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- OCTOBER 2007
SEVENTH CIRCUIT CLARIFIES ENFORCEABILITY OF YIELD
MAINTENANCE CLAUSE IN RIVER EAST
In September, 2006, a federal district court in Illinois held that a prepayment fee  calculated using a yield maintenance formula was an unenforceable penalty. The case is River East Plaza, L.L.C. v. The Variable Annuity Life Insurance Company, 2006 WL 2787483 (N.D. Ill., Sept. 22, 2006). The United States Court of Appeals for the Seventh Circuit recently reversed this holding and held that the fee as calculated using the yield maintenance formula was enforceable. 
In 1999 Variable Annuity Life Insurance Company made a loan in the original principal amount of $12,700,000. The term of the loan was twenty years. The note provided that the loan could only be prepaid if the borrower paid a prepayment fee. The prepayment fee was the greater of (a) one percent of the principal balance and (b) the difference between the discounted present value of the remaining payments of principal and interest and the outstanding amount of principal. The discount to present value was based on the rate of United States Treasury bonds or notes with maturity dates the same as the maturity date of the loan. The rates were determined as of the date that the borrower gave its notice of intent to prepay. This is a standard yield-maintenance clause.  Three years later, in 2002, the borrower had an opportunity to sell the property and wanted to pay off the loan in connection with the sale. The borrower requested a payoff from the lender. The lender calculated the amount of the prepayment fee at approximately $4,713,000, or thirty-eight percent of the principal balance.  The borrower paid the fee under protest and then brought an action in state court for a declaratory judgment that the prepayment fee was an unenforceable penalty.
DISTRICT COURT DECISION
The lender removed the case to the United States District Court for the Northern District of Illinois which held that the prepayment fee as calculated using the yield maintenance formula was an unenforceable penalty. According to the district court, Illinois law, which governed in this diversity case, uses a liquidated damages analysis to determine whether a prepayment provision is a penalty. Under a liquidated damages analysis, among other things, the amount of damages must be reasonable at the time of contracting. The district court determined that the yield maintenance calculation in the River East note was not reasonable because the amount of the prepayment fee calculated using the yield maintenance formula did not bear a relationship to the damages that the lender sustained as a result of the prepayment. The district court wrote that the prepayment provision should represent the present value of the lost interest if the lender reinvests the principal in a comparable real estate investment. The Treasury rate used in the yield maintenance calculation was much lower than the rate of a comparable commercial real estate loan at the time of the prepayment, making the prepayment fee artificially high. This calculation overcompensates the lender, according to the district court.  The borrower showed evidence suggesting that the lender in fact did not invest the money that was prepaid in treasuries, but put it in higher yielding investments. The district court held that the lender was entitled only to the alternative one percent prepayment fee. 
SEVENTH CIRCUIT OPINION
The lender appealed the district court’s decision to the Seventh Circuit Court of Appeals. In a decision dated August 22, 2007 and reported at 2007 WL 2377383, the Seventh Circuit reversed the district court’s decision. The Seventh Circuit noted that since the Illinois Supreme Court had not addressed the enforceability of a prepayment fee in a commercial mortgage, the Seventh Circuit would have to make an Erie guess about how the Illinois Supreme Court would rule in this question. The borrower argued that an Illinois court would analyze the prepayment fee under a liquidated damages analysis. The lender argued that under Illinois law, the prepayment clause would be considered to be a bargained-for form of alternative performance and not as liquidated damages. The Seventh Circuit noted that an Illinois case had specifically cited the second sentence of Section 356 of the Restatement (Second) of Contracts,  a traditional liquidated damages test,  which provides, “A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty.” The Seventh Circuit observed that penalty clauses are distinguishable from alternative forms of performing obligations. Comment c to Section 356 provides in part, “In determining whether a contract is one for alternative performances, the relative value of the alternatives may be decisive.” The court then considered the relative values of the prepayment provision in the River East note. The value to the borrower was clear: by paying off the loan early, the borrower paid only $3.9 million in interest, rather than the $13 million that the borrower would have paid over the term of the note if the borrower had not prepaid. The benefit to the lender was that the lender received its principal and had the choice to invest in Treasuries or re-invest the money in another investment with a higher return and higher risk. Since the alternative performances for both the borrower and lender had value, reasoned the Seventh Circuit, the prepayment provision was not a penalty but was a bargained-for alternative means of performance and was therefore enforceable. The Seventh Circuit held that the lender was entitled to judgment as a matter of law on the question of the enforceability of the prepayment provision, and reversed the district court on this issue. The Seventh Circuit noted that an issue remained regarding the calculation of the amount of the prepayment charge, and remanded the case to the district court for further proceedings on this issue.
