Persons and businesses extending credit at a cost and their counsel have for a long time been - or should have been - aware of the requirements of Section 4 of the Interest Act (Canada) (the "Act"). Section 4 requires that where a person (the "Lender") extends credit to another person (the "Borrower"), and the Borrower is required to pay value to the Lender in exchange for such credit (such value being typically what is commonly considered to be "interest"), in order to get anything more than a return of 5% per annum on the outstanding credit (owed from time to time), the Lender must ensure that the documentation entered into by the Borrower with the Lender specifies what the consideration is on an annualized basis. The usual situations in which an annualized specification is required is where the interest payable on the credit extended is:
(i) described as being calculated on a basis of a "yearly" period of less than 365 days (or less than 366 days in a leap year), with the "yearly period" being frequently defined as 360 days; and
(ii) described as a percentage of the credit extended calculated and payable (and compounded if not paid) on a monthly basis (ie, 2% per month).
In both these cases, the Lender must disclose the annualized version of these rates. Traditionally, lenders have responded to this requirement by either making a relatively simple mathematical calculation to obtain the annualized equivalent rate and then specifying the precise equivalent rate, or by specifying a formula pursuant to which the Borrower may (with relative ease) make its own mathematical calculation to arrive at the required annualized rate.
Section 4 applies where the credit extended by the Lender is secured by personalty, or not secured at all. It does not apply where the credit is secured by real estate.
The matter of what a Lender must do to comply with Section 4 was dealt with - and expanded upon - by the Ontario Superior Court of Justice in its recent (January 10, 2018) decision in the Solar Power Network Inc. v. ClearFlow Energy Finance Corp. case (hereinafter, the "Solar Case"). As stated in paragraph (1) of the judgement, Solar Power Network Inc. and related entities were renewable energy companies specializing in installing solar panels in commercial, institutional and industrial rooftops. The respondent ClearFlow Energy Finance Corp. was a project finance company that provided financing to the solar energy and clean technology sector. And that was precisely the relationship between ClearFlow (as "Lender") and Solar Power Network (as "Borrower"). The Lender provided a number of separate loans (or financings) to the Borrower to enable it to obtain and install solar power equipment. The loans were initially intended - by both parties - to be of a short term nature, with the Borrower arranging for longer term more "conventional" financing in due course. The loans were documented in various ways, including loan agreements and promissory notes, but, as observed by the Court, regardless of the form of the documentation, each loan provided for three different "components" of remuneration payable by the Borrower in connection with the making of the loans, namely:
(i) An interest rate which was usually set at 12% per annum, compounded and calculated monthly, and, 24% per annum following default (the "Base Interest").
(ii) An administration fee charged at the outset of the loan transaction calculated as a percentage of the principal amount of the loan advanced. If a loan was not repaid on time, then the initial administrative fee was tacked on to the principal balance of the loan and carried forward as an extended loan, with a new administrative fee being charged on the total amount of the extended loan. These fees are referred to herein as the "Administration Fees"; and
(iii) A discount of 0.003% of the outstanding principal balance of a loan, calculated on a daily basis for each day that the loan was outstanding. If the discount fee had not been paid when the initial term of the loan had expired, the outstanding balance of the discount fee applicable to the loan during its initial term would be added on to the loan and carried forward to form part of the principal amount of the extended loan, to which a further discount fee would be applicable. These discount fees are referred to herein as the "Discount Fees".
The Court observed that the Administration Fees were calculated over 90 or 180 day periods, while the Discount Fees were calculated daily.
There were a number of issues between the parties which the Court had to consider. Two of those issues related to the proper categorization of the Administration Fees and the Discount Fees for the purpose of applying Section 4 of the Act to these charges. The first issue relating to Section 4 was whether or not the Administration Fees and the Discount Fees were "interest" within the meaning of Section 4. A second question relating to Section 4 was whether or not, if either one or both of the Administration Fees and the Discount Fees were to be considered as interest within the meaning of Section 4, did Section 4 operate to limit the Lender's entitlement to interest - including the Base Interest - to a "mere" 5% per annum.
