PHOENIX (Legal Newsline) - A majority of the Arizona Supreme Court has ruled that a nearly $1.4 million late fee assessed on a final loan balloon payment constitutes an unenforceable penalty.

The majority of the high court, in an April 25 decision, vacated a state Court of Appeals opinion; reversed a Maricopa County Superior Court’s partial summary judgment in favor of defendant La Sonrisa De Siena LLC on a liquidated damages claim; and remanded the case to the trial court for further proceedings, including entry of partial summary judgment for plaintiff Dobson Bay Club on its declaratory relief claim concerning the late fee.

The Supreme Court also awarded Dobson Bay its reasonable attorney fees.

Justice Ann A. Scott Timmer authored the majority opinion, in which Chief Justice Scott Bales, Vice Chief Justice John Pelander and Justice Robert M. Brutinel joined.

As Timmer explained in the 15-page ruling, a liquidated damages contract provision is enforceable if the pre-determined amount for damages seeks to compensate the non-breaching party rather than penalize the breaching party. 

In 2006, Canadian Imperial Bank of Commerce loaned Dobson Bay and related entities $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.

Dobson Bay, the Supreme Court noted, 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 attorney fees, and a 5 percent late fee assessed on the payment amount. If Canadian Imperial Bank foreclosed the deed of trust, Dobson Bay also was obligated to pay costs, trustee’s fees and reasonable attorney fees.

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.

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 argued 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.

The parties then 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.

The superior court granted partial summary judgment for La Sonrisa, ruling the late fee was enforceable as liquidated damages.

The appeals court reversed.

The Supreme Court granted review, explaining the enforceability of late fee provisions in commercial loan agreements presents a “legal issue of statewide importance.”

The high court concluded the fee is unreasonable.

“First, the 5 percent fee is static, payable on demand whether the payment is one day late or one year late,” Timmer wrote for the majority. “Five percent of the loan principal is a significant sum of money, which did not likely reflect losses from a short delay in payment.

“Because the fee did not account for the length of time Canadian Imperial Bank would be deprived of the balloon payment, the fee could not reasonably predict the Bank’s loss.

The $1.4 million late fee also did not “reasonably approximate” either the actual costs of handling and processing the late balloon payment or the loss of use of that payment, the majority said.

“In view of Dobson Bay’s obligation to pay regular and default interest, collection costs, trustee’s fees and costs, and attorney fees as a consequence of the six-month delay in paying the balloon, an approximate $1.4 million late fee is unreasonable and an unenforceable penalty,” Timmer wrote.

“La Sonrisa is not precluded, however, from seeking actual damages incurred for handling and processing the late balloon payment and for losing use of the payment if La Sonrisa has not already been compensated for that loss by the other fees and costs Dobson Bay is required to pay under the note and deed of trust.”

Justice Clint Bolick dissented, arguing his colleagues have invalidated a “core and unambiguous provision of a contract freely negotiated for mutual benefit between sophisticated parties represented by competent counsel.”

“As children, we learn that the rules of the playground dictate that if someone makes a promise, no matter how solemnly, it is unenforceable if the person making the promise had his fingers crossed behind his back,” Bolick wrote. “As we grow up, we learn instead that many promises are moral and legal obligations, with consequences properly attached to breaking them. Still, some grown-ups prefer the playground rules.

“After Dobson Bay reaped the full benefits of its bargain, it defaulted on its repayment obligation and looked to the courts to avoid significant agreed-upon consequences of that default.”

Bolick argues the majority has rewarded the breaching party by removing a “critical” term to which it assented. To “add insult and injury,” the court also has required the non-breaching party to pay its attorney fees, he argues.

“Our decision will inevitably have a corrosive effect on the making and enforcement of contracts in Arizona, with predictable and substantial adverse economic consequences, notwithstanding that freedom of contract is enshrined in our organic law,” the justice wrote.

The majority, in its opinion, took issue with Bolick’s characterization of its decision.

“Our dissenting colleague colorfully compares our decision to a child’s cry of ‘backsies’ to sidestep a promise,” Timmer wrote. “Rather than invoking playground rules, however, we apply long-established common law principles that render contractual penalty provisions -- even when agreed upon by sophisticated parties -- unenforceable as a matter of public policy.

“This is nothing unique.”

From Legal Newsline: Reach Jessica Karmasek by email at jessica@legalnewsline.com.

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