Daily Development for Friday, October 10, 2000

By: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
randolphp@umkc.edu

MORTGAGES; PREPAYMENT; "YIELD MAINTENANCE;" DEFEASANCE: Terms of "defeasance clause" invoked by prepayment, permitting to lender obtain substitute investment of the same grade as mortgage and to charge borrower the difference between the cost of that investment and the prepayment amount, are subject to judicial review on the basis of "good faith and fair dealing," and court will determine whether lender was fair in grading both the original mortgage and the substitute investment.

LaSalle National Bank v. Metropolitan Life Insurance Co., No. 98 CH 3566 (Ill Cir. Ct., 10/30/00).

Judge Ellis, in this 112page opinion, ruled in favor of Merchandise Mart Owners, L.L.C. ("Mart Owners"), 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 MetLife 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 comes after a lengthy bench trial that generated more than 5700 pages of testimony.

The Mart is a unique, 3.7 millionsquarefoot structure in downtown Chicago that provides space for the showroom industry, including contract furnishings, home furnishings, floor covering and giftware, as well as casual furniture. It also has some office and retail tenants. Kennedy family patriarch Joseph P. Kennedy bought the Merchandise Mart in 1945, for $13 million. The plaintiff in this case, LaSalle National Bank, was the holder of legal title to the property, not personally but solely as trustee under an Illinois land trust. The entire beneficial interest was held by Mart Owners, a limited partnership in which the limited partners were trustees of testamentary trusts of the Kennedy family.

The dispute arose out of the prepayment provision in MetLife's 1987 20year 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 was made.

According to the court, "Because high quality security instruments typically carry low yields, a determination that the 1987 Loan was of high quality would enable MetLife to claim a substantial prepayment penalty because of the gap between the Note's interest rate of 9.75% and the lower rate payable on a high quality substitute security instrument."

Apparently the parties settled on this unusual language because they could not reach agreement, during loan negotiations, on a more exact benchmark. As Judge Reid notes, on page 4 of the opinion, "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."

Not surprisingly, MetLife argued that the mortgage, at the time it was made, was comparable in investment quality to an "A" rated corporate bond. MetLife's attorneys produced the original loan proposal submitted by Mart Owners, which referred to the Mart as the "preeminent market center building in the world" and which praised the internal design and construction of the Mart as "superior" and as having a projected life far greater than most buildings. The proposal also described the thencurrent management, operation and maintenance of the Mart as exceeding the qualitative and quantitative scope of services usually provided to commercial real estate projects. MetLife also noted that Mart Owners, in their own internal evaluations, valued the Mart at more than $400 million.

On the other hand, Mart Owners argued that the loan was on a substandard property that, at the time it was made, did not generate sufficient income to cover the required debt service and necessitated a $60 million escrowed holdback of the loan proceeds by MetLife, to be distributed only upon the achievement of a 1:2 debtservicecoverage ratio and the performance of $30 million of rehabilitation work. (Mart Owners estimated that the total cost of necessary renovations would be $100 million). Mart Owners further argued that the building was losing office, retail and showroom tenants and that the real estate market at the time was severely depressed. Mart Owners produced a 1998 statement by a MetLife executive, which stated that the Mart was a "barn of a building" that had "little or no use in the 21st Century." Mart Owners argued also not surprisingly that as a result of the foregoing, the benchmark for determining the prepayment fee should be the lowestrated bonds (in effect, "junk bonds"), which carried a rate higher than the 9.75% mortgage rate; therefore, according to Mart Owners, no prepayment fee was due at the time of the sale to Vornado.

The court's ruling focused solely on the following issues: (1) MetLife's "good faith" in determining the "investment quality of the Note on the date hereof" (i.e., April 16, 1987); (2) MetLife's "good faith" in selecting a "security instrument" as the basis for the imposition of a prepayment fee, if any (which instrument must be available for "purchase" my MetLife); and (3) MetLife's "good faith" assessment of whether the security instrument it selected was of "comparable" investment quality to that of the 1987 loan.

The court cited Illinois case law for the proposition that the duty of good faith prevented a party from making an "arbitrary determination." The court stressed that MetLife was required to determine the investment quality of a comparable instrument "on the date it closed," and that this "determination should have been based upon what MetLife then knew or discovered through inquiry to be the investment quality of the 1987 loan."

