VCC Healthcare Fund LLC v. Double G Arrowhead Orchards LP

Filing 13

ORDER - The judgment below is vacated. The Clerk shall remand the case to the Bankruptcy Court for further proceedings. Signed by Judge David G Campbell on 7/20/2011. (KMG)

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1 WO 2 3 4 5 IN THE UNITED STATES DISTRICT COURT 6 FOR THE DISTRICT OF ARIZONA 7 8 9 10 11 12 13 14 15 16 ) ) Double G Arrowhead Orchards Limited ) ) Partnership, ) ) Debtor _________________________________ ) ) VCC Healthcare Fund, LLC, ) ) Appellant ) ) vs. ) Double G Arrowhead Orchards Limited ) ) Partnership, ) ) Appellee. ) IN THE MATTER OF No. CV11-0004-PHX-DGC BK No. 2:10-bk-20370 EWH ORDER 17 18 This is an appeal from the December 13, 2010 order of the Bankruptcy Court denying 19 one of Appellant’s claims as an unenforceable penalty (Doc. 9 at 15-16). The matter has 20 been fully briefed (Doc. 8, 10, 12), and the parties do not request oral argument. For reasons 21 that follow, the Court will vacate the judgment below and remand for further proceedings. 22 A. 23 Background. The key facts relied on by both sides do not appear to be in dispute. Compare Doc. 8 24 at 5-7 with Doc. 10 at 5-8. Double G Arrowhead Orchards Limited Partnership 25 (“Arrowhead”) borrowed $19 million on a ten-year commercial note, secured by commercial 26 property located in Glendale, Arizona. The property is Arrowhead’s sole substantial asset. 27 VCC Healthcare Fund, LLC (“VCC”) now owns the lender’s rights to the note. The note 28 contains a provision to which the Court will refer as the “Prepayment Clause.” 1 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). 2 3 4 5 6 7 Doc. 9 at 5(c) (emphasis in original). The calculation of the “Yield Maintenance Amount” 8 (“YMA”) is not relevant to the inquiry here because Arrowhead does dispute the accuracy 9 of the calculation. For purposes of this order, it suffices that the YMA is a derivative of the 10 yield rate of U.S. Treasuries and that the $4,576,429.44 payment in this dispute represents 11 the YMA rather than the 1%-of-outstanding-principal figure. 12 Arrowhead defaulted on the note, VCC accelerated the note and initiated foreclosure, 13 and Arrowhead filed for Chapter 11 bankruptcy. VCC filed claims in the Bankruptcy Court 14 asking for $17,937,304 in principal repayment and approximately $356,748 in accrued 15 interest and late fees. When Arrowhead filed a motion seeking permission to auction the 16 property securing the note and to use the proceeds to pay claims of VCC and other creditors, 17 VCC took the position that auctioning the property would trigger the Prepayment Clause and 18 require an additional payment to VCC of $4,576,429.44. Arrowhead objected, and the 19 Bankruptcy Court held that VCC’s recovery would be limited to VCC’s actual damages 20 because the Prepayment Clause is an “unenforceable penalty” under Arizona law. Doc. 9 at 21 15:18.1 22 23 24 25 26 27 1 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. 28 -2- 1 VCC argues that the Bankruptcy Court erred as a matter of law in finding that (1) the 2 Prepayment Clause was a liquidated damages provision, and (2) the Prepayment Clause was 3 unenforceable as a penalty. Doc. 8. Arrowhead responds that both findings were correct as 4 a matter of law.2 Doc. 10. 5 B. Discussion. 6 On appeal, a federal district court reviews issues of law from a bankruptcy court de 7 novo and factual findings for clear error. In re Strand, 375 F.3d 854, 857 (9th Cir. 2004). 8 The court below applied Arizona law (Doc. 11 at 69), and the parties do not appear to dispute 9 that Arizona law controls. 10 Under Arizona law, an agreement to pay a specific amount of money in the event of 11 a breach constitutes an unenforceable penalty unless (1) the harm caused by any breach is 12 incapable or very difficult of accurate estimation, and (2) the amount is a reasonable forecast 13 of just compensation for the harm caused by the breach. Larson-Hegstrom & Assoc’s, Inc. 14 v. Jeffries, 701 P.2d 587, 591 (Ariz. App. 1985); accord Pima Sav. and Loan Ass’n v. 15 Rampello, 812 P.2d 1115, 1118 (Ariz. App. 1991). These determinations must be made as 16 of the time the contract was made, not with hindsight. Rampello, 812 P.2d at 1118 (“[T]he 17 question is whether the stipulated amount was, when all the facts are considered, reasonable 18 at the time of the contract and not whether it was reasonable with the benefit of hindsight.”). 19 The Bankruptcy Court based its holding on the finding that “the YMA, which is 25% 20 of VCC’s principal balance, was not a reasonable forecast of compensation for breach at the 21 time the loan was made.” Doc. 9 at 16:1-2. The Court does not agree. 22 The Bankruptcy Court did not address whether the harm caused by any breach of the 23 note in this case was, at the time of contracting, incapable or very difficult of accurate 24 estimation. This requirement of Arizona law clearly is satisfied. When the lender and 25 Arrowhead entered into this loan, the harm caused by Arrowhead’s possible future breach 26 2 27 28 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. -3- 1 could not be calculated with any accuracy. The commercial loan was to be repaid over ten 2 years. The parties to the loan did not know when a breach might occur, what amount of 3 principal and interest would have been repaid at that time, what ability Arrowhead might 4 have to make additional partial repayment of the loan, what commercial interest rates would 5 prevail at the time of breach, or what conditions might exist in the commercial real estate 6 market to affect the value of the loan’s collateral. As a result, it would have been impossible 7 for them to calculate in advance what damages the lender might suffer from a breach. 