Source: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-azd-2_11-cv-00004/USCOURTS-azd-2_11-cv-00004-0/pdf.json

Nature of Suit Code: 422
Nature of Suit: Bankruptcy Appeals Rule 28 USC 158
Cause of Action: 28:0158 Notice of Appeal re Bankruptcy Matter (BAP)

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WO

IN THE UNITED STATES DISTRICT COURT

FOR THE DISTRICT OF ARIZONA

IN THE MATTER OF

Double G Arrowhead Orchards Limited

Partnership,

Debtor _________________________________

VCC Healthcare Fund, LLC, 

Appellant

vs.

Double G Arrowhead Orchards Limited

Partnership,

Appellee. 

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No. CV11-0004-PHX-DGC

BK No. 2:10-bk-20370 EWH

ORDER

This is an appeal from the December 13, 2010 order of the Bankruptcy Court denying

one of Appellant’s claims as an unenforceable penalty (Doc. 9 at 15-16). The matter has

been fully briefed (Doc. 8, 10, 12), and the parties do not request oral argument. For reasons

that follow, the Court will vacate the judgment below and remand for further proceedings.

A. Background.

The key facts relied on by both sides do not appear to be in dispute. Compare Doc. 8

at 5-7 with Doc. 10 at 5-8. Double G Arrowhead Orchards Limited Partnership

(“Arrowhead”) borrowed $19 million on a ten-year commercial note, secured by commercial

property located in Glendale, Arizona. The property is Arrowhead’s sole substantial asset.

VCC Healthcare Fund, LLC (“VCC”) now owns the lender’s rights to the note. The note

contains a provision to which the Court will refer as the “Prepayment Clause.” 

Case 2:11-cv-00004-DGC Document 13 Filed 07/20/11 Page 1 of 6
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 VCC seems to have asserted in the Bankruptcy Court that the Prepayment Clause

applies in this case because it has not been triggered by default (the note states that

prepayment may not occur if the borrower is in default, Doc. 9 at ¶ 5(a)), and because the

proposed sale of collateral in the Bankruptcy Court would be tantamount to prepayment of

the loan. The Bankruptcy Court did not address these issues, and they are largely

unaddressed in the parties’ briefing. As a result, the Court will not discuss them on appeal.

The Court will limit its ruling to the issue decided by the Bankruptcy Court – whether the

Prepayment Clause constitutes an unenforceable penalty.

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The Prepayment Clause reads in part as follows:

Prepayment Consideration. Lender shall not be obligated to

accept any prepayment of the principal balance of this Note

unless it is accompanied by all Prepayment Consideration due

in connection therewith. . . . The ‘Prepayment Consideration’ shall be computed as follows: . . . August 1, 2010 through May

31, 2017: The greater of: (i) one percent (1%) of the outstanding

principal balance of this Note at the time of prepayment; or

(ii) the Yield Maintenance Amount (hereinafter defined).

Doc. 9 at 5(c) (emphasis in original). The calculation of the “Yield Maintenance Amount”

(“YMA”) is not relevant to the inquiry here because Arrowhead does dispute the accuracy

of the calculation. For purposes of this order, it suffices that the YMA is a derivative of the

yield rate of U.S. Treasuries and that the $4,576,429.44 payment in this dispute represents

the YMA rather than the 1%-of-outstanding-principal figure.

Arrowhead defaulted on the note, VCC accelerated the note and initiated foreclosure,

and Arrowhead filed for Chapter 11 bankruptcy. VCC filed claims in the Bankruptcy Court

asking for $17,937,304 in principal repayment and approximately $356,748 in accrued

interest and late fees. When Arrowhead filed a motion seeking permission to auction the

property securing the note and to use the proceeds to pay claims of VCC and other creditors,

VCC took the position that auctioning the property would trigger the Prepayment Clause and

require an additional payment to VCC of $4,576,429.44. Arrowhead objected, and the

Bankruptcy Court held that VCC’s recovery would be limited to VCC’s actual damages

because the Prepayment Clause is an “unenforceable penalty” under Arizona law. Doc. 9 at

15:18.1

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2

 Arrowhead also suggests the Prepayment Clause applies only when the borrower is

not in default, and asserts that it was in default here. Doc. 10 at 6-7. Because the

Bankruptcy Court did not reach this issue, the Court will not address it.

