We begin with the notion, well established (at least until recently) that the "default" interpretation of a lease agreement - that understanding that the courts will infer from the existence of the agreement unless the parties provide otherwise - is that loans cannot be prepaid. The lender is entitled to the interest for the contracted life of the loan. The concept dates back at least to the 1845 English decision in Brown v. Cole, 14 L.J. (N.S.) Ch. 167, Chancery. See also Debra P. Stark, New Developments in Enforcing Prepayment Charges After an Acceleration of a Mortgage Loan, Prepayment and Yield Maintenance in Bankruptcy, American Bar Association, Section of Real Property, Probate and Trust Law, Atlanta, Georgia, August 12, 1991, pp. 5-7; Alexander, Mortgage Prepayment: The Trial of Common Sense, 72 Cornell L. Rev. 288, 306 (1987). This is still the majority rule, but has recently come under attack.

Perhaps the leading common law authority to reject the perfect tender in time rule is the Pennsylvania Supreme Court in Mahoney v. Furches, 468 A. 2d 458, 461 (Pa. 1983), which held: "where a mortgage note is silent as to the right of prepayment, there arises a presumption that the debt may be prepaid." Also see, Hatcher v. Rose, 407 S.E.2d 172 (N.C. 19910; Spillman v. Spillman, 509 So.2d 1207 (La. 1987). More recently, the new Restatement of Mortgages has recommended rejection of the rule. Restatement (Third) of Property: Mortgages § 6.1 (1997).

Other courts, even taking into account these rulings, have continued to adhere to the established common law, opining that the important values of predictability and certainty in market regulation are best served by adhering to clear, established common law rules. See, e.g. Promenade Towers Mutual Housing Corp. v. Metropolitan Life Ins. Co., 324 Md. 588, 592-94, 597 A.2d 1377, 1379-80 (1991) ("It is clear that the majority rule in this country is, and for a long time has been, that, absent special agreement, the mortgagor in an unregulated transaction who promises to repay the loan, in installments at specified times or at a specified date, does not have a right to compel the creditor to accept prepayment"); Ridgley v. Topa Thrift & Loan Ass'n, 62 Cal. Rptr. 2d 309, 318 (citing Gutzi Associates v. Switzer, 215 Cal. App 3d 1636, 1644, 264 Cal. Rptr. 538 (1989).

To many, especially those unschooled in the lender’s business objectives, this rule appears counterintuitive. They reason that a lender ought to prefer to be paid sooner than later, and that in any event a lender can always relend money that is prepaid. Such thinking fails to take into account that replacing mortgage loans involves staffing and infrastructure that simply collecting on existing loans does not, and that, in the view of the lender, the simpler the business plan, the better. Added complexity leads to hidden costs that are difficult to estimate and therefore difficult to recover through pricing new loans.

In any event, courts hostile to the "perfect tender in time" rule have read language in mortgage loan instruments to permit prepayment even where the language, at least from the lender’s standpoint, is somewhat vague on the point. See, e.g., Latimer v. Grundy County National Bank, 239 Ill. App. 3d 1000, 1002 (Ill. App. Ct. 1993) (the phrase "if not sooner paid" contained in the contract indicated an intent that the borrower could prepay); Garner v. Sisson Properties, 198 Ga. 203, 31 S.E. 2d 400 (1944) (prepayment permitted where the contract provided for payment "on or before" a date certain); Schotte v. Meredith, 138 Pa. 165, 20 A. 936 (1890) (permitting prepayment where the contract provided for payment "within" a certain period of time). Compare: Scalese v. Wong, 84 Cal.App. 4th 863, 101 Cal.Rptr. 2d 40 (2000), review denied sub nom Pegorare v. Wong, 2001 Cal. LEXIS 27 (Cal. Sup.Ct., Jan. 10, 2001), where the note stated both that the balance could be repaid "on or before" the due date and that borrowers could not pay the balance on the note "at any time prior to its due date." The court took parole evidence to clarify the ambiguity and concluded that no prepayment was permitted.) Compare: Cimarron West Properties v. Lincoln Loan Co., 123 Or.App. 614, 860 P.2d 871 (1993) ( "on or before" does not authorize prepayment).

As the general rule is that prepayment is not an available option unless the parties so provide, it is not surprising that most courts have had little difficulty upholding the validity of provisions that provide simply that the mortgagor is prohibited from prepaying the loan during an identified period at the beginning of the loan term. Such provisions are called "lock in clauses." See, e.g. Prudential Insurance Co. v. Rand & Reed Powers Partnership, 141 F.3d 834 (8th Cir.1998); Trident Center v. Connecticut Gen. Life Ins. Co., 847 F.2d 564 (9th Cir.1988). In Tyler v. Equitable Life Assur. Soc., 512 So.2d 55 (Ala. 1987), the court held that a lender may exact a fee in exchange for waiving the "lock in" period, but some bankruptcy decisions have held otherwise, since the lender did not provide specifically for a fee in the documents themselves. See, e.g., In re Vest Associates, 217 B.R. 696 (Bankr.S.D.N.Y.1998); Continental Securities Corp. v. Shenandoah Nursing Home Partnership, 188 B.R. 205 (W.D.Va.1995).

Some legal scholars, who also have argued against the "perfect tender in time" rule, also argue that courts should set aside these "lock in provisions" when prepayment would be economically efficient. Alexander, Mortgage Prepayment: The Trial of Common Sense, 72 Corn.L.Rev. 288 (1987). But the Restatement of Mortgages would honor "lock in" provisions because in this case the parties have expressly agreed upon the issue, and the business deal should be honored, even though the Restatement would view the situation differently if the parties had not addressed prepayment at all.

Note that a "lock in" clause combined with a prohibition on transfer may amount to an unlawful restraint on alienation. See Terry v. Born, 24 Wash.App. 652, 604 P.2d 504 (1979). A covenant not to transfer (as opposed to a due on sale clause) is rare in mortgages, but does appear in alternative instruments, such as installment land contracts. A number of cases have acknowledged the argument that such clauses constitute unlawful restraints, but have found it inapplicable because the lender had a duty to consent reasonably to a proposed transfer. Carey v. Lincoln Loan Co., 165 Or.App. 657, 998 P.2d 724 (2000). But compare East Bay Limited Partnership v. American Gen. Life & Acc. Ins. Co., 744 F.Supp. 1118 (M.D.Fla. 1990) (combination of prohibitions on transfer and prepayment upheld, but with no discussion of restraint on alienation).

Professor Lefcoe has argued, however, that courts will honor "lock in" provisions, but only by an award of damages, not by specific performance. G. Lefcoe, Prepayment Disincentives in Securitized Commercial Loans, 449 PLI/Real 237, 246 (1999), although he cites as authority only a 1993 law review article by Professor Whitman. (Lefcoe, by the way, refers to the provision as a "lockout," although Nelson and Whitman refer to the same concept as "lock in."

Professor Lefcoe argues that lock in clauses are potentially disastrous for borrowers, and, in light of the fact that lenders, arguably, will be compensated only by damages, probably are less preferable than defeasance provisions (discussed below) or yield maintenance clauses that might be upheld (at least outside of bankruptcy) as liquidated damages clauses even when favorable to the lender.

Lenders and borrowers generally are not content with abiding by the concept of "perfect payment in time," and the vast majority of long term loan arrangements, of course, do permit prepayment, but in many cases the documents provide that the borrower must pay a premium fee in connection with such prepayment (borrowers call such fee a "penalty").

Again, until recently, most courts have viewed the contractual provisions for prepayment with a premium the statement of an option right, with a price. At least where the prepayment is a voluntary act on the part of the borrower, most common law courts have accepted the notion that such a provision is neither a contractual penalty nor a liquidated damages provision nor an interest charge (which could lead to usury problems. It is nothing more or less than an optional form of performance. See. E.g. Boyd v. Life Ins. Co. of Southwest, 546 S.W.2d 132 (Tex. Civ. App. 1977) (no usury issue - simply an optional payment provision); Meyers v. Home Savings & Loan Assoc., 113 Cal. Rptr. 358 (Cal. App. 1974) (no liquidated damages analysis required because an optional form of payment).

But, increasingly, common law courts are evaluating the reasonableness of the charge before deciding whether to uphold it. This indicates that these courts are not accepting its characterization as a simple cost for alternative performance. In a leading case, Lazzereschi Investment Co., v. San Francisco Federal S&L Assoc., 99 Cal. Rptr. 417 (Cal. App. 1971), the court first characterized the prepayment fee as a charge for an alternative method of payment, and therefore found it not to be a penalty. In evaluating the question of whether the charge amounted to a restraint on alienation, however, the court resorted to the now famous approach of California courts of measuring the "reasonableness of the restriction" against the "degree of restraint." It found that the prepayment charge in the case was reasonable, but the injecting of the reasonableness analysis into the issue at all makes the case a watershed opinion.

In their fine treatise on Real Estate Finance Law 3d. Ed. (West 1994) (Practitioner’s Treatise) at 484 et seq. Grant Nelson and Dale Whitman conclude that prepayment charges ought to be evaluated as a form of damages for breach of a contractual agreement not to prepay. If the amount of the penalty can satisfy the test for liquidated damages, they conclude, it should be upheld. Also see Alexander, Mortgage Prepayment: The Trial of Common Sense, 72 Cornell L. Rev. 288, 306 (1987). Dale Whitman, however, believes that state courts should be quite generous in evaluating the validity of these liquidated damages provisions. At the time the prepayment premium is negotiated, the actual "damage" that will be suffered by the lender at the time of the hypothetical prepayment is impossible to gauge accurately, and consequently almost any attempt by the parties, engaged in head to head bargaining, ought to be accepted by the court as "reasonable." See Whitman, Mortgage Prepayment Clauses: An Economic and Legal Analysis, 40 U.C.L.A.L.Rev. 851 (1993).

