Daily Development for Monday, August 24, 2009
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Husch Blackwell Sanders
Kansas City, Missouri

Here’s another of those great ten pound DD’s from Jack Murray.  Anyone interested in the subject matter will be interested in every one of the lengthy comments, essentially DD’s themselves, and there’s no way the editor is going to make any drastic cuts in what Jack has to say. But get ready for a longer than normal read.

MORTGAGES: PREPAYMENT: DRAFTING: Even though lender drafted prepayment provision in commercial mortgage note that did not reflect true intent of the parties, court would not void provision because, as written, premium would always be negative and deemed to be zero and lender would never collect a prepayment premium, therefore producing an "absurd" result.

BKCAP, LLC v. Captec Franchise Trust 2000-1, 572 F.3d 353 (7th Circuit 2009).

In this case the Seventh Circuit (surprisingly) came to the aid of the lender, who had incorrectly drafted the prepayment provision contained in the mortgage note. According to the court, "This case demonstrates that even experienced, sophisticated business entities can encounter difficulty when drafting carefully negotiated loan documents."   The court noted that the prepayment provision had been poorly drafted and the dispute between the parties as to the amount owing under the provision was approximately $800,000, "an amount worthy of the litigation effort expended here."

When the loan was being negotiated, the borrowers were unhappy with the lender's standard form of prepayment-premium provision. They wanted the right to prepay without penalty after the first ten years of the loan term. The lender agreed to this modification and redrafted the Note to define the prepayment premium as:

“equal 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 . . . .”

The court refused to adopt the plain-language reading of the revised prepayment-premium provision because doing so would, it reasoned, result in an absurd result, i.e., even if the U.S. Treasury rate dropped significantly, the "stream of monthly payments" variable (calculated through the tenth year of the loan) would always be less than the premium as calculated under the second "outstanding principal balance" variable, thereby creating a prepayment premium that would always be negative and "deemed to be zero under the contract." The court stated that, "That was not the intent of the parties, who, as rational business entities, agree that the purpose of the Prepayment Premium is to provide some penalty in the event the borrowers prepay."

But the court refused to accept the lender's "solution" of including the balloon payment in order to produce a "Positive Prepayment Premium and avoid an absurd result," and also rejected the borrowers' "strict construction" argument, finding that the rule of construing ambiguities against the drafter does not give courts "a license to bypass relevant, extrinsic evidence in favor of simply declaring judgment for the non-drafter." The court found that the clause as written was ambiguous because it made no economic sense, and held that the interpretation of the language required extrinsic evidence. The court therefore remanded the case for a trial on the issue of the parties' intended meaning of the prepayment-premium provision.

Reporter's Comment 1: It is certainly unusual for a court to favor the lender (or at least give it a chance to avoid summary judgment) in connection with the enforceability of a prepayment premium when the clause is drafted by the lender and is admittedly ambiguous or incorrect based on the parties' actual intentions. See, e.g., Sundance Apartments I, Inc. v. General Electric Capital Corp., 581 F.Supp. 2d 1215 (U.S.D.C. S.D. Florida 2008). In Sundance,  the borrower, Sundance, brought an action against the lender (the trustee of a commercial mortgage-backed security trust created by the lender) and the servicer, claiming that the yield-maintenance prepayment provision in the loan agreement was "deceptive," forcing Sundance to make a prepayment (under protest) in excess of the actual premium due. The court agreed with Sundance's interpretation of the provision, upholding the borrower's claims of breach of contract and violation of the Florida Deceptive and Unfair Trade Practices Ac

t as valid claims, and denying the lender's and servicer's motions to dismiss. The yield-maintenance provision in the Loan Agreement entered into between the parties read as follows:

As used herein, "Yield Maintenance Amount" means the sum of the present value on the date of prepayment of each Monthly Interest Shortfall (as hereinafter defined) for the remaining term of the Loan discounted at the Discount Rate.

The Monthly Interest Shortfall is calculated for each monthly payment date and is the product of (A) the prepaid principal balance of the Loan divided by 12, and (B) the positive result, if any, from (1) the yield derived from compounding semi-annually the Loan's Contract Rate minus (2) the Replacement Treasury Rate (as hereinafter defined).