The Court's review and analysis of the aforementioned fees is enlightening and brings some clarification to the meaning of Section 4 (which was previously absent in the case law). This is of critical importance for lenders and their counsel in devising the appropriate wording for the payment of the consideration to be provided in exchange for the extension of credit. In particular, the questions dealt with were:
- Are the Administration Fees "interest" within the meaning of Section 4?
The Court held that the Administration Fees were not interest. In coming to this conclusion, the Court took note of several aspects of the relationship between the parties, some of which were arguably "fact specific" to the Solar Case. In particular:
(a) the Administration Fees were compensation for the Lender's "administrative work in setting up and administering the loans";
(b) the Borrower's applications to obtain the loans and the loan documents themselves required negotiation and were "document intensive";
(c) on the average, 35 invoices from 15 separate suppliers were required with respect to the subject matter of each loan;
(d) additional administrative work was required once the Lender ascertained that the Borrower was having financial difficulties; and
(e) the Administration Fees were charged on a one-time basis only, and would only be charged if a loan was not repaid within its term.
- Were the Discount Fees interest within the meaning of Section 4?
The Court held that the Discount Fees were a form of interest, and did so, notwithstanding that the Lender argued that these fees were an additional consideration for its administration of the financings, and, notwithstanding that the Borrower did not present any evidence to the contrary. The Court stated that when looking at the "substance" of the Discount Fees, the following matters indicated that these fees should be considered interest (ie, essentially, consideration for the use of money over a period of time, with the consideration being determined with reference to the principal amount of the credit extended and the length of time that the credit is outstanding):
(a) the Discount Fees were not connected to the creation of a new loan or a renewal of an existing loan, or the documentation pertaining thereto;
(b) unlike the Administration Fees which varied depending on the "risk and resulting work undertaken by the Lender", the Discount Fees were the same for all types of loans and loan documentation (Editorial comment: in deciding whether or not to charge interest, and in particular, the rate of interest, a creditor usually does take into account the riskiness of the loan transaction);
(c) while the Administration Fees were charged at the beginning of the loan term (or upon a renewal of an existing loan) the Discount Fees varied, and in particular, increased, over the period of a loan's term;
(d) in cross-examination, a representative of a Lender acknowledged that the Borrower's obligation to pay the Discount Fees "incentivized" the Borrower "to make earlier payout of the loans". The fact that the Discount Fees were designed to "encourage the hastening of the pay down of the loans" savours of interest, not a fee for the time and efforts required to administer the loans.
- If the Discount Fees were interest, does Section 4 require that only the Discount Fees be reduced to 5% per annum, or is the Lender additionally limited to collecting 5% per annum with respect to the Base Interest?
As the Court held that the Administration Fees were not interest, Section 4 did not apply to these fees in the sense of requiring the disclosure of an annualized rate. However, the parties disagreed as to whether or not Section 4 should, in addition to applying to the Discount Fees, also apply to the Base Interest Rate. The Base Interest Rate, taken by itself, did not breach the requirements of Section 4. That rate was stipulated to be 12% per annum, compounded and calculated monthly, 24% per annum after default*. The Court held that the meaning (and Parliament's intent) of/for Section 4 was to limit the Lender to 5% per annum even though part of the interest stipulated did not breach the Section 4 requirements, but another part (or parts) thereof did so. In other words, if a creditor obligates its debtor to pay two or more "types" of interest, and one of those "types" is worded so as to breach Section 4, that breach "taints" all other interest obligations, even though the other types(s) of interest comply with Section 4 (ie, even though they are specified to be calculated on an annual basis). The Court observed that "the case law has repeatedly recognized that Section 4 of the Act should be applied equally to sophisticated and unsophisticated parties". Thus the fact that the Lender and the Borrower in the Solar Case were "sophisticated" (ie, financially experienced business parties, and that each had their own counsel) did not relieve the Lender of its Section 4 obligations. Additionally, the Court stated that "As draconian as it may seem to limit all of the interest to 5% where the offending Discount Fees are only a small portion of the overall interest obligation, the result is in keeping with the consumer protection purpose of this legislation".
- Did the fact that the loan documents contained a formula for calculating the annual rate of interest for the Discount Fees satisfy the requirements of Section 4?