Notwithstanding these comments, legal analysts should keep in mind that the fundamental approach reflected in a number of prepayment clause calculations is simply a price for an option, and not an attempt to liquidate damages. Any prepayment premium that consists of a fixed sum of money clearly is not an attempt to liquidate damages for prepayment of an amortizing loan, since the degree of injury to the lender is not fixed, but will decline as the principal amount declines over time.

A prepayment premium that is measured by a certain period of interest - say six month’s or one year’s interest - on the amount of the prepayment is considerably safer from attack, but still the argument is far from perfect. Such a computation does take into account any reductions brought about by amortization, but does not reflect the fact that the lender’s potential "loss" will be affected by market conditions at the time of the loan. When the prepayment occurs for the purpose of refinancing, of course the lender will suffer some loss since typically the market for money is lower than rate on the note, or the borrower would have no incentive to refinance. The extra interest "kicker" represented by the prepayment premium reflects the fact that the lender will have some time delay before being able to place that loan. But if the prepayment occurs in connection with some other event, such as the sale of the property or for some involuntary payment, as described below, then a court may conclude that the lender ought to be able to relend at the same or higher return, even taking the cost of replacing the loan into account. Therefore, the court could find that a formula which could produce such a windfall for the lender is not a reasonable attempt to liquidate damages.

As the following discussion indicates, lenders increasingly are phrasing prepayment premium clauses so that they will apply to involuntary payment situations. This not only increases the liklihood that courts will analyze the prepayment premium arrangements as liquidated damages clauses, but also decreases the liklihood that courts will conclude that the more traditional prepayment premium computations, described above, will satisfy the liquidated damages test. Such reasoning is perhaps what is driving lenders to move toward more sophisticated "yield maintenance" premium computations, as described below.

In probably the majority of prepayment situations, the borrower is prepaying the loan because there will be a new mortgage loan replacing it, either in connection with the sale of the property to another or in connection with a refinancing by which the borrower increases the size or decreases the interest rate on the secured loan. These prepayments are voluntary acts on the part of the borrower, and the analysis set forth above, evaluating prepayment premiums as an alternative form of performance, makes some sense.

But one problem that has dogged the judicial analysis in this area is the insistence of many mortgage lenders to exact prepayment penalties when it is clear that the borrower is forced to prepay the loan due to circumstances that are not of the borrower’s choosing. In Lazzareschi, supra, the borrower claimed that the prepayment was made necessary by the liquidation of the real property security caused by a divorce settlement. The more common situation, however, are those where the borrower must prepay because of an insured injury to the property that cannot reasonably be repaired (or which the lender refuses to permit to be repaired with insurance proceeds) or because of a total or partial condemnation of the property by eminent domain (where, again the lender will not permit the property to be restored by use of condemnation proceeds.)

Of course, the first question to be addressed in such cases is whether the parties contemplated that the prepayment premium be payable when the prepayment was not due to a voluntary decision by the borrower. Where the language of the prepayment clause does not specifically address the situation of an insured casualty or an eminent domain award, the usual approach is to conclude that the parties did not intend that the prepayment premium requirement would attach. Chestnut Corp. v. Bankers Bond & Mortgage Col, 149 A.2d 48 (Pa. 1959) (insured damage to property); DeKalb County v. United Family Ins. Co., 219 S.E.2d 7078 (Ga. 1975) (eminent domain); Silverman v. State, 370 N.Y.S. 2d 234 (App. Div. 1976) (semble).

But lenders have become more sophisticated in recent years, and borrowers can expect that commercial lenders will include both application of insurance proceeds and application of eminent domain proceeds as events triggering application of the prepayment premium, as well as any other "involuntary event" the lender can conceive and describe. Generally speaking, if the parties say it clearly enough in the instruments, courts have had little difficulty accepting the fact that a premium can be charged in such instances, although, not surprisingly, the "reasonableness" of such charges comes under greater scrutiny now that the payment is not a voluntary act of the borrower.

A perhaps more difficult analytic problem arises when the prepayment is the result of an acceleration of the loan balance in response to a default. Here, of course, the prepayment still is involuntary on the part of the borrower, and there is the additional factor that the acceleration was a voluntary act on the part of the lender, and not brought about entirely by circumstances beyond the control of either party. The lender will argue strenuously, of course, that the borrower in fact did not suffer the acceleration involuntarily, but brought it on by the volitional act of defaulting on the mortgage. Whatever the merits of the parties’ arguments, the hard reality is that the vast majority of the decisions have not permitted collection of a prepayment penalty when the documents do not specifically so provide. Here are a few representative cases: Matter of LHD Realty Corp., 726 F.2d 327 (7th Cir.1984);General Mortg. Assoc. v. Campolo Realty & Mortg. Corp., 678 So.2d 431 (Fla.App.1996) ; In re Planvest Equity Income Partners IV, 94 B.R. 644 (Bkrtcy.Ariz.1988); 3C Associates v. IC & LP Realty Co., 137 A.D.2d 439, 524 N.Y.S.2d 701 (1988); Rodgers v. Rainier Natl. Bank, 111 Wash.2d 232, 757 P.2d 976 (1988); George H. Nutman, Inc. v. Aetna Business Credit, Inc., 115 Misc.2d 168, 453 N.Y.S.2d 586 (1982); Kilpatrick v. Germania Life Ins. Co., 183 N.Y. 163, 167, 75 N.E. 1124, 1125 (1905).

Note that if the court concludes that the borrower has defaulted expressly to trigger acceleration and avoid prepayment, it may foil that motive notwithstanding the substantial authority cited above. See, discussion in Eyde Bros. Devel. Co. v. Equitable Life Assur. Soc., 697 F.Supp. 1431 (W.D.Mich.1988); In re LHD Realty Corp., 726 F.2d 327, 331 (7th Cir.1984); Rodgers v. Rainier Nat'l. Bank, 111 Wash.2d 232, 757 P.2d 976 (1988).

Where, however, there was just a threat to accelerate, and the borrower paid off the loan, the prepayment penalty was upheld. Mutual Life Ins. Co. of New York v. Hilander, 403 S.W.2d 260 (Ky. 1966) Similarly, where the lender did accelerate, but rescinded the acceleration, but the borrower still prepaid, the premium was upheld. West Portland Development Co. v. Ward Cook, Inc., 246 Or. 67, 424 P.2d 212 (1967).

The courts have almost uniformly upheld prepayment premiums where the documents provided specifically that they could be enforced upon acceleration. Virginia Housing Devel. Authority v. Fox Run Limited Partnership, ___ Va. ___, 497 S.E.2d (1998); Biancalana v. Fleming, 53 Cal.Rptr.2d 47 (1996); Golden Forest Properties v. Columbia Sav. & Loan Ass'n, 202 Cal.App.3d 193, 248 Cal.Rptr. 316 (1988); Pacific Trust Co. TTEE v. Fidelity Fed. Sav. & Loan Assn., 184 Cal.App.3d 817, 229 Cal.Rptr. 269 (1986) (junior mortgagee must include prepayment fee in amount necessary to redeem senior mortgage). Contra, see Clinton Capital Corp. v. Straeb, 248 N.J.Super. 19, 589 A.2d 1363 (Ch. Div. 1990). See Stark, New Developments in Enforcing Prepayment Charges After an Acceleration of a Mortgage Loan, 26 Real Prop. Prob. & Tr. J. 213 (1991).

The most recent case to illustrate the willingness of the courts to uphold express language permitting charging a prepayment premium upon acceleration involves an interesting twist - the property had been the subject of a civil forfeiture proceeding due to the owner’s alleged use of the proceeds of a criminal enterprise to acquire the property. The lenders accelerated due to nonpayment of the monthly installments at about the same time the government filed its forfeiture claim. The government sold the property at auction, pursuant to federal statutes, and produced a surplus of about $2 million over the accrued principal and interest, but the prepayment penalties exceeded $1.8 million. The lenders were entitled to enforce their mortgages because they were bona fide purchasers of an interest in the property, innocent of any knowledge of the crimes, even though the crimes had occurred before they acquired their interest. The court held that this protection extended as well to prepayment premium provisions, and upheld the right to the premiums pursuant to express language in the instruments. U.S. v. Harris, No. 01a0096p.06, 2001 FED. App. 0096P (6^th Cir. 4/4/01)

In bankruptcy, lenders have an additional concern. They are not only focused on the enforcability of their money claims, but whether the court will treat these claims as secured by the mortgage. Where the existing indebtedness eats up all the available security, and the lender is undersecured, the issue, of course is moot. But where the lender is oversecured, which is often the case with lenders with high priority, the lender will want to claim that if prepayment occurs during bankruptcy it will have a priority claim to collect the prepayment premium set forth in the instruments.

