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Law Surrounding Prepayment Premiums - Banking & Finance

Published on : 10 Nov 2015
Author(s):Sunil Thacker

Banking Lawyers in Dubai

There is a severe need for consistency in the market dealing with publicly traded securities as rapid advancements in the legal diaspora can add unwitting complexity to the requirements of the debtors. If the contracts between borrowers and lenders do not outline distinct covenants which comply with the local laws and precedents of the court, it can result in inadvertent and protracted litigation which can be detrimental to both parties.

The language of a contract is inadvertently the bone of contention between the contracting parties when it presents itself as a dispute that results in or sets a tone of litigation. Here, it is imperative to note that when two parties agree to be bound by contractual obligations, it is usually the result of several hours or even months of negotiation. On the other hand, a trustee that agrees to the terms and conditions of a debt security is not necessarily a party to the discussion or the drafting of the terms of the security but frequently finds himself wedged between the terms of the agreement and in the face of litigation. This two-part series paper seeks to explore and discuss the legal effect of prepayment premiums charged by banks. The First part deals with acceleration clauses found in debt instruments and the second part with the make-whole premiums which has the effect of offsetting the downside risk when the borrower, after enjoying a favorable interest rate on loan during the periods of rising interest rates, unilaterally opts to prepay the loan
The concept and use of make-whole premiums has been used widely in a variety of debt instruments and permits the borrower to redeem the debt before its maturity but subject to the condition that premium is paid.  In other words, borrowers pay a charge in the form of premium for prepaying the debt. One interpretation of such premium is that these charges are nothing but liquidated damages for loss of business (or; loss of revenue) to lender resulting from borrower’s early settlement. 
Debt instruments also provide for acceleration clauses whereby borrower’s performance matures fully upon his/her breach of contract. A question that however arises is whether courts would allow and accept enforceability of contract whereby borrower upon default is required to pay:-
  • acceleration of payment of principal loan amounts;
  • accrued interest; and
  • other outstanding and charges arising from or agreed under the loan agreement.
A question, therefore, arises whether liquidated damages are enforceable and whether such clauses are in fact penal and fair in nature. Liquidated damages covenants serve multiple purposes including certainty, cost, and expenses incidental to proving losses and in a broad sense - serve the public interest. It has also been argued that ‘clauses which simply accelerate liability cannot be considered to be penalties.. the courts have usually enforced such clauses on the ground that they do not increase the contract breaker’s overall obligations.‘(i)  The other view holds that imposition of such high penalties (ii) are unreasonable, against the public order as well as against national interest iii. 
Under what events or circumstances would courts come to the rescue of borrowers and rule in their favor and treat lender’s acceleration fee as unreasonable or unenforceable? This questions and other aspects relating to the enforceability of such clauses as penalties under the English law were discussed and summarized in Edgeworth v Ramblas Investments. In September 2008, in the week leading up Lehman Brothers fallout, the acquisition of the Madrid headquarters of Banco Santander which was given the elucidatory name of Ciudad Financiera (Finance City) and considered the most significant real estate asset in Europe; also made the headlines. Marme Inversiones paid for the acquisition by partly using financing where Royal Bank of Scotland agreed to inject Euro 1.6 billion into Marme as a syndicated loan. The remaining sum as junior debt to Marme’s parent- Ramblas, a Dutch company; and other loans such as a personal loan from RBS to the two owners of Marme and Ramblas (the Ramblas).