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VCC argues that the Bankruptcy Court erred as a matter of law in finding that (1) the

Prepayment Clause was a liquidated damages provision, and (2) the Prepayment Clause was

unenforceable as a penalty. Doc. 8. Arrowhead responds that both findings were correct as

a matter of law.2

 Doc. 10.

B. Discussion.

On appeal, a federal district court reviews issues of law from a bankruptcy court de

novo and factual findings for clear error. In re Strand, 375 F.3d 854, 857 (9th Cir. 2004).

The court below applied Arizona law (Doc. 11 at 69), and the parties do not appear to dispute

that Arizona law controls.

Under Arizona law, an agreement to pay a specific amount of money in the event of

a breach constitutes an unenforceable penalty unless (1) the harm caused by any breach is

incapable or very difficult of accurate estimation, and (2) the amount is a reasonable forecast

of just compensation for the harm caused by the breach. Larson-Hegstrom & Assoc’s, Inc.

v. Jeffries, 701 P.2d 587, 591 (Ariz. App. 1985); accord Pima Sav. and Loan Ass’n v.

Rampello, 812 P.2d 1115, 1118 (Ariz. App. 1991). These determinations must be made as

of the time the contract was made, not with hindsight. Rampello, 812 P.2d at 1118 (“[T]he

question is whether the stipulated amount was, when all the facts are considered, reasonable

at the time of the contract and not whether it was reasonable with the benefit of hindsight.”).

The Bankruptcy Court based its holding on the finding that “the YMA, which is 25%

of VCC’s principal balance, was not a reasonable forecast of compensation for breach at the

time the loan was made.” Doc. 9 at 16:1-2. The Court does not agree.

The Bankruptcy Court did not address whether the harm caused by any breach of the

note in this case was, at the time of contracting, incapable or very difficult of accurate

estimation. This requirement of Arizona law clearly is satisfied. When the lender and

Arrowhead entered into this loan, the harm caused by Arrowhead’s possible future breach

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could not be calculated with any accuracy. The commercial loan was to be repaid over ten

years. The parties to the loan did not know when a breach might occur, what amount of

principal and interest would have been repaid at that time, what ability Arrowhead might

have to make additional partial repayment of the loan, what commercial interest rates would

prevail at the time of breach, or what conditions might exist in the commercial real estate

market to affect the value of the loan’s collateral. As a result, it would have been impossible

for them to calculate in advance what damages the lender might suffer from a breach.

Because this prong of the Arizona test is satisfied, the key question is whether the

Bankruptcy Court correctly determined that the amount fixed in the contract was not a

reasonable forecast of just compensation for the harm caused by a possible breach. The

Bankruptcy Court did not make specific findings as to what a reasonable forecast of

compensation would have been at the time the loan was made. The court also did not state

why it considered the YMA formula unreasonable, other than to note that the YMA in this

case constitutes 25% of the principal balance. But the mere fact that a payment represents

25% of the principal does not necessarily make the payment a penalty under Arizona law.

The key inquiry is the reasonableness of the payment “in light of all the facts and

circumstances in any given case.” See Jeffries, 701 P.2d at 591; see also Rampello, 812 P.2d

at 1118. “[T]he amount fixed is reasonable to the extent that it approximates the loss

anticipated at the time of the making of the contract, even though it may not approximate the

actual loss.” Rampello, 812 P.2d at 1118.

