Jeff H. Ecklund, Esq.
Faegre & Benson
Minneapolis, Minnesota
Prepayment: Restrictions Placed
on Owners — Legal Relief
Mark Twain, the great American writer, once said, “If you pick up a starving dog, and feed him, he will not bite you. And that is the principal difference between a dog and a man.” In my opinion, that is one of the chief differences between a dog and the United States government. Because all of you owners have been, in essence, some of you for twenty plus years, providing low income housing (in essence, subsidizing low income housing programs on behalf of Congress) and taking little or no return. That is not what you bargained for when you got in this.
Civil Action
We have filed a civil action. One of the key things in this action to keep in mind is that the sole defendant is the United States of America. In particular, your main gripe is not per se with Farmers Home or any other Agency per se; it is with a series of statutes that Congress passed, starting in 1979, which took away your prepayment rights. Now, we’ve heard a lot about prepayment, and what’s always remarkable to me is that there is no one generally accepted definition of prepayment. Everyone seems to have his own idea of what it is.
To get to the real meaning of what prepayment is, and what it should mean, is very simple: simply look at the contracts with the United States government. Every one of you has a promissory note, signed by you or one of your partners or colleagues on behalf of the entity — whether it be a partnership or corporation that owns the units. That contract has very explicit language in it regarding prepayment rights. What it means is very different from some of the concepts that have floated around. Prepayment, I’ve heard used in one context, is where you can prepay under some circumstances if you agree to a restrictive use covenant for a period of 20 years, or if you agree to make your property available to current, existing tenants for the life of the property, and many other variations depending upon the category of the loan and the circumstances under which the covenant was attached.
What Prepayment Means
That is not prepayment as it was originally intended and for which you contracted. If there is one thing you should understand today, it is what prepayment was initially meant to mean. When you got into these projects, obviously there was some return on development, and you’d get your minimal Return on Investment. But, one of the driving forces for people to get into these projects in the first place was the prospect of being able to get out of them when you wanted, particularly for the pre-79 owners (but, even in some senses, for the post-79 owners): to get out when you wanted and to take your profit on the property.
You’ve been subsidizing low income housing for a number of years. Many owners of course, were banking on the prospect of being able to sell your properties and go to market at some point prior to retirement, and actually using the proceeds to fund your retirement. That’s exactly what you were entitled to do, and it is a breach of contract for the government to have taken it away.
Legal Action Filed
We did file an action in October 1996. I’ll talk just briefly about the action. As of today, we have an action that I value at about $75 million. We have thousands upon thousands of units, and it is growing every week. The states that are represented so far include Alabama, Alaska, California, Indiana, Michigan, Minnesota, Nebraska, North Dakota, Texas, Washington and Wisconsin. There are more units in some states than others, but all of those states are currently represented. This is a joint action; it is not a class action. Assuming we get big enough to have enough leverage to perhaps talk settlement with the government, the only people that will get any benefit from the size and leverage afforded by the suit will only be those who are actually parties to the suit. That’s a technicality with a lot of practical significance, but unlike a class action, it will only benefit those that are parties.
This is the language in your promissory note, and every singly one of you, whether you’re a pre-79 loan holder or post-79 loan holder, has this language in your note. Post-79 have it about two thirds of the way down on the reverse side of the promissory note, and pre-79 have it about two thirds of the way down on the first page. It simply says:
Prepayments of scheduled installments, or any portion thereof, may be made at any time at the option of borrower.
Any time, at your option. “Any time” means any time, not after 20 years, not after six months. Any time you have the financial wherewithal to prepay, and you make your own determination unilaterally, and it is propitious to prepay (in other words, it is to your best interest to prepay at any given time given your economic circumstances), you should be able to prepay.
If the system had worked the way it was originally intended, this would be the carrot that would still be left hanging out for all future owners and developers. If Congress had honored these rights, they’d have people lined up waiting to develop new projects when you got out. That’s how our capitalistic system is supposed to work.
Breach of Contract
“Option” means that if you choose not to prepay, you don’t have to. Additionally, you don’t need any governmental approval to do it. So any extra contractual — anything other than this — and the other prerequisites to prepayment, breach the contract.