Section 506(b) of the Bankruptcy Code provides that "fees, costs, or charges" are secured by the mortgage only if they are "reasonable." This question of "reasonableness" likely will be treated as a bankruptcy issue independent of whether the fee is collectible as a matter of state law. Some cases have treated the question of "reasonableness" as an independent state law question. See In re Financial Center Associates, 140 B.R. 829 (Bkrtcy.N.Y.1992); In re Skyler Ridge, 80 B.R. 500 (Bkrtcy.Cal.1987); In re Kroh Bros. Development Co., 88 B.R. 997 (Bkrtcy.Mo.1988); In re Morse Tool, Inc., 87 B.R. 745 (Bkrtcy.Mass.1988). (Interestingly, Skyler Ridge and In Re Kroh Bros. which are cases commonly cited for the "reasonableness analyis," have been repudiated specifically by the courts of Kansas, the state whose law they purported to apply. TMG Life Ins. Co. v. Ashner, 898 P.2d 1145, 1159, held that the rulings in these cases that the prepayment premiums were unreasonable "appears to limit the freedom of contract of the parties by replacing the parties' judgment regarding the appropriate discount rate with the court's. . . .") Perhaps it is worth noting specially that one New York case upheld a fee that other cases have found problematic. In re Financial Center Associates, 140 B.R. 829 (Bkrtcy.N.Y.1992). Here, the "defeasance style" prepayment premium provision employed a Treasury security reference rate, but state that the lender's lost interest stream would be discounted to present value. In context, this produced a fee of nearly 25% of the principal being prepaid. The court held that even though the formula might overestimate the lender's loss, it was good enough to satisfy the reasonableness test for liquidated damages under New York law. The court also described § 506(b) as a "safety valve" to be used sparingly, and made no serious effort to apply it to the clause before it.

A few recent cases have determined that Section 506(b) states an independent federal bankruptcy question of the reasonableness of the fee. See In re Wiston XXIV Ltd. Partnership, 170 B.R. 453 (D.Kan.1994), refusing to enforce a fixed prepayment fee of $1.2 million in the 4th year of a 10-year loan with an original balance of $10.8 million; In re A.J. Lane & Co., 113 B.R. 821 (Bkrtcy.Mass.1990); In re Imperial Coronado Partners, Ltd., 96 B.R. 997 (9th Cir. BAP 1989) (state law preempted, but fee not allowable under § 506 (b)).

It could be argued, in fact, that the bankruptcy courts that have purported to rely upon state law as the measure of "reasonableness" have done so only for convenience of reference, and that they in fact view the question as a federal bankruptcy law question. The Bankruptcy Code does not compel reference to state law in this case; the word appears in the federal statute. Thus, although Skyler Ridge and Kroh Bros., for instance, have been repudiated in Kansas, they continue to be embraced by federal cases and scholars evaluating prepayment penalties in bankruptcy.

In the latest draft of their treatise on Real Estate Finance Law, as yet unpublished, Nelson and Whitman see a different policy affecting bankruptcy treatment of prepayment provisions. Although they tend to support the enforceability of contracted for prepayment premiums outside of bankruptcy, with only minimal judicial oversight, they believe that public policy requires greater scrutiny of these arrangements in bankruptcy:

Notwithstanding this suggestion that bankruptcy cases are different, the bankruptcy decisions are likely to affect the thinking of state courts over time. If state law courts are confronted with a continuing succession of bankruptcy court decisions finding prepayment premiums "unreasonable," and if they accept the notion, advocated by Nelson and Whitman, that prepayment premium agreements generally should be evaluated by the standard applicable to liquidated damages clauses, we can anticipate, as stated above, that state courts will find suspect many of the more traditional prepayment arrangements.

It virtually goes without saying that prepayment premiums in housing finance are not "politically correct," and have been heavily regulated by state legislatures over the years. A detailed recitation of the statutes and their various provisions is beyond the scope of this work. Suffice it to say that the vast majority of such legislation affects only residential real estate, and a great deal of that applies only to "consumer finance" transactions - residential loans that are not first lien purchase money mortgages.

One reason that I will not discuss these statutes in any detail is that, as explained in the next section, they have been preempted in the vast majority of significant loan transactions by Federal statute and regulations.

Although federal policy generally is to protect lenders from state limitations on collection of prepayment premiums, there is a small amount of federal regulation that limits prepayment practices.

Prepayment penalties in mortgage loans guaranteed by the Veterans Administration and insured by the Federal Housing Administration are prohibited. See 38 CFR § 36.4310 (VA); 24 CFR § 203.22(b) (FHA). Federally-chartered credit unions are prohibited by the National Credit Union Administration from imposing prepayment premiums or restrictions. 12 CFR §§ 701.21(c)(6), 701.21(g)(4). In addition, Federal Reserve Regulation Z, enforcing the Federal Truth in Lending Act, which requires mortgage lenders, in transactions covered by the Act, to disclose whether or not a prepayment penalty will be imposed or a rebate of a precomputed finance charge will be given for early payment.12 CFR § 226.18(k) and Official Staff Interpretation, 12 CFR Pt.226, Supp.I, at 18(k).

A federal regulation, promulgated in 1983, in connection with the preemption of state regulation of due on sale clause practices, prohibits all lenders, whether federally chartered or not, from collecting prepayment penalties resulting from acceleration under due-on-sale clauses contained in loans secured by homes "occupied or to be occupied by the borrower." 12 CFR 591.59(b)(2). For further consideration of the background of this regulation see Nelson and Whitman, Congressional Preemption of Mortgage Due–on–Sale Law: An Analysis of the Garn–St. Germain Act, 35 Hast.L.J. 241, 299–301 (1983).

The most wide spread federal regulation, however, as indicated, is permissive. Regulations of the Office of Thrift Supervision permit federally-chartered savings and loan associations to contract for prepayment premiums without limitation by federal or state law.12 CFR § 560.34; See In re Imperial Coronado Partners, Ltd., 96 B.R. 997 (9th Cir. BAP 1989); Toolan v. Trevose Fed Sav. & Loan Ass'n, 288 Pa.Super. 211, 431 A.2d 1012 (1981). Some federal farm loan programs also preempt local law and permit prepayment premiums. See, generally, Note, Current Developments in Agricultural Bankruptcies and Insolvencies, 5 Drake J.Agric.L. 137, 166 (2000).

The most important federal intervention from the standpoint of commercial lending is the ruling of the Comptroller of the Currency that prepayment fees are "interest" for purposes of the "most favored state" regulations. O.C.C. Interpretive Letter No. 744, published in Interpretations and Actions, October 1996, applying 12 C.F.R. § 7.4001(a), based on National Bank Act, 12 U.S.C. § 85. In effect, this means that, under the well known Marquette rule, a national bank located in a state that imposes no restriction on prepayment fees can "export" that unrestrictive policy throughout all states in which the bank does business. Many banks have taken liberal advantage of this ruling to insulate themselves from state law prepayment regulation, as well as from disagreeable usury and late payment charge limits.

The Comptroller of the Currency has also directly preempted state law for national banks in a manner similar to that granted to federally chartered thrift institutions by the Office of Thrift Supervision, but only with respect to adjustable rate loans. 12 CFR § 34.23.

Finally, in 1996 the Office of Thrift Supervision, which has authority to construe and apply the Alternative Mortgage Instrument Parity Act to non-federally-regulated lenders, adopted a regulation which purported to preempt state law, for such lenders, on a broad range of loan terms and provisions 12 CFR § 560.220, incorporating 12 CFR § 560.34. Any state statute restricting collection of prepayment fees by a non-federally-regulated lender is preempted by the Parity Act. National Home Equity Mortg. Ass'n v. Face, 239 F.3d 633 (4th Cir.(Va.) 2001); Shinn v. Encore Mortg. Services, Inc., 96 F.Supp.2d 419 (D.N.J.2000). Note that these regulations likely are applicable only to adjustable rate mortgages or other "alternative" forms of housing finance. The regulations do not apply to commercial loans.

For a recent discussion of preemption of state law prepayment provisions, see the Bulletin of the Michigan Financial Institutions Bureau:

http://www.cis.state.mi.us/fib/cf/bulletin/mtgprepy.pdf

For some of the reasons described above, and undoubtedly because of market pressures as well, the most common form of prepayment clause now in use in commercial loan instruments is some version of the "yield maintenance clause." There are several forms of this clause set forth as Appendices B, C, and D to these materials.

The theoretical notion of yield maintenance is essentially to provide to the lender the value represented by the loss the long term secured return it suffers when a loan is prepaid. A good idea, and one that would appear to strike any reviewing court as a "reasonable" approach. But the devil, of course, is in the details. The exact amount of the fee usually is established at the time of prepayment, depending upon market conditions at that time. But typically the parties agree upon a formula by which the fee will be determined. The formula looks at the return that the lender would have received had the lender not been prepaid, and attempts to put a price on what it would take to duplicate that secured return. But exactly what is the "equivalent" investment which must be priced?

Both borrowers and lenders, in the negotiation of these clauses, find themselves arguing at cross purposes. The lender, which earlier might have been inclined to argue for a higher return and more onerous security provisions in light of the weakness of the borrower’s credit position, now will want to argue that the borrower is just this side of King Midas, and consequently the this loan will be difficult to replace except with the most secure of long term investments. The borrower, which all along has been attempting to convince the lender that it is providing a very low credit risk, now is faced with arguing that the credit risk should not be valued somewhat lower than the lender might propose in connection with forecasting the prepayment premium.

The following discussion appeared as a Daily Development on the DIRT internet discussion group for real estate lawyers. The author of this article is the editor of DIRT, and usually writes the Daily Developments. But this piece, although edited by the author, was reported by Jack Murray of First American Title Insurance Company and is reprinted with his permission. To maintain the distinction between Jack’s commentary and the author’s, we have retained the original format of the DIRT discussion, with basic description of the holding followed by commentary by the Reporter and then by the Editor (who is the author here):

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 yield maintenance 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.

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.

Here are some general comments on the yield maintenance provision by Stevens Cary, from his wonderful article (California oriented) "Representing Borrower in Commercial Real Estate Secured Financing," in the July 2000 California CEB Real Property Reporter:

In his article, cited above, Stevens Carey makes the following suggestions for "borrower’s do’s and don’ts" in negotiation over prepayment premiums.