The court summarized the parties' arguments as follows, based on the language in the above prepayment provision:

Sundance alleges that the term "prepaid principal balance" found in the [yield maintenance] Provision must be read to mean "the prepaid balance of the loan for each payment remaining in the term as amortized" in light of its plain meaning and industry custom. Defendants, however, rejected that interpretation and instead read the term to mean "a principal balance fixed at the time of prepayment," which allegedly generates a windfall (the "Windfall Interpretation") and permitted Defendants to recover a yield greater than they would have recovered if Sundance had made its regular payments through the maturity of the loan.

Id. at 1218.

The court ruled that the provision was deceptive and misleading because it "was intended to allow [the lender], or its successor, to charge Sundance a repayment amount that allegedly exceeds the plain meaning and common understanding of the term 'yield maintenance.'" Id. at 1221. Sundance alleged that it had suffered "actual damages" when it paid the prepayment amount demanded by the lender under protest, and argued that its actual damages should be "calculated as the difference between the alleged correct yield maintenance prepayment amount and the Windfall Interpretation as well as costs, attorney's fees, and other relief." Id. at 1219.

Reporter's Comment 2: The Sundance and BKCAP cases, supra, clearly illustrate the importance of clarity and completeness when drafting yield-maintenance provisions in mortgage-loan documents. Although in most cases an ambiguity will be construed by a court in the borrower's favor when the lender has drafted the loan documents, the BKCAP case, supra, indicates that this rule may not apply when it would result in an "absurd" economic result. As the court cogently noted in BKCAP, "while disputes over the meaning in loan documents can be somewhat dry, this one is more interesting than most such cases." But it would not be wise to rely on such a holding when drafting prepayment provisions in loan documents. If the lender's counsel is not absolutely certain that the prepayment provision as drafted reflects the parties' actual intent, the language should be reviewed by a business person familiar with calculating enforceable yield-maintenance prepayment premiums.

Reporter's Comment 3: In another significant ruling on the meaning of the language contained in a prepayment-premium provision negotiated by the parties and drafted by the lender, the Illinois Appellate Court (First Judicial District), in LaSalle Nat'l Bank v. Metropolitan Life Insurance Co., Nos. 1-00-4074 and 1-01-1255 (cons., Nov. 26, 2002), issued a 23-page Order upholding the Cook County Circuit's Court ruling in favor of the borrower's interpretation of a prepayment-premium provision. In a 112-page opinion, the Circuit Court ruled in favor of Merchandise Mart Owners, L.L.C., and awarded Mart Owners the entire $53 million held in escrow with the court. This amount constituted the disputed prepayment fee of $47 million, and the interest accrued thereon till the date of the ruling, claimed by Metropolitan Life Insurance Company as the result of the sale of the mortgaged Chicago commercial property, the Merchandise Mart ("Mart"), to Vornado Real Estate Investment Trust ("Vornado

") for $625 million in 1998 (prior to the end of the loan term). This ruling came after a lengthy bench trial that generated more than 5700 pages of testimony. The dispute arose out of the language in the prepayment provision in MetLife's 1987 20-year nonrecourse loan to Mart Owners in the amount of $250 million, which was secured by a first mortgage on the Mart. The prepayment clause in the mortgage was highly unusual. The provision contained "lockout" language that prevented any prepayment during the first 10 years of the loan. The mortgage could be prepaid during the last 10 years, but a "prepayment fee" would be due and payable by the mortgagor equal to the excess, if any, that would be required (over and above the outstanding principal balance) to purchase, on the date of prepayment, a "security instrument selected in good faith" by MetLife that, in the "good faith judgment" of MetLife, was of "comparable investment quality" to the original 1987 loan as of the date the loan w

as made.

The trial court acknowledged that "It is clear from the testimony and court documents, and the language in the body of the opinion, that Mart Owners clearly always expected to pay a prepayment premium of some undetermined amount." But the trial court also stated that "MetLife [the lender] knew or had reason to know that Mart Owners attached that meaning [suggested by Mart Owners] to the provision, and Mart Owners did not know or have reason to know that MetLife attached a different meaning to the provision. Accordingly ... the provision has the meaning attached by Mart Owners."

