Lenders be advised. Prepayment penalties and yield maintenance clauses have recently come under attack in Illinois. More specifically, the United States District Court for the Northern District of Illinois has recently held that under Illinois law a prepayment penalty provision contained in an underlying commercial note was an unenforceable penalty. River East Plaza, LLC v. Variable Annuity Life Co., No. 03 C 4354, 2006 WL 2787483 (N.D. Ill. Sept. 22, 2006).
At the heart of the dispute was the lender’s use of U.S. Treasury securities as the basis for determining the reinvestment rate under the prepayment premium of the Note. The Court accepted the borrower’s argument that the lender was overcompensated because the reinvestment rate was based upon a Treasury security of a similar maturity date of the Loan without any additional “spread” or interest points. Id. at *10. The overcompensation occurred because (1) the lender was able to reinvest in a basically risk-free investment treasury investment or, alternatively, (2) a comparable risk transaction that would have yielded a greater return:
Under either scenario, River East asserts that [Variable] is overcompensated on its original investment – either through decreased risk or a larger return. Instead of using a treasury-based reinvestment rate, River East contends that a reinvestment rate of a Treasury security with an added spread (or interest points) would accurately reflect the risk [Variable] undertook in making a commercial real estate loan to River East and, accordingly, adequately compensate [Variable] for the prepayment. Id.
It appears that the fallout from the decision has already occurred and borrowers are aggressively filing declaratory judgment actions seeking to invalidate their yield maintenance provisions. For example, in Cornerstone Leased Drug Stores, LLC v. Wells Fargo Bank Northwest,1 the borrower filed a complaint to determine the enforceability of a $20.6 million prepayment penalty. Count I seeks a declaratory judgment that the prepayment penalty constituted an unlawful penalty. The borrower seeks the refund of the prepayment penalty based on the theory of unjust enrichment and also contests the method pursuant to which the lender calculated the prepayment penalty.
Railway Plaza Naperville, LLC. v. Federal Home Loan Mortgage Corporation, Glaser Financial Group, Inc and MMA Financial, Inc.2 also places at issue the validity of yield maintenance. Railway, as the developer of an apartment complex in Naperville, Illinois, entered into a multifamily note pursuant to which it borrowed $41 million from Freddie Mac. Like Cornerstone, Railway posited that the prepayment penalty constitutes an unenforceable penalty and does not bear any reasonable relationship to Freddie Mac’s probable damages. The complaint contains two counts: (1) declaratory judgment; and (2) equitable restitution/unjust enrichment. The amount of the prepayment penalty is $3,593,131.
The River East decision will be one to watch as it is currently on appeal before the Seventh Circuit Court of Appeals. River East Plaza, LLC. v. The Variable Annuity Life Insurance Co., No. 06-3856 (7th Cir.) Note, however, that until the Seventh Circuit decides the appeal, the ruling by the district court is binding precedent only upon the district court, which issued the opinion, and such an opinion does not serve as binding precedent on state courts or other federal courts. Gould v. Bowyer, 11 F.3d 82, 84 (7th Cir. 1993); see also U.S. ex rel. Bidani v. Lewis, No. 97CV6502, 1998 WL 1820753, *9 n.7 (N.D. Ill. Dec. 29, 1998); Ass’n of Community Orgs. for Reform Now (ACORN) v. Edgar, 880 F. Supp. 1215, 1218 (N.D. Ill. 1995); People v. Ming, 316 Ill. App. 3d 1274, 1280, 738 N.E.2d 628, 633 (5th Dist. 2000).
1. Cornerstone was filed on February 15, 2007 and is presently pending in the Chancery Division of the Circuit Court of Cook County, Illinois. It is docketed as Case No. 07 CH 4352.