Carey notes that most lenders require the borrower to give prior notice of any intended prepayment. The prepayment notice should not itself accelerate the loan (or partially accelerate in the event of a partial prepayment). Rather, the instruments should provide that the effect of the notice should be simply to put the lender on notice that the borrower may be paying off the loan. Otherwise, if the borrower is relying on a refinancing or sale to effectuate the prepayment, the loan or sale closing could be delayed or may not occur at all, leaving the borrower with an acceleration demand to address.

Some loan documents impose strict and very limited timing requirements for prepayment that the borrower should attempt to soften. Among other matters, the borrower should consider: (1) How many days’ advance notice must be given; (2) Whether the prepayment must be made on a particular date or dates (e.g., a payment date); and (3) Whether all payments under the loan must be received by a certain time of day to be considered received on that day.

Carey points out that the combination of these and other restrictions may lead to shocking results.

Consider, for example, a loan providing that (1) a prepayment without premium may be made only during the last 30 days of the loan, (2) the maturity date is September 1, (3) all prepayments must be made on a payment date (which is the first day of each month), and (4) all payments received after noon are deemed received on the next business day. Under such a loan, there is actually no right to prepay without premium! Even if the free prepayment window is the last 60 days of the loan, the only time the borrower may prepay without premium is the morning of August 1 of the final year of the loan. If the source of prepayment is a loan or a sale, it may be difficult to coordinate the closing of the loan or sale to ensure that the prepayment occurs by a particular time on a particular day of the month.

Carey also recommends that the borrower should also request a window of time at the end of the loan term during which the borrower may prepay the loan without penalty. The borrower needs some flexibility to coordinate the closing of the sale or refinancing that will generate the proceeds to pay off the loan. Otherwise, it may be difficult to ensure that the funds will be available on the maturity date. Another solution to this problem is to give the borrower a free extension after the stated maturity to the extent reasonably necessary to coordinate the payoff of the loan with the closing of the sale or refinancing that is the source of the payoff. Some lenders will provide such extensions for no more than a modest processing fee.

As capital markets and mortgage markets have converged, the concept of the defeasance clause, for decades a staple in the municipal bond market has worked its way into the thinking of many mortgage analysts. Under such a clause, the borrower is permitted to substitute the security provided for a loan with another form of security. In fact, in some other systems, the right of defeasance is assumed to be part of a secured loan arrangement unless the parties provide specifically otherwise. The emerging Chinese mortgage law may so provide. See Randolph and Lou, Chinese Real Estate Law (Kluwer International, 2001) Sec. 8.8.2.3.. The Restatement of Mortgages also recommends that American common law assume that defeasance is available as a matter of right, and cannot be bargained away. Restatement (Third) of Property: Mortgages Sec. 6.2(b) (1997). The Restatement does provide that the substituted security must be readily transferrable and of equal security value to the mortgage it replaced. But the judgment as to what constitutes adequate replacement security under the Restatement ultimately is left to the courts, and not to the parties, and the parties are unable to provide otherwise. This author is less trusting of the wisdom and experience of the courts in such complex financial matters, and objects to the Restatement’s attempt to permit the mortgagor to "force feed" the mortgagee with substitute security that it doesn’t wish to accept. Even if defeasance is presumed to be available, the parties ought to be able to contract to avoid it or to limit its usage to certain agreed formats.

An example of a "defeasance clause" is set forth as Appendix D to this article.

In an article set forth following these materials in this course materials book, Professor Lefcoe points out that the defeasance practices now used by REMIC securitizers require the use of a replacement pool consisting of U.S. treasury securities and "lock out" any defeasance for the first two years. Both features are required to protect the status of the mortgage as a qualified investment. 26 C.F.R. part 1 Sec. 1,860G(8). Obviously, the securitization industry would resist the broad and mandatory defeasance rights which the Restatement of Mortgages promotes. Even if the current tax laws are changed, additional obstacles will arise in the future, and capital markets need bargaining flexibility to address these issues. There is nothing in the concept of mandatory defeasance that is so vital as to negate this flexibility. After all, mortgagors in America have essentially lived without a defeasance right for 200 years.

In theory, defeasance clauses should be subject to less judicial scrutiny than prepayment premiums, because they are not a penalty and operate more like an option. They can be used in more circumstances than the need to release property for refinancing or total or partial resale. They are not subject to a "reasonableness" evaluation under a literal application of the Bankruptcy Code, but this does not necessarily mean that they will be honored in the course of bankruptcy court ordered release of security in connection with reorganization plans. In many circumstances, the court is not required to honor the express mortgage right of the lender, but only to provide the "indubitable equivalent" of its security position, permitting the bankruptcy court to arrange for substitute security that, in the court’s view, provides adequate protection.

The securitization industry’s primary protection against this manipulation of defeasance rights in bankruptcy is to stay out of bankruptcy court, which of course is the objective of the "bankruptcy remote entities" that are a staple in many modern securitized transactions. Discussion of these devices is beyond the scope of this chapter.

In his discussion of prepayment issues, cited above, Stevens Carey warns borrowers about the hidden costs in the "Treasury securities-based defeasance clauses. When Treasury rates are less than the loan rate (as they usually are), then a larger principal amount of U.S. Treasuries must be purchased to generate the necessary income to service the loan. The excess price may be shockingly high (as much as 25 percent of the loan), especially if defeasance occurs early in the term of the loan and the positive spread between the loan rate and U.S. Treasury rates is significant. The price may be even higher due to constraints imposed by the loan documents and practical considerations in mixing and matching the amounts and rates of the U.S. Treasuries to the varying amounts of monthly principal amortization and interest. In very exceptional circumstances, the borrower might have no cost or even a discount if U.S. Treasury rates have risen sufficiently.

Although similar to prepaying the loan with a yield maintenance premium, the cost of the new collateral is often more than the sum of a prepayment and yield maintenance premium (which, unlike the cost of defeasance, is based on a hypothetical calculation). See Lefcoe, Yield Maintenance and Defeasance: Two Distinct Paths to Commercial Mortgage Payment, 28 Real Est LJ 202 (Winter 2000). The time and transaction costs alone may make a significant difference. See Hill & Herbert, Defusing Defeasance: The Real CMBS Millenium Bug, CMBS World 34 (Fall 1999). Moreover, lenders tend to impose many more restrictions on a defeasance right (e.g., opinion letters and rating letters), which may add even more costs, delays, and uncertainty than a prepayment right would entail.

Professor Lefcoe’s work in this area stands on its own, and we have included his brief discussion of market issues after the Appendix.

The Borrower shall have the right to prepay the Principal Amount outstanding and all accrued interest thereon upon the following terms and conditions: (1) no prepayment premium shall be due and payable with respect to any prepayment which is made within the ninety (90) day period immediately preceding (a) the Adjustment Date, or (b) the Maturity Date; (2) the Principal Amount may be prepaid in whole, but not in part; (3) in the event Borrower prepays the Loan other than during one of the two periods described in the immediately preceding subsection, than in any such event Borrower shall pay a prepayment fee, at the time of and simultaneously with any such prepayment, which shall be calculated as three percent (3%) of the amount being prepaid (e.g., if the amount prepaid is $100,000, then the prepayment fee shall be $3,000); and (4) Borrower may not prepay the Loan unless and except upon simultaneous payment of all accrued and unpaid interest and other amounts then outstanding under this Note and the Loan Documents.

PREPAYMENT PREMIUM ADDENDUM (Fixed Rate Notes)

PREPAYMENT PREMIUM. Upon prepayment of all or part of the outstanding principal balance of the Note before the Maturity Date, Borrower will pay Lender a Prepayment Premium which shall be equal to the maximum of (i) zero, or (ii) that amount, calculated on any prepayment date, which is derived by subtracting: (a) the principal amount of the Note or portion of the Note to be prepaid from (b) the Net Present Value of the Note or portion of the Note to be prepaid on such date of prepayment.

For purposes of the foregoing, the following definitions shall be applicable:

"Net Present Value" shall mean the amount which is derived by summing the present value of each prospective payment of principal and interest which, without such full or partial prepayment, could otherwise have been received by Lender over the remaining contractual life of the Note (or for a lesser period if the remaining term of the applicable fixed rate is less than the term of the Note) if Lender had instead initially invested the Note proceeds (or the then-outstanding Note amount at the beginning of the applicable fixed rate adjustment period) at the Initial Money Market Rate. The individual discount rate used to present value each prospective payment of interest and/or principal shall be the Money Market Rate at Prepayment for the maturity matching that of each specific payment of principal and/or interest.

"Initial Money Market Rate" shall mean the rate per annum determined solely by Lender, on the first day of the applicable fixed rate adjustment period or as mutually agreed upon by the Borrower and Lender, as the rate at which Lender would be able to borrow funds in Money Markets for the amount of this Note (or the then outstanding Note amount at the beginning of the applicable fixed rate adjustment period) and with an interest payment frequency and principal repayment schedule equal to this Note and for a term as may be arranged and agreed upon by Borrower and Lender. Such a rate shall include FDIC insurance, reserve requirements and other explicit or implicit costs levied by any regulatory agency. Borrower acknowledges that Bank is under no obligation to actually purchase and/or match funds for the Initial Money Market Rate of this Note.

"Money Market Rate At Prepayment" shall mean that zero-coupon rate, calculated on the date of prepayment, and determined solely by Lender, as the rate in which Lender would be able to borrow funds in Money Markets for the prepayment amount matching the maturity of a specific prospective Note payment date. Such a rate shall include FDIC insurance, reserve requirements and other explicit or implicit costs levied by any regulatory agency. A separate Money Market Rate at Prepayment will be calculated for each prospective interest and/or principal payment date.

