JOHN R. TUNHEIM, District Judge.
This matter is before the Court on appeal from the March 4, 2013, order of United States Bankruptcy Judge Kathleen H. Sanberg.
Debtors collectively own three "pools" of real property in Dakota and Hennepin Counties. (Civ. No. 13-1013, Bankr. Transmittal, Ex. 15 ("Stipulated Facts") ¶ 2, Apr. 30, 2013, Docket No. 6.) Debtors are indebted to the Trust under three separate promissory notes ("the Note") secured by interests in the pools of real property pursuant to mortgages (collectively, "the Loan Documents"). (Id. ¶ 3.) The original principal amount of the loans totaled $37,396,000. (Id.) The Note includes a default interest provision providing that upon default the interest rate on the remaining principal will be 5.0% plus the non-default rate of 5.04%. (Bankr. Transmittal, Ex. 1 ("Proof of Claim") at 10, 14.) The Note states that the borrower "acknowledges that it would be extremely difficult or impracticable to determine [the Trust]'s actual damages resulting from any late payment or default, and such late charges and default interest are reasonable estimates of those damages and do not constitute a penalty." (Id. at 14.) The Note also states that "if such increased rate of interest may not be collected under applicable law," then the default interest will be the maximum rate allowed under applicable law. (Id.)
Bowles defaulted under the terms of the Loan Documents on May 31, 2011, when Steven B. Hoyt, guarantor of the loan and chief manager of Bowles, filed for personal Chapter 11 protection. (Stipulated Facts ¶ 5; Bankr. Tr. at 52:1-2, Apr. 30, 2013, Docket No. 7.) Bowles also defaulted under the terms of the Loan Documents by failing to make payments due under the Note beginning in April 2012. (Stipulated Facts ¶ 5.) The Trust gave notice of acceleration by letter dated January 19, 2012. (Id.)
Each of the Debtors filed for Chapter 11 protection on or about May 8, 2012, and filed a joint Chapter 11 reorganization plan on August 1, 2012. (Stipulated Facts ¶¶ 1, 8.) The Debtors are solvent and under their proposed plans, unsecured creditors will receive the full amount of their claims. (Id. ¶ 9.) The Trust timely filed Proofs of Claim on August 17, 2012. (Id. ¶ 6.) The Proofs of Claim listed pre-petition default interest for the period from May 31, 2011, to May 7, 2012, totaling $1,516,739.80. (Id.) Bowles timely objected to the Proofs of Claim and the parties were unable to come to a resolution regarding the inclusion of the default interest.
The Bankruptcy Court held a hearing on February 12, 2013. (Bankr. Tr. at 1.) Debtors' chief manager (Hoyt) and Rakesh Patel, a CW Capital vice-president, offered the only testimony at the hearing. (Bankr. Tr. at 4.) Other evidence included the Loan Documents, the Pooling and Servicing Agreement, and related documents. (See Bankr. Transmittal, Attach. 18.)
The Trust offered evidence regarding the types of damages that the default interest would compensate. First, Patel testified that default interest compensated the Trust for "the additional risk profile that the loan takes on when it's defaulted." (Bankr. Tr. at 112:5-7.) Second, Patel testified that default interest compensated the Trust for costs incurred by the special servicer as a result of the default, including salary expenses and overhead. (Id. at 102:19-24.) Patel also discussed advances of principal and interest that the Trust or the master servicer of the loan made to bondholders while the Loan was in default. (Id. at 113:4-114:8.) The amounts advanced totaled $1,798,377.85. (Id. at 152-53.) The parties dispute the extent to which Bowles' Chapter 11 reorganization plan requires Bowles to reimburse the Trust for the advanced principal and the interest on those advances. (See, e.g., id. at 163:10-11.)
Patel testified as to the predictability of the damages resulting from default. He stated that "there is no way to know what the damage is [or] what the defaults would have been at the time" that the Note was drafted, (id. at 99:5-7), and that the damages resulting from the additional risk of a defaulted loan are "a little bit harder to put a number behind," (id. at 112:9-10).
