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

IN THE

SUPREME COURT OF THE STATE OF ARIZONA
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.

No. CV-16-0029-PR
Filed April 25, 2017

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

Opinion of the Court of Appeals, Division One
239 Ariz. 132, 366 P.3d 1022 (App. 2016)
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
 DOBSON BAY, ET AL. V. LA SONRISA DE SIENA LLC
Opinion of the Court

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

JUSTICE TIMMER, opinion of the Court:

¶1 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. 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

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Opinion of the Court

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.”).

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Opinion of the Court

¶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).

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Opinion of the Court

¶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

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Opinion of the Court

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. § 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 flexibility
to respect the parties’ right to stipulate to damages for a breach but, when
appropriate, prevent imposition of a penalty.

B. Application of Restatement Second § 356(1) to this case

¶16 The late fee provision in the promissory note here provides:

If any installment payable under this
Note (including the final installment due on the
Maturity Date) is not received by Lender prior
to the calendar day after the same is due . . .
Borrower shall pay to Lender upon demand an
amount equal to the lesser of (a) five percent
(5%) of such unpaid sum or (b) the maximum
amount permitted by applicable law to defray
the expenses incurred by Lender in handling
and processing such delinquent payment and to
compensate Lender for the loss of the use of
such delinquent payment . . . .

La Sonrisa seeks 5% of the late balloon payment; “the maximum amount
permitted by applicable law” is not at issue.

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Opinion of the Court

¶17 Dobson Bay, as the party seeking to avoid enforcement of the
late fee provision, has the burden of persuading this Court that the
provision imposes an unenforceable penalty. Cf. United Behavioral Health v.
Maricopa Integrated Health Sys., 240 Ariz. 118, 122 ¶ 14, 377 P.3d 315, 319
(2016) (stating that the party claiming that a contractual arbitration
provision is preempted by federal law bears the burden of proving it); Goode
v. Powers, 97 Ariz. 75, 81, 397 P.2d 56, 60 (1964) (noting that a challenger to
a contract bears the burden of showing illegality); Duenas v. Life Care Ctrs.
of Am., Inc., 236 Ariz. 130, 136 ¶ 14, 336 P.3d 763, 769 (App. 2014)
(concluding that party challenging a contract term bears the burden of
showing unconscionability); see also DJ Mfg. Corp. v. United States, 86 F.3d
1130, 1134 (Fed. Cir. 1996) (“A party challenging a liquidated damages
clause bears the burden of proving the clause unenforceable.”). To decide
the matter, we do not apply any bright-line rules but construe the clause
“according to the circumstances of the case, and in the light of all the facts
surrounding it.” Miller Cattle, 38 Ariz. at 190, 298 P. at 643.

¶18 We review the grant of partial summary judgment de novo as
an issue of law. See Cramer v. Starr, 240 Ariz. 4, 7 ¶ 8, 375 P.3d 69, 72 (2016).
Whether a contract provides for liquidated damages or a penalty is also an
issue of law we review de novo. See Rampello, 168 Ariz. at 300, 812 P.2d at
1118.

1. Anticipated or actual damages

¶19 Dobson Bay argues that the late fee provision was neither a
reasonable forecast of anticipated damages nor reasonably related to actual
damages incurred as a result of the untimely balloon payment because La
Sonrisa’s loss has been compensated already by payment of default interest
and collection costs. La Sonrisa asserts that actual damages are irrelevant.
It contends that when the loan was made, the 5% late fee was a reasonable
forecast of just compensation for harm that could be caused by Dobson
Bay’s default in timely making the balloon payment.

a. Anticipated damages

¶20 The late fee did not reasonably forecast anticipated damages
likely to result from an untimely balloon payment.

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Opinion of the Court

¶21 First, the 5% fee is static, payable on demand whether the
payment is one day late or one year late. 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. Cf. Miller Cattle, 38 Ariz. at
190, 298 P. at 643 (stating that a principal rule used to decide whether a
contract imposes a penalty or liquidated damages is whether the payment
“is a fixed and definite sum, regardless of the nature or extent of the breach
of the contract, or whether it is based upon, and varies with, the nature and
extent of the breach”); Grand Union Laundry Co. v. Carney, 153 P. 5, 7 (Wash.
1915) (cited with approval in Miller Cattle, 38 Ariz. at 190, 298 P. at 643)
(“[A]nother feature that some times influences courts to construe a
provision for liquidated damages into a penalty [is that] of fixing for any
one of several different kinds and degrees of breach an equal forfeiture of
money.”).

