In a recent decision (DLF Limited v. Punjab National Bank, W.P.(C), 8520/2010, decision dated May 27, 2010, (“the DLF judgment”)) the Delhi High Court has dealt with two important issues in relation to prepayment fees being charged by Indian banks, that is, (i) whether in the absence of a provision in the loan agreement, a borrower is entitled to prepay the loan amount; and (ii) in case of a prepayment, can the bank charge a “prepayment fee” unless such fee is specified in the loan agreement?
What is prepayment premium?
A term loan (as opposed to an on demand loan which is repayable any time the lender wants to after the date of advance) is required to be repaid on specified payment date or dates (called the repayment schedule or maturity dates). Prepayment is where the borrower prepays the loan in advance of the repayment schedule.
Banks are generally reluctant to allow the prepayment of a loan. This is because the bank makes treasury allocations in anticipation of the specified term of a loan, the repayment schedule, and the interest expectation. An early prepayment disrupts this schedule and also means that the borrower has to pay lesser interest (since interest is calculated from the time the loan is disbursed, till it is repaid). Under a fixed-rate loan, the lender will also lose profit resulting from the prepayment of principal if the market interest rates have declined since the loan was originally extended (and hence once the lender re-disburses the money, he earns a lower amount). Even if the interest rate remains where it is expected to be for each interest period, prepayment within an interest period may result in a loss for the lender. For this reason, lenders tend to require prepayments to be made only on specified interest payment dates.
The other common instance where a borrower wishes to prepay the loan is when he is able to refinancethe loan, that is, is able to borrow an amount equivalent to the existing outstanding under the loan from another lender at a lower cost.
To compensate for this loss of earning, a loan agreement, if it permits prepayment, provides for aprepayment penalty, or “break costs”. The intent of this clause is to compensate the bank for the loss of earnings as a result of the prepayment.
From a borrower’s perspective two important aspects need to be kept in mind while negotiating the prepayment clause and the prepayment penalty, (i) the flexibility to prepay the loan without the lender’s permission; and (ii) predictability (that is, certainty on what the quantum of the prepayment penalty, if any would be).
For example, the Loan Market Association (“the LMA”), the definitive organisation for loans in the European market, in its standard agreement, defines break costs as the difference between the interest which a lender should have received in the interest period in which the prepayment is made and the amount which the lender would be able to obtain by placing the same funds on deposit with a leading bank in the interbank market for the relevant interest period. What this definition does is, (i) impose an obligation on the lender to deposit the funds with a leading bank (and not let them stay idle); and (ii) restrict the borrower’s obligation to one interest period. It is assumed that by the time the interest period is completed, the lender would have found other avenues where the funds can be parked.
Unfortunately in India, there is no standard for determining the prepayment fee and there is no obligation on a lender to provide evidence on how the prepayment fee has been arrived at. It is quite common for borrowers to agree at an arbitrary percentage, or even worse – that the prepayment fee shall be as determined by the bank from time to time. Further, in several contracts, there is no provision for prepayment at all, which was the case in the loan agreement, which was the subject matter of the DLF judgment.
Facts of the case
The petitioner DLF, had taken a loan of Rs. 1000 crores from Punjab National Bank (“PNB”). DLF prepaid the loan amount and then applied for release of the security, which had been deposited with PNB. PNB refused to release the security till prepayment charges of Rs. 20 crores were paid.
DLF filed a writ petition stating that PNB was illegally withholding the release of the security and since the loan agreement did not provide for prepayment penalty, PNB was not entitled to charge the same. DLF also stated that a claim for prepayment penalty in the absence of a clause in the loan agreement violated the guidelines of the Reserve Bank of India (“the RBI”), which mandate that all charges be intimated to the borrower upfront.
There was a preliminary challenge by PNB to the maintainability of the writ on the ground that it was a contractual matter and not subject to writ jurisdiction. This was dismissed and is not relevant to the present post.
PNB argued that the reason why prepayment charges were not mentioned is because DLF had never expressed the intention to prepay the loan and since DLF had subsequently requested prepayment, they could only do so after payment of prepayment fees, which PNB had intimated to DLF. PNB also argued that they had displayed a policy to levy a prepayment fee of two per cent on their website, which was in compliance with the RBI guidelines. PNB challenged the very right of a borrower to prepay a loan in the absence of a specific provision in the loan agreement and stated that before the scheduled repayment date, DLF could not repay the loan.
The Court’s decision
The Court held that, whilst under law DLF was obliged to re-pay the debt immediately, PNB had by contract allowed suspension of this obligation (that is, PNB’s right to call for repayment) till the repayment dates specified in the loan agreement. This did not mean that DLF was restricted from the obligation prior to the specified dates. In fact, unless the agreement specifically provides for a prohibition, the borrower has a right of prepayment, since “every borrower has an inherent right to free himself from the loan.”
Further, since PNB had not in any manner informed DLF of its obligations with respect to a prepayment penalty, their actions of demanding such penalty at the time of discharge of the obligation is violative of the RBI Guidelines and PNB’s own Fair Practices Code.
The Court also rejected PNB’s argument that the prepayment penalty of two per cent was specified in the bank’s website and therefore DLF was obliged to pay the same, since the loan agreement did not any manner specify that other general practices of the bank would become applicable to the loan. Without incorporation of the general terms and conditions specified on the website in the loan agreement, PNB could not rely on any such terms and conditions becoming a part of the agreement with DLF.
Interestingly, the judgement records that the Judge had asked counsel for PNB to justify the basis on which the two per cent prepayment charge was based. The learned counsel could provide no rational justification, except that the amount was specified in the website of the bank.
The two most important conclusions that can be arrived from the judgement are (i) that in the absence of specific contractual obligations, a borrower has an inherent right to prepay a loan; and (ii) that unless the loan agreement specifically allows for the same, a lender is not entitled to charge a prepayment penalty.
The judgment is an eye-opener for banks in terms of the importance of contractual provisions reflecting the bank’s rights. If the bank requires that amounts cannot be prepaid (or that they can be prepaid only on payment of prepayment penalty) then such a right should be specifically recorded in the loan agreement. Further, banks should also be prepared to justify the manner in which prepayment penalty is calculated; failing which there is a genuine chance that the amount may be dismissed as a penalty and not compensation. Even for borrowers however, the prudent idea would be to have their prepayment right clearly recorded in the agreement, so that they do not have to go to court to prove their rights.
[First published in http://www.mylaw.net, 20 June 2011]