (10th) anniversary of the First Full Payment Date at the Stated Rate . . . and the outstanding principal balance of this Note as of the date of the prepayment (the “Differential”). In the event the Differential is less than zero, the Prepayment Premium shall be deemed to be zero.

Thus, according to the plain language of the promissory notes, the prepayment penalty is the difference between:

(1) the present value of the stream of monthly payments that borrowers were scheduled to make from the date of prepayment through year 10 of the loan and

(2) the outstanding principal balance at the date of prepayment.

The lender, however, submitted calculations showing that number would always be negative since the first number included payments only through year 10, while the second number included the full outstanding balance. Therefore, the borrowers could never be liable for a prepayment penalty.

The Seventh Circuit concluded that “while the contract language defining the Prepayment Premium is clear, it is nonetheless ambiguous because it makes no economic sense.” The result made no economic sense because “the purpose of the Prepayment Premium is to provide some penalty in the event that Borrowers prepay.” Accordingly, the court reversed the district court’s order granting summary judgment and remanded for a factual determination of the meaning of the prepayment penalty clause.

Posted by: Darren A. Craig

Categories: Bankruptcy & Banking Law