¶22 La Sonrisa asserts that the 5% late fee did not necessarily
establish a fixed sum of approximately $1.4 million as “[a]t the time the
parties formed their agreement, the exact amount of the final installment
was unknown because the loan documents provided Dobson Bay with the
flexibility to pay all, some, or none of the principal prior to the maturity
date.” But the note permits Dobson Bay to prepay the loan principal only
“in whole” and “not in part,” except that any condemnation or casualty
insurance proceeds would be applied to pay down the principal. Thus,
unless Dobson Bay prepaid the entire principal amount, meaning the late
fee provision would not apply, the parties contemplated that the balloon
payment would approximate the entire loan principal, requiring a late fee
of roughly $1.4 million for an untimely payment.

¶23 Second, the late fee either duplicated other fees triggered by a
default or was grossly disproportionate to any remaining sums needed to
compensate for the anticipated losses identified in the late fee provision. Cf.
United Dairymen of Ariz. v. Schugg, 212 Ariz. 133, 138 ¶ 16, 128 P.3d 756, 761
(App. 2006) (“The right to recover liquidated damages is limited by the
express terms of the parties’ agreement.”); 11 Joseph M. Perillo, Corbin on
Contracts § 58.11 at 457 (rev. ed. 2005) (“The probable injury that the parties
had reason to foresee is a fact that largely determines the question whether
they made a genuine pre-estimate of that injury . . . .”).

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Opinion of the Court

¶24 The late fee is calculated as the lesser of 5% of the delinquent
payment or the maximum amount permitted by law “to defray the
expenses incurred by [Canadian Imperial Bank] in handling and processing
such delinquent payment and to compensate [Canadian Imperial Bank] for
the loss of the use of such delinquent payment.” It is debatable whether
this quoted language qualifies each calculation method or just the latter one.
But it matters not. Requiring an “either-or” comparison to fix the late fee
suggests that both calculation methods were intended to compensate for
the same categories of loss: (1) the costs in handling and processing a late
payment, and (2) the loss of use of the payment. Cf. Smith v. Melson, Inc.,
135 Ariz. 119, 121, 659 P.2d 1264, 1266 (1983) (“A contract should be read in
light of the parties’ intentions as reflected by their language and in view of
all the circumstances.”); State ex rel. Goddard v. R.J. Reynolds Tobacco Co., 206
Ariz. 117, 122 ¶¶ 23–24, 75 P.3d 1075, 1080 (App. 2003) (stating that words
used in a contract must be read in context); see also In re Mkt. Ctr. E. Retail
Prop., Inc., 433 B.R. 335, 344, 363 (Bankr. D.N.M. 2010) (interpreting almost
identical language as stating the purpose for the late fee).

¶25 Both categories of loss identified in the late fee provision are
substantially addressed elsewhere in the promissory note and deed of trust.
Assuming that “handling and processing” includes actions taken to collect
the late payment, those costs would be compensated by Dobson Bay’s
required payment of “all costs of collection,” including reasonable attorney
fees, and, in the event of foreclosure, “all expenses incident to such
proceeding,” including attorney fees and trustee’s fees and costs. The loss
of use of money would be compensated by continuing payments of regular
interest plus default interest. Cf. Ariz. E. R.R. Co. v. Head, 26 Ariz. 259, 262,
224 P. 1057, 1058 (1924) (“Interest is the compensation paid for the use of
money.”).

¶26 What’s left to compensate by payment of a $1.4 million late
fee? La Sonrisa and the dissent rely on an affidavit from Mitchel
Medigovich, a commercial lending expert, who opined that a 5% late fee is
a reasonable forecast of just compensation for impairment of a bank’s
economic interests due to an untimely balloon payment. But much of this
anticipated impairment falls outside the two categories of loss identified by
the parties in the late fee provision. For example, Medigovich states that a
predetermined late fee compensates for post-default “reputational risks,”
“regulatory risks,” and the “risk of expense of preserving the collateral.”

