In a closely watched case, the U.S. Court of Appeals for the Seventh Circuit, in River East Plaza, L.L.C. v. The Variable Annuity Life Insurance Company, recently reversed the U.S. District Court for the Northern District of Illinois and held that a "Treasury-flat" yield maintenance premium in a commercial mortgage was enforceable under Illinois law. A yield maintenance premium requires a borrower to pay the lender for the loss of interest that the lender will suffer as a result of a borrower's repaying the loan prior to its scheduled maturity date.
In River East, the borrower sought a mortgage loan to finance the purchase and development of a retail center. The lender agreed to make the loan on terms acceptable to the borrower. One of the terms included a prepayment clause that required the borrower to pay the lender a premium in the event that the borrower elected to repay the loan prior to the maturity date of the loan. Specifically, the note required that if the borrower prepaid the loan, the borrower would pay the lender a premium equal to the greater of one percent of the outstanding principal balance of the loan or the yield maintenance amount tied to the prevailing interest rate on U.S. Treasury bonds or notes maturing closest to the loan's maturity date. Several years after the loan closed, the borrower wanted to prepay the loan, and it disputed the enforceability of the prepayment premium. Eventually, the borrower paid the premium under protest and then brought suit against the lender.
At the trial level, the district court found in favor of the borrower. The district court believed that Illinois courts would apply a liquidated damages analysis and concluded that the prepayment clause in the note was unreasonable.
In reversing the district court, the Seventh Circuit began by noting that "prepayment clauses are nothing new." The court framed the question before it as whether an Illinois court would consider the prepayment provision in the note a penalty that is unenforceable or a contract for alternative performance. The court then looked at the relative values of prepaying or not prepaying the loan. If the borrower had not prepaid the loan, it would have been obligated to pay $13 million in interest over the remainder of the term of the loan. By electing to prepay the loan, the borrower had to pay the lender under the terms of the note $3.9 million as a premium in addition to the principal of the note. In looking at these alternatives, the court found nothing to "convince" it that the prepayment provision was a disguised penalty.
Further, the court noted that, under Illinois law, the lender could have expressly precluded the borrower from prepaying the loan. Instead, the lender accommodated the borrower's desire to have the right to prepay the loan subject to the borrower's paying the required premium. The borrower made the election to prepay the loan and save $13 million in interest. The lender received its principal and premium, and was free to invest the money in U.S. Treasuries (in which case the lender would receive what it bargained for under the note as if the note had not been prepaid), hold its cash (in which case it would receive less than what it bargained for under the note) or invest its cash in a new real estate loan with the attendant risks of making real estate loans.
The Seventh Circuit rejected the district court's application of a liquidated damages analysis. Liquidated damages arise when there is a breach by one of the parties to the contract, the court noted. Here, there was no breach. The parties had explicitly provided that the borrower may prepay the loan if the borrower paid the lender the required fee. Moreover, the Seventh Circuit concluded that even if a liquidated damages analysis was applicable, the prepayment premium was reasonable.
The holding in East Plaza comforts lenders that numerous loans with similar yield maintenance provisions are enforceable. The court was aware of the importance of its decisions when it stated: "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."
Attorneys from Duane Morris, representing fourteen insurance companies, filed an amicus brief which contained several arguments that the Seventh Circuit included in its opinion.