Patel was unable to provide the exact amount of the Trust's actual damages at the hearing because he "didn't know that [he] would be asked to give those numbers." (Id. at 111:21-22.) Patel did testify, however, that a default interest rate of four to five percent was typical in his experience with similar types of loans. (Id. at 142:6-22.) Patel also testified that the interest rate going forward under the Chapter 11 reorganization plans is lower than the Note rate. (Id. at 170:5-13.) Patel concluded that under the proposed Chapter 11 reorganization plan, the default interest will not be sufficient to cover the costs incurred by the Trust and, as a result, the Trust will not be made whole even if its claim for default interest is allowed. (Id. at 170:9-13.)
Bowles offered evidence of various types of damages for which compensation is provided by portions of the Loan Documents other than the default interest provision. Hoyt testified that Bowles is required to compensate the Trust for specific costs associated with default (including attorneys' fees, late fees, and costs of administration and enforcement) in addition to the default interest. (Id. at 84:16-24.) He suggested that enforcing the default interest provision in these circumstances would result in "double debt paying, if not triple debt paying." (Id. at 85:3-4.) Patel, on the other hand, testified that the default interest was not duplicative of a yield maintenance premium that was due upon default, late fees, or processing charges. (Id. at 136-38.)
In an order dated March 4, 2013, the Bankruptcy Court concluded that the default interest provision was enforceable and allowed the Trust's claim for default interest. (Mem. & Op. at 10-12.) Bowles appealed the order, (Notice of Appeal, Apr. 30, 2013, Docket No. 1), and elected to have the District Court hear the appeal pursuant to 28 U.S.C. § 158(c)(1)(A), (Notice of Appeal, Attach. 3).
In bankruptcy proceedings, the Court sits as an appellate court and reviews the Bankruptcy Court's conclusions of law de novo. See In re Reynolds, 425 F.3d 526, 531 (8th Cir. 2005). The district court reviews findings of fact for clear error. Id.; see also Fed. R. Bankr. P. 8013 ("Findings of fact, whether based on oral or documentary evidence, shall not be set aside unless clearly erroneous . . . ."). "A finding is clearly erroneous when although there is evidence to support it[,] the reviewing court is left with the definite and firm conviction that a mistake has been committed." DeBold v. Case, 452 F.3d 756, 761 (8th Cir. 2006) (internal quotation marks omitted). The Bankruptcy Court determines the credibility of witnesses and the weight to be accorded testimony. See Fed. R. Bankr. P. 8013 ("[D]ue regard shall be given to the opportunity of the bankruptcy court to judge the credibility of the witnesses."); cf. Imperial Cas. & Indem. Co. v. Carolina Cas. Ins. Co., 402 F.2d 41, 44 (8th Cir. 1968). On appeal, the Court views the evidence in the light most favorable to the party that prevailed before the Bankruptcy Court and gives that party the benefit of all reasonable inferences that may be drawn from the evidence. See Imperial Cas. & Indem. Co., 402 F.2d at 44.
Whether the Trust is entitled to recover default interest as part of its claim in Bowles' Chapter 11 proceedings depends on whether the default interest provision is enforceable under Minnesota law. See Raleigh v. Ill. Dep't of Revenue, 530 U.S. 15, 20 (2000) ("Creditors' entitlements in bankruptcy arise in the first instance from the underlying substantive law creating the debtor's obligation, subject to any qualifying or contrary provisions of the Bankruptcy Code."); see also 11 U.S.C. § 502(b)(1).
Under Minnesota law, in determining whether a contractual provision is enforceable as liquidated damages,
Meuwissen v. H.E. Westerman Lumber Co., 16 N.W.2d 546, 550-51 (Minn. 1944) (internal quotation marks omitted). While the circumstances of the agreement described above are relevant, Minnesota law also requires liquidated damages clauses to satisfy two conditions in order to be enforceable: "`(a) the amount so fixed [must be] a reasonable forecast of just compensation for the harm that is caused by the breach, and (b) the harm that is caused by the breach [must be] one that is incapable or very difficult of accurate estimation.'" Gorco, 99 N.W.2d at 74-75 (quoting Restatement (First) of Contracts § 339 (1932)). If these conditions are met, "a contract provision for liquidated damages can be enforced without proving actual damages." Willgohs v. Buerman, 115 N.W.2d 59, 62 (Minn. 1962). It follows that a liquidated damages provision is not necessarily unenforceable simply because the actual damages a party happened to suffer are smaller than the amount specified in the contract, or even non-existent. The question is whether the amount fixed was a reasonable forecast at the time the parties entered the agreement.