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 DOBSON BAY, ET AL. V. LA SONRISA DE SIENA LLC
Opinion of the Court

Medigovich addresses the categories of loss identified in the late fee
provision by stating that late fees properly subsidize a lender’s debt
collection practices and compensate for the loss of expected funds. He does
not explain, however, what amounts, if any, are reasonably needed to
compensate for these expected losses when, as here, the borrower is already
obligated to pay all collection costs and interest at both the regular rate and
a default rate. Consequently, Medigovich’s affidavit does not persuade us
that a flat $1.4 million late fee was a reasonable forecast of Canadian
Imperial Bank’s anticipated losses from a late balloon payment that would
not have been compensated by the payment of regular interest, default
interest, and collection costs.

¶27 This case is distinguishable from MetLife Capital Financial
Corp. v. Washington Avenue Associates L.P., 732 A.2d 493 (N.J. 1999), on which
La Sonrisa and the dissent rely. There, the court concluded that a 5% late
charge assessed against delinquent monthly installment payments of about
$14,000 was enforceable as liquidated damages. Id. at 495–96, 502. The
reasonableness of applying the charge against a final balloon payment was
not at issue. See id. at 495 (“We now consider whether the five percent late
charge assessed against each delinquent payment . . . constitute[s]
reasonable stipulated damages provisions.”); see also MetLife Capital
Financial Corp. v. Washington Ave. Assoc., L.P., 713 A.2d 527, 531 (N.J. App.
1998) (stating that application of the late charge against a final balloon
payment of about $69,000 was not at issue), aff’d in part, rev’d in part, 732
A.2d 493 (N.J. 1999). Assessing a $700 late fee for an untimely installment
payment may well reflect a reasonable assessment of the internal costs of
monitoring and collecting late installment payments during the loan
tenure. But that is a far cry from assessing a nearly $1.4 million fee for a
delayed balloon payment of the loan principal, particularly given that the
lender here was otherwise entitled to compensation for its collections costs
and loss of use of the funds.

¶28 In sum, a flat 5% late fee did not reasonably predict the
damages that would be sustained by Canadian Imperial Bank for a late
balloon payment of the entire loan principal.

b. Actual damages

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Opinion of the Court

¶29 The $1.4 million late fee did not reasonably approximate
either the actual costs of handling and processing the late balloon payment
or the loss of use of that payment.

¶30 The summary judgment papers did not address the actual
losses incurred by Canadian Imperial Bank and La Sonrisa after Dobson
Bay’s default. Nevertheless, the record reflects that neither lender spent
significant time handling and processing the late payment. The only
outstanding payment was the last payment, and nothing suggests that
either lender had much to “handle and process” before the trustee’s sale
was initiated. Cf. In re Mkt. Ctr. E. Retail Prop., Inc., 433 B.R. at 364
(concluding that after default on a balloon payment “there would be little
or no more administrative expenses in handling and processing delinquent
payments” and “[a]ll that is left to do is have the attorneys sue to
foreclose”). The note already required Dobson Bay to pay any collection
costs, including attorney fees. It is inconceivable that any remaining
administrative collection costs approached $1.4 million, particularly in light
of the short time between the default and initiation of the trustee’s sale—
about three months. Thereafter, the deed of trust applied to require Dobson
Bay to pay attorney fees and trustee’s fees and costs.

¶31 La Sonrisa was also compensated for the loss of use of money
suffered by it and its assignor, Canadian Imperial Bank, by Dobson Bay’s
obligation to pay regular and default interest. Cf. K.B. v. State Farm Fire &
Cas. Co., 189 Ariz. 263, 267, 941 P.2d 1288, 1292 (App. 1997) (“An assignee
steps into the shoes of her assignor.”). Dobson Bay was current on the loan
until the maturity date. La Sonrisa did not dispute Dobson Bay’s
representation at oral argument before this Court that La Sonrisa received
between $600,000 and $700,000 in default interest alone for the six-month
delay in paying the balloon amount.

¶32 In sum, nothing indicates that either lender, separately or
together, suffered an uncompensated loss that approached $1.4 million.

