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Dobson Bay Club II DD, LLC v. La Sonrisa De Siena, LLC

Supreme Court of Arizona

April 25, 2017

DOBSON BAY CLUB II DD, LLC, A DELAWARE LIMITED LIABILITY COMPANY; DOBSON BAY CLUB III KD, LLC, A DELAWARE LIMITED LIABILITY COMPANY; DOBSON BAY CLUB IV KG, LLC, A DELAWARE LIMITED LIABILITY COMPANY; AND DARBY AZ PORTFOLIO, LLC, A DELAWARE LIMITED LIABILITY COMPANY, Plaintiffs/Appellants,
v.
LA SONRISA DE SIENA, LLC, AN ARIZONA LIMITED LIABILITY COMPANY, Defendant/Appellee.

         Appeal from the Superior Court in Maricopa County The Honorable John Christian Rea, Judge No. CV2013-000989

         Opinion of the Court of Appeals, Division One 239 Ariz. 132, 366 P.3d 1022 (App. 2016)

         REVERSED AND REMANDED VACATED

         COUNSEL:

          Brian J. Pollock (argued), Jared L. Sutton, Lewis Roca Rothgerber Christie LLP, Phoenix, Attorneys for Dobson Bay Club II DD, LLC, et al.

          Michael A. Schern, Mark A. Hanson, Schern Richardson Finter Decker PLC, Mesa; and Stephen C. Biggs (argued), Smith LC, Phoenix, Attorneys for La Sonrisa de Siena, LLC

          D. Jeffrey Craven, The Craven Firm PLLC, Phoenix, Attorneys for Amicus Curiae Arizona Private Lender Association

          JUSTICE TIMMER authored the opinion of the Court, in which CHIEF JUSTICE BALES, VICE CHIEF JUSTICE PELANDER, and JUSTICE BRUTINEL joined. JUSTICE BOLICK dissented.

          OPINION

          TIMMER, JUSTICE

         ¶1 A liquidated damages contract provision is enforceable if the pre-determined amount for damages seeks to compensate the nonbreaching party rather than penalize the breaching party. We here hold that a nearly $1.4 million late fee assessed on a final loan balloon payment constitutes an unenforceable penalty.

         I. Background

         ¶2 In 2006, Canadian Imperial Bank of Commerce loaned Dobson Bay Club II DD, LLC and related entities ("Dobson Bay") $28.6 million for Dobson Bay's purchase of four commercial properties. The loan was secured by a deed of trust encumbering those properties. Under the terms of a promissory note, Dobson Bay was to tender interest-only payments to Canadian Imperial Bank until the loan matured in September 2009, when the entire principal would become due-the "balloon" payment. In 2009, the parties extended the loan maturity date to September 2012.

         ¶3 Dobson Bay bore significant consequences for any delay in payment. In addition to continuing to pay regular interest, Dobson Bay was required to pay default interest and collection costs, including reasonable attorney fees, and a 5% late fee assessed on the payment amount. If Canadian Imperial Bank foreclosed the deed of trust, Dobson Bay was also obligated to pay costs, trustee's fees, and reasonable attorney fees.

         ¶4 As the 2012 loan maturity date approached, the parties negotiated to extend that date but could not reach an agreement. The maturity date passed, and Dobson Bay failed to make the balloon payment.

         ¶5 La Sonrisa de Siena, LLC ("La Sonrisa") bought the note and deed of trust from Canadian Imperial Bank and promptly noticed a trustee's sale of the secured properties. It contended that Dobson Bay owed more than $30 million, including a nearly $1.4 million late fee. Dobson Bay disputed it owed various sums, including the late fee. Litigation ensued. Dobson Bay secured new financing and paid the outstanding principal and undisputed interest in March 2013. (Dobson Bay simultaneously deposited the disputed amounts with the superior court pending the litigation.) The parties filed cross-motions for partial summary judgment on whether the late fee provision in the note was an enforceable liquidated damages provision or, instead, an unenforceable penalty.

         ¶6 The superior court granted partial summary judgment for La Sonrisa, ruling that the late fee was enforceable as liquidated damages. The court of appeals reversed, holding "as a matter of law, that absent unusual circumstances the imposition of a flat 5% late-fee on a balloon payment for a conventional, fixed-interest rate loan is not enforceable as liquidated damages." Dobson Bay Club II DD, LLC v. La Sonrisa de Siena, LLC, 239 Ariz. 132, 140 ¶ 22, 366 P.3d 1022, 1030 (App. 2016).

         ¶7 We granted review because the enforceability of late fee provisions in commercial loan agreements presents a legal issue of statewide importance. We have jurisdiction pursuant to article 6, section 5(3) of the Arizona Constitution and A.R.S. § 12-120.24.

         II. Discussion

         A. Enforceability of liquidated damages provisions

         ¶8 Parties to a contract can agree in advance to the amount of damages for any breach. See Miller Cattle Co. v. Mattice, 38 Ariz. 180, 190, 298 P. 640, 643 (1931). Such "liquidated damages" provisions serve valuable purposes. They provide certainty when actual damages would be difficult to calculate, and they alleviate the need for potentially expensive litigation. Cf. Mech. Air Eng'g Co. v. Totem Constr. Co., 166 Ariz. 191, 193, 801 P.2d 426, 428 (App. 1989) (noting that a liquidated damages provision "promotes enterprise by increasing certainty and by decreasing risk-exposure, proof problems, and litigation costs); Restatement (Second) of Contracts ("Restatement Second") § 356 cmt. a. (Am. Law Inst. 1981) ("The enforcement of such provisions . . . saves the time of courts, juries, parties and witnesses and reduces the expense of litigation.").