In the court's opinion, MetLife acted arbitrarily and unreasonably where, as occurred in this case, "MetLife knew it had as security an aging property that was in need of over $100 million in rehabilitation and serious construction (40% of the $250 million loan); where the current cash flow on a nonrecourse loan was below the level needed to meet the debt service; where the 'truthinlending' effective rate of the loan was raised from 9.75% to 12.82% by the failure to fund $60 million at the closing and only funding $190 million with the payments due on the full face amount of the $250 million loan; and where the 'value' of the property was based on post construction rentup assumptions by the loan underwriters at MetLife that were not true as of the date of closing. As of April 16, 1987, this was a high risk hybrid construction/end loan that could not be found to be 'investment grade' by any objective standards."

According to the court, MetLife had breached the contract by "failing to base its prepayment penalty demand on the investment quality of the 1987 loan 'on the date hereof,'" i.e., it had based its analysis on projections that assumed a fully rehabilitated and retenanted property. The court found that "the failure to perform express contractual duties is a breach, regardless of whether the party acts in good faith (citation omitted)."

According to the court, MetLife also materially breached the contract by selecting an index instead of a "security instrument" that was available for "purchase," and further breached the contract by failing to act in good faith in assessing whether the security instrument to be selected was of "comparable" investment quality to the original note. Therefore, the court held, "MetLife's conduct, in adopting an approach doomed to failure and in rejecting available alternative investments, failed all three of the alternative standards of good faith. That breach by MetLife was material."

Furthermore, the court held, MetLife was not entitled to recovery under equitable principles because it "did not suffer any injury in connection with prepayment" because of the higher rates available on alternative instruments at the time of prepayment.

The court determined that "a proper objective approach to this problem would have been to assign a value to all of the issues raised and equate those issues to corporate bonds." The court then set forth, in a chart, the "value" that it assigned to each of the factors that it believed, as the result of the evidence at trial, were relevant as to the value of the property at the time of the loan, i.e., the 67.6% loantovalue ratio; the strength of the borrower and management; the constructioncost component of the loan; the .94 debtservicecoverage ratio; and the "effective" 12.82% interest rate as the result of the escrowed and heldback proceeds. The chart created by the court correlated each of these value factors to a rating based on bond ratings from AAA (the highest) to C (the lowest).

According to the court, the "average" rating of the 1987 MetLife loan at the time it was made was 5.2, which correlated to a B+ bond rating under the chart. The court stated that therefore the loan should be the equivalent of this rating, "assuming that all of these issues are of equal weight in the valuation of the loan. The evidence points to that conclusion."

The court stated that it was entitled to make alternative findings when the "interest of judicial economy and expediency dictate." Based on this rationale, the court then held that even if the prepayment clause were ambiguous, the provision had the meaning understood by Mart Owners and not the meaning argued by MetLife, because "MetLife knew or had reason to know that Mart Owners attached that meaning to the provision, and Mart Owners did not know or have reason to know that MetLife attached a different meaning to the provision." The court stated that "MetLife failed all three of the alternative standards for good faith with regard to determining the investment quality of the Note, including the requirement that MetLife not act 'in a manner inconsistent with the reasonable expectations of the parties.'" The court further found that "Mart Owners did not reasonably expect that MetLife would select an index of unspecified bonds rather than bonds with a definite 'security instrument' as the alternate security."

Based on the foregoing reasoning, the court ordered that all escrowed funds, with interest thereon, be returned to Mart Owners. Judge Reid required MetLife to post a $20 million bond appeal bond. MetLife is currently reviewing its options, and will likely appeal this decision.

Reporter's Comment 1: This is an unusual and somewhat puzzling decision, in my humble estimation. For 95 pages of the opinion, I believed that Judge Reid was going to rule for MetLife. Then, abruptly, he created his own subjective determination of what he thinks "good faith" is (or ought to be), and ruled down the line for Mart Owners.

Reporter's Comment 2: The good news [for lenders]: This is not really a "prepayment" decision at all, and should have no effect on the validity and enforceability of standard yieldmaintenance mortgage provisions. As mentioned above, Judge Reid stated in the opinion that "The evidence at trial failed to reveal any other loan with a prepayment penalty provision similar to the one at issue in this case." True to his word, not one prepayment decision is cited in the entire opinion.