2. Difficulty of proof of loss

¶33 We next consider the difficulty of proving the losses actually
sustained by Canadian Imperial Bank and La Sonrisa in handling and
processing the late balloon payment and by being deprived of use of that

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payment. Restatement Second § 356 cmt. b & illus. 2–4. In doing so, we
examine the difficulty of either proving that a loss occurred or establishing
its amount with certainty. Id. § 356 cmt. b.

¶34 La Sonrisa would have had no difficulty proving it sustained
a loss in handling and processing the late balloon payment, if a loss
occurred. (Because La Sonrisa noticed the trustee’s sale about a week after
acquiring the loan, it may not have expended any resources handling and
processing the balloon payment.) It could have produced evidence of the
tasks undertaken by it to do so. La Sonrisa would have had slightly more
difficulty precisely proving the amount of damages incurred from any such
loss depending on what activities constituted “handling and processing”
and how it allocated the costs of these activities. Cf. Garrett v. Coast & S. Fed.
Sav. & Loan Ass’n, 511 P.2d 1197, 1203 (Cal. 1973) (invalidating a late fee
provision and noting that “[t]he lender’s charges could be fairly measured
by the period of time the money was wrongfully withheld plus the
administrative costs reasonably related to collecting and accounting for a
late payment”).

¶35 La Sonrisa would have had no difficulty proving that either
lender sustained a loss by being deprived of the use of the balloon payment.
Interest on the outstanding amount could have been assessed to
compensate for the loss of use of money. Cf. Ariz. E. R.R. Co., 26 Ariz. at
262, 224 P. at 1058. And La Sonrisa would be entitled to collect interest
earned when Canadian Imperial Bank was the note payee and the loan was
in default. Cf. K.B., 189 Ariz. at 267, 941 P.2d at 1292. Indeed, the
promissory note required Dobson Bay to pay regular interest and default
interest for that purpose.

¶36 In sum, under the circumstances here, the difficulty of
proving La Sonrisa’s loss as identified in the late fee provision was slight.

3. Consideration of factors

¶37 We are persuaded that the late fee is an unenforceable
penalty. The difficulty of proving losses attributable to handling and
processing the balloon payment was slight. We therefore give less latitude
to Canadian Imperial Bank and Dobson Bay’s approximation of anticipated
or actual harm. See Restatement Second § 356 cmt. b.

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Opinion of the Court

¶38 As explained, the late fee neither reasonably forecasted
anticipated damages for the losses identified in the late fee provision nor
reasonably approximated the actual losses. 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. 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. See Gary Outdoor
Advert. Co., 133 Ariz. at 243, 650 P.2d at 1225.

C. The dissent

¶39 Our dissenting colleague colorfully compares our decision to
a child’s cry of “backsies” to sidestep a promise. 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. Courts will likewise disregard the parties’ intent
and refuse to enforce contract terms that are unconscionable, illegal, or
otherwise against public policy. Cf. Maxwell v. Fidelity Fin. Servs., Inc., 184
Ariz. 82, 88, 907 P.2d 51, 57 (1995) (“[E]ven if the contract provisions are
consistent with the reasonable expectations of the party they are
unenforceable if they are oppressive or unconscionable.” (internal
quotations and alterations omitted)); Goodman v. Newzona Inv. Co., 101 Ariz.
470, 474, 421 P.2d 318, 322 (1966) (recognizing “the fundamental right of the
individual to [have] complete freedom to contract . . . so long as his contract
is not illegal or against public policy”). That the dissent prefers to ignore
these principles does not affect their applicability.

¶40 The dissent is also incorrect that our decision runs afoul of the
Arizona Constitution’s “contract clause,” article 2, § 25, an argument La
Sonrisa has never made. Our colleague contends that we assign Dobson
Bay a burden of persuasion that is so insubstantial it “impair[s] the
obligation of contract.” See infra ¶ 46. But judicial invalidation of a contract
provision does not implicate the contract clause. Cf. Tidal Oil Co. v.
Flanagan, 263 U.S. 444, 451 (1924) (finding no violation of the federal