All the regulations and the statutes that have been passed since, that purport to restrict that right, constitute a breach of this. That’s not to say Congress can’t do what it did, it can if it feels it must protect against the displacement of low income tenants when people start to prepay, it can do that. That’s what it did. But, if in so doing, it breaches a contract, namely your contract, it has to compensate the owners. Because you both bargained when you signed these contracts that you could get out at any time at your option.
US v. Winstar
There was a decision last year in the United State Supreme Court: United States v. Winstar. That case solidified the principle that the government must abide by it’s own contracts. The government had argued, much like they are arguing in some of the current housing cases, that the plaintiffs in this particular case (the parties that brought the case) should not be reimbursed for the damages because the right to sue the government and collect damages is limited by Congress’s right to pass statutes. But, the Court ruled 7 to 2 that when there is a specific contract, when the government signs contracts with specific regulatory obligations, the principle is simple and important: in the U.S. everyone is required to fulfill contracts, even the government. And, traditional laws regarding contract law apply. It is very clear.
In evaluating a case such as this, such as the case we have, you look at the documents in the case. You use ordinary principles of contract construction to establish a breach. Precisely what we are doing in this case. The key language is simply this:
Prepayments of scheduled installments, or any portion thereof, may be made at any time at the option of borrower.
To give you a little history on Section 515, the program began in 1962 and grew very rapidly. The loans that we now call pre-79 loans (which of course were prior to 1979) were the only the only loans there were — you’ve got to get into this when you think about this. When you look back at all this, you’ve got to separate out where we are today from where everyone was prior to 79, to understand the reality of this. The effect of what has happened over the years has been to rewrite history in a sense in a way that seems really Machiavellian or sneaky, to say the last. In looking back, it wasn’t all planned from the beginning, but that was the natural result. The government, of course, did what it had to do to protect its interests as it went along. When we look back on the series of those steps that it took, we say, “My goodness, how did it get there?”
79, 80 Prepayment Legislation
So you have to be real careful to go back to the beginning. Prior to 79, everyone signed this contract. Around 79, Congress began to get a little concerned about prepayments on the Farmers Home side. They passed a law in 79 that purported, in essence, to eliminate this prepayment right (at any time at your option) and replace it with the system that we now call post-79 loans. In other words, that we’re going to attach a 20 year covenant to the loans. So if you’re going to prepay before 20 years, either you or your buyer still has to abide by the strictures of the program; in other words, low income rents until 20 years from the origination date of the loan is over. But, in 79, that statute attempted to do it for everyone, even those people, obviously, who had already signed, not only the people who would sign in the future.
So, Congress passed the statute that attached these 20 year covenants on to everybody’s contract, which essentially breached your right to go to market at any time at your option. There was a big hue and cry. You know what happened? Congress said yes, we made a mistake and changed it’s mind. The next year, in 1980, it gave all the people their rights back, who had already signed the contract. It eliminated the 20 year penalty, what it had attempted to add, from all of your loans. They said, only the people who in the future sign this contract, will have this 20 year covenant. That was in some sense, obviously, fair because everyone who went into the projects after 79 knew they would have a 20 year covenant. It wasn’t like they had forced a 20 year covenant on the people who had already signed contracts prior to 79. But, that statute became the reason for this so-called dichotomy between the pre-79 and post-79 loans. So that was a satisfactory resolution.
88 Prepayment Legislation
Then, almost ten years go by: 1979 to 1987. In the late 80’s, again, there seems to be a trend toward prepayment. On the HUD side, they have a little different system, they can’t prepay until 20 years are over. Contrast that to Farmers Home where you can prepay before 20 years if you have a covenant, but you can’t raise your rents until the 20 years are over. HUD can neither prepay nor raise rents until the 20 years are over. So in the late 80’s, both on the Farmers Home and HUD side, prepayment pressures start to build. A lot of people had been in their projects a long time and wanted to get out and make the money they’d been assured they could make at the beginning when they signed up. They could go into other projects, other businesses, or retire.
In 88, Congress determined that almost 400,000 Farmers Home units (both pre- and post-79) were in danger of being prepaid. It is significant that it was both pre— and post-; there were a lot of people who have post-79 loans, who even though they were well within the 20 years and couldn’t raise the rents until the 20 years were over, they still wanted to sell. There is, there was then, and there would be today, if Congress honored these contracts, there would be a market for post-79 projects even though your rents are restricted for 20 years. You see that on the HUD side today. Last year Congress reinstated HUD’s prepayment rights, and you can see that the interest in purchasing HUD projects that are less than 20 years and have a few years to go from the low rent restrictions, is hot. There are a lot of people out there that are interested in buying them because they know in a few years they can go to market with them; now, they can buy them at a discount because some of the people want to get out before the end of 20 years. They’re marketable.