The appellate court agreed with the reasoning of the trial court, and stated that "[t]he Loan contained a prepayment premium which was unique to MetLife and the product of extensive negotiations between the parties." (The appellate court also apparently agreed with Judge Reid, who stated in his circuit court opinion that, "The language of the prepayment penalty provision at issue in this case is unique. The evidence at trial failed to reveal any other loan with a prepayment penalty provision similar to the one at issue in this case"). The appellate court also found that the testimony showed that the individuals who analyzed this provision internally at MetLife were aware of these facts, as well as the requirement that "the comparable instrument selected had to be available for purchase on the date of prepayment but did not actually have to be purchased."

a. The appellate court concurred with the circuit court's finding that "the prepayment provision was clear and unambiguous," and rejected MetLife's claim that the circuit court had unfairly shifted the burden of proof on to MetLife to demonstrate its compliance with the prepayment provision instead of requiring Mart Owners to prove that MetLife had breached the provision.

b. Making reference to the three separate factors that the circuit court found were determinative as to whether MetLife had breached the prepayment provision, the appellate court found that it was "necessary to address only one of the court's findings, specifically its conclusion that MetLife materially breached the loan agreement by failing to select a comparable security instrument that was available for 'purchase' by MetLife."

c. The appellate court found that the evidence presented at trial clearly established that instead of selecting an actual "security instrument" that was "available for purchase" by MetLife, it selected an index of A-rated corporate bonds that (as acknowledged by MetLife's own experts) was not available for purchase. According to the court, "MetLife's asserted good faith in the selection of the bond index does not alter the clear fact that MetLife did not comply with the express terms of the prepayment provision and, thus, cannot excuse its breach." The court further stated that it would "decline MetLife's invitation to take judicial notice of MetLife's purported ability to buy the index upon which it relied," and rejected MetLife's claim that Mart Partners had unfairly changed its position to MetLife's detriment during the course of the litigation. The court also concurred with the finding of the circuit court that MetLife's breach of the prepayment provision was material, noting

that the provision was unique and had been heavily negotiated by the parties.

d. Turning to the issue of whether MetLife was entitled to a prepayment fee as a matter of equity, the appellate court (while noting that MetLife had not cited any authority in support of an "equitable prepayment penalty") ruled that MetLife had not suffered any harm because "[a]s the circuit court found, alternative security instruments yielding at the same or greater rate as the loan's note were available for purchase by MetLife at the time of prepayment." The court noted that at the trial the circuit court had determined that the testimony of Mart Owners' expert was more credible regarding the availability of specific commercial backed mortgage securities, and refused to "second guess" the trial court or hold that its finding in this regard constituted reversible error.

e. The appellate court next rejected MetLife's claim that it had been erroneously deprived of its right to a jury trial (finding that MetLife had never indicated that it wanted the issues tried by a jury). Finally, the court also rejected MetLife's claim that the circuit court erred in denying its post-trial motion seeking to reopen the proofs so that it could offer evidence (not submitted at the trial) that would support a "middle ground" of approximately $20 million. MetLife sought to introduce new evidence concerning the yields on corporate bonds rated below the A-rated bonds that MetLife had selected as comparable security instruments. MetLife argued that although the circuit court had held that MetLife did not select the comparable instrument in good faith it should be allowed to prove its "actual damages" and not forfeit all rights to a prepayment fee, which would result in the Mart Owners being unjustly enriched. However, the appellate court agreed with the reasoning of Jud

ge Arnold (who succeeded Judge Reid as circuit court judge and heard MetLife's motion on this matter), who "concluded that MetLife's failure to offer evidence of a 'middle ground' prepayment penalty at trial was the result of MetLife's own deliberate 'all or nothing' trial strategy." The appellate court refused to rule that the circuit court abused its discretion in denying MetLife's motion on this issue, and stated that "there is no indication from the record that the proofs MetLife sought to introduce were not available at the time of trial." The court further found that even if MetLife had been able to introduce such evidence, it "would not have changed the court's judgment since the evidence would not have gone to the salient issues of MetLife's breach or MetLife's entitlement to equitable relief."

f. MetLife subsequently elected to appeal the appellate court's decision to the Illinois Supreme Court, but the case was settled in early 2003 for an undisclosed amount.

Reporter's Comment No. 4: The moral of the Metropolitan Life opinion: stick with objective criteria for determination of the comparable prepayment security instrument and rate and never, EVER, draft a prepayment clause that provides for a subjective "good faith" determination of a security instrument of "comparable investment quality" as of the original date of the note (at least in Cook County, Illinois). There is a great risk in being a "pioneer" and deviating from standard industry practice in favor of a subjective determination. For a lender to do so is to act at its peril. An institutional lender is just asking for a court - at least in Illinois - to rewrite its mortgage and second-guess its decisions in order to reach an "equitable" result. A prepayment provision should be carefully and comprehensively drafted so that its meaning is clear and there is no ambiguity that may open the door to a challenge by a clever borrower. See, e.g., Littlejohn v. Parrish, 163 Ohio App. 3d 4

56, 463-64 (2005) (holding that mortgage, which provided that there was no prepayment penalty but that any prepayment was subject to the mortgagee's approval, imposed duty of good faith and fair dealing "when one party has discretionary authority to determine certain terms of the contract"; court refused summary judgment for mortgagee and remanded case for further proceedings). Cf. Preserve at the Fort, Ltd. v. Prudential Huntoon Paige Associates, 129 P.3d 1015, 1017-18 (Colo. App. 2004) (agreeing with trial court ruling that "the rider [to the deed of trust note executed by the plaintiff borrower] controls, negates or supplants any language in the note that might permit prepayment, and bars prepayment except as provided in the rider).