"Money Markets" shall mean one or more wholesale funding mechanisms available to Lender, including negotiable certificates of deposit, eurodollar deposits, bank notes, fed funds interest rate swaps or others.

In calculating the amount of Prepayment Premium, Lender is hereby authorized by Borrower to make such assumptions regarding the source of funding, redeployment of funds and other related matters as Lender may deem appropriate. If Borrower fails to pay any Prepayment Premium when due, the amount of such Prepayment Premium shall thereafter bear interest until paid at the Default Interest Rate as defined in the Note (computed on the basis of a 360-day year, actual days elapsed).

Any prepayment of principal shall be accompanied by (i) a payment of interest on the entire outstanding principal balance (without deduction for the amount prepaid) accrued to the Prepayment Date, and (ii) the Prepayment Premium. Any partial prepayment shall be applied to the principal installments in the inverse order of their maturities.

In the event of more than one prepayment, a Prepayment Premium shall be due and payable with respect to each such prepayment, and the Prepayment Premium shall be separately computed with respect to each successive prepayment, taking into account any previous partial prepayments of principal.

The amount of any Prepayment Premium as computed by Lender shall be binding and conclusive upon Borrower.

In the event there is an uncured event of default under the Note and Lender exercises its right pursuant to the Note to declare the unpaid principal balance of the Note to be immediately due and payable, then, in addition to all of the other rights and remedies available to Lender under the Loan Documents, Borrower shall immediately pay to Lender the Prepayment Premium with respect to the entire unpaid principal balance of the Note. For purposes of computing the Prepayment Premium which is due following such a declaration, the "Prepayment Date" shall be the date of such declaration or another date selected by Lender, in its discretion, which is after the date of such declaration, and on or before the date on which the unpaid principal balance of the Note, all accrued interest hereon, and all other amounts due under the Note have been paid in full.

In the event of any involuntary prepayment, other than an involuntary prepayment governed by the prior paragraph, the Borrower shall be obligated to pay to Lender, simultaneously with such involuntary prepayment (i) interest on the amount so prepaid accrued through and including the date of prepayment, and (ii) a Prepayment Premium in the amount determined pursuant to the Note. For purposes of computing the Prepayment Premium with respect to prepayments made pursuant to this paragraph, the Prepayment Date shall be the date on which such involuntary prepayment is actual received by Lender.

Payments shall be made directly to Lender by electronic transfer of funds using the Automated Clearing House System. All installments shall be applied first in payment of interest, calculated monthly on the unpaid principal balance, and the remainder of each installment shall be applied in payment of principal. The entire unpaid principal balance plus accrued interest thereon shall be due and payable on , 2021 (the "Maturity Date").

Borrower shall have the right, upon thirty (30) days advance written notice, beginning April 1, 2006 of paying this note in full with a prepayment fee. This fee represents consideration to Lender for loss of yield and reinvestment costs and shall also be payable whenever prepayment occurs as a result of a condemnation of all or substantially all of the Property. The fee shall be the greater of Yield Maintenance or 1% of the outstanding principal balance of this note.

As used herein, "Yield Maintenance" means the amount, if any, by which (i) the present value of the Then Remaining Payments (as hereinafter defined) calculated using a periodic discount rate (corresponding to the payment frequency under this note) which, when compounded for such number of payment periods in a year, equals the per annum effective yield of the Most Recently Auctioned United States Treasury Obligation having a maturity date equal to the Maturity Date (or, if there is no such equal maturity date, then the linearly interpolated per annum effective yield of the two Most Recently Auctioned United States Treasury Obligations having maturity dates most nearly equivalent to the Maturity Date) as reported by The Wall Street Journal five business days prior to the date of prepayment; exceeds (ii) the outstanding principal balance of this note (exclusive of all accrued interest).

If such United States Treasury obligation yields shall not be reported as of such time or the yields reported as of such time shall not be ascertainable, then the periodic discount rate shall be equal to the Treasury Constant Maturity Series yields reported, for the latest day for which such yields shall have been so reported, as of five business days preceding the prepayment date, in Federal Reserve Statistical Release H.15 (519) (or any comparable successor publication) for actively traded United States Treasury obligations having a constant maturity most nearly equivalent to the Maturity Date.

As used herein, "Then Remaining Payments" means payments in such amounts and at such times as would have been payable subsequent to the date of such prepayment in accordance with the terms of this note.

As used herein, "Most Recently Auctioned United States Treasury Obligations" means the U.S. Treasury bonds, notes and bills with maturities of 30 years, 10 years, 5 years, 2 years and 1 year which, as of the date the prepayment fee is calculated, were most recently auctioned by the United States Treasury.

Upon the occurrence of an Event of Default (as defined in the Lien Instrument) followed by the acceleration of the whole indebtedness evidenced by this note, the payment of such indebtedness will constitute an evasion of the prepayment terms hereunder and be deemed to be a voluntary prepayment hereof and such payment will, therefore, to the extent not prohibited by law, include the prepayment fee required under the prepayment in full privilege recited above or, if such prepayment occurs prior to May 1, 2006 and results from an Event of Default followed by an acceleration of the whole indebtedness, then such payment will, to the extent not prohibited by law, include a prepayment fee equal to the greater of Yield Maintenance or 6% of the outstanding principal balance of this note.

Notwithstanding the above and provided Borrower is not in default under any provision contained in the Loan Documents (as defined in the Lien Instrument), this note may be prepaid in full at any time, without a prepayment fee, during the last 60 days of the term of this note.

Provisions in related Deed of Trust dealing with prepayment fee:

Insurance. Grantor agrees to keep the Property insured for the protection of Beneficiary and Beneficiary's wholly owned subsidiaries and agents in such manner, in such amounts and in such companies as Beneficiary may from time to time approve, and to keep the policies therefor, properly endorsed, on deposit with Beneficiary, or at Beneficiary's option, to keep certificates of insurance (Acord 27 for all property insurance and Acord 25-S for all liability insurance) evidencing all insurance coverages required hereunder on deposit with Beneficiary, which certificates shall provide at least thirty (30) days notice of cancellation to Beneficiary and shall list Beneficiary as the certificate holder; that insurance loss proceeds (less expenses of collection) shall, at Beneficiary's option, be applied on the Indebtedness, whether due or not, or to the restoration of the Property, or be released to Grantor, but such application or release shall not cure or waive any default under any of the Loan Documents. If Beneficiary elects to apply the insurance loss proceeds on the Indebtedness, no prepayment privilege fee shall be due thereon.

Note Provisions:

__. Acceleration Upon Default. At the option of Holder, if Borrower fails to pay any sum specified in this Note within seven (7) days of the due date, or if an Event of Default occurs, the Secured Indebtedness, and all other sums evidenced and/or secured by the Loan Documents, including without limitation any applicable prepayment fees (collectively, the "Accelerated Loan Amount") shall become immediately due and payable.

__. Interest Upon Default. The Accelerated Loan Amount shall bear interest at the Default Rate which shall never exceed the maximum rate of interest permitted to be contracted for under the laws of the State. The Default Rate shall commence upon the occurrence of an Event of Default and shall continue until all defaults are cured.

__. Limitation on Interest. The agreements made by Borrower with respect to this Note and the other Loan Documents are expressly limited so that in no event shall the amount of interest received, charged or contracted for by Holder exceed the highest lawful amount of interest permissible under the laws applicable to the Loan. If at any time performance of any provision of this Note or the other Loan Documents results in the highest lawful rate of interest per-missible under applicable laws being exceeded, then the amount of interest received, charged or contracted for by Holder shall automatically and without further action by any party be deemed to have been reduced to the highest lawful amount of interest then permissible under applicable laws. If Holder shall ever receive, charge or contract for, as interest, an amount which is unlawful, at Holder's election, the amount of unlawful interest shall be refunded to Borrower (if actually paid) or applied to reduce the then unpaid Loan Amount. To the fullest extent permitted by applicable laws, any amounts contracted for, charged or received under the Loan Documents included for the purpose of determining whether the Interest Rate would exceed the highest lawful rate shall be calculated by allocating and spreading such interest to and over the full stated term of this Note.

__. Prepayment. Borrower shall not have the right to prepay all or any portion of the Loan Amount at any time during the term of this Note except as expressly set forth in the Defined Terms. If Borrower provides notice of its intention to prepay, the Accelerated Loan Amount shall become due and payable on the date specified in the prepayment notice.

__. Prepayment Fee.

(a) Any tender of payment by Borrower or any other person or entity of the Secured Indebtedness, other than as expressly provided in the Loan Documents, shall constitute a prohibited prepayment. If a prepayment of all or any part of the Secured Indebtedness is made following (i) an Event of Default and an acceleration of the Maturity Date, (ii) the application of money to the principal of the Loan after a casualty or condemnation, or (iii) in connection with a purchase of the Property or a repayment of the Secured Indebtedness at any time before, during or after, a judicial or non-judicial foreclosure or sale of the Property, then to compensate Holder for the loss of the investment, Borrower shall pay an amount equal to the Prepayment Fee (as hereinafter defined).

(b) The "Prepayment Fee" shall be the greater of (A) the Prepayment Ratio (as hereinafter defined) multiplied by the difference between (x) and (y), where (x) is the present value of all remaining payments of principal and interest including the outstanding principal due on the Maturity Date, discounted at the rate which, when compounded monthly, is equivalent to the Treasury Rate compounded semi-annually, and (y) is the amount of the principal then outstanding, or (B) one percent (1%) of the amount of the principal being prepaid.