Additionally, Minnesota courts "look with candor, if not with favor, upon a contract provision for liquidated damages when entered into deliberately between parties who have equality of opportunity for understanding and insisting upon their rights." Gorco, 99 N.W.2d at 74. Therefore, under Minnesota law, liquidated damages provisions are presumed valid, see id., and a party seeking to invalidate a liquidated damages provision must rebut the provision's presumptive validity by showing that the amount fixed was unreasonable under the circumstances or that actual damages were readily ascertainable, see, e.g., 606 Vandalia P'ship v. JLT Mobil Bldg. Ltd. P'ship, No. C3-99-1723, 2000 WL 462988, at *5 (Minn. Ct. App. Apr. 25, 2000); Schindler Elevator Corp. v. Stuart Corp., No. C1-94-308, 1994 WL 396348, at *3 (Minn. Ct. App. Aug. 2, 1994).
As an initial matter, Bowles argues that the Bankruptcy Court failed to scrutinize the default interest clause to the extent required by Minnesota law. Bowles contends that rather than independently determining whether the Gorco requirements were satisfied, the Bankruptcy Court found that the default interest clause was enforceable simply because the contract stated that the requirements were satisfied. Bowles points to the following language from the order:
(Mem. & Op. at 11.) The Court finds, however, that the Bankruptcy Court applied the appropriate analysis and did not rely exclusively upon the existence of the parties' agreement stating that requirements of enforceability were met. (See Mem. & Op. at 10-12.) While the Bankruptcy Court did make note of the parties' contractual agreement that the Gorco factors were satisfied, it also considered and relied upon evidence from the hearing, including Patel's testimony suggesting that the default interest rate was not unreasonable or disproportionate to actual damages and that the actual damages would have been difficult to calculate.
Bowles' next argues that the Bankruptcy Court's findings of fact were clearly erroneous. Bowles claims that the Bankruptcy Court clearly erred in finding (1) that Patel testified that actual damages were difficult or impracticable to calculate; and (2) that Patel testified that the default interest was a reasonable forecast of the Trust's damages. The Court notes that the Bankruptcy Court's ultimate conclusion that the default interest clause was enforceable did not require the Bankruptcy Court to affirmatively find that the Gorco requirements were satisfied. Rather, the provision was presumptively valid and the burden was on Bowles to show either that damages were readily ascertainable or that the default interest was not a reasonable forecast for damages. Accordingly, even if there was insufficient evidence to support the Bankruptcy Court's two findings of fact here, it would not alter the conclusion that the default interest clause was enforceable because Bowles did not present sufficient evidence to overcome the provision's presumptive validity.
As to the first purportedly erroneous finding, the Bankruptcy Court stated:
(Mem. & Op. at 6.) The Bankruptcy Court also explained that "the Note expressly states that the damages resulting from default are `difficult and impracticable' to calculate, which Mr. Patel confirmed with his testimony." (Id. at 11.) Bowles contends, however, that Patel actually testified that there were ways to quantify the Trust's damages, but he was simply not prepared to offer that testimony at trial.
The Court gives substantial deference to the factual findings of the Bankruptcy Court, see Imperial Cas. & Indem. Co., 402 F.2d at 44, and finds that there was sufficient evidence from which the Bankruptcy Court could reasonably infer that actual damages were difficult or impracticable to calculate even if Patel did not use that exact terminology. Patel testified that "there [was] no way to know what the damage is [or] what the defaults would have been at that time." (Bankr. Tr. at 99:1-7.) He also testified that the default interest compensated the Trust for the additional risk profile that the Trust takes on when the loan is in default and that these damages are "a little bit harder to put a number behind."
