Tales of WHOA! Company sues lender over early termination fee

RMA Journal, The, Feb, 2006 by Michael L. Weissman

Six hundred thousand dollars was at stake in JMD Holding Corp. v. Congress Financial Corporation, (1) after JMD terminated a $40 million revolving credit facility 13 months early and Congress imposed a penalty.

Congress and JMD had established an asset-based credit facility with a maximum credit line of $5 million in 1997. In 1998, the line was increased to $40 million in an agreement that provided for an early termination fee if the credit facility were terminated prior to August 2000. The borrower granted Congress a security interest in all of its assets.

In June 1999, Congress sent the borrower a notice of default because a number of loan covenants had been violated. At the date of the notice, the early termination fee was 1.5% of $40 million, or $600,000. Congress accelerated the payment of all of the borrower's obligations and demanded immediate payment.

On July 1, 1999, the parties executed a letter of agreement in which Congress agreed to waive the early termination fee if the borrower repaid its loans by September 3, 1999. That did not happen. On November 10, 1999, Congress charged the borrower's loan account $600,000 for the early termination fee. Two weeks later, the borrower paid its entire indebtedness to Congress.

On December 28, 2000, JMD sued Congress to recover the early termination fee, claiming it was unenforceable. However, JMD's sole evidence was the affidavit of its president, who simply concluded it was a penalty.

The New York Court of Appeals sustained Congress's position. The court noted that the $600,000 penalty was in the nature of liquidated damages that parties to a contract may agree upon when actual damages are difficult to predict at the outset of the contractual relationship. To recharacterize the $600,000 charge as a penalty, the borrower had to show that the damages caused by early termination were readily ascertainable when the loan agreement was executed or that the early termination fee was grossly disproportionate to the losses the lender may sustain. The affidavit of the borrower's president was not sufficient to bear this burden of proof.

To further bolster its conclusion, the court pointed out that Congress had to have sufficient funding in place at all times to satisfy the borrower's needs. It said Congress incurred costs to provide the funding, and, because of its commitment to the borrower, Congress could not loan those funds to other borrowers. The court also observed that a liquidated damage clause linked to the maximum amount of the loan commitment rather than the outstanding loan balance was commonly found in asset-based loan facilities negotiated by sophisticated commercial parties.

What's the point? Liquidated damage clauses are quite common for early termination of asset-based lending facilities, and borrowers have a heavy burden of proof to establish that they are tantamount to a penalty. The clear tendency in the law is to uphold a freely negotiated liquidated damage clause where actual damages are difficult to determine at the outset of the relationship.

Notes

(1.) 4 N.Y.3d 373, 828 N.E.2d 604, 795 N.Y.S. 2d 502 (2005).

Michael Weissman is counsel to the Chicago law firm of Holland & Knight, LLP. He has documented commercial and real estate transactions for banks and commercial finance lenders and has prosecuted civil and bankruptcy cases on behalf of financial institutions. Contact him by e-mail at Michael.Weissman@hklaw.com.