August 2, 2007

As anyone familiar with commercial lending can attest, prepayment premiums are a common part of many lending relationships, particularly in fixed-rate credit facilities. Often referred to as "yield maintenance" premiums, prepayment premiums used in fixed-rate facilities are designed to allow a lender to lock in a certain return it expects to receive on the loan so the lender is financially indifferent to being prepaid. If the loan is repaid prior to its maturity, the borrower must pay the lender a portion of the return that the lender would have received during the balance of the loan term, in addition to the principal and any accrued interest.

Although there are good business justifications for prepayment premiums, their enforceability under Illinois law is limited. Evaluated in the same manner as liquidated damages provisions, prepayment premiums are generally enforceable only if they represent a reasonable estimation of the economic loss a lender will suffer when a loan is prepaid. Yield maintenance premiums that are clearly disproportionate to that estimate, or serve merely to prevent or punish prepayment, will likely be unenforceable.

Recent Case Law

The United States District Court for the Northern District of Illinois recently considered the enforceability of a yield maintenance premium under Illinois law in an important and enlightening case, River East Plaza, L.L.C. v. the Variable Annuity Life Company, et al.

River East Plaza involved a fixed-rate commercial real estate mortgage loan that was prepaid by the borrower. The prepayment premium in dispute would have compensated the lender for the difference between (i) the present value of the principal and interest payments the lender would have received through the balance of the term, discounted at a rate equal to the yield to maturity of U.S. Treasury securities with a comparable maturity, and (ii) the outstanding principal. In essence, this formula sought to make the lender whole by having the borrower pay the spread between the current loan rate and a "reinvestment rate" that the lender could earn from an alternative investment vehicle over the loan term.

In analyzing the prepayment premium, the court noted that no "differential" had been added to the reinvestment rate in order to make it better approximate the return the lender could have received on a similar investment. For example, since the loan rate was priced 1.27% higher than the U.S. Treasury rate when the loan was made, that spread might have been a reasonable differential to account for the added risk to the lender.

Accordingly, the court agreed with the borrower's argument that the reinvestment rate used in the prepayment premium was unreasonably low because it did not include a risk differential. Therefore, the prepayment premium overcompensated the lender by allowing it to either (i) receive the same return without the risk bargained for in the original loan or (ii) reinvest the prepayment proceeds in a comparable investment and receive a windfall double return. The court did not agree with the lender's argument that the lack of a differential was reasonable compensation for the time lag it would suffer between repayment and reinvestment because on the date of repayment, the lender could have easily funneled the prepayment proceeds into its substantial existing holdings of Ginnie Maes, Freddie Macs or corporate bonds—all of which had a comparable level of risk and return.

As a result, the lender was awarded a significantly lower prepayment premium, calculated under an alternate formula contained in the loan documents. Without that stipulation in the loan documents, the lender would have been entitled to its actual damages.

The River East Plaza case shows that Illinois courts are willing to evaluate prepayment premiums in significant detail and invalidate those that do not represent a reasonable estimation of a lender's damages. Although the case dealt with a yield maintenance premium in a fixed-rate commercial real estate loan, the court's reasoning could be extended to prepayment premiums calculated differently and used in other situations. In light of this, commercial lenders should use caution when crafting prepayment premiums and consult with counsel to ensure that they accomplish their business goals, while mitigating the risk of unenforceability.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.