There are several interesting issues in the Seventh Circuit’s decision. First, it is interesting to note that, while the district court considered the fact that the lender arguably benefited from the prepayment as a reason why the yield maintenance provision was an unenforceable penalty, the Seventh Circuit considered the lender’s potential ability to make a better investment as a bargained-for alternative performance and therefore the basis for finding that this prepayment provision was not a penalty.
Second, while the Seventh Circuit began its analysis by following the borrower’s argument that a liquidated damages analysis should govern, this inquiry quickly morphed into following the lender’s argument that the test should be whether the prepayment clause represents bargained-for alternative performance. The transition point from the borrower’s test to the lender’s test was comment c to Section 356 of the Restatement, which comment provides that a contract provision may not be a penalty if both parties benefit from the alternative performance. Based on the court’s conclusion that the yield maintenance clause was not a penalty because the clause had value to both parties, the Seventh Circuit arguably adopted the lender’s suggested test for determining the enforceability of the clause rather than the borrower’s test.
Third, while the Seventh Circuit went through the liquidated damages analysis because of the possibility that an Illinois court would apply a liquidated damages analysis, the court questioned whether a liquidated damages analysis was an appropriate test for a voluntary prepayment.  Prepayments can be voluntary, such as when a borrower decides to sell the property (as was the case in River East) or when the borrower refinances, or involuntary, such as when the borrower defaults. Arguably a liquidated damages analysis should only apply when there is a breach of the contract, not when the borrower chooses to exercise a contractual alternative.  The Seventh Circuit quoted at length from an article by Professor Dale Whitman to the effect that a liquidated damages analysis should not apply to voluntary prepayments.  When a lender seeks to enforce a prepayment provision in bankruptcy, Section 506(b) of the Bankruptcy Code imposes a reasonableness limitation on the enforceability of prepayments fees, regardless of whether the payment is voluntary or involuntary. 
Finally, this case is one of several recent federal court cases upholding the enforceability of yield maintenance clauses. Since the district court decision in River East, the Eighth Circuit Court of Appeals has affirmed a district court decision enforcing a prepayment fee with a yield maintenance provision  and a federal districtcourt in Ohio has held that a prepayment fee based on a yield maintenance formula was enforceable.  It is important to remember that these cases are all federal courts in diversity cases predicting how state courts would rule. State courts could reach different results. The last paragraph of the opinion dealing with the question of the enforceability of the prepayment charge suggests that the Seventh Circuit was aware of its role with regard to state law issues:
We are convinced that a contrary result would have broad implications for both lenders and borrowers of mortgage-secured loans in Illinois, and might inadvertently effect a wide-ranging alteration of the law of real estate financing in Illinois. “The responsibility for making innovations in the common law of Illinois rests with the courts of Illinois, and not with the federal courts.” [citations omitted]
What practical lessons can attorneys learn about yield maintenance provisions from the River East case?