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Opinion of the Court

contract clause where a state supreme court declared a contract void and
unenforceable because “the obligation of contracts against state action[] is
directed only against impairment by legislation and not by judgments of
courts”); Barrows v. Jackson, 346 U.S. 249, 260 (1953) (citing Tidal and holding
that a state court’s refusal to enforce a racially restrictive covenant did not
violate the federal contract clause); see also Fields v. Elected Officials’ Ret. Plan,
234 Ariz. 214, 218 ¶ 16, 320 P.3d 1160, 1164 (2014) (noting that the Court
interprets Arizona’s contract clause using an “analysis similar to that
employed by the Supreme Court” when interpreting the federal contract
clause); Hall v. Elected Officials’ Ret. Plan, 241 Ariz. 33, 383 P.3d 1107, 1126 ¶
69 (2016) (Bolick J., dissenting in part and concurring in the judgment in
part) (noting, with regard to the state contract clause, that “[h]istorically,
Arizona courts have applied the United States Supreme Court’s test for
determining violations of the Contract Clause of the Federal Constitution”).

¶41 Even if the contract clause had been argued here and applies,
it would not change our decision. The contract clause only limits the state’s
ability to impair existing contract obligations; it does not curtail application
of proscriptive principles that existed at the time of contract creation. Cf.
State v. Direct Sellers Ass’n, 108 Ariz. 165, 169–70, 494 P.2d 361, 365–66 (1972)
(“The [contract clause of the federal constitution] means only that no state
may impair the obligation of an [e]xisting contract.”); Foltz v. Noon, 16 Ariz.
410, 417, 146 P. 510, 512 (1915) (noting that a statute will not violate the
Arizona Contract Clause “when applied to contracts made subsequent to
its taking effect”); Samaritan Health Sys. v. Superior Court, 194 Ariz. 284, 293
¶ 41, 981 P.2d 584, 593 (App. 1998) (“[Arizona’s] contract impairment clause
only limits the legislature’s ability to impair obligations under existing
contracts.”). Our cases proscribed penalty clauses long before origination
of the loan here, and the note incorporated this proscription. Cf. Bhd. of Am.
Yeomen v. Manz, 23 Ariz. 610, 615, 206 P. 403, 404 (1922) (“It is a familiar rule
that the law in force at the time a contract is executed enters into and forms
a part of the contract.”); Qwest Corp. v. City of Chandler, 222 Ariz. 474, 484 ¶
34, 217 P.3d 424, 434 (App. 2009) (“[A]ll contracts incorporate applicable
statutes and common-law principles.”). Consequently, our refusal to
enforce a penalty provision did not impair the parties’ contract obligations
here.

III. Conclusion

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 DOBSON BAY, ET AL. V. LA SONRISA DE SIENA LLC
Opinion of the Court

¶42 We vacate the court of appeals’ opinion, reverse the trial
court’s partial summary judgment in favor of La Sonrisa on the liquidated
damages claim, and remand to that court for further proceedings, including
entry of partial summary judgment for Dobson Bay on its declaratory relief
claim concerning the late fee. We award Dobson Bay its reasonable attorney
fees pursuant to A.R.S. § 12-341.01 subject to its compliance with ARCAP
21(c).

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 DOBSON BAY, ET AL. V. LA SONRISA DE SIENA LLC
JUSTICE BOLICK, Dissenting

BOLICK, J., dissenting.

¶43 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. 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.

¶44 The Court today invalidates a core and unambiguous
provision of a contract freely negotiated for mutual benefit between
sophisticated parties represented by competent counsel. 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. The majority determines that the liquidated
damages provision agreed to by the parties is an unenforceable penalty,
based on its thorough examination of the Restatement (Second) of
Contracts. Because I believe that over the course of that journey the
majority lost the forest for the trees, I respectfully dissent.

¶45 The relevant provision of the Restatement (Second) is
consistent with A.R.S. § 47-2718, which provides that a contract term “fixing
unreasonably large liquidated damages is void as a penalty.” As with all
statutes, we must construe this provision, if at all possible, in a
constitutional manner. State v. Thompson, 204 Ariz. 471, 474 ¶ 10, 65 P.3d
420, 423 (2003).

¶46 Freedom of contract allows individuals to order their affairs
and exchange goods and services, without coercion, in accord with their
personal values and priorities. The Arizona Constitution so venerates
contractual freedom that it is enshrined in our Declaration of Rights. Article
2, section 25 commands, “No . . . law impairing the obligation of a contract,
shall ever be enacted.” That provision requires us to indulge every
presumption in favor of upholding a contract negotiated as this one was,
and to assign a substantial burden of demonstrating unenforceability to the
party challenging the terms to which it willingly and knowingly agreed.
The majority purports to assign the burden of persuasion to Dobson Bay,
see ¶ 17, but that “burden” is so insubstantial as to transform § 47-2718 into
“a law impairing the obligation of a contract.”

