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Kennedy family patriarch Joseph P. Kennedy bought the Merchandise Mart in 1945, for $13 million. The plaintiff in this case, LaSalle National Bank, was the holder of legal title to the property, not personally but solely as trustee under an Illinois land trust. The entire beneficial interest was held by Mart Owners, a limited partnership in which the limited partners were trustees of testamentary trusts of the Kennedy family.

The dispute arose out of the prepayment provision in MetLife's 1987

20year nonrecourse loan to Mart Owners in the amount of $250 million, which was secured by a first mortgage on the Mart. The prepayment clause in the mortgage was highly unusual. The provision contained "lockout" language that prevented any prepayment during the first 10 years of the loan. The mortgage could be prepaid during the last 10 years, but a "prepayment fee" would be due and payable by the mortgagor equal to the excess, if any, that would be required (over and above the outstanding principal balance) to purchase, on the date of prepayment, a "security instrument selected in good faith" by MetLife that, in the "good faith judgment" of MetLife, was of "comparable investment quality" to the original 1987 loan as of the date the loan was made.

According to the court, "Because high quality security instruments typically carry low yields, a determination that the 1987 Loan was of high quality would enable MetLife to claim a substantial prepayment penalty because of the gap between the Note's interest rate of 9.75% and the lower rate payable on a high quality substitute security instrument."

Apparently the parties settled on this unusual language because they could not reach agreement, during loan negotiations, on a more exact benchmark. As Judge Reid notes, on page 4 of the opinion, "The language of the prepayment penalty provision at issue in this case is unique. The evidence at trial failed to reveal any other loan with a prepayment penalty provision similar to the one at issue in this case."

Not surprisingly, MetLife argued that the mortgage, at the time it was made, was comparable in investment quality to an "A" rated corporate bond. MetLife's attorneys produced the original loan proposal submitted by Mart Owners, which referred to the Mart as the "preeminent market center building in the world" and which praised the internal design and construction of the Mart as "superior" and as having a projected life far greater than most buildings. The proposal also described the thencurrent management, operation and maintenance of the Mart as exceeding the qualitative and quantitative scope of services usually provided to commercial real estate projects. MetLife also noted that Mart Owners, in their own internal evaluations, valued the Mart at more than $400 million.

On the other hand, Mart Owners argued that the loan was on a substandard property that, at the time it was made, did not generate sufficient income to cover the required debt service and necessitated a $60 million escrowed holdback of the loan proceeds by MetLife, to be distributed only upon the achievement of a 1:2 debtservicecoverage ratio and the performance of $30 million of rehabilitation work. (Mart Owners estimated that the total cost of necessary renovations would be $100 million). Mart Owners further argued that the building was losing office, retail and showroom tenants and that the real estate market at the time was severely depressed. Mart Owners produced a 1998 statement by a MetLife executive, which stated that the Mart was a "barn of a building" that had "little or no use in the 21st Century."

Mart Owners argued also not surprisingly that as a result of the foregoing, the benchmark for determining the prepayment fee should be the lowestrated bonds (in effect, "junk bonds"), which carried a rate higher than the 9.75% mortgage rate; therefore, according to Mart Owners, no prepayment fee was due at the time of the sale to Vornado.

The court's ruling focused solely on the following issues: (1) MetLife's "good faith" in determining the "investment quality of the Note on the date hereof" (i.e., April 16, 1987); (2) MetLife's "good faith" in selecting a "security instrument" as the basis for the imposition of a prepayment fee, if any (which instrument must be available for "purchase" my MetLife); and (3) MetLife's "good faith" assessment of whether the security instrument it selected was of "comparable" investment quality to that of the 1987 loan.

The court cited Illinois case law for the proposition that the duty of good faith prevented a party from making an "arbitrary determination." The court stressed that MetLife was required to determine the investment quality of a comparable instrument "on the date it closed," and that this "determination should have been based upon what MetLife then knew or discovered through inquiry to be the investment quality of the 1987 loan."

In the court's opinion, MetLife acted arbitrarily and unreasonably where, as occurred in this case, "MetLife knew it had as security an aging property that was in need of over $100 million in rehabilitation and serious construction (40% of the $250 million loan); where the current cash flow on a nonrecourse loan was below the level needed to meet the debt service; where the 'truthinlending' effective rate of the loan was raised from 9.75% to 12.82% by the failure to fund $60 million at the closing and only funding $190 million with the payments due on the full face amount of the $250 million loan; and where the 'value' of the property was based on post construction rentup assumptions by the loan underwriters at MetLife that were not true as of the date of closing. As of April 16, 1987, this was a high risk hybrid construction/end loan that could not be found to be 'investment grade' by any objective standards."

According to the court, MetLife had breached the contract by "failing to base its prepayment penalty demand on the investment quality of the

1987 loan 'on the date hereof,'" i.e., it had based its analysis on projections that assumed a fully rehabilitated and retenanted property.