Reporter's Comment No. 5: The Circuit Court of Cook County, Illinois recently entered an interesting ruling on the enforceability of a commercial-loan prepayment provision. See Cornerstone Leased Drugstores LLC v. Wells Fargo Bank Northwest, NA, Circuit Court of Cook County, Illinois, No. 07 CH 04352 (June 19, 2009). This case was decided solely on the basis of the meaning of the contractual language regarding prepayment contained in the (identical) mortgage notes executed by Cornerstone Leased Drug Stores LLC ("Cornerstone") in connection with forty-two 25-year mortgages on properties located in 16 states. The Court agreed with the defendant, Wells Fargo Bank Northwest ("Wells Fargo," which served as trustee for the five institutional lenders who actually loaned the money and were designated as trust-beneficiaries) with respect to its calculation, under each of the notes, of the Reinvestment Yield under the prepayment provision and the conversion to a monthly yield as provided by

 the provision. This case, as with the ones cited and discussed earlier, has direct relevance for commercial mortgage lenders.

The court summarized the issues as follows:

“There are two portions of [the prepayment provision] that are critical to the resolution of the dispute between the parties. The first is part (i) of the definition of "Reinvestment Yield," and in particular the parenthetical statement: "(or such other display as may replace such displays on the Bloomberg service or any other generally available service)." The second is contained within the definition of "Prepayment Consideration" providing the method of calculating the total amount of the remaining payments due under the note: "such sum to be determined by discounting (monthly on the basis of a 360-day year composed of twelve 30-day months).”

The prepayment premium was to be calculated (pursuant to the applicable provision) by reference to the "Reinvestment Yield," which, as stated in the provision,

“means the yield to maturity of either (i) the yield reported as of 11:00 A.M. (New York City time) on the date of calculation on the display designated USD on the Bloomberg Financial Markets Screen (or such other display as may replace such displays on the Bloomberg service or any other generally available service) for actively traded U.S. Treasury securities having a constant maturity equal to the remaining average life of the Note, or (ii) if such yields shall not be reported as of such time or the yields reported as of such time shall not be ascertainable (including by way of interpolation), the Treasury Constant Maturity Series yields reported for the latest day for which such yields shall have been so reported as of the Business Day next preceding the Determination Date in Federal Reserve Statistical Release H-15 (519) (or any comparable successor publication) for U.S. Treasury securities having a constant maturity equal to the remaining average life of the Note as of the De

termination Date: provided however, if no maturity exactly corresponding to the remaining average life of the Note shall appear therein, yields for the two most closely corresponding reported maturities (with one being shorter and the other longer) shall be calculated pursuant to the foregoing sentence and the Reinvestment Yield shall be interpolated from such yields on a straight-line basis (rounding in each of such relevant periods, to the nearest month). All such prepayments must occur on a Business Day.”

Cornerstone subsequently refinanced the loan and exercised its right to prepay in the summer of 2006. However, on the stipulated date for calculation of the prepayment premium (August 16, 2006), a "matched" Treasury security that would mature on the maturity date of the loan (March 3, 2019) did not appear on the Bloomberg USD screen. The parties then agreed, as per the language in the prepayment provision, to interpolate the prepayment consideration using the two most closely corresponding reported U.S. securities, one shorter than March 3, 2019 and one longer. But the parties disagreed on whether they could only look to the Bloomberg USD screen to ascertain such interpolation based on the U.S. Treasury securities most closely corresponding to March 2019 (as argued by Wells Fargo), or whether the parties could look to different screens for such purpose (as argued by Cornerstone). The court ruled in favor of Wells Fargo, noting that "Paragraph 6 [the prepayment provision] of the No

tes, while admittedly complex, is not ambiguous."  The court further noted that: "The plain language of the note anticipates the possibility that changes might occur over the course of those 25 years, but does not provide the parties with an alternate financial markets screen from which to obtain information on the interest rate borne by U.S. Treasury securities."