¶47 “The law of liquidated damages is unique within the common
law of contracts because it overtly affronts freedom of contract.” Larry A.

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 DOBSON BAY, ET AL. V. LA SONRISA DE SIENA LLC
JUSTICE BOLICK, Dissenting

Dimatteo, A Theory of Efficient Penalty: Eliminating the Law of Liquidated
Damages, 38 Am. Bus. L.J. 633, 634 (2001). That is because it allows courts
to displace the intent of the parties by determining that a provision amounts
to a penalty. Such discretion should be exercised with great care, for as the
majority aptly notes, liquidated damages provisions “serve important
purposes,” such as providing certainty when actual damages would be
difficult to calculate and avoiding the costs and delays of litigation. See ¶ 8.

¶48 Moreover, “a party concerned foremost with performance,
especially a timely performance, may use such a clause in the hope that it
will provide a further inducement for performance.” Dimatteo, 38 Am. Bus.
L.J. at 634. Certainly that is the case with the contract here. Dobson Bay
sought a considerable loan—$28.6 million—to purchase four commercial
properties. Under the contract terms, it would make interest-only
payments for a prescribed period, after which it would repay the entire
principal in a “balloon” payment. The timely return of the principal is a
critical, indeed defining, feature of the loan. The contract underscored that
fact by requiring, in addition to other fees described by the majority, a 5%
fee for late interest payments or principal repayment. Absent evidence to
the contrary by the party properly bearing the burden of proof, we may
presume that the substantial loan Dobson Bay sought would not have been
made absent this assurance.

¶49 The lender was not voracious. Before the balloon payment
was originally due in 2009, the parties negotiated a three-year extension.
As the new date approached, the parties negotiated over another extension
but failed to reach agreement. Thereafter the note was sold to La Sonrisa
which then commenced foreclosure proceedings.

¶50 The majority applies two factors in determining whether the
liquidated damages provision is “reasonable”: the anticipated or actual loss
caused by the breach, and the difficulty of proof of loss. See ¶ 12. Proving
the provision is reasonable based on actual damages makes little sense in
most instances, given that the point of a liquidated damages provision is to
avoid litigation that requires proving actual damages. Accordingly, the
proper inquiry “is whether the stipulated amount was, when all of the facts
are considered, reasonable at the time of the contract and not whether it was
reasonable with the benefit of hindsight.” Rampello, 168 Ariz. at 300, 812
P.2d at 1118. At the same time, citing a comment to Restatement (Second)
§ 356, the majority notes that if the difficulty of forecasting actual damages
is great, considerable latitude is appropriate in assigning liquidated
damages. Although the difficulty of forecasting the amount of loss here

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 DOBSON BAY, ET AL. V. LA SONRISA DE SIENA LLC
JUSTICE BOLICK, Dissenting

was great, the majority extends no such latitude.

¶51 The majority concludes that the lender is compensated for
losses owing to a dilatory final payment elsewhere in the contract;
specifically, through collection costs and foreclosure expenses. See ¶ 25.
Further, “[t]he loss of use of money would be compensated by continuing
payments of regular interest plus default interest.” Id. Given that we have
no idea the use to which the lender would have put the money had it been
returned in a timely manner, that conclusion is conjecture, and illustrates
precisely why liquidated damages provisions are preferable to protracted
litigation and judicial second-guessing.

¶52 The main cost to the lender of failing to recover the loan
corpus in a timely fashion, and the most difficult to calculate in advance, is
opportunity cost. La Sonrisa produced a declaration from Mitchel
Medigovich, who has extensive experience as an Arizona trustee and real
estate broker and originator. He attests that when a borrower unilaterally
extends the due date of a balloon payment, it imposes costs, including
opportunity costs, upon the lender. He likens the situation to a car rental
company with a fixed fleet of cars. If a renter unilaterally extends a rental
even by one day, it diminishes fleet availability and the ability to provide
new rentals, which has economic ripple effects throughout the enterprise.