As to the second disputed finding of fact, the Bankruptcy Court stated, "at the hearing, Mr. Patel provided the only evidence as to whether the default interest was a reasonable forecast for damages incurred in the event of default." (Mem. & Op. at 11.) Bowles contends that Patel did not testify that the default interest was a reasonable forecast for damages incurred in the event of default because the Bankruptcy Court sustained an objection by Bowles' counsel and prevented Patel from directly testifying that the 5.0% default interest was reasonable. (See Bankr. Tr. at 142:23-143:11.)
Again, the Court finds that the Bankruptcy Court could reasonably have interpreted Patel as testifying that the default interest was a reasonable forecast for damages. As the Bankruptcy Court noted, Patel testified that the 5.0% default interest rate was typical in his experience with similar loans. Patel further testified as to the various expenses incurred by the Trust as a result of the default that the default interest would cover and testified that the Trust will not be made whole even if the default interest provision is enforced. If the Court accepts Patel's testimony as true, the default interest will not fully compensate the Trust for expenses incurred as a result of the default. The Bankruptcy Court could have reasonably interpreted Patel's testimony to mean that the default interest was not an unreasonably large forecast of the Trust's damages.
Although the Court has found that the Bankruptcy Court did not clearly err in its interpretation of Patel's testimony, the Court must address a series of additional arguments Bowles makes in favor of its position that the default interest provision is an unenforceable penalty as a matter of law.
First, Bowles contends that it proved that all types of damage for which default interest could possibly compensate were already covered by other provisions in the Loan Documents. Bowles may be correct that if other provisions of the Loan Documents covered all conceivable types of damage, the default interest provision would be an unenforceable penalty. See In re AE Hotel Venture, 321 B.R. 209, 216 (Bankr. N.D. Ill. 2005) ("Default interest is not a `reasonable' charge . . . if it compensates for an injury that has already been compensated in some other way under the parties' agreement."). But Bowles has failed to show that the loan provisions cover all conceivable types of damages resulting from default. To the contrary, no provision of the Loan Documents compensate the Trust for the increased risk of lending to a defaulted borrower, which Patel testified was one of the types of damages covered by the default interest. See In re Terry Ltd. P'ship, 27 F.3d 241, 244 (7th Cir. 1994). Patel further testified that the default interest did not duplicate other provisions of the Loan Documents and the Bankruptcy Court may have credited this testimony as well. Because Bowles has not shown that other provisions in the Loan Documents compensate the Trust for all types of damage resulting from default, the Court cannot conclude that the default interest provision is an unenforceable penalty on this basis.
Second, Bowles contends that the increased risk of lending to a party who has defaulted is not a legitimate category of damages to consider in determining the validity of a default interest provision. Bowles relies on an unpublished opinion from the District of Oregon, Cal. Bank & Trust v. Shilo Inn, Nos. 3:12-CV-00506, 508, 509, 2012 WL 5605589, at *2-5 (D. Or. Nov. 15, 2012). Yet Shilo Inn did not explicitly forbid the consideration of increased risk. Rather, the court simply determined that the creditor in that case had not proved that the default interest rate was reasonably related to the scope of the increased risk. See id. at *5 ("Plaintiff's bald assertions that the default interest provisions are valid because they are intended to compensate Plaintiff for . . . its increased risk of dealing with defaulted borrows [is] unpersuasive. Generally, every loan that a bank makes to a borrower carries such risks. Such general assumptions of risk simply do not explain why the five percent increases on Shilo Inn's outstanding loan balances in this instance are reasonable.").