Cornerstone also argued that the Reinvestment Yield should have been calculated on a semi-annual, rather than a monthly basis. But after carefully reviewing the language in the prepayment provision, the court agreed with Wells Fargo that in order to be consistent with the terms of the Notes the Reinvestment Yield had to be calculated on a monthly basis. According to the court:

“Since the discount factor is comprised of the "Reinvestment Yield plus 50 basis points," the Notes direct the parties to apply the Reinvestment Yield as if it accrued monthly, and then to add 50 basis points to that number. The word monthly in this section of the note provides the clear and unambiguous direction for that calculation. As such, there is no issue of material fact . . . and Wells Fargo's Motion for Summary Judgment is granted.”

Reporter's Comment No. 6: The basic purpose of a yield-maintenance prepayment provision in a commercial real-estate loan document is to provide a fee to the lender that will compensate it for the difference between the original interest on the loan and the yield available from U. S. Treasury instruments at the time of prepayment. The prepayment clause in the Cornerstone case provided that "the Notes direct the parties to apply the Reinvestment Yield as if it accrued monthly, and then to add 50 basis points to that number." This adding of basis points, which is not all that common any more in connection with prepayment-premium provisions in commercial mortgage-loan documents, was probably done by the lender to blunt any argument that prepayment based on U.S. Treasury instruments without the addition of such basis points would constitute a "windfall" for the lender. But this specific language (certainly not a bad idea) had no bearing on the court's ruling, which was based strictly o

n contractual interpretation; this was not a true "yield maintenance" case where the validity or enforceability of such a clause in general was questioned. For years, institutional lenders such as insurance companies have used "yield maintenance" clauses to calculate prepayment premiums, and such clauses are considered the industry norm.

See, e.g., Richard F. Casher, Prepayment Premiums: Hidden Lake is a Gem, 19-9 ABI J. 1 (Nov. 1, 2000):

A yield-maintenance clause typically assumes that the prepayment premium and the prepaid principal will be invested in U.S. Treasury securities (Treasuries) that will mature at the same time as the prepaid loan and that the dollars so invested will return the same yield that the insurance company would have realized had its loan not been prepaid. Treasuries are used as the reinvestment norm because there exists no standard commercial mortgage loan rate, given the uniqueness of each commercial loan and the inherent difficulty (if not impossibility) of identifying an identical or similar loan; in contrast, the market for treasuries is deep and highly liquid.

See also Restatement (Third) of Property: Mortgages 6.2 comment a (1997):

“The primary purpose of [prepayment] clauses is to protect the mortgagee against the loss of a favorable interest yield . . . . Prepayment may also result in further losses, such as the administrative and legal costs of making a new loan . . . and in some cases additional tax liability.”

The Cornerstone case (at least at the trial level) once again, as with the other decisions cited above, clearly illustrates the importance of clarity in the drafting of a mortgage prepayment provision, and in the Cornerstone case it would appear the lenders (and their counsel) did it right. The borrower had contended that it was overcharged by $2,260,000 based on the defendant's calculation (the total prepayment amount paid to Cornerstone, pursuant to Wells Fargo's calculation, was $20,621,812). The court noted in its ruling that there was no ambiguity and therefore no need to examine parol evidence (although the court in the BKCAP case described above held otherwise based on the facts of the case). See also Friedman v. LaSalle Nat. Bank, 2004 WL 937304 (Ohio App. 11 Dist., April 26, 2004), at *3 ("[t]he prepayment provision is clear on its face and unambiguous. Therefore we will not consider the parol evidence [the borrower] advances")). It is almost impossible to overemphasize t

he fact that the mortgage prepayment provision should be carefully, clearly, and comprehensively drafted so that its meaning is clear and there is no ambiguity that may open the door to a challenge by a clever borrower. Most of the recent cases dealing with the enforceability of prepayment premiums in commercial loans deal with interpretation of the contractual language, not the validity of yield-maintenance provisions in general. The BKCAP case (supra) notwithstanding, the general rule is that any ambiguity will be construed by a court in the borrower's favor when the lender has drafted the loan documents. See, e.g., Littlejohn v. Parrish, supra Comment No. 4,, 163 Ohio App. at 463-64.

Reporter's Comment No. 7: When it comes to the enforceability of prepayment premiums, language does matter!

The Reporter for this item was Jack Murray of the First American Title Insurance Chicago office.

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