¶53 Medigovich summarized the consequences of a late final
payment and the purpose of a liquidated damages provision:

Many lenders including banks make projections for expected
and scheduled repayment of loans with which the lender
makes interest payments to depositors, new loan
commitments to prospective borrowers, bond payments to
investors or to replenish capital reserves. In any event, failure
of the borrower to make any scheduled payment including a
payment due upon maturity of the loan, particularly in the
case of [a] large commercial loan such as in this case puts the
lender at great risk of default of its own commitments . . . .
Consequently, in most commercial transactions, the parties
agree that if the Borrower fails to make a final payment of
principal on the due date, (a unilateral extension), the
economic impact to the Lender is incalculable and therefore a
Late Fee is necessary as liquidated damages to the lender.

¶54 Such late fees are not a penalty because (1) “[a] lender with a

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 DOBSON BAY, ET AL. V. LA SONRISA DE SIENA LLC
JUSTICE BOLICK, Dissenting

non-performing loan has significantly increased risk of recovery,” (2), “in
addition to the expense of managing the non-performing asset, the lender is
denied the ability to reinvest expected . . . payments into new performing
investments at current market rates” (emphasis added), and (3) “the lender
may be at risk of defaulting on other loan commitments wherein funding is
contemplated by the loan maturing.” Whether any or all of those factors
will occur in a particular loan context is unpredictable, and the cost of
possible lost opportunities is inherently difficult to calculate.

¶55 Consequently, Medigovich observes, customary late fees for
commercial transactions typically start at 4% or 5% and range up to 10%.
In Medigovich’s view, the 5% fee here was “perhaps below what is
reasonable for the circumstances,” which involved “a complex transaction
with multiple properties as the collateral and multiple entities as the
Borrower.” 1

¶56 Thus, even though La Sonrisa did not bear the burden of
proving that the liquidated damages provision was reasonable, it supplied
powerful evidence that the economic damages flowing from default or
delayed final payment were potentially substantial, difficult to forecast or
calculate, and not fully encompassed by other fees in the contract.

¶57 In contrast, Dobson Bay, the party that purportedly bore the
burden of proof, presented by way of contravening evidence: absolutely

1 Here, the lender sold the note to La Sonrisa. Amicus Arizona Private
Lender Association explains the circumstances that give rise to such a sale:

These lenders often have a significant portion of
their total available funds invested at any given
time. . . . Therefore, it is important to private
lenders that their borrower repay on time to free
up cash for new loans to keep the money
moving and working for the business. . . . Thus
when a borrower defaults on the repayment of
the principal, the lender may be forced to sell
the note to a collection agency at a discount.
Late fees and default interest make the
defaulted notes more attractive to collection
firms, resulting in higher purchase prices for the
notes, which helps the lender to protect against
losses and keep its capital in the market.

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 DOBSON BAY, ET AL. V. LA SONRISA DE SIENA LLC
JUSTICE BOLICK, Dissenting

nothing. 2

¶58 Unsurprisingly, the trial court, which weighed the evidence
presented by La Sonrisa and the absence thereof by Dobson Bay, concluded
that the liquidated damages provision was enforceable. The court of
appeals, by contrast, held that as a matter of law, “absent unusual
circumstances,” a 5% liquidated damages provision in a contract like this is
unenforceable. Dobson Bay, 239 Ariz. at 140 ¶ 22, 366 P.3d at 1030. The court
cited neither law nor precedent for such a sweeping substantive
pronouncement, although at least it provided a clear rule to which
contracting parties could conform themselves.

¶59 The majority’s opinion here is more legally grounded but also
far more nebulous. Is a default fee based on a percentage amount per se
invalid because it does not vary with the duration of the default, even
though amount-based late fees may not fully compensate for lost
opportunity costs; or do the parties have to litigate every time to find out,
which defeats the important purposes of liquidated damages clauses?
Either way, the economic consequences may be severe. As La Sonrisa’s
expert attested, again unrebutted by the party ostensibly bearing the
burden of proof, percentage-based liquidated damages provisions for late
balloon payments are common components of commercial loan contracts.
Every single one is now in legal purgatory.