By an Upside Fee Agreement (the Agreement) relating to the junior debt, RBS would be entitled to a significant sum as fee if specific events such as nonpayment of personal loan triggered. Royal Bank of Scotland had transferred their rights and obligations under the Agreement in favor of Edgeworth Capital. With the financial crash affecting one and all across the globe, the breach of the personal loan by Ramblas resulted and like a domino set off an event of default under the junior loan which was accelerated Capital in 2010. Upon default, Edgeworth Capital instituted an action claiming payments under the Agreement and junior loans. Ramblas contended/asserted that a bare reading of the Agreement suggested that no fees became due or payable under the Agreement and further that Edgeworth’s claim was in the form of a penalty and consequently inadmissible and unenforceable under English law. The Court held under:-
Edgeworth became entitled to claim the fee when Ramblas defaulted. The court noted that although the circumstances in which the financing contracts were executed were challenging and the fact that the junior loan was essentially a bridging loan, there was a definite commercial justification for Edgeworth to charge a substantial fee. In deciding whether a clause should be construed as the penalty or not, the court held:-
  • a clause will be a penalty where it is “extravagant and unconscionable with a predominant function of deterrence.”
  • a clause will not be a penalty if it is a genuine pre-estimate of loss.
  • even if it is not a pure pre-estimate of loss, it will not be a penalty where it is commercially justifiable, and it can be shown that its effective function is not deterrence.
This brings us back to the question as to whether pre-payment premiums are liquidated damages or not (v).  An analysis of Edgeworth v Ramblas suggests that clauses such as acceleration clause setting out that monies must be settled upon triggering of one or series of defaults by one of the parties will be enforceable as liquidated damages as long as such claims are genuine pre-estimate of damages; and are not designed to pressurize or succumb a defaulting party to any pressure to perform or settle. The courts also have in other matters rejected arguments based on the premise that if contract provision includes a penalty element that also invalidates provision accelerating the payment of outstanding loan citing that the doctrine relating to penalties is not a rule of illegality but that of public policy (vi) (vii)   
Security creation in the United Arab Emirates is categorized by distinct jurisdictions developed and existing under the realm of the federal on-shore legal systems namely -
  • the mainland legal system that is a civil law jurisdiction where the law is based broadly on sharia principles and the French legal system; and
  • the jurisdiction of the Dubai International Financial Centre that was established in the year 2004 which is subject to its own laws and court modeled closely on international standards and principles of common law.
The DIFC Courts recognize and accept liquidated damages clauses in the agreements viii. Pursuant to Article 21 of DIFC Law number 7 of 2005 on Law of Damages and Remedies allows an aggrieved party to claim from defaulting party - the specified sum agreed under the contract irrespective of its actual loss.  Article 21 (2) of the same law provides that the amount by way of liquidated damages agreed under the contract may be reduced to a reasonable amount where it is ‘manifestly disproportionate’ to the loss envisaged as capable of results in relation to the loss resulting from the non-performance and to the other circumstances. Article 40 (2) of Law 7 of 2005 also allows DIFC Courts to award punitive damages. 
Article 40 (2) reads as under:-
“40 (2) The Court may in its discretion on application of a claimant, and where warranted in the circumstances, award damages to an aggrieved party in an amount no greater than three times the actual damages where it appears to the Court that the defendant’s conduct producing actual damages was deliberate and particularly egregious and offensive.”
Article 122 of the DIFC Law number 6 of 2004 (the DIFC Contract Law) also dealing with non- performance provisions allow an aggrieved party to claim from defaulting party - the specified sum agreed under the contract. Interestingly, however, part (2) of the same article provides that the amount by way of liquidated damages agreed under the contract may be reduced to a reasonable amount where it is grossly excessive in relation to the harm resulting from the non-performance and to the other circumstances. We will examine and discuss Article 122 (2) in greater detail in part 2 of the series dealing with make-whole premiums as this clause (ix) forms the basis to decide whether that form of prepayment would be consistent and valid.
Banking Laws of UAE
DIFC is a relatively new jurisdiction and till date, there are no DIFC court precedents that elaborately discuss the legal implications of liquidated damages causes in greater detail x. 
