Writing a sample calculation into the contract itself might have highlighted this “absurd” clause in time to fix it

I’m more convinced than ever of the value of including sample calculations right in the body of a contract, as suggested in my “Contract simplification” posting from several years ago.

In a recent Seventh-Circuit case, a group of affiliated franchisees of restaurants such as Burger King and Chili’s had negotiated $49 million dollars worth of corporate promissory notes. During the negotiations, the borrowers asked for a change in the lender’s standard definition of “Prepayment Penalty.” The quoted term ended up being defined in all 34 promissory notes as:

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.

BKCAP, LLC v. CAPTEC Franchise Trust 2000-1, Nos. 08-3239 & 08-4038, slip op. at 4 (7th Cir. Aug. 5, 2009) (amended opinion).

Unfortunately, according to the appeals court, the computed prepayment penalty would always be zero — which would be absurd under the circumstances because the parties clearly didn’t intend that:

… As illustrated by calculations that Lender submitted with its motion for summary judgment, even if the Reinvestment Rate (i.e., the U.S. Treasury rate) drops substantially, the first “stream of monthly payments” variable is always smaller than the second “outstanding principal balance” variable. Hence, subtracting the two variables yields a Prepayment Premium that is always negative and therefore “deemed to be zero” under the contract. That was not the intent of the parties, who, as rational business entities, see id., agree that the purpose of the Prepayment Premium is to provide some penalty in the event that Borrowers prepay.

Id. at 11 (emphasis in original).

The appeals court reversed a summary judgment in favor of the lender and directed the district court to conduct a trial to determine what the parties really meant — good luck with that, and watch the lawyers’ meters run. See id. at 17-18.

Worth noting: The court specifically mentioned calculations that the lender submitted with its motion for summary judgment. It’s a shame the promissory-note drafters didn’t think to include one or two such calculations in the body of the contract itself — by being forced to work through the calculations, they might well have spotted the problem with their language in time to do something about it.