For attorneys representing lenders, don’t use language that the prepayment provision constitutes liquidated damages. Consider instead including in the note or loan agreement recitals to the effect that (if applicable) the lender is making long-term financial commitments to third parties based on receiving the payments negotiated in this agreement; that the lender’s financial performance and ability to meet its commitments depend not just on total returns from loan but timely payment on the terms negotiated; that if the borrower prepays, the lender will have redeploy the funds and may not be able to achieve the same level of return in the market, and that this yield maintenance clause was specifically intended by borrower and lender to protect the lender against this risk; that borrower acknowledges that lender could have prohibited prepayment altogether or borrower could have negotiated different prepayment terms, but that in that event the interest rate would have been higher to compensate the lender for this risk; that lender is not required to actually invest the funds in US Treasuries; and that the calculation of the prepayment charge using a yield maintenance clause is bargained-for consideration and does not represent damages or a penalty. The lender also may want to provide the borrower with some examples of how the yield maintenance provisions would work. Lenders who are seeking to enforce prepayments based on yield maintenance formulas in court need to be prepared to have an expert testify about how the yield maintenance formula was calculated. 
For attorneys representing borrowers, the most important lesson is understanding that yield maintenance clauses like the one in River East can produce astronomical numbers and advising the client about this. Borrowers are often focused on the interest rate and the non-recourse provisions, and the terms of the prepayment provision often are beneath their radar, so it would be prudent to document this advice. The borrower’s attorney needs to understand the prepayment provision and try to negotiate the best terms that he can for his client.  Depending on whether the law in his or her state is settled, the borrower’s attorney should make an exception in his enforceability opinion for the enforceability of the prepayment provisions. Finally, if matters reach a point that the lender is making demand for payment of the prepayment penalty, the borrower’s attorney should be sure to check the lender’s calculations. In the River East case, the lender overstated the prepayment fee by almost a million dollars.
The Seventh Circuit’s decision in River East is an important decision regarding the enforceability of prepayment provisions in general and yield maintenance calculations specifically. It contains important lessons for lenders and borrowers.
 For detailed analysis of the law of regarding prepayment fees generally, see John C. Murray, Enforceability of Prepayment-Premium Provisions in Mortgage Loan Documents, John C. Murray Reference Library, http://www.firstam.com/ekcms/uploadedFiles/firstam_com/References/Reference_Articles/John_C_Murray_Reference/Mortgages_and_Financing/prepaymentarticle.pdf?menu=682 (last visited on October 22, 2007); Dale A. Whitman, Mortgage Prepayment Clauses: An Economic and Legal Analysis, 40 U.C.L.A. L. Rev. 851 (April 1993).
 River East Plaza, L.L.C. v. The Variable Annuity Life Ins. Co. , 2007 WL 2377383 (7 th Cir., Aug. 22, 2007).
 For background on the use of yield maintenance clauses to calculate prepayment charges, see George Lefcoe, Yield Maintenance and Defeasance: Two Distinct Paths to Commercial Mortgage Prepayment, 28 Real Est. L.J. 202 (Winter 2000).
 Negotiations continued between the lender and the borrower over the date of prepayment and the calculation of the prepayment. Eventually the lender credited the borrower $826,922.27 as a result of errors in the lender’s calculations.
 At trial the borrower introduced testimony of the lender’s Director of Mortgage Loans that the prepayment calculation in the note was “very, very punitive.” The district court quoted this testimony twice in its opinion. One article has suggested that these comments were made in an unrelated proceeding in a different matter. Gregory A. Thorpe, River East Plaza: Liquidated Damages Analysis Applies to Prepayment Premium, 42 Real Prop. Prob. & Trust J. 41, 45 n. 20 (Spring 2007).
 The district court extensively cited In Re Kroh Bros., 88 B.R. 997 (Bankr. W.D. Mo. 1988) and In re Skyler Ridge, 80 B.R. 500 (Bankr. C.D. Cal. 1987) in support of its holding. These cases have been heavily criticized. See John C. Murray, Prepayment Premiums: A Bankruptcy Court Analysis of Reasonableness and Liquidated Damages, 105 Com. L.J. 217, 228 (2000); Debra P. Stark, New Developments in Enforcing Prepayment Charges After an Acceleration of a Mortage Loan, 26 Real Prop. Prob. & Trust J. 213 (1991).