The YMA calculation appears to be a reasonable approximation of the loss the lender

would suffer if the loan was prepaid. YMA is defined in the note as “the present value, as

of the Prepayment Date, of the remaining scheduled payments of principal and interest from

the Payment Date through the Maturity Date,” determined by discounting such payments by

the Treasury rate. Doc. 8 ¶ 5(d). In other words, the YMA seeks to give the lender the

benefit of the bargain under the note – the present value of the principal and interest it would

have received had the loan been repaid over its ten-year life.

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Arrowhead offers two reasons why the Prepayment Clause is not a reasonable

estimate of just compensation: (1) the Prepayment Clause presumes that damages will be

sustained even if interest rates change in favor of the lender by virtue of the 1%-of-principal

provision; and (2) the Treasury rate used in the YMA formula is systematically lower than

interest rates for commercial mortgages, thereby resulting in a windfall to the lender. Doc.

10 at 13-17.

The Court cannot conclude that the Prepayment Clause is unreasonable because it

includes a minimum payment of 1% of the loan amount. First, the minimum 1% payment

is not at issue here. Interest rates have dropped since the loan was made, and the

prepayment premium in this case therefore is calculated using the alternative YMA formula.

Second, requiring a 1% prepayment premium even when interest rates have risen is not

necessarily unreasonable because a lender incurs costs when it is required by early payment

of the note to reinvest its fund in the market – costs anticipated by the 1% prepayment

requirement. Arrowhead has presented no evidence to show that the 1% prepayment

requirement is not a reasonable estimation of such costs.

Nor can the Court conclude that the YMA is unreasonable because it uses Treasury

rates. The sophisticated parties to this commercial loan not only concluded that Treasury

rates would constitute a just basis for calculating approximate damages from a breach, they

also specifically agreed that the Prepayment Clause “is a bargained for consideration and not

a penalty.” Doc. 9 at ¶ 5(c). Moreover, although it is true that Treasury rates generally are

lower than commercial real estate loan rates, and that the use of Treasury rates to calculate

YMA might therefore overstate to some extent the amount of loss the lender would incur

when it was required to reinvest its funds in a lower market after early payment of the loan,

the fact also remains, as noted above, that the lender would incur additional costs in any such

reinvestment. See In re Fin. Ctr. Assocs. of E. Meadow, L.P., 140 B.R. 829, 836-37 (Bankr.

E.D.N.Y. 1992). Arrowhead has provided no evidence from which the Court can conclude

that such costs are not reasonably approximated by the difference between prevailing

commercial rates and Treasury rates. See In re Hidden Lake Ltd. P’ship, 247 B.R. 722, 729

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(Bankr. S.D. Ohio 2000) (“The more commonly expected breaches . . . produce a situation

where loss to the lender would be hard to estimate at the time the loan is closed because of

the inability to predict future interest rates and the uncertainty of the availability of a suitable

substitute investment opportunity for the lender. Use of the Treasury obligation as a

reference point for the calculation, although generally overcompensating Aetna, is not an

unreasonable estimate.” (emphasis added)). Indeed, Arrowhead has provided no calculation

of projected damages when the loan was made from which the Court could conclude that the

YMA does not constitute a reasonable approximation of those damages. As a result, the

Court cannot conclude that YMA failed, at the time of contracting, to provide a reasonable

forecast of just compensation for the harm caused by a breach.

Applying de novo review, the Court concludes that under Arizona law (1) the harm

caused by any breach of the note was, at the time of contracting, incapable or very difficult

of accurate estimation, and (2) Arrowhead has not shown that the Prepayment Clause failed,

at the time of contracting, to provide a reasonable forecast of just compensation for the harm

caused by any future breach. Larson-Hegstrom, 701 P.2d at 591. Arrowhead therefore has

failed to show that the Prepayment Clause is an unenforceable penalty under Arizona law.

IT IS ORDERED:

1. The judgment below is vacated.

2. The Clerk shall remand the case to the Bankruptcy Court for further

proceedings.

DATED this 20th day of July, 2011.

Case 2:11-cv-00004-DGC Document 13 Filed 07/20/11 Page 6 of 6