The court found that "the failure to perform express contractual duties is a breach, regardless of whether the party acts in good faith (citation omitted)."

According to the court, MetLife also materially breached the contract by selecting an index instead of a "security instrument" that was available for "purchase," and further breached the contract by failing to act in good faith in assessing whether the security instrument to be selected was of "comparable" investment quality to the original note. Therefore, the court held, "MetLife's conduct, in adopting an approach doomed to failure and in rejecting available alternative investments, failed all three of the alternative standards of good faith. That breach by MetLife was material."

Furthermore, the court held, MetLife was not entitled to recovery under equitable principles because it "did not suffer any injury in connection with prepayment" because of the higher rates available on alternative instruments at the time of prepayment.

The court determined that "a proper objective approach to this problem would have been to assign a value to all of the issues raised and equate those issues to corporate bonds." The court then set forth, in a chart, the "value" that it assigned to each of the factors that it believed, as the result of the evidence at trial, were relevant as to the value of the property at the time of the loan, i.e., the 67.6% loantovalue ratio; the strength of the borrower and management; the constructioncost component of the loan; the .94 debtservicecoverage ratio; and the "effective" 12.82% interest rate as the result of the escrowed and heldback proceeds. The chart created by the court correlated each of these value factors to a rating based on bond ratings from AAA (the highest) to C (the lowest).

According to the court, the "average" rating of the 1987 MetLife loan at the time it was made was 5.2, which correlated to a B+ bond rating under the chart. The court stated that therefore the loan should be the equivalent of this rating, "assuming that all of these issues are of equal weight in the valuation of the loan. The evidence points to that conclusion."

The court stated that it was entitled to make alternative findings when the "interest of judicial economy and expediency dictate." Based on this rationale, the court then held that even if the prepayment clause were ambiguous, the provision had the meaning understood by Mart Owners and not the meaning argued by MetLife, because "MetLife knew or had reason to know that Mart Owners attached that meaning to the provision, and Mart Owners did not know or have reason to know that MetLife attached a different meaning to the provision." The court stated that "MetLife failed all three of the alternative standards for good faith with regard to determining the investment quality of the Note, including the requirement that MetLife not act 'in a manner inconsistent with the reasonable expectations of the parties.'" The court further found that "Mart Owners did not reasonably expect that MetLife would select an index of unspecified bonds rather than bonds with a definite 'security instrument' as the alternate security."

Based on the foregoing reasoning, the court ordered that all escrowed funds, with interest thereon, be returned to Mart Owners. Judge Reid required MetLife to post a $20 million bond appeal bond. MetLife is currently reviewing its options, and will likely appeal this decision.

Reporter's Comment 1: This is an unusual and somewhat puzzling decision, in my humble estimation. For 95 pages of the opinion, I believed that Judge Reid was going to rule for MetLife. Then, abruptly, he created his own subjective determination of what he thinks "good faith" is (or ought to be), and ruled down the line for Mart Owners.

Reporter's Comment 2: The good news [for lenders]: This is not really a "prepayment" decision at all, and should have no effect on the validity and enforceability of standard yield maintenance mortgage provisions. As mentioned above, Judge Reid stated in the opinion that "The evidence at trial failed to reveal any other loan with a prepayment penalty provision similar to the one at issue in this case." True to his word, not one prepayment decision is cited in the entire opinion.

Reporter's Comment 3: The moral of this opinion: stick with objective criteria for determination of the comparable prepayment security instrument and rate and never, EVER, draft a prepayment clause that provides for a subjective "good faith" determination of a security instrument of "comparable investment quality" as of the original date of the note (at least in Cook County, Illinois). There is a great risk in being a "pioneer" and deviating from standard industry practice in favor of a subjective determination. For a lender to do so is to act at its peril. An institutional lender is just asking for a court at least in Illinois to rewrite its mortgage and secondguess its decisions in order to reach an "equitable" result.

Reporter's Comment 4: It is interesting that in the body of the opinion, the court goes to great lengths to describe the considered, laborious process that MetLife went through to arrive at the "A" bond reference rate and then, in the last 17 pages of the opinion, the court abruptly proceeds to substitute its own version of a "good faith" analysis by creating a chart "assign[ing] a value to all of the issues raised and equat[ing] those values to corporate bonds." Note that (as the court readily admits) none of these factors is weighted: each is treated as being of equal importance. Talk about hindsight! It is highly unlikely that any sophisticated lender would treat each of the factors described by the court as being of equal weight.

Reporter's Comment 5: Perhaps the strangest statement by the court is the following, which appears on page 108 of the opinion:

"MetLife knew or had reason to know that Mart Owners attached that meaning [suggested by Mart Owners] to the provision, and Mart Owners did not know or have reason to know that MetLife attached a different meaning to the provision. Accordingly ... the provision has the meaning attached by Mart Owners."

Huh?? Now the court apparently is telling MetLife what they REALLY were thinking instead of what they thought they were thinking. This is Alice in Wonderland stuff.