River East Plaza v. Variable Annuity Life Ins.

• Decision Date: 22 August 2007
• Docket Number: No. 06-3856.,06-3856.
• Citation: 498 F.3d 718
• Parties: RIVER EAST PLAZA, L.L.C., formerly known as MCL Clybourn Square South, L.L.C., Plaintiff-Appellee, v. The VARIABLE ANNUITY LIFE INSURANCE COMPANY, Defendant-Third Party Plaintiff-Appellant, v. Daniel E. McLean, Third Party Defendant-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

498 F.3d 718

RIVER EAST PLAZA, L.L.C., formerly known as MCL Clybourn Square South, L.L.C., Plaintiff-Appellee, v. The VARIABLE ANNUITY LIFE INSURANCE COMPANY, Defendant-Third Party Plaintiff-Appellant, v. Daniel E. McLean, Third Party Defendant-Appellee.

No. 06-3856.

United States Court of Appeals, Seventh Circuit.

Argued April 11, 2007.

Decided August 22, 2007.

Arthur M. Holtzman (argued), Pedersen & Houpt, Chicago, IL, for Plaintiff-Appellee.

George Eric Brunstad, Jr. (argued), Bingham McCutchen, Hartford, CT, for Defendant-Appellant.

Before CUDAHY, KANNE, and WOOD, Circuit Judges.

KANNE, Circuit Judge.

This diversity case involves a loan used to finance a significant commercial real estate development. When the borrower sold the property and pre-paid the loan, it balked at paying a "prepayment fee" according to the terms of the note. The borrower eventually paid the fee, subject to a reservation of rights, and sued the lender. After a bench trial, the district court entered judgment in favor of the borrower and the lender now appeals. For the reasons set forth below, we reverse the judgment of the district court and remand the case for further proceedings.

I. HISTORY

River East Plaza, L.L.C. (River East) is a real estate developer.¹ Third party defendant Daniel E. McLean is the president of River East. River East had worked with another party to develop a large retail store on the north side of Chicago. In 1999, the other developer offered to sell its share of the project to River East for roughly $12 million. River East, through a mortgage broker, shopped around for a loan to allow it to buy out the other developer's share. Variable Annuity Life Insurance Company (VALIC) offered to meet River East's demand for a closing date before the end of the year and agreed to an interest rate that River East wanted. Among the other terms of VALIC's offer was a "yield maintenance" prepayment clause. A yield maintenance prepayment clause is an attempt to ensure that prepayment does not deprive the lender of the yield that they bargained for over the life of the loan.

The final version of the note contained a yield maintenance calculation which the parties describe as "Treasury-flat." To arrive at the amount of the yield maintenance fee in the event that River East decided to prepay, the parties would need to know the outstanding principal as of the date of prepayment and the scheduled loan payments from that date to maturity. They would also need to determine the prevailing interest rate on United States Treasury bonds or notes maturing closest to the loan's maturity date of January 2020 ("Treasuries"). With those three amounts in hand, the clause calculates the difference between the scheduled payments and potential interest if the prepaid principal were invested in Treasuries. That amount is compared to an amount equal to one percent of the outstanding principal. The larger of these two numbers is then compared with the highest rate allowed by law and the lesser of those two numbers is the yield maintenance fee. In short, the remaining interest due under the note is discounted by the current interest rate on Treasuries. The provision is described as Treasury-flat because parties can (and apparently occasionally do) negotiate a discount rate that is different from the Treasury yield.

Some examples are in order. If River East decided to exercise the privilege of prepayment and interest rates had fallen since the time that the loan was funded, River East would be on the hook to pay VALIC the difference between what VALIC would have received in interest over the life of the loan and what VALIC could receive by investing the prepaid principal into Treasuries. Assuming that VALIC placed the unexpected principal into Treasuries and received the prepayment fee from River East, the expected yield that VALIC bargained for would be "maintained" by River East supplementing the interest on the reinvested funds with the prepayment fee. If, however, River East prepaid the loan and interest rates had risen substantially in the interim, the interest on the Treasuries would presumably exceed the interest rate called for in the loan and the prepayment fee would equal the minimum fee of one percent of the outstanding principal. But in no case would the fee exceed the maximum interest rate allowed by law.

The parties dickered over several of the terms in the note. River East sought to have the yield maintenance fee removed, but VALIC refused. Prior to closing, River East's counsel offered to both parties a seven-page opinion letter that, among many other opinions, "express[ed] no opinion as to the enforceability of any provision . . . providing for a prepayment premium in the event . . . such premium is held to be a penalty." Appellant's App. at 183F. Nevertheless, the parties went forward with the closing.