(c) The "Treasury Rate" shall be the annualized yield on securities issued by the United States Treasury having a maturity equal to the remaining stated term of this Note, as quoted in the Federal Reserve Statistical Release [H. 15 (519)] under the heading "U.S. Government Securities - Treasury Constant Maturities" for the date on which prepayment is being made. If this rate is not available as of the date of prepayment, the Treasury Rate shall be determined by interpolating between the yield on securities of the next longer and next shorter maturity. If the Treasury Rate is no longer published, Holder shall select a comparable rate. Holder will, upon request, provide an estimate of the amount of the Prepayment Fee two weeks before the date of the scheduled prepayment.

(d) The "Prepayment Ratio" shall be a fraction, the numerator of which shall be the amount of principal being prepaid, and the denominator of which shall be the principal then outstanding.

__. Waiver of Right to Prepay Note Without Prepayment Fee. Borrower acknowledges that Holder has relied upon the anticipated investment return under this Note in entering into transactions with, and in making commitments to, third parties and that the tender of any prohibited prepayment, shall, to the extent permitted by law, include the Prepayment Fee. Borrower agrees that the Prepayment Fee represents the reasonable estimate of Holder and Borrower of a fair average compensation for the loss that may be sustained by Holder as a result of a prohibited prepayment of this Note and it shall be paid without prejudice to the right of Holder to collect any other amounts provided to be paid under the Loan Documents.

BORROWER EXPRESSLY (A) WAIVES ANY RIGHTS IT MAY HAVE UNDER WASHINGTON LAW TO PREPAY THIS NOTE, IN WHOLE OR IN PART, WITHOUT FEE OR PENALTY, UPON ACCELERATION OF THE MATURITY DATE OF THIS NOTE, AND (B) AGREES THAT IF, FOR ANY REASON, A PREPAYMENT OF THIS NOTE IS MADE, UPON OR FOLLOWING ANY ACCELERATION OF THE MATURITY DATE OF THIS NOTE BY HOLDER ON ACCOUNT OF ANY DEFAULT BY BORROWER UNDER ANY LOAN DOCUMENT, INCLUDING BUT NOT LIMITED TO ANY TRANSFER, FURTHER ENCUMBRANCE OR DISPOSITION WHICH IS PROHIBITED OR RESTRICTED BY THE DEED OF TRUST, THEN BORROWER SHALL BE OBLIGATED TO PAY CONCURRENTLY THE PREPAYMENT FEE SPECIFIED IN SECTION ___. BY EXECUTING THIS NOTE, BORROWER AGREES THAT HOLDER'S AGREEMENT TO MAKE THE LOAN AT THE INTEREST RATE AND FOR THE TERM SET FORTH IN THIS NOTE CONSTITUTES ADEQUATE CONSIDERATION FOR THIS WAIVER AND AGREEMENT.

Related Deed of Trust provisions: [Note: There are only a couple of references to the prepayment fee in the deed of trust; one is in the insurance section; the other is in the section dealing with the allocation of sale proceeds from the sale of the property following a default]

_____ REQUIREMENTS FOR RESTORATION. Unless otherwise expressly agreed in a writing signed by Beneficiary, the following are the Requirements For Restoration:

(a) If the Net Insurance Proceeds or Net Condemnation Proceeds are to be used for the Restoration, . . .

(b) . . .

(c) If (i) within sixty (60) days after the occurrence of any damage, destruction or condemnation requiring Restoration, Grantor fails to submit to Beneficiary and receive Beneficiary's approval of plans and specifications or fails to deposit with Beneficiary the additional amount necessary to accomplish the Restoration as provided in subparagraph (a) above, or (ii) after such plans and specifications are approved by all such governmental authorities and Beneficiary, Grantor fails to commence promptly or diligently continue to completion the Restoration, or (iii) Grantor becomes delinquent in payment to mechanics, materialmen or others for the costs incurred in connection with the Restoration, or (iv) there exists an Event of Default, then, in addition to all of the rights herein set forth and after ten (10) days' written notice of the non-fulfillment of one or more of these conditions, Beneficiary may apply the Restoration Funds to reduce the Secured Indebtedness in such order as Beneficiary may determine, and at Beneficiary's option and in its sole discretion, Beneficiary may declare the Secured Indebtedness immediately due and payable together with the Prepayment Fee.

________ APPLICATION OF PROCEEDS OF SALE. In the event of a sale of the Property pursuant to Section 11.02 of this Deed of Trust, to the extent permitted by law, the Beneficiary shall determine in its sole discretion the order in which the proceeds from the sale shall be applied to the payment of the Secured Indebtedness, including without limitation, the expenses of the sale and of all proceedings in connection with the sale, including reasonable attorneys' fees and expenses; Impositions, Premiums, liens, and other charges and expenses; the outstanding principal balance of the Secured Indebtedness; any accrued interest; any Prepayment Fee; and any other amounts owed under any of the Loan Documents.

ARTICLE 6: PREPAYMENT; DEFEASANCE

(a) The principal balance of this Note may not be prepaid in whole or in part except as expressly permitted pursuant hereto.

(b) Subject to compliance with and satisfaction of the terms and conditions of this Article 6 and provided that no Event of Default exists under this Note, Borrower may elect to obtain a release (the "Release") of the Property from the lien of the Security Instrument on any Payment Date after the Lockout Period Expiration Date (defined below) by delivering to Lender, as security for the payment of all interest and principal due and to become due pursuant to this Note through the Maturity Date, plus the principal balance of this Note scheduled to be outstanding on the Maturity Date, Defeasance Collateral (defined below) sufficient to generate Scheduled Defeasance Payments (defined below) (the Release and the delivery of the Defeasance Collateral, a "Defeasance").

(c) As a condition precedent to a Defeasance, and prior to any Release, Borrower shall have complied with all of the following:

(i) Borrower shall provide not less than sixty (60) days' prior written notice to Lender specifying a Payment Date upon which it intends to effect a Defeasance hereunder (the "Defeasance Date").

(ii) All accrued and unpaid interest on the principal balance of this Note to and including the Defeasance Date, the scheduled amortization payment due on such Defeasance Date, and all other sums due under this Note, the Security Instrument and the Other Security Documents, shall be paid in full on or prior to the Defeasance Date.

(iii) Borrower shall execute and deliver to Lender any and all certificates, opinions, documents or instruments required by Lender in connection with the Defeasance and Release, including, without limitation, a pledge and security agreement satisfactory to Lender creating a first priority lien on the Defeasance Collateral (a "Defeasance Security Agreement"). This Note shall thereafter be secured by the Defeasance Collateral delivered in connection with the Defeasance. After Defeasance, this Note cannot be prepaid in whole or in part or be the subject of any further Defeasance.

(iv) Borrower shall have delivered to Lender an opinion of Borrower's counsel in form and substance satisfactory to Lender stating: (A) that the Defeasance Collateral and the proceeds thereof have been duly and validly assigned and delivered to Lender and that Lender has a valid, perfected, first priority lien and security interest in the Defeasance Collateral delivered by Borrower and the proceeds thereof; (B) that if the holder of this Note shall at the time of the Release be a REMIC (defined below), (1) the Defeasance Collateral has been validly assigned to the REMIC Trust which holds this Note (the "REMIC Trust"), (2) the Defeasance has been effected in accordance with the requirements of Treasury Regulation 1.860(g)-2(a)(8) (as such regulation may be amended or substituted from time to time) and will not be treated as an exchange pursuant to Section 1001 of the IRS Code, and (3) the tax qualification and status of the REMIC Trust as a REMIC will not be adversely affected or impaired as a result of the Defeasance; and (C) that the delivery of the Defeasance Collateral and the grant of a security interest therein to Lender shall not constitute an avoidable preference under Section 547 of the U.S. Bankruptcy Code or applicable state law. The term "REMIC" shall mean a "real estate mortgage investment conduit" within the meaning of Section 860D of the IRS Code. The term "IRS Code" shall mean the United States Internal Revenue Code of 1986, as amended, and the related Treasury Department regulations, including temporary regulations.

(v) Borrower shall have delivered to Lender written confirmation from the Rating Agencies (defined in the Security Instrument) that such Defeasance will not result in a withdrawal, downgrade or qualification of the then current ratings by the applicable Rating Agencies of the Securities or Participations (each as defined in the Security Instrument). If required by the Rating Agencies, Borrower shall, at Borrower's expense, also deliver or cause to be delivered a non-consolidation opinion with respect to the Defeasance Obligor (as defined below), if any, in form and substance satisfactory to Lender and the Rating Agencies.

(vi) Borrower shall have delivered to Lender a certificate satisfactory to Lender given by Borrower's independent certified public accountant (which accountant shall be satisfactory to Lender) certifying that the Defeasance Collateral shall generate the Scheduled Defeasance Payments.

(d) In connection with any Defeasance hereunder, if Borrower shall continue to own any assets other than the Defeasance Collateral following the Release, Borrower shall, at Borrower's expense, establish or designate a successor entity, which shall be a single purpose, bankruptcy remote entity acceptable to Lender (the "Defeasance Obligor") and Borrower shall transfer and assign all obligations, rights and duties under and to this Note and the Defeasance Security Agreement together with the pledged Defeasance Collateral to such Defeasance Obligor. Such Defeasance Obligor shall assume the obligations under the Note and any Defeasance Security Agreement and shall be bound by and obligated under Sections 3.1, 7.2, 7.4(a), 11.2, 11.7 and 14.2 and Articles 13 and 15 of the Security Instrument; provided, however, that all references therein to "Property" or "Personal Property" shall be deemed to refer only to the Defeasance Collateral delivered to Lender, and Borrower shall be relieved of its obligations under such documents and, except with respect to any provisions therein which by their terms expressly survive payment of the Debt in full, the Other Security Documents.