         ¶9 Parties, however, do not have free rein in setting liquidated damages. Because "[t]he central objective behind the system of contract remedies is compensatory, not punitive, " parties cannot provide a penalty for a breach. Restatement Second § 356 cmt. a; see also id. ("Punishment of a promisor for having broken his promise has no justification on either economic or other grounds and a term providing such a penalty is unenforceable on grounds of public policy."). "A [contract] term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty." Id. § 356(1). The contract remains valid, however, and the non-breaching party can still recover actual damages. See Gary Outdoor Advert. Co. v. Sun Lodge, Inc., 133 Ariz. 240, 243, 650 P.2d 1222, 1225 (1982); Miller Cattle, 38 Ariz. at 190, 298 P. at 643.

         ¶10 Arizona courts have used different methods to decide whether stipulated damages provisions are enforceable as liquidated damages or void as penalties. This Court has considered whether the stipulated amounts were reasonably related to actual damages. See Marshall v. Patzman, 81 Ariz. 367, 370, 306 P.2d 287, 289 (1957); Tennent v. Leary, 81 Ariz. 243, 249, 304 P.2d 384, 388 (1956); Weatherford v. Adams, 31 Ariz. 187, 197, 251 P. 453, 456 (1926); Armstrong v. Irwin, 26 Ariz. 1, 9, 221 P. 222, 225 (1923). We have also examined liquidated damages provisions prospectively, considering whether they were reasonable at the time the contracts were created. See Gary Outdoor Advert. Co., 133 Ariz. at 242-43, 650 P.2d at 1224-25; Miller Cattle, 38 Ariz. at 190, 298 P. at 643.

         ¶11 Our court of appeals has generally applied a two-part test developed under the Restatement (First) of Contracts ("Restatement First") (Am. Law Inst. 1928) § 339. Under that test, which our dissenting colleague implicitly relies on, see infra ¶ 50, a stipulated damages provision is an unenforceable penalty unless "(1) the amount fixed is a reasonable forecast of just compensation for harm that is caused by the breach, and (2) the harm caused is 'incapable or very difficult of accurate estimation.'" Dobson Bay Club, 239 Ariz. at 136 ¶ 9, 366 P.3d at 1026 (citing Restatement First § 339); see also Pima Sav. & Loan Ass'n v. Rampello, 168 Ariz. 297, 300, 812 P.2d 1115, 1118 (App. 1991); Mech. Air Eng'g Co., 166 Ariz. at 193, 801 P.2d at 428; Larson-Hegstrom & Assocs., Inc. v. Jeffries, 145 Ariz. 329, 333, 701 P.2d 587, 591 (App. 1985).

         ¶12 In this case, the court of appeals applied Restatement Second § 356(1), which reframed the Restatement First test in 1981 to harmonize with Uniform Commercial Code ("UCC") § 2-718(1). See Dobson Bay Club, 239 Ariz. at 136 ¶ 9 n.2, 366 P.3d at 1026 n.2; Restatement Second § 356 reporter's note. Section 356(1) provides that a liquidated damages provision is enforceable, "but only at an amount that is reasonable in the light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss." This test requires courts to consider (1) the anticipated or actual loss caused by the breach, and (2) the difficulty of proof of loss. Whether a fixed amount is a penalty turns on the relative strengths of these factors. As explained by comment b to § 356:

If the difficulty of proof of loss is great, considerable latitude is allowed in the approximation of anticipated or actual harm. If, on the other hand, the difficulty of proof of loss is slight, less latitude is allowed in that approximation. If, to take an extreme case, it is clear that no loss at all has occurred, a provision fixing a substantial sum as damages is unenforceable.

         ¶13 La Sonrisa urges us to disavow the Restatement Second § 356(1) test to the extent it "retrospectively" considers actual damages. It contends that this approach undermines the contracting parties' freedom to allocate risk and defeats the purpose of a liquidated damages provision by requiring the non-breaching party to establish actual damages. Not so.

         ¶14 Section 356(1) provides two methods for deciding whether the parties' damages forecast was reasonable. The amount is reasonable if it approximates either the loss anticipated at the time of contract creation (despite any actual loss) or the loss that actually resulted (despite what the parties might have anticipated in other circumstances). See Restatement Second § 356 cmt. b. The non-breaching party is not required to prove actual damages to enforce a liquidated damages provision, and a court will respect the parties' agreement if it is "reasonable" in relation to anticipated or actual loss. But if the difficulty of proof of loss is slight and either no loss occurs or the stipulated sum is grossly disproportionate to the loss, the parties' stipulation would be unreasonable and therefore unenforceable as a penalty. See id. This approach is consistent with this Court's opinions. See Marshall, 81 Ariz. at 370, 306 P.2d at 289 (holding that stipulated damages were "unconscionable under the circumstances" and unenforceable because the non-breaching party suffered no loss); Weatherford, 31 Ariz. at 197, 251 P. at 456 ("Where the amount retained is grossly disproportionate to the actual damages . . . and, especially, when there is available a simple method for ascertaining the exact damages, [a stipulated damages provision] will be considered as a penalty.").

         ¶15 We adopt the Restatement Second § 356(1) to test the enforceability of a stipulated damages provision. First, § 356(1) aligns with UCC § 2-718(1), which Arizona has adopted. See A.R.S. ยง 47-2718(A). Thus, courts can apply the same test to both UCC-governed and non-UCC-governed contracts. Second, the test best accommodates the goal of compensating the non-breaching party for a loss rather than penalizing the breaching party. Under the Restatement Second test, courts have ...


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