Several years later, River East sought to sell the property. The tenant had a right of first refusal, and offered to purchase the property. But the tenant would not assume the loan. River East eventually sold the property to the tenant and prepaid the loan.

The parties then began to dispute the size and enforceability of the prepayment penalty. River East eventually paid the penalty under protest, and brought suit in the state courts of Illinois. VALIC removed the case to the federal district court and counter-claimed against River East and McLean for costs and fees. The parties agree that, due to a mathematical error, VALIC's agent had overcharged River East by nearly one million dollars when it computed the prepayment fee. VALIC returned the overcharge, with interest, but the parties still dispute whether the amount returned was the correct amount. The district court conducted a bench trial, and entered judgment in favor of River East on the question of whether the prepayment fee was enforceable under Illinois law. The district court did not enter judgment on the question of whether VALIC had accurately returned the overcharge (that question being moot due to the court's first holding), and the court dismissed VALIC's cross-claim. This appeal followed.

II. ANALYSIS

VALIC appeals the judgment entered after a bench trial. We review the district court's findings of fact for clear error and review legal conclusions de novo. Trustmark Ins. Co. v. General & Cologne Life Re of America, 424 F.3d 542, 551 (7th Cir.2005). A federal court sitting in diversity applies the substantive law of the state in which the district resides. Erie R.R Co. v. Tompkins, 304 U.S. 64, 78, 58 S.Ct. 817, 82 L.Ed. 1188 (1938). When the highest court in the state has spoken on a question of law, we apply that rule. Reiser v. Residential Funding Corp., 380 F.3d 1027, 1029 (7th Cir.2005). When the highest court has not spoken, we attempt to predict how the highest court would hold. Id.

We have three questions before us on the appeal. First, whether the prepayment clause is enforceable under Illinois law. Second, if the clause is enforceable, whether the amount refunded by VALIC was the correct amount. Third, again only if the clause is enforceable, whether River East or McLean owes costs and fees to VALIC.

A. Enforceability of the Prepayment Fee

Yield maintenance prepayment clauses are nothing new. See Dale A. Whitman, Mortgage Prepayment Clauses: A Legal and Economic Analysis, 40 UCLA L.REV. 851, 871 (1993). The idea behind a yield maintenance clause is to protect a lender during times when interest rates are falling. "Yield maintenance formulas are calculated to cover the lender's reinvestment loss when prepaid loans bear above-market rates." George Lefcoe, Yield Maintenance and Defeasance: Two Distinct Paths to Commercial Mortgage Prepayment, 28 REAL EST. L.J. 202, 202 (2000). A lender who makes a long-term loan expecting a particular rate of interest runs the risk that prepayment during a period of lower interest rates will reduce its income. VALIC argues that some lenders, itself included, need to be able to rely on predictable payments in order to live up to their other financial and regulatory obligations. When the loans in question are measured in eight digit figures, as in this case, the lost interest income can be substantial.

One method that lenders might use to guard against this risk is to refuse to allow borrowers to prepay the loan. See RESTATEMENT (THIRD) PROP. (MORTGAGES) § 6.2 (1997) ("an agreement that prohibits payment of the mortgage obligation prior to maturity is enforceable"). Or lenders might charge a fixed fee, a percentage of the loan balance, or a declining percentage of the loan balance. Whitman, 40 UCLA L.REV. at 871. However, assuming that the borrower would like the privilege of prepaying the loan instead of being locked in for its entire term, fees based on fixed numbers or the loan balance do not take into account long-term fluctuations in interest rates. Hence the development of yield maintenance clauses: formulas that attempt to account for the expected interest, the outstanding principal, and fluctuations in prevailing interest rates.

We should note at the outset that the parties are unable to agree on the legal standard that Illinois courts would apply to this question. River East maintains that Illinois would analyze the prepayment fee under a liquidated damages analysis. Appellee's Br. at 17-31. VALIC argues that Illinois would consider the clause to be a bargained-for form of alternative performance. Appellant's Br. at 16-19. The district court applied Illinois's liquidated damages analysis but did not cite any Illinois cases to support that decision. River East Plaza, L.L. C. v. Variable Annuity Life Co., No. 03 C 4354, 2006 WL 2787483 at *8-9 (N.D.Ill. Sep. 22, 2006).

The parties can point us to no case from the Illinois Supreme Court that establishes a rule of law for the enforceability of prepayment fees in commercial real estate loans, and we are unable to find one. Illinois has placed...