Congress knew that in 87. So, they passed another law which many of you know by the name of Emergency Low Income Housing Preservation Act (ELIHPA). Actually, it passed in 87 and became effective in February 88; so I call it the 1988 Legislation. In 79, Congress takes away everyone’s rights. And, they realized they were wrong, so they give the rights back to the people that already have the contract and change the system and required that everyone after 79 to have a 20 year covenant. Then, years later, in 1988, the legislation takes away the rights of the pre-79 loan holders. There was a hue and cry, but not nearly as great as in 79. The reason is, in some sense, political. In 1988, the statute passed in 87, you already had all sorts of projects up and running that had a 20 covenant attached. Those people’s rights were, in a sense, watered down from what the pre-79 people had. So it was easier to take away the rights from the pre-79 people in 1988 than it was in 1979 because you had all sorts of people with post-79 loans out there. The purpose of the 1980 legislation was essentially to put the pre-79 people in the same situation the post-79 people were in.
But, keep in mind, the post-79 people were contractually entitled to this: any time at your option. They took it away in 88 just like they took it away in 79. Although, in 88, it hasn’t been revoked. Why? If Congress said they were wrong once in 79, why aren’t they wrong again in 88? They are wrong.
1992 Legislation
Then, what happens in 92? First of all in 1990, LIPHA comes in, which essentially makes permanent ELIPHA. But, the Low Income Emergency Preservation Act does not address Farmers Home projects at all — it just addressed HUD. It wasn’t until 1992 that Congress came back and they looked at the situation again. This time, they added yet another 20 year (I’m oversimplifying — you’ll see more as we get into this) that in essence adds further restrictions to post-79 loans, that already had restrictions. They already had 20 years contractual; now, they added another 20 years with the 92. And, they reaffirmed the watered down rights of the pre-79’s. So what you have by 88 and 92, Congress has actually taken away more rights than even the 79 legislation did.
I want to show you the actual language of the statute at 42 U.S.C. § 1472. The 1979 language said:
The Secretary may not accept an offer to prepay any loan made under § 515 pursuant to a contract entered into before or after December 21, 1979.
They were taking away the rights of the people that had already contracts (that are now called pre-79’s) as well as anyone in the future. What they did essentially was to say you can’t prepay unless you agree in your contracts to a 15 year covenant if you’re not receiving Interest Credit, and a 20 year contract in all other cases. So, when I say it restricts prepayment rights, this is what I mean; I’ll refer to this, to simplify things, simply as the 20 year covenant. But, they attempt to do this for all past loans, all future loans. What they forgot at the time, is that they were taking away rights from preexisting contract holders. That’s breach of contract. There was a big hue and cry; and, Congress changed it’s mind and said, “Yes, we’re wrong.”
The 1980 legislation says it applies only to those after 1979; so they preserved the pre-79 rights and didn’t give them to anyone after 79. So people knew when they signed their contracts after 79 that they had 20 year covenants. That’s fair. It’s unfair to breach a contract, to take away the right right to prepay any time at your option and add a 20 year covenant if you sign the contract. That’s what they did. They gave pre-79 rights back and created what we call today post-79 loans.
Negotiate Incentives for Pre-79
Then, 1988 comes. This is when they essentially put all the pre-79 loans in the same boat as the post-79 people. They added essentially a 20 year restrictive use period: all contracts entered into before December 21, 1979 are required to at least attempt to reach an agreement to extend the use for 20 years. And, there are further restrictions which I’ll talk about. But, this is the first one, and it is actually the less onerous.
Before you can prepay, you’ve got to negotiate; this is where the incentives come in; they try to give you what they call incentives to agree to this. That’s pre-79 loans. In essence, by adding the covenant, which is precisely what Congress did in 1979 — took away the rights of the pre-79’s, but they’ve never given them back, and you still don’t have them.