Additionally, other authority supports treating the increased risk of dealing with a defaulted borrower as a valid category of damages for which default interest may compensate. See, e.g., In re Kimbrell Realty/Jeth Court, LLC, 483 B.R. 679, 691-92 (Bankr. C.D. Ill. 2012) (upholding a default interest provision that explicitly provided compensation for the fact that the "risk of nonpayment . . . will be materially increased" following default). If lenders were unable to utilize default interest provisions to compensate for the increased risk associated with defaulting borrowers, lenders would likely decide to compensate for the potential risk of default by increasing the borrower's non-default interest rate. See In re 785 Partners LLC, 470 B.R. 126, 132 (Bankr. S.D.N.Y. 2012) ("One can only speculate whether the non-Default Rate would have been greater if the parties had not included a separate default rate of interest."). Furthermore, because increased risk is difficult if not impossible to quantify in advance, utilizing a form of liquidated damages to compensate for this type of damage is particularly appropriate under Minnesota law. See In re Nw. Airlines Corp., 393 B.R. 352, 357 (Bankr. S.D.N.Y. 2008) ("As the Minnesota courts also recognize, liquidated damages clauses are most clearly appropriate when actual damages are difficult to calculate in advance, such as damages for lost profits or goodwill." (citing Meuwissen, 16 N.W.2d at 550)). Accordingly, the Court concludes that the Bankruptcy Court did not err in relying upon the fact that the default interest was intended to compensate the Trust for increased risks following default.
Third, Bowles contends that the default interest is unenforceable because the Trust was unable to demonstrate what its actual damages were. However, as the Court has repeatedly stressed, Bowles held the burden of demonstrating that actual damages were readily ascertainable. The Trust had no obligation to show actual damages and Bowles cannot shift its burden to the Trust merely by asking Patel what the Trust's actual damages were. Bowles also suggests that the damages incurred are readily quantifiable, but that Patel simply was unprepared to present the numbers at the hearing. Yet, the issue is whether the Trust's damages "were readily ascertainable
Fourth, Bowles purports to have demonstrated that the Trust's actual damages were vastly smaller than the approximately $1.5 million of pre-petition default interest at issue. However, Bowles made no attempt to quantify the increased risk that the Trust faces going forward. Further, even if Bowles had shown that the Trust's actual damages were smaller than the amount of default interest it sought, liquidated damages may be enforceable even if a party's actual damages turn out to be smaller than the agreed amount, or even if the party is unable to prove actual damages at all. See Willgohs, 115 N.W.2d at 62. While the amount of damages actually suffered may be probative of whether the amount fixed was a reasonable forecast, it is far from dispositive. In light of the conflicting evidence as to the Trust's actual damages, the Court cannot conclude that the 5.0% rate is unreasonable.
Lastly, at oral argument, counsel for Bowles argued that a liquidated damages provision is unenforceable where it provides the same amount of damages whether a breach is trivial or significant. Bowles relied on a comment from the Restatement (First) of Contracts that supports this position. See Restatement (First) of Contracts § 339 cmt. b (1932). However, the default interest provision does not, in practice, result in the same amount of damages for all breaches. Because the default interest provision simply increases the rate of interest, an earlier default will result in larger total amounts of default interest than a later default. Additionally, the Court finds that such a strict limitation on the circumstances in which parties are permitted to contractually agree to liquidated damages would be inconsistent with Minnesota law. The Court also notes that the Restatement (Second) of Contracts § 356 (1981) (which replaced Section 339) omits the comment in question.
In sum, the Court concludes that the default interest provision is enforceable. Despite having held the burden of proof below, Bowles repeatedly argues that the Trust did not present sufficient evidence to establish the enforceability of the provision. (See, e.g., Bankr. Tr. 17:19-22 ("[W]hat we're really going to hear is really an absence of information about what that default interest was supposed to cover.").) Other than Hoyt's testimony that he personally believed the default interest rate results in "at least double debt paying, if not triple debt paying," (Bankr. Tr. at 85:3-4), Bowles proffered almost no affirmative evidence that the default interest fails either of the two Gorco requirements, 99 N.W.2d at 74-75. The Bankruptcy Court implicitly acknowledged Bowles' failure to rebut the provision's presumptive validity when it noted "the absence of any other evidence" as to the provision's reasonableness beyond Patel's testimony. (Mem. & Op. at 11.) For the reasons above, the Court finds that the Bankruptcy Court did not err as a matter of fact in its interpretation of Patel's testimony or err as a matter of law in its determination that the two Gorco requirements were satisfied.
Based on the foregoing, and all the files, records, and proceedings herein,