 The first sentence of Section 356 of the Restatement (Second) of Contracts states: “Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in the light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss.”
 An alternative statement of the test for liquidated damages is found in the Uniform Commercial Code. Section 2-718(1) of the uniform version of the Uniform Commercial Code provides in relevant part:
Damages for breach by either party may be liquidated in the agreement but only at an amount which is reasonable in light of the anticipated or actual harm caused by the breach, the difficulties of proof of loss, and the inconvenience or nonfeasibility of otherwise obtaining an adequate remedy. A term fixing unreasonably large liquidated damages is void as a penalty.
In 2003 the National Conference of Commissioners of Uniform State Laws and the American Law Institute proposed amendments to Section 2-718(1) that would make a distinction between commercial and consumer loans. These amendments, among other things, inserted the words "and, in a consumer contract," in the first sentence of Section 2-718(1), so that the first sentence would read, "Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in the light of the anticipated or actual harm caused by the breach, and, in a consumer contract, the difficulties of proof of loss, and the inconvenience or nonfeasibility of otherwise obtaining an adequate remedy." The 2003 amendments also drop the last sentence of Section 2-718(1), which provides, "A term fixing unreasonably large liquidated damages is void as a penalty." However, no state has adopted the 2003 amendments to Article 2.
 One author has taken the position that the district court’s opinion that Illinois law requires a liquidated damages analysis of prepayment provision is not a correct interpretation of Illinois law. Gregory A. Thorpe, River East Plaza Liquidated Damages Analysis Applies to Prepayment Premium, 42 Real Prop. Prob. & Trust J. 41, 51-55 (Spring 2007).
 See Clean Harbors, Inc. v. John Hancock Life Ins. Co., 833 N.E. 2d 611, 618 (Mass. App. 2005).
 Dale A. Whitman, Mortgage Prepayment Clauses: An Economic and Legal Analysis, 40 U.C.L.A. L. Rev. 851 (April 1993).
 Section 506(b) of the Bankruptcy Code provides,
To the extent that an allowed secured claim is secured by property the value of which, after any recovery under subsection (c) of this section, is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose.
This statute applies to prepayment fees. See Holmes v. Citigroup Investments AgriFinance (In re Holmes), B.R. 317, 321 (Bankr. M.D. Ga. 2005); In re Outdoor Sports Headquarters, Inc., 161 B.R. 414, 424 (Bankr. S.D. Ohio 1993). The First Circuit has recently held that when the debtor’s assets exceed the claims of creditors, a secured creditor who cannot meet the reasonableness test of Section 506(b) nevertheless may be able to collect its prepayment fee under Section 502 of the Bankruptcy Code. Gencarelli v. UPS Capital Business Credit, 2007 WL 2446883 (1 st Cir., Aug. 30, 2007).
 CP Holdings, Inc. v. California Public Employees Retirement System , 2006 WL 3203751 (8 th Cir., Nov. 7, 2006).
 Chillicothe Telephone Co. v. The Variable Annuity Life Insurance Co., 2007 WL 397058 (S.D. Ohio, Jan. 31, 2007).
 In prepayment cases the outcome sometimes depends on the quality of the lender’s witness who explains how the prepayment was calculated. Compare In re CP Holdings, Inc., 332 B.R. 380, 386-87 (W.D. Mo. 2006) (court relies extensively on lender’s expert witness and holds that yield maintenance clause is enforceable), aff’d, 2006 WL 3203751 (8 th Cir., Nov. 7, 2006) with UPS Capital Business Credit v. Gencarelli, 2006 WL 3198944 (D.R.I., Nov. 3, 2006), rev’d on other grounds, 2007 WL 2446883 (1 st Cir., Aug. 30, 2007) (district court finds that lender’s witness was “clueless” and that lender is not entitled to prepayment fee).
 See Atlantic Ltd. Partnership v. John Hancock Mutual Life Ins. Co., 95 F. Supp. 2d 678, 683 (E.D. Mich. 2000) (court lists changes to prepayment calculations that borrower should have asked for).
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