In 1992, same language, paragraph 4, look what they did:
(4) (A) Agreement by borrower to extend low income use. - Before accepting any offer to prepay, or requesting refinancing in accordance with subsection (b)(3) of this section of, any loan made or insured under section 1484 or 1485 of this title pursuant to a contract entered into prior to December 15, 1989, the Secretary shall make reasonable efforts to enter into an agreement with the borrower under which the borrower will make a binding commitment to extend the low income use of the assisted housing and related facilities involved for not less than the 20-year period beginning on the date on which the agreement is executed.
I don’t think many people actually realized this at the time. Instead of saying “before 1979,” all of a sudden, they did the same thing in 92 to the post 79’s. Every thing prior to 89 now has this restriction on it, which includes pre-79’s and post-79’s. All contracts after 1989 have no prepayment rights whatsoever. Again, that’s fair because everyone who’s signed a contract after 89 knew that.
Additional Covenant
But, this says there’s another 20 year covenant attached for all contracts entered into prior to the date of enactment of this act, which was December 15, 1989. That was the act that also eliminated the absolute right to prepay for everyone who signed a contract after 89. By changing the language from “before 79” to “before 89,” they added the post-79 loans.
What that means is that since the post-79 loans already have a 20 year covenant on them, they are obligated by this statute (Congress has obligated) to give the post-79 holders agree to yet another 20 year covenant on top of the 20 years you already have. So those of you that think you can prepay the post-79 loans when the 20 years is up, you may be able to prepay, but you are going to have yet another term on it. Or at the very least, you going to have to face a forced sale.
In other words, every ten years or so, it is reassessed, and the Congress does something else to keep you in the programs. I don’t think it is going to stop.
QUESTION: At this point, all pre-89 loans have a 40 year restriction?
ANSWER: That is sort of an over-simplification, but for the post-79 loans, yes, essentially. Although, by regulation, they can do other things to you. This is the minimum requirements. The regulations don’t always quite track the statutes. And, in fact, some of you may be familiar with some of the tenant law suits that have been brought to get the government to adequately implement the statutes. It gets into a lot of complicated things, and tenants have been successful in the past; in fact, there was a case in Minnesota called Lifgren which successfully challenged the then current regulations as being contrary to what the statute required.
In essence, for those loans that don’t have the 20 year covenant in them, the pre-79’s, yes, the statute obligates you to enter into a further 20 years; so if you’ve been in already for 20 years and not been able to get out, it is effectively 40.
Although what you said is practically correct, technically it is just more complicated. For the post-79 loans, they’ve got the 20 year covenant and then, in addition, they’ve got the obligation to enter into another one. Although the regulations today don’t actually require that, they do require a restrictive covenant. I think the one they actually require is that all current tenants can stay there for the life of the property. If that is challenged, this is what’s required: enter into another 20 years, or a forced sale.
Cienega Gardens
In addition to these statutes, actually in 94, a group of owners in California filed a lawsuit called Cienega Gardens v. U.S. This is from the text of the opinion, as part of the findings of the judge, but just illustrates again that as Congress became concerned about the prospect of a mass of prepayments, it enacted ELIPHA to honor that threat and put in a moratorium on prepayments. I’m showing this to illustrate the principle in the last paragraph, which is important. The plaintiffs in that case don’t seek to change the law or to say the law is unconstitutional, they seek damages for breach of contract. That is important because, given that fact that we’re going after damages and not trying to change the law, a lot of the traditional government defenses such as the Sovereign Act and others, that have in the past been successful in such lawsuits are simply inapplicable here. That’s one of the principles that is so important in the Winstar case, too.
What’s happening is that people are trying to get damages, and not trying to change the law. So, the traditional principles of contracts apply. What they’re talking about is what we lawyers call liability. This is the hub of the case in terms of establishing a breach. In other words, the government has done wrong. Everyone had this option to prepay at any time at your option; the government has taken this away in stages, in a manner that has been politically successful, but legally, you’ve lost your rights. And, you’re entitled to them back. We recognize the government can pass these types of laws, but if they do so, and damage you, you’re entitled to compensation.
That leads us to the second part in any case, which is damages.
