Daily Development for Monday, October 3, 2006
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; PREPAYMENT PREMIUM; “PENALTY” ANALYSIS: Federal judge concludes that standard yield maintenance clause using treasury rate as discount is invalid as a penalty in Illinois.

River East Plaza, LLC v. The Variable Annuity Life Company, 2006 WL 278243  (N.D. Ill. 9/22/06)

This case, obviously, is just in.  The facts report a very common scenario that has happened around the country in the last few years, and likely will continue to happen, albeit with not quite the same “bite” as federal interest rates creep up.

Borrower entered into a $13 million, 20 year mortgage loan (amortized at a 28 year schedule, with a balloon) in 1999.  The lender required a provision for a prepayment “fee” that required the borrower to pay, in connection with any prepayment, the greater of one percent of the then outstanding balance or, essentially, the present value of the  interest payable for balance of  the original loan term less what the lender could earn by reinvesting at the treasury rate prevailing at time of prepayment for the same term.  The borrower was required to give 60 days notice prior to such prepayment.

Borrower had a chance to resell the property three years later, when $12.3 million of the loan was still outstanding.  The buyer required that the loan be released, and, as there was apparently no defeasance clause, this meant the mortgage had to be paid.  But treasury rates had plummeted, and continued to plummet as the parties discussed the deal.  At the time of the sale, the estimated prepayment fee calculation was $3.8 million.  The borrower balked, and discussions ensued, and the number just got bigger and bigger as treasuries dropped.  Ultimately, the lender demanded, and the borrower paid, in protest, a prepayment fee of $4.76 million.  (This was erroneously overstated, and a reduced claim was stipulated in the trial.)

The court found that Illinois, unlike most other states, analyzes prepayment premiums as a liquidated damages issue, rather than just a fee for a choice of an alternate payment schedule.  In fact, some Illinois mortgage experts dispute this interpretation of Illinois law.  Anticipating the liquidated damages construction, counsel for the lender refused to opine at the time of the loan that the prepayment language was enforceable, expressing the view to the other side that she regarded the fee as an unenforceable penalty.

The trial judge, relying on bankruptcy opinions in Kansas and Missouri (both of which have been generally discredited in their own jurisdictions) concluded that the prepayment fee was a penalty, and order a refund of the fee, less the one percent that the alternative fee calculation permitted the lender.  Of course, the attorney’s fees also will be a big number.

The court had before it, but did not cite, the federal district court opinion in In re CP Holdings, Inc., 2005 U.S. Dist. LEXIS 24461 (W.D. Mo. 9/30/2005), the DIRT DD for 11/05/05, affirming a bankruptcy court ruling in which the editor testified.  (The prepayment - due to acceleration on default - was pre-filing, and state law liquidated damages analysis was used in that case.) 

The court found that the lender should have fixed the hypothetical reinvestment rate at the same spread over treasuries that existed at the time that the loan was made.  It pointed out that the lender did in fact reinvest monies in the same amount at or above that rate shortly after the prepayment. 

Bite-your-tongue department: The Director or Mortgage Loans for the lender’s parent is quoted by the court as testifying that the prepayment provision was “very, very punitive,” serving only to punish nonperformance.”  The court dryly notes that it drew an adverse inference from the lender’s failure to recall this witness to explain his remarks when it presented its case.

Comment 1:  The editor believes, although the opinion doesn’t say so, that this loan was securitized after it was made.  In the CP Holdings case, the editor emphasized that repayment schedule, in addition to overall interest return, was critical, and that it would be a complex and difficult process to replace a prepaid loan with a set of investments that performed in the same way.  If there is not a perfect match, some of the securitized investors could be wiped out completely.

Further, it is always difficult to project what the mortgage market will be in the future.  A liquidated damages calculation doesn’t have to be perfect, just a good try.  Using the treasury rate uses a stable rate that gives some protection to the lender against the uncertain future.

Even a nonsecuritized loan is faced with uncertainty as to whether other real estate loans in fact present the same risks as the one prepaid.  This was a nonrecourse loan on a building that became a Costco.  Haven’t we seen a lot of these “big boxes” empty around the country - former hardware superstores and the like?  Each location presents different risks.  Why isn’t the lender entitled to some “play” in computing the risk of replacing the loan?

Comment 2: Some jurisdictions take a “second look” at the factors influencing the reasonableness of the liquidated damages computation at the time of default.  This is a bad idea in general, but Illinois, the editor is informed, doesn’t do that.  So, although the lender may have reaped a windfall due to the index chosen when the loan was prepaid very early in a low interest market, this formula was going to operate long term, and likely wouldn’t always have been so generous.

Comment 3: The question now for this lender, and significant for many others, is whether this decision - clearly out of step with what most lawyers now believe the law to be - should be appealed to the Seventh Circuit, inviting a possibly more authoritative affirmance or saving the day with a ringing reversal. 

Comment 4:  My own thought , when I heard the number - more than 30% of the loan balance, was that settlement was better than litigation.    It is difficult to convince a trial court judge that such a large number is not punitive, no matter how much one talks about the uncertainties of money markets over a projected 20 year loan life.  But maybe settlement just wasn’t an available option.  In fact, the lender had miscalculated the premium (its way) and was demanding an even higher amount than the court found the formula produced until after the suit was filed.  But my thoughts were “after the fact” analysis.  When you really think the law is on your side, even if the facts aren’t, it’s hard to tell your client to walk away from a $3.8 million claim.

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