Revisiting Edgeworth v Ramblas at this point would suggest that the provisions contained within the DIFC Contract Law as well as the DIFC Law of Damages and Remedies are consistent with commercial justification offered in the above precedent and DIFC courts would take in to account factors such as whether a clause is a genuine pre-estimate of loss, whether such clause qualifies as liquidated damages. Interestingly however DIFC Courts (pursuant to Article 40 (2) of Law number 7 of 2005) can also award punitive damages, something that will not be enforced by English Courts. Most foreign countries may also refuse to enforce Article 40 (2) on policy grounds xi.
  • Richard Hooley, Penalty Clauses, Lecture notes dated 31 October 2008 referring to Protector Endowment Loan Co v Grice (1880) 5 QBD 592 and the Angelic Star [1988] 1 Llyod’s Rep 122.
  •  A penalty is in the form and nature of a punishment for non-observance of a contractual provision; it consists of the imposition of an additional or different liability upon breach of the contractual stipulation. An award of damages, on the other hand, serves as compensation to the claimant.
  • See Mohamed Aziz v Caixa d’Estalvis de Catalunya, Tarragona i Manresa (Catalunya Caixa)  (2013) Case C-415/11, [2013] 3 CMLR , The national court must in particular compare that rate with the statutory interest rate, and determine whether it is appropriate for securing the attainment of the objectives pursued in Spain and does not go beyond what is necessary to achieve them.
  • Edgeworth Capital (Luxembourg) S.A.R.L and another v Ramblas Investments B.V; [2015] EWHC 150 (Comm)
  • See for instance, Bank of New York Mellon v. GC Merchandise Mart, L.L.C., et al. (In re Denver Merchandise Mart,. Inc.), No. 13-10461 (5th Cir. Jan. 27, 2014) where the courts referring to Colarado law and section 506(b) of the Bankruptcy Code held ‘a prepayment premium is not a remedy for breach of contract, but rather is consideration for a borrower’s right or privilege to prepay (p. 5). Accordingly, a prepayment premium is not liquidated damages and is not subject to the reasonableness for liquidated damages.’
  • Oresundsvarvet Aktiebolag v. Marcos Diamantis Lemos (The “Angelic Star”)[1988] 1 Lloyd’s Rep 122, Sir John Donaldson MR  said “Clearly a clause which provided that in the event of any breach of contract a long-term loan would immediately become payable and that interest thereon for the full term would not only be payable but would be payable at once would constitute a penalty as being “a payment of money stipulated as in terrorem of the offending party“.
  • For instance in South Africa, the Western Cape High Court of Cape Town placed reliance on borrower’s argument citing that acceleration clause was the abuse of lender’s position and consequently against the public policy. The court relying on Everfresh Market Virginia (Pty) Ltd v Shoprite Checkers (Pty) Ltd 2012 (3) BCLR 219 (CC), Paragraph 22 said ‘Many people enter into contracts daily and every contract has the potential not to be performed in good faith. The issue of good faith in contract touches the lives of many ordinary people in our country’ and held that email demand made by the lender cannot be applied by the lender to gain the massive commercial advantage to the significant disadvantage of the debtor and further that acceleration clause in the present matter had draconian implications.
  • Pursuant to Article 390 of the UAE Federal Law Number 5 of 1985 (the Civil Transactions Law), parties may fix the amount of compensation in advance by making a provision in the contract or by a subsequent agreement. This would mean that parties under UAE law are not under the legal obligation to pay liquidated damages. Further Article 390 (2) permits the courts to vary the contract executed between the parties to reflect the actual loss.
  • In addition to other laws including Article 17 of the DIFC Law of Damages and Remedies.
  • The DIFC courts in (CFI 004 of 2007 between Arabtec Construction LLC v Ultra Fuji International LLC) enforced liquidated damages clause in favor of the claimant. Also, in CFI 034 of 2012 Amit Dattani and Others v. Damac Park Towers Company Limited, the DIFC courts of First Instance dealing with liquidated damages held
  • Refer DIFC Guide to Enforcement - Open for Consultation dated 25 April 2012 available on ‘Few courts will enforce judgments for the recovery of taxation. Many courts in the Arab world will refuse to enforce a judgment which is contrary to the principles of Sharia.’



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