Liability
First, I want to anticipate your questions on liability. During the course of my work, I’ve come across many people who ask about the nature of prohibition. Because, like the Cienega Gardens case, when we say prohibition, it really isn’t an absolute prohibition on prepayment. In Cienega, for example, the HUD owners can still prepay if they can show there is no adverse effect to the market for low income housing if they do prepay. But, since that is such a far away prospect, impossible according to the aggrieved wishes of the owners that it is, in effect, an absolute prohibition. The Farmers Home case is stronger than that. You’ve also got this out in Farmers Home; in other words, if you can establish there is no adverse effect to the market, and some other conditions, you can prepay. No one can be able to do that. In addition, in Farmers Home, the government has purported to force you to go through a sale, which I don’t think enables you to get your fair market value. If you don’t agree to the incentives and to an extension of your term for providing low income housing, you have to go through this forced sale. It has rarely happened because no one wants to do it. Before you can prepay, according to the statute, you have to go through this: you have to make your property available for six months to a non-profit or public agency. No guarantee that you will get your fair market value or the same value you would have gotten if you were able to prepay any time at your option, which you are contractually entitled to do. No one wants to do this. This is, in my opinion, the strongest aspect of the breach.
There are exceptions. The exceptions originally apply to pre-79 loans only, like ELIPHA did, but they pulled the same date switch and applied it to the post-79 loans in 1992. Now, a lot of people ask another question, which is: what happens if I agree to these incentives and sign another 20 year restrictive covenant or some other type of restrictive covenant? The restrictive covenant is the thing that prevents you from raising your rents until the period is over. That was a big issue in this case.
Incentives and This Suit
The Court was very clear that by agreeing to enter into further restrictions and getting incentives, you’re not giving up your rights to sue for breach of contract; you’re just making the best of an already really bad situation. You’re not saying by accepting incentives that you’re giving up your right to sue for breach of contract. That’s clear.
So, don’t worry about applying for incentives. If you want to apply, apply if you haven’t already done so. It looks like the Legislation last year eliminated all incentives for post-79 loans.
One other question I want to anticipate: what happens if I haven’t filed an application for prepayment? This is another issue that has come up in the context of the legal issues in this case. The long and the short of it is: by statute, you cannot do what you’re supposed to be able to do; the statute, no matter what you do, is not going to give you the right to prepay at any time at your option. So it is futile to ask to do it. The government is going to deny any such request. If you haven’t done it, but had intended to do so if you could have, that’s when the breach occurs. The important thing to keep in mind is that the government, by repudiating your right to prepay at any time at your option, does not necessarily breach your contract until the time you want to prepay. Some people don’t want to prepay; they’re happy to own their 8 or 20 unit building for 40 or 50 years; and their contract is never breached because they have no intention to prepay. Even though they may not have an intention today, they might five years from now when the situation changes and their life situation is different. They should be entitled at that point in time to make a decision to prepay.
Damages
Now, what about damages? On pre-79 loans, where you have the absolute right to prepay at any time at your option, no 20 year restrictive covenant. You can prepay, pay off your mortgage with a commercial loan, pay off your mortgage any time you want to, keep the property and raise your rents; or, I call it the lost rent scenario. Or, you could have sold that property to someone else who could raise the rents; that’s the lost sale scenario.
On the post-79 loans, you can prepay whenever you want, but you can’t raise the rents until the 20 years are over, so any lost rent scenario on the post-79 side of it doesn’t start until the 20 years are up. But, lost sale — you can still sell whenever you want; since you haven’t been able to, you are out your net proceeds, plus the money in the Reserve account at the time you would have sold, plus the interest on those monies up until the date of trial, plus the amount of negative cash flow that you may have been experiencing because of phantom income (because if you had been able to get out, you wouldn’t be experiencing that problem), and minor adjustments for the fact at the end of the loan you will in fact still own the property. This lawsuit doesn’t get you out of the program, it just compensates you for not being able to get out. So, you have to deduct a little bit for the present value worth of the property at the end of the 40 or 50 years, which you will then theoretically be able to sell. That is a very small sum; present value of large sums of money far in the future, and even not so far in the future, aren’t that big today.