8 Because this prong of the Arizona test is satisfied, the key question is whether the 9 Bankruptcy Court correctly determined that the amount fixed in the contract was not a 10 reasonable forecast of just compensation for the harm caused by a possible breach. The 11 Bankruptcy Court did not make specific findings as to what a reasonable forecast of 12 compensation would have been at the time the loan was made. The court also did not state 13 why it considered the YMA formula unreasonable, other than to note that the YMA in this 14 case constitutes 25% of the principal balance. But the mere fact that a payment represents 15 25% of the principal does not necessarily make the payment a penalty under Arizona law. 16 The key inquiry is the reasonableness of the payment “in light of all the facts and 17 circumstances in any given case.” See Jeffries, 701 P.2d at 591; see also Rampello, 812 P.2d 18 at 1118. “[T]he amount fixed is reasonable to the extent that it approximates the loss 19 anticipated at the time of the making of the contract, even though it may not approximate the 20 actual loss.” Rampello, 812 P.2d at 1118. 21 The YMA calculation appears to be a reasonable approximation of the loss the lender 22 would suffer if the loan was prepaid. YMA is defined in the note as “the present value, as 23 of the Prepayment Date, of the remaining scheduled payments of principal and interest from 24 the Payment Date through the Maturity Date,” determined by discounting such payments by 25 the Treasury rate. Doc. 8 ¶ 5(d). In other words, the YMA seeks to give the lender the 26 benefit of the bargain under the note – the present value of the principal and interest it would 27 have received had the loan been repaid over its ten-year life. 28 -4- 1 Arrowhead offers two reasons why the Prepayment Clause is not a reasonable 2 estimate of just compensation: (1) the Prepayment Clause presumes that damages will be 3 sustained even if interest rates change in favor of the lender by virtue of the 1%-of-principal 4 provision; and (2) the Treasury rate used in the YMA formula is systematically lower than 5 interest rates for commercial mortgages, thereby resulting in a windfall to the lender. Doc. 6 10 at 13-17. 7 The Court cannot conclude that the Prepayment Clause is unreasonable because it 8 includes a minimum payment of 1% of the loan amount. First, the minimum 1% payment 9 is not at issue here. Interest rates have dropped since the loan was made, and the 10 prepayment premium in this case therefore is calculated using the alternative YMA formula. 11 Second, requiring a 1% prepayment premium even when interest rates have risen is not 12 necessarily unreasonable because a lender incurs costs when it is required by early payment 13 of the note to reinvest its fund in the market – costs anticipated by the 1% prepayment 14 requirement. Arrowhead has presented no evidence to show that the 1% prepayment 15 requirement is not a reasonable estimation of such costs. 16 Nor can the Court conclude that the YMA is unreasonable because it uses Treasury 17 rates. The sophisticated parties to this commercial loan not only concluded that Treasury 18 rates would constitute a just basis for calculating approximate damages from a breach, they 19 also specifically agreed that the Prepayment Clause “is a bargained for consideration and not 20 a penalty.” Doc. 9 at ¶ 5(c). Moreover, although it is true that Treasury rates generally are 21 lower than commercial real estate loan rates, and that the use of Treasury rates to calculate 22 YMA might therefore overstate to some extent the amount of loss the lender would incur 23 when it was required to reinvest its funds in a lower market after early payment of the loan, 24 the fact also remains, as noted above, that the lender would incur additional costs in any such 25 reinvestment. See In re Fin. Ctr. Assocs. of E. Meadow, L.P., 140 B.R. 829, 836-37 (Bankr. 26 E.D.N.Y. 1992). Arrowhead has provided no evidence from which the Court can conclude 27 that such costs are not reasonably approximated by the difference between prevailing 28 commercial rates and Treasury rates. See In re Hidden Lake Ltd. P’ship, 247 B.R. 722, 729 -5- 1 (Bankr. S.D. Ohio 2000) (“The more commonly expected breaches . . . produce a situation 2 where loss to the lender would be hard to estimate at the time the loan is closed because of 3 the inability to predict future interest rates and the uncertainty of the availability of a suitable 4 substitute investment opportunity for the lender. Use of the Treasury obligation as a 5 reference point for the calculation, although generally overcompensating Aetna, is not an 6 unreasonable estimate.” (emphasis added)). Indeed, Arrowhead has provided no calculation 7 of projected damages when the loan was made from which the Court could conclude that the 8 YMA does not constitute a reasonable approximation of those damages. As a result, the 9 Court cannot conclude that YMA failed, at the time of contracting, to provide a reasonable 10 forecast of just compensation for the harm caused by a breach. 11 Applying de novo review, the Court concludes that under Arizona law (1) the harm 12 caused by any breach of the note was, at the time of contracting, incapable or very difficult 13 of accurate estimation, and (2) Arrowhead has not shown that the Prepayment Clause failed, 14 at the time of contracting, to provide a reasonable forecast of just compensation for the harm 15 caused by any future breach. Larson-Hegstrom, 701 P.2d at 591. Arrowhead therefore has 16 failed to show that the Prepayment Clause is an unenforceable penalty under Arizona law. 17 IT IS ORDERED: 18 1. The judgment below is vacated. 19 2. The Clerk shall remand the case to the Bankruptcy Court for further 20 21 proceedings. DATED this 20th day of July, 2011. 22 23 24 25 26 27 28 -6-

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