(e) The following terms shall have the meaning set forth below:

(i) The term "Defeasance Collateral" as used herein shall mean direct, non- callable and non-redeemable obligations of the United States of America for the payment of which its full faith and credit is pledged, each of which shall be duly endorsed by the holder thereof as directed by Lender or accompanied by a written instrument of transfer in form and substance wholly satisfactory to Lender (including, without limitation, such instruments as may be required by the depository institution holding such securities or by the issuer thereof, as the case may be, to effectuate book-entry transfers and pledges through the book-entry facilities of such institution) in order to perfect upon the delivery of the Defeasance Collateral a first priority security interest therein in favor of the Lender in conformity with all applicable state and federal laws governing the granting of such security interests. Borrower shall authorize and direct that the payments received from such obligations shall be made directly to Lender or Lender's designee and applied to satisfy the obligations of Borrower or, if applicable, the Defeasance Obligor, under this Note.

(ii) The term "Scheduled Defeasance Payments" as used herein shall mean the scheduled payments of interest and principal in accordance with the terms of the Defeasance Collateral (without consideration of any reinvestment of interest therefrom), providing for payments prior, but as close as possible, to all successive Payment Dates after the Defeasance Date through and including the Maturity Date, and in amounts equal to or greater than the scheduled payments of interest and principal due under this Note, including the principal balance of this Note scheduled to be outstanding on the Maturity Date.

(iii) The term "Lockout Period Expiration Date" shall mean the date which is the earlier of (A) the second anniversary of the date that is the "startup day," within the meaning of Section 860G(a) (9) of the IRS Code, of a REMIC that holds this Note; or (B) the fifth anniversary of the first day of the first full calendar month following the date of this Note.

(f) Upon Borrower's compliance with all of the conditions to Defeasance and a Release set forth in this Article 6, Lender shall release the Property from the lien of the Security Instrument and the Other Security Documents. All costs and expenses of Lender incurred in connection with the Defeasance and Release, including, without limitation, Lender's counsel's fees and expenses, shall be paid by Borrower simultaneously with the delivery of the Release documentation. Any revenue, documentary stamp or intangible taxes or any other tax or charge due in connection with the Defeasance shall be paid by Borrower simultaneously with the occurrence of any Defeasance.

(g) If a Default Prepayment (defined below) occurs, Borrower shall pay to Lender the entire Debt, including, without limitation, an amount (the "Default Consideration") equal to the greater of (i) the amount (if any) which when added to the then outstanding principal amount of this Note will be sufficient to purchase Defeasance Collateral providing the required Scheduled Defeasance Payments assuming Defeasance would be permitted hereunder; or (ii) one percent (1%) of the Default Prepayment. For purposes of this Note, the term "Default Prepayment" shall mean a prepayment of the principal amount of this Note made after the occurrence of any Event of Default or an acceleration of the Maturity Date under any circumstances, including, without limitation, a prepayment occurring in connection with reinstatement of the Security Instrument provided by statute under foreclosure proceedings or exercise of a power of sale, any statutory right of redemption exercised by Borrower or any other party having a statutory right to redeem or prevent foreclosure, any sale in foreclosure or under exercise of a power of sale or otherwise.

(h) Notwithstanding anything to the contrary herein, Borrower may prepay the principal balance of this Note without premium or penalty (i) in whole during the three (3) months prior to the Maturity Date; or (ii) in whole or in part in connection with a prepayment resulting from the application of insurance proceeds or condemnation awards pursuant to Sections 3.3 and 3.6 of the Security Instrument or changes in tax and debt credit pursuant to Section 7.3(a) or (b) of the Security Instrument, but in each instance Borrower shall be required to pay all other sums due hereunder, and no principal amount repaid may be reborrowed.

Yield Maintenance and Defeasance:

Copyright © 1999 George Lefcoe

Highly leveraged real estate owners who don't sell or refinance in good times risk losing their properties if their mortgages fall due when real estate values are too low to support refinancing. With the typical commercial fixed rate loan maturing in seven to ten years, owners are lucky to catch one good cycle. Portfolio lenders know this, and allow prepayment, usually through yield maintenance clauses. Yield maintenance formulas are calculated to cover the lender's reinvestment loss when prepaid loans bear above market rates.

Issuers of commercial mortgage backed securities (CNOS) prefer mortgage prepayment by defeasance. Since about half of all commercial mortgages are originated for inclusion in CMBS packages, borrowers, lenders, and, in some situations, judges will need to know the difference between yield maintenance and defeasance. This paper compares the two arrangements, explains why CMBS issuers prefer defeasance, and why many commercial mortgagors might not.

A Nutshell Comparison

Under a yield maintenance formula the borrower discharges the debt with a one-time fee sufficient to enable the lender, reinvesting at current rates, to earn no less than what it would have earned had the borrower not prepaid. By contrast, defeasance effects no early termination of the debt. Instead, the borrower is allowed to substitute for the mortgage a carefully assembled package of noncallable and nonprepayable U.S. government obligations.

Quite often, the costs of yield maintenance and defeasance will be nearly the same, except for the considerable expense of arranging defeasance. Most yield maintenance clauses peg the prepayment premium to the difference between the original mortgage interest rate and the market rate of a Treasury obligation of comparable maturity.

If the purpose of the premium is to offset any loss the lender might otherwise suffer on reinvesting prepaid sums, the mortgage/Treasury differential overcompensates the lender. Treasury obligations, being safer than mortgages, command lower rates. One lawyer offers the example of a $10,000,000 loan, ten year maturity, 8% interest rate, being prepaid one minute after origination, at a time when Treasuries of comparable maturity were yielding 6.5%. Along with repayment of the $10,000, 000, the borrower's prepayment fee would be $1,000,000 even though rates hadn't changed at all during the intervening minute. In similar circumstances, the defeasing borrower would have to purchase over $11,000,000 worth of Treasuries to fund an account yielding 8% interest, in precisely the amounts and at the same times the mortgage payments would have been due.

Comparing the costs of yield maintenance to defeasance requires a close look at the particular yield maintenance provision. Some yield maintenance clauses are less expensive than defeasance because the borrower's obligation is calculated as the difference between the current Treasury rate and the Treasury rate at the date of loan origination, or between a current mortgage rate and the original mortgage loan rate. Other yield maintenance clauses are more expensive than defeasance because they set a minimum payment of 1% of the prepaid loan balance regardless of interest rates. When rates have risen enough that the borrower can purchase Treasuries for less than the prepaid mortgage balance, the borrower's defeasance cost could be lower than a 1% yield maintenance premium. But under many yield maintenance clauses, the borrower pays absolutely nothing when the original vield exceeds the current yield. Regardless of interest rate trends, the defeasing borrower always incurs the expense of purchasing Treasury obligations.

Besides reinvestment losses, yield maintenance prepayment could result in two additional types of losses to lenders: the costs of processing the new loan and temporary reductions in interest income while the lender "parks" the funds in low yielding, short term government securities, pending mortgage reinvestment. Most yield maintenance provisions disregard these items, realistically assuming that lenders recoup fully their loan origination costs from borrower fees, and reinvest funds almost instantaneously. But some lenders levy fixed fees or reserve the right to recoup these costs, if incurred, from the prepaying borrower.

Defeasance costs divide into processing fees and the actual cost of acquiring the Treasuries. The borrower's request to defease must be supported by the opinion of a recognized rating agency, prepared at the borrower's expense, that the defeasance will not cause a downgrade, qualification or withdrawal of the then current ratings on the mortgage certificate. Once the servicer designated in the CMBS offering accedes to the request, the borrower will pay processing fees, and for the preparation of a defeasance security agreement, a comfort letter from the borrower's Certified Public Accountant that the cash flow from the substituted collateral exactly matches all scheduled mortgage payments, and a legal opinion that the borrower has fully complied with all defeasance requirements, including Treasury Regulations regarding REMICs (more about this later). The borrower will also have to form a special purpose entity to act as the successor borrower.

Actually accumulating the matching Treasury collateral is complicated because of the many differences between mortgages and Treasuries. Principal is repaid on a Treasury at maturity. Most loans call for periodic amortization. Treasury interest is payable semi-annually and not compounded. Mortgage interest is payable monthly and compounded. Most prepaying borrowers will require the services of a bond trader.

A poorly arranged defeasance can be quite costly, particularly when the Treasuries purchased produce payments in advance of actual need on which the borrower earns nothing. In one case, a borrower, arranging a securitized loan, sued its financial advisors for breach of contract and its legal advisors for malpractice partly because of a defeasance clause giving the lender the first right to purchase the U.S. obligations. The borrower's expert testified that the total cost of defeasing the borrower's $174,000,000 note could range between $223,776,000 and $292,612,920, depending on the efficiency of the execution.

Yield maintenance formulas calculated at the loan level are no guarantee that all bondholders will be made whole when loans are prepaid.

To offer an example, consider a $50,000,000 loan, all principal due in 10 years, secured by two twin office towers, each appraised by the lender at $37,500,000. The interest rate is fixed at 8%. One day after the loan closes, the borrower receives and accepts an offer of $45,000,000 for one of the towers. Providently, the borrower had contracted for the right to prepay $30 million of the debt in exchange for a release of the mortgage on one tower.

Under a yield maintenance provision, the borrower's prepayment fee would depend significantly on the precise language of the clause. Suppose the provision defined original yield as 8% and current yield as a Treasury of like maturity, then trading at 5.5%. The borrower would be liable for 2.5%, the difference between 8% and 5.5%, multiplied by the prepaid sum, discounted to present value. Had the yield maintenance clause measured original and current yield from the same yardstick-utilizing mortgage or Treasury rates in both instances-the borrower would incur no prepayment fee obligation.