Proforma for Damages
This is a proforma that applies mostly to pre-79 loans, but the numbers are not atypical of the post-79 loans. This is an actual 56 unit project. I’ll be the first to admit it is what you might call a top of the line project. But even for a project that is not so top of the line, the numbers work out to be significant. What we have is a loan that originated in January 1979, so it is a pre-79 loan. It is a 40 year loan. Effective interest rate of 1%. Original amount of the mortgage is $1,268,000. What we’ve done then, we have two lines: one is pre-trial, one is post-trial. Pre-trial are all the damages that are incurred through lost rent that you’ve experienced up until the time of the trial; post-trial damages are lost rent that you will experience after the time of the trial because if you’re still stuck in the program, you’re going to have future lost rent. For the assumption of this analysis, we’ve assumed a trial in November of 98, which may be a little bit optimistic (I’m hopeful that I’m not too optimistic). We’ll also have what’s called a conversion date of February 1989, about a year after ELIPHA; that’s the date that this owner would have prepaid, gone to market and raised his rents if he had been allowed to.
From 1989 on is when the damages start. The damages for this project are the loss of $180 in increased rent per month per unit. I’d say nationwide, the average is closer to $100, but this is a project in a good location. You’ve got $180 per month per unit; up until the time of trial, you’ve got 117 months from the time you would have prepaid in 1989 to the time of trial in 98. Given 56 units, $180 loss per month per unit, you’ve got loss damages for a period of about 10 years for $1,179,360. Just $180 a month, multiplied by the number of units, multiplied by the number of months. That’s all it is. That’s a 40 year FmHA term, so the mortgage is $2,019.
QUESTION: On the $180, how did you come up with that for 1989?
ANSWER: How in 89? This project has a lot of records and a series of appraisals. I think we may have a summary of an actual survey of unsubsidized commercial housing at various points in time. And, this was drawn in part from that.
It is the difference between what you get at fair market rates, rental rates for unsubsidized commercial housing, less your FmHA Basic Rent. And this is now the figure. This particular owner feels that his costs (his management costs, his ownership costs, his costs of operating the management) would have gone down by going to market. At least, for this analysis, I’m assuming it was a wash. Some people may have increases: in some states, for example there’s a property Tax Credit for subsidized housing, so when you go to market, your property taxes go up. That’s one expense you look at. Increased advertising expenses for going to market. Changing over tenants.
But, the biggest component is the cost of the debt associated with paying off your mortgage. You’ve got to get a commercial loan. You assume for purposes of this analysis, 9%, 15 years. In larger cities, you can get a lower rate; their claims are higher because the difference between 1% and 7% is less than between 1% and 9%. If you assume 9%, 15 years here, we have taken the amount of interest you would have paid up until trial under a commercial loan (which is greater than the interest you would have paid if you’d stayed in the program and paid off the government loan). You’re paying $610,000 more in interest under the commercial loan than you would have if you’d stayed in the program, but your increase in profit is $1,179,000. So you still have $588,000 in extra money, despite the fact you’ve gone up to 9% interest rate. We subtract that out for damages incurred prior to trial. Likewise, after the date of trial, the amount of interest you would have paid in the government loan is $73,000, the commercial amount is $127,000, which is more again, so we subtract that out from your increased profits.
Bottom Line
The bottom line is before trial, you have $568,000 in lost profits, after trial, $2,374,000 in lost profits. You add to your current damages before trial, the amount of the Reserve, in this case it is $91,000. Then you add to that, the interest you would have earned on your lost profits and your lost Reserve up until the time of trial, when you theoretically get your money. The interest on the $568,000 in lost profits and the $91,000 Reserve for a period of several years until trial is $335,000 (rounded off); you add that to the actual damages. You have pre-trial damages (including lost profit, Reserve account, and lost interest on those two sums up until the date of trial) of $994,000. You add to that the $2,374,000 in net lost profits after trial (of course, you’ve got to reduce that to present value; in other words, what amount of money today will give you a stream of income over the course of the remaining 40 years term of the loan of some $2 million; what is that worth to you today?), and the present value of that using 8% (we’re using 8% for the purpose of this proforma for present value and interest) is $503,000.
You add all of those numbers and you come up with $1,479,000. That is, for this project, a conservative amount because we’re assuming 9%, we’re assuming a 1% effective interest rate (in reality, it’s not 1% given overage and other factors, the effective interest rate is really 2% or 3%). When we get down to this nitty gritty stage of the case, it will all be figured out in more detail.
I’m very enthused about this case. I think it is very strong in liabilities.
Q&A re: Ecklund Lawsuit
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