Trouble Averted: Seventh Circuit Court Upholds Yield Maintenance Provision

The U.S. Court of Appeals for the Seventh Circuit restored the efficacy of a common lender protection when it determined that a yield maintenance prepayment clause was enforceable under Illinois law. The Seventh Circuit’s opinion, River East Plaza, L.L.C. v. The Variable Annuity Life Co., ___ F.3d ___, 2007 WL 2377383 (7th Cir. Aug. 22, 2007), reversed a decision made last fall by the U.S. District Court for the Northern District of Illinois, which struck a standard yield maintenance clause as an unenforceable penalty. SeeRiver East Plaza LLC v. The Variable Annuity Life Company, No. 03 C 4354, 2006 WL 2787482 (N.D. Ill. Sept. 22, 2006).

The prepayment formula at issue reduced to present value all unpaid installments of principal and interest by reference to the yield to maturity on a U.S. Treasury bond or note having a maturity date closest to the maturity date of the loan. Commenting that prepayment clauses are nothing new, the Seventh Circuit went on to distinguish penalties or liquidated damages clauses in general from alternative forms of performing contractual obligations. “In order to distinguish between the two, ‘a court will look to the substance of the agreement to determine whether . . . the parties have attempted to disguise a provision for a penalty that is unenforceable . . . . In determining whether a contract is one for alternative performances, the relative value of the alternatives may be decisive.’” River East, 2007 WL 2377383, *3 (quoting Restatement Second of Contracts § 356 cmt c.). After considering the relative values of performance alternatives, the Court found that “River East voluntarily prepaid, and by doing so River East escaped paying $13 million in interest over seventeen years by prepaying $3.8 million in 2003.” Id. at *5. The Court concluded that “[t]he relative value of the alternatives for both parties leads us to believe that the clause is not punitive in nature.” Id. at *5.

In addition, the Court rejected the rubric of liquidated damages to determine if prepayment clauses are unreasonable: “Certainly under any ordinary view of the contract’s unambiguous terms, the prepayment is not a breach: the parties explicitly provided that River East would be allowed to prepay. The fee for prepaying seems a long stretch from damages for a breach if both parties entered the contract believing that the contract allowed River East to prepay.” Id. at *5. The Court also noted that Illinois cases are silent as to the application of a liquidated damages analysis to prepayment provisions.

The Seventh Circuit clearly appreciated the implications that the district court’s ruling might have in the mortgage market. In reversing the district court, the Court was “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.” Id. at *8.