Reporter's Comment 3: . The moral of this 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 secondguess its decisions in order to reach an "equitable" result. Reporter's Comment 4:. It is interesting that in the body of the opinion, the court goes to great lengths to describe the considered, laborious process that MetLife went through to arrive at the "A" bond reference rate and then, in the last 17 pages of the opinion, the court abruptly proceeds to substitute its own version of a "good faith" analysis by creating a chart "assign[ing] a value to all of the issues raised and equat[ing] those values to corporate bonds." Note that (as the court readily admits) none of these factors is weighted: each is treated as being of equal importance. Talk about hindsight! It is highly unlikely that any sophisticated lender would treat each of the factors described by the court as being of equal weight.

Reporter's Comment 5:. Perhaps the strangest statement by the court is the following, which appears on page 108 of the opinion:

"MetLife 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."

Huh?? Now the court apparently is telling MetLife what they REALLY were thinking instead of what they thought they were thinking. This is Alice in Wonderland stuff.

Reporter's Comment 6:. 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. Mart Owners had even hired a consultant who would be entitled to two percent of any reduction he could achieve in the amount of the prepayment premium to be paid by Mart Owners. When MetLife first advised this consultant, in April 1997, that it had preliminarily selected A to BBB bonds as the comparable investment, the consultant did not object or complain and, as the court noted in its opinion, "At no time prior to January 1998 did Mart Owners or its representatives object to the fee as described by MetLife or claim that no fee was due, or demand an explanation as to how the comparable instrument was selected." In connection with the sale of the Mart in 1998 to Vornado, Vornado had agreed to pay 50% of any prepayment fee incurred by Mart Owners up to $10 million. In addition, Mart Owners could direct the payment of their share of the prepayment fee out of the $181 million cash component of the sale transaction.

The Reporter for this case was Jack Murray of First American Title Insurance Company Chicago.

Editor's Comment 1: The editor is limited to commenting only upon Jack's report of this unpublished decision, but nevertheless a few comments appear to be in order. First, although Jack correctly notes that the prepayment provision is somewhat unusual in today's market, the concept of a "defeasance" clause, which is effectively what MetLife did here, as an alternative to a prepayment right has been a staple of the government bond marketplace for at least a half century. The editor has already heard some talk in securitization circles of using defeasance as the industry standard for dealing with prepayment issues, so the opinion has greater significance than might first appear.

Editor's Comment 2: The editor is far less troubled than Jack with the notion that, where an ambiguity exists, and party A knows that the party B is relying on a given construction, but the party B does not know that there is a possible alternative construction, then party A, the party with the knowledge and the ability to avoid unjust reliance, has a duty to clarify the ambiguity, and is punished for its failure to do so by living with the construction upon which party B relied. Honoring good faith reliance and punishing inequitable delay in asserting one's position are common equitable concepts, and not so far fetched.

Editor's Comment 3: Although we may not agree with the ultimate outcome, the editor must confess that a determination of "equivalent value," without clear standards being established, necessarily must be subject to judicial scrutiny for reasonableness and fairness. Otherwise, the lender could do anything it wanted. Lenders may prefer the latter result, but it ain't gonna happen.

Editor's Comment 4: On the other hand, the editor is foursquare in Jack's camp on Jack's main point, that commercial law ought not to rely upon concepts of "good faith" as the measure of commercial responsibilities, because reliance upon this concept invites the courts to second guess the business judgments of the parties, and most courts demonstrably are incapable of doing that in a way that even objective observers within the business community find acceptable.

The editor notes that reliance upon good faith judgment and equitable principles of contract relationships is quite common in Civil Law countries. The editor lacks exhaustive knowledge of judicial selection and training in such countries, but the fact that judging in such countries is a career, rather than a reward for successful trial practitioners (largely tort and criminal specialists), suggests that judges in such countries who deal with business disputes perhaps have a bit more of an orientation toward the thinking of parties involved in business transactions than the typical trial judge in an American court.

Therefore, unlike the Civil Law system, it would appear to be wise for American transactions lawyers to supply in the contracts their own benchmarks of reasonable behavior wherever possible.

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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