¶60 I prefer the approach taken by the New Jersey Supreme Court
in MetLife, 732 A.2d at 499, which is more faithful to the Restatement and
protective of freedom of contract. MetLife involved a contract containing
percentage-based late and default fees as liquidated damages, in addition
to collection and various other fees. Id. at 495–96. At trial, MetLife’s expert
testified that a 5% late fee was the industry custom and standard, and was
a reasonable forecast of costs including “lost investment opportunities.” Id.
at 496. Unlike here, the party challenging the provision actually produced
contrary evidence. Id. at 497. The trial court found both the late fee and a
12.55% default fee represented reasonable liquidated damages. Id. The

2 “Under a traditional common law analysis, the burden of proof regarding
the enforceability of a liquidated damages clause rests squarely on the party
seeking to set it aside.” Dimatteo, 38 Am. Bus. L.J. at 664–65. “Although
courts recognize this traditional allocation of burden of proof, in reality the
onus seems to be upon the non-breaching party to prove
reasonableness. . . . In fact, some courts remain largely influenced by any
disproportion between the stipulated amount and actual damages.” Id. at
667–68. That is an accurate depiction of the majority analysis.
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 DOBSON BAY, ET AL. V. LA SONRISA DE SIENA LLC
JUSTICE BOLICK, Dissenting

court of appeals reversed for reasons similar to those in the majority
opinion here. Id. at 497–98.

¶61 The Supreme Court reversed the court of appeals. It began by
noting that a “need for close scrutiny arises from the possibility that
stipulated damages clauses may constitute an oppressive penalty.” Id. at
498. But the court should assess such provisions on a “continuum; the more
uncertain the damages caused by a breach, the more latitude courts give the
parties on their estimate of damages.” Id. The court held that “liquidated
damages provisions in a commercial contract between sophisticated parties
are presumptively reasonable and the party challenging the clause bears
the burden of proving its unreasonableness.” Id. at 499.

¶62 Applying those standards, the court concluded that the 5%
late fee was reasonable because (1) “[i]t seems evident that late payments
on larger loans would present a greater risk to the lender” given that they
constitute a larger portion of a lender’s portfolio, and (2) “damages
resulting from the loss of investment opportunity increases with the size of
the late installment payment,” thus “a lender suffers both larger
administrative and ‘opportunity cost’ damages when a borrower is late
with a larger payment.” Id. at 500. Because operational “costs are spread
over an entire loan portfolio, it is difficult to identify specific damages
attributable to the late payment or default of one specific borrower.” Id.

¶63 Given the difficulty in forecasting damages from late
payment or default, the court looked to what was permitted by statute “and
what constitutes common practice in a competitive industry.” Id. The
testimony that 5% was the industry standard was (as here) uncontradicted.
Id. By contrast, cases in which fixed-percentage liquidated damages
provisions were struck down “involved unusually large percentages or
explicit evidence of a coercive intent.” Id. at 501–02 (citing cases).

¶64 The court also sustained the 12.55% default interest rate. “As
with the costs of late payments, the actual losses resulting from a
commercial loan default are difficult to ascertain.” Id. at 503. “The lender
cannot predict the nature or duration of a possible default,” nor “is it
possible when the loan is made to know what market conditions might be”
at time of default or “what might be recovered from a sale of the collateral.”
Id. “For example, a lender cannot know what its own borrowing costs will
be if a borrower defaults . . . nor accurately predict what economic return it
will lose when the borrower fails to repay the loan on time.” Id. Because
the 12.55% default interest rate “appears to be a reasonable estimate of

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 DOBSON BAY, ET AL. V. LA SONRISA DE SIENA LLC
JUSTICE BOLICK, Dissenting

potential damages, falls well within the range demonstrated to be
customary, and because a stipulated damages clause negotiated between
sophisticated commercial entities is presumptively reasonable,” the court
sustained it. Id.

¶65 Our Court likewise should presume that a liquidated
damages provision negotiated by sophisticated parties is valid and
conclude that the party bearing the burden of demonstrating its
unreasonableness failed to sustain that burden in this case. Instead, we
reward the party breaching the contract by removing a critical term to
which it assented and, as a necessary consequence adding both insult and
injury, require the non-breaching party to pay its attorney fees. 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. With great respect to my colleagues, I
dissent.

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