Now consider the position of bondholders if the mortgage loan had been securitized before the partial prepayment. For simplicity, assume the securitization contained only the one underlying mortgage of $50,000,000.

The issuer created an A and a B tranche ("tranche" is French, for "slice"). The A tranche investor purchased the right to receive the first principal and interest payments, at 7%, on $30,000,000. The B tranche investor bought the right to receive the next $20,000,000 at 7.7%. Finally, the issuer sold to C an interest only (10) strip for the one percent premium on the A tranche -- the difference between the mortgagor's 8% interest rate and the A tranche investor's 7% coupon rate.

C's purchase was especially important to the issuer because, besides fee income, the issuer's profit depends on the spread between the mortgage interest rate and what bond investors receive. The issuer could patiently pocket the difference each month but preferred cash now, as do most issuers.

Again, assume the mortgagor partially prepaid one day after A, B, and C purchased their respective interests. A will be fully repaid. Because securitized debt is traded at a spread above Treasuries, whether A can reinvest in a comparable 7% deal depends on whether Treasury rates, and the spread between Treasuries and mortgage rates, have remained constant. Assuming no change in these numbers , the A tranche holder will be able to reinvest without loss-- except for transactions costs. Those costs could be more than covered by the borrower's 2.5% yield maintenance fee. But there would be no source of recovery from a yield maintenance clause precisely calculated to measure the mortgagee's reinvestment loss.

B's situation is enviable. Far from costing B anything, the borrower's prepayment delivers a windfall to B. Before prepayment, B's loan to value ( LTV) ratio was 66%. After prepayment, it would improve to 53%. Given that A had accepted 7% on an LTV of 40%, what would B have rationally accepted? The difference between that rate and 7.7% is the measure of B's windfall. Anything B recovers from the mortgagor's yield maintenance fee adds to B's windfall.

C stands to suffer a substantial loss. The mortgagor's obligation to pay interest ceases with prepayment. C will get nothing, unless the borrower is obligated for a prepayment fee and C has been given the right to receive it. Of course, knowledgeable purchasers of IO strips consider prepayment fee allocation formulas, in deciding what they will pay. "There is seemingly no end to the number of ways underwriters can distribute the penalties."

Defeasance saves the CMBS issuer struggling to devise an acceptable formula for allocating yield maintenance payments fairly among competing classes of bondholders by assuring that all the investors in the securitized pool continue receiving their payments on schedule. The cash keeps flowing but from U.S. Treasury obligations, not a mortgage, increasing the value of the investment by the amount investors prefer government bonds to mortgages.

The Real Estate Mortgage Investment Conduit (REMIC) is a tax code authorized vehicle which enables mortgage investors to purchase shares of pooled mortgages while avoiding the double taxation of interest income, first at the conduit level when interest payments mortgagors make to loan servicers are forwarded to the bond trustee, and again when bondholders receive their payments from the trustees.

Tax at the entity level is only avoided if the REMIC remains an entirely passive recipient of interest payments, not actively engaged in trading, originating or servicing mortgages. Otherwise, REMICs could compete unfairly with businesses that are subject to entity level tax, or be exploited by such firms to defer or avoid tax on "active" earnings. REMICs are taxed on 100% of the income derived from prohibited sources.

The REMIC must consist of a fixed pool of "qualified" mortgages, basically, loans acquired at the REMIC startup date or acquired within three months pursuant to a contract entered on that date. Loans cannot be prepaid within the first two years of startup, which explains the two year "lock out" in all REMIC securitized mortgages.

Except for precisely defined "defective obligations" (mainly, loans in or near default), no mortgage may be substituted for another originally included in a REMIC pool. This rules out substituting one mortgaged property for another, an option that would save the borrower the cost of the spread between Treasury and mortgage rates. Only Treasury obligations can be substituted for prepaid mortgages, and only two years after the REMIC startup date.

An alternate tax pass- through entity, available since 1996, known as a FASIT (Financial Asset Securitization Investment Trust) accommodates the debtor substituting one asset for another with no adverse tax consequences. FASITs were designed to allow the securitization of revolving consumer debt – car and credit card loans – and are allowed to substitute debt instruments. Thus, while a REMIC could not invest in construction loans, to be "taken out" with long-term financing, a FASIT could. But FASITs have rarely been used for securitized mortgages. They raise numerous as yet unanswered tax questions, and would result in significant front-end tax liabilities for some securitized mortgage issuers.

Except in bankruptcy, courts have universally enforced absolute prohibitions against prepayment (variously called "lock outs" or "lock ins"). They also uphold yield maintenance provisions, even those which significantly overcompensated the lender because they carried a premium based on the difference between the contract mortgage rate and the Treasury rate at the time of prepayment. Some lawyers are dismayed by this, recalling Corbin's admonition that "justice requires nothing more than compensation measured by the amount of the harm suffered."

Analyzed as liquidated damage clauses, prepayment provisions that predictably overcompensate lenders could be faulted as unreasonably high, unnecessary because the lender's damages can readily be calculated at date of breach, and in excess of actual loss, calculated ex post. To avoid applying these familiar limits on liquidated damage clauses, some courts characterize prepayment fees as not damages for breach at all, but as contracts for alternate performance, like options. Other courts emphasize that such provisions should be upheld in commercial mortgage loans because they are, presumably, "fairly bargained".

Conventionally, the "fairly bargained" standard was an attempt to identify "process"

unconscionability, so that courts could reserve their intervention in the private contract arena to alleviating the plight of helpless or desperate borrowers. Commercial mortgagors don't easily fit within that class of protected consumers, despite their occasional claims to the contrary.

Another rationale for denying commercial mortgagors relief from harsh prepayment clauses is that prepayment arrangements figure prominently, if often subtly, in loan pricing. When courts limit lenders to actual loss, instead of enforcing agreed prepayment penalties, borrowers reap a windfall by obtaining for free what would have cost them a higher interest rate or front end fee. To avoid unjust enrichment, borrowers should be made to reimburse lenders for lost earnings. Courts recognizing the legitimacy of the lender's claim might well decide not to interfere with the contract in the first place, anticipating that in many cases what the borrower saves in prepayment relief will be offset by the lender's foregone interest on the underlying loan.

In order to protect undersecured and unsecured creditors, many bankruptcy courts limit prepaid lenders to actual damages, rigorously calculated to return no more than reinvestment loss, unless the lender had agreed to a prepayment formula yielding a lesser sum. Some courts claim to be applying state liquidated damage rules – although mistaken in their analysis of state law. Others, more responsibly, predicate their opinions on Section 506(b) of the Bankruptcy Code. That section empowers bankruptcy judges to allow secured creditors "reasonable fees, costs or charges. Although some bankruptcy courts allow as a "reasonable" fee over compensatory yield maintenance fees, most limit the tender to actual reinvestment loss.

A legal threat to REMICs would arise from a black letter prescription in the Restatement of the Law (3d) Property (Mortgages), if courts took it seriously. Probably thinking only of portfolio lenders, the Restatement authors would allow borrowers to contravene an absolute prohibition against prepayment by providing "substitute security equal in value to the mortgage obligation ... that is substantially the equivalent of cash".

This provision would impair REMIC tax status if mortgagors prepaid during the two year lock out period; interest received on the collateral would be subject to entity level tax. Also, the Restatement would not limit substitute collateral to U.S. government obligations. It would allow borrowers to replace mortgages with "short-term certificates of deposit issued by financial institutions and fully covered by federal deposit insurance" and "short-term commercial paper issued by large firms and highly rated by national rating agencies". REMIC tax status only extends to Treasuries.

The Restatement authors appear to have overlooked the difference between portfolio and CUBS lenders in another respect. The Restatement defends prepayment provisions that overcompensate lenders as not necessarily inefficient by contending that mortgagors can simply re-negotiate with lenders to "split" the savings achievable by refinancing at lower rates. Portfolio lenders might well re-negotiate, especially if they were also providing the refinancing.

REMIC trustees and servicers are severely limited in their authority to modify the provisions of loans not in default. Re-negotiating the prepayment provision could constitute an impermissible loan modification, and result in a 100% tax on interest following the modification.

Tax considerations aside, re-negotiation would be more difficult than in a portfolio loan since CMBS bondholders are not all affected in the same way by prepayment. The class of bondholders who would forfeit the "excess" prepayment fee implicit in an over compensatory yield maintenance provision, would seldom be the same class of bondholders who would benefit from the credit-enhancing effect of a prepayment on the loan portfolio. Prepayment is often a blessing to the holders of the "first loss piece" and, usually, the holders of the mezzanine or "B" interests, described in the above example. But it can leave the holders of interest-only strips in the cold. In order to defend over compensatory prepayment fees as efficient, in the CMBS context, some rationale is required other than the borrower's ability to re-negotiate.

Each commercial real estate borrower's challenge lies in pricing the difference between yield maintenance and defeasance provisions, mindful of its own anticipated prepayment needs. In shopping for loans, borrowers will not necessarily have to choose between portfolio and CMBS lenders. Some CMBS lenders offer yield maintenance and other prepayment options, often at a price, to lure borrowers who resist defeasance. Conversely, even portfolio lenders, until now content with yield maintenance clauses, may desire the option of securitizing their loans, leading them towards defeasance.

Courts are more likely than ever to regard prepayment provisions as contracts for alternate performance, not penalties for breach, precisely because commercial mortgagors have choices, and loan rates, increasingly, take account of prepayment arrangements because CMBS issuers and investors are pricing them.

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