The Lender argued that, assuming that Section 4 did apply to the Discount Fees, it had complied with Section 4 because it had included a formula which should have enabled the Borrower to easily calculate the annualized rate that the Discount Fees represented. This formula is very similar to the formula that lenders and their counsel frequently use. In essence, it provides that where an amount of interest, fees or other charge is stated to be applicable at a rate based on a period comprising less than 365 days (or less than 366 days in a leap year), the "equivalent yearly rate" is determined by dividing the specified rate by the number of days in the period and then multiplying that result by the actual number of days in the calendar year. The Solar Case Discount Fees rate was stated to be 0.003, and the Lender's position was that all that the Borrower needed to do (to determine the annual equivalent) was to multiply 0.003 by 365 (or 366 in a leap year). Notwithstanding the apparent simplicity of this formula, the Court held that "a formula does not necessarily allow for (a) clear understanding to occur. Formulas can be confusing and even misleading". Interest was required to be paid on outstanding interest when a loan rolled over, thus the Court declared that it was "…not accurate to say that by simply multiplying 0.003% times 365 that the Discount Fees annualized rate would be…clearly understood (by the Borrower". Unless and until the Solar Case decision is overturned or legislatively altered, lenders and their counsel should no longer rely on the efficacy of an "equivalent rate formula" to satisfy Section 4's requirements, and precise statements of equivalent rates per 365 (or 366 in a leap year) day periods should be included in loan documentation.
- How are lenders and their counsel to calculate annualized interest rates?
In considering whether or not an "equivalent rate formula" would - or would not - satisfy Section 4's requirements, the Court observed that there were "two potential methods of expressing the equivalent rate of interest". These are:
(a) simply multiplying the stated interest rate by the number of compounding periods (or interest payment intervals) in the year (ie, 2% per month times 12 months is "equivalent" to 24% per annum"). This is called the "nominal interest rate";
(b) where a calculation is made in which takes into account the value that a lender gets when it doesn't have wait until the end of the year to obtain the benefit of the interest it is entitled to. This is called the "effective annual rate". It factors in the "effect that compounding has on the overall interest rate (ie, 2% per month, when factoring in the monthly compounding, is "equivalent" to 26.8% per annum)". Although not expressly stated, this writer assumes that the Court is referring here to the concept of the value or benefit that a creditor receives when it obtains interest - primarily determined with respect to a period of one year - at intervals more frequent than yearly. This is sometimes referred to as the "re-investment of interest theory".
The Court concluded that the more accurate method of calculation of the annualized rate required by Section 4 is the "effective annual rate".**
Some other conclusions and observations of the Court in the Solar Case worth noting are:
(I) The Lender argued that it received legal opinions from the Borrower's counsel which stated that the loan documents were "enforceable". The Lender argued that these legal opinion letters supported its position that the Borrower "knew the fees were in fact fees and not interest". The Court held that since the opinion letters included the (usual) stipulation that the enforceability opinions were limited by "laws affecting creditors' rights generally", and since Section 4 affects creditors' rights generally, the Lender was not entitled to rely on the Borrower's counsel's legal opinions. Had those opinions not included the usual limitation statement, might the Court have come to a different conclusion in the Solar Case? We'll probably never know, but it does emphasize the significance of the need for lawyers to include (reasonable) limitations and qualifications to enforceability opinions.
(II) The Lender also argued that after the Borrower encountered financial difficulties and it entered into several "forbearance agreements", those agreements provided a defense for the Lender due to the presence of a provision to the effect that the indebtedness owed by the Borrower, together with interest, fees, costs, etc. "(were) unconditionally owing by the Borrower to the Lender without offset, defense or counterclaim of any kind, nature or description whatsoever" (underlining here for emphasis purposes). The Court disposed of this argument because a more recent forbearance agreement (four had been entered into) qualified the above provision by concluding with "except as may be otherwise required by law". The Court held that that exception did permit the Borrower to challenge the Lender's entitlement to interest under the loan documents.
* Interestingly, if the loan indebtedness had been secured by a charge on real estate, Section 8 of the Act would have prohibited the Lender from charging and collecting interest at any rate per annum in excess of the rate per annum stipulated as being applicable before default.
** Section 6 of the Act has often been considered to require disclosure of what amounts to the effective annual interest rate, but only for indebtedness secured by real property mortgages and only where there are periodic "blended" payments of principal and interest called for under the terms of the payment/repayment of the secured debt.