Daily Development for Wednesday, August 22, 2007
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

MORTGAGES; PREPAYMENT; YIELD MAINTENANCE; FEDERAL FUNDS RATE:  River East reversed!!  Whether Illinois would treat a yield maintenance prepayment provision as liquidated damages or as optional performance, the use of federal funds as the index to establish the hypothetical return on the invested prepaid sums is not a penalty and is enforceable.

River East Plaza, L.L.C. v. The Variable Annuity Life Insurance Company, No. 06-3856 (7th Cir. 8/22/07)

This widely watched (and feared) case was the subject of the DIRT DD for 10/03/06.  The federal district court had held a relatively standard yield maintenance clause in a commercial mortgage was unenforceable as a penalty because it used a hypothetical investment in Treasury obligations to determine the return that the lender would be able to get with the prepaid loan proceeds, requiring the borrower to pay the present value between the yield on that hypothetical investment and the projected return on the prepaid note had it continued to be paid as originally scheduled to maturity.

The trial court had first concluded that Illinois law would view such a provision as a liquidated damages clause, which would be valid only if it constituted a reasonable attempt by the parties to estimate the probably loss to the lender as a consequence of the prepayment.  The court then conclude that the use of the Treasury index made the computation under the yield maintenance clause unreasonable, because a Treasury investment is much safer than any mortgage loan and the lender would always be “overcompensated” by using such an index as opposed to looking at its hypothetical return should it make a real estate investment similar to that involved in the prepaid loan.

The appeals court, for purposes of analysis, accepted the trial court’s conclusion that Illinois would use liquidate damages analysis to approach a prepayment clause.  It noted that there was no relevant Illinois case so holding, and that in many jurisdictions [in fact, most] such provisions are treated as setting forth an alternative form of performance, and not as a response to a “default” at all.  The court also carefully distinguished both cases involving prepayment provisions calling for the payment of a premium upon acceleration and also bankruptcy cases.  It said nothing, however, that would suggest that it would find the use of Treasuries in a yield maintenance provision in either case to be unenforceable or unreasonable.  In fact, in the case of acceleration - in which the use of a liquidated damages analysis is always appropriate - this opinion will certainly help lenders.

The court took a somewhat different take in the analysis of a liquidated damages provision.  Analyzing Illinois law, it appeared to view the analysis of whether the estimated damages actually corresponded to the probable damages to be suffered from breach as only a step to the ultimate conclusion of whether the provision in question operated as a penalty.  In other words, the primary focus on the court is whether the clause in question serves a “neutral” purpose of compensation or an inappropriate purpose in threatening a party with undue reprisal in the event of a breach.

Looked at in this way, the court stated, the clause in question could not possibly be viewed as a threat designed to force the borrower to pay over time, rather than to prepay.  It noted that if the borrower in this case had paid the note off over its term, the borrower would have paid over $13 million in interest.  As a consequence of paying early, the borrower avoided paying that interest but paid a “penalty” - the prepayment premium - of around $3.9 million.  Of course, the value of paying $13 over time, brought down to the present day, may be somewhat less than $3.9 million, depending upon what indeces are used.  But the court noted River East got a bargain by avoiding paying the interest.  In any event, the court concluded “[t]his [prepayment provision] hardly seems to be a clause whose ‘sole purpose is to secure performance of the contract.’” [quoting from Illinois precedent.] In fact, the court posited, the borrower gets a benefit by having any credit against its interest o
bligation at all.  Compelling the lender to use the Treasury index to compute a credit against the Borrower’s obligation to pay interest, in the court’s view of the case, actually hurts the position of the Lender and helps the Borrower.

The court, quite properly, went on to comment that a liquidated damages approach is not necessarily the proper analysis in a case like this, where the borrower is paying voluntarily, and not as a consequence of a acceleration following default.  The court as noted, simply accepted the trial court’s premise that liquidated damages analysis was appropriate and then reversed the trial court’s conclusion even with such premise.

In a minor, but possible significant coda, the court noted that there was a comparatively tine disagreement between the parties concerning the precise amount of the prepayment premium.  The lender had first demanded an erroneously high premium - more than an million dollars overstated.  The borrower paid under protest.  During discovery the lender’s error was uncovered, and the lender reimbursed the borrower for the overpayment, with interest.  But the parties disputed whether in fact the reimbursement was $1600 too much.  The court remanded on this issue, as it said that it did not understand fully enough the approach taken by the trial court in resolving this dispute.  Ironically, this kept the court from ruling on the entire issue of attorney’s fees, which of course is likely to be a rather large number here.  If the borrower should prevail on the refund dispute, the court noted, the trial court might treat the attorney’s fee issue differently than if the lender prevailed.  But
 it is unlikely that this case ever will again reach the trial court, as the attorneys in the case likely would generate far more than $1600 in attorney’s fees in prehearing phone calls.  It’s better at this point to settle the remaining difference.

Comment: This case has ramifications for disputed prepayment premium claims all over America.  It also puts into question probably thousands of attorney opinions approving the enforceability of prepayment premium provisions.  (Borrower’s counsel refused to opine as to enforceability here in the event the court elected to treat the provision as a possible penalty.)  But, like a number of other high profile cases it really should have been expected.  Remember de la Cuesta - the predictable U.S. Supreme Court overruling of Wellenkamp?  Even Kelo, the editor believes, was a predictable result, although not necessarily a predictable analysis.  In short - emergency’s over and all the securitized commercial mortgage lawyers can go back to afternoon squash games.  

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