The Canada Interest Act (the "Act") provides, in essence, that any arrangement or understanding whereby a debtor is obliged to pay a "fine, penalty or rate of interest" on real estate secured indebtedness which has the "effect of increasing the charge" on any arrears of the indebtedness (ie, upon or after default by the debtor) is prohibited. The Section goes on to provide that "interest on arrears of interest or principal" may be charged/collected, as long as the interest rate is not greater than the rate payable prior to default. Section 9 of the Act additionally provides that where a debtor has paid more than it is obliged to pay under Section 8, the excess is to be paid back or credited to the debtor.
A frequently occurring motivation for a creditor to wish to stipulate for a post-default rate of interest higher than the pre-default rate, is to induce the debtor to pay on time. However, in enacting Section 8, presumably, Parliament concluded that, as a matter of public policy, it was inequitable or unfair to allow creditors to "penalize" their debtors for failure to pay on time.
In pondering the application of Section 8 to credit transactions, consider the following scenarios:
- Scenario #1 - a creditor ("C") extends credit (say $100.00) to a debtor ("D") for 12 months. "D" agrees to pay interest at 5% per annum until default, and after default, until payment is made in full, "D" is to pay 8% per annum.
- Scenario #2 - "C" extends $100.00 credit to "D" for a term of 12 months. "D" agrees to pay interest at 5% per annum for the first 11 months, and thereafter, to pay interest at a rate of 8% per annum until all indebtedness is fully paid.
- Scenario #3 - "C" extends $100.00 credit to "D" for 12 months. Interest is payable at 8% per annum, but, the parties agree that if "D" actually pays interest at 5% per annum and repays the indebtedness in full when it is due, then at the time of repayment in full, "C" will forgive the difference between 8% per annum and 5% per annum. If payment is not made in full when due, then the interest payable would be 8% per annum both before and after default.
- Scenario #4 - "C" extends $100.00 credit to "D" for 12 months. In addition to "D"'s obligation to repay the $100.00, "D" agrees to pay a "finder's fee" or a "processing fee" of $10.00 to "C" at the end of the 12-month period, so that "D"'s obligation is to pay $110.00 at or by the end of the term. Additionally however, "C" promises "D" that if "D" makes payment in full by the end of the term, then "C" will forgive the $10.00 fee.
- Scenario #5 - "C" extends $100.00 credit to "D" for 12 months. No interest is payable by "D" during the term, but if repayment in full is not made by the end of the term, then "D" is obligated to pay interest, from and after default, at a rate of 5% per annum.
- Scenario #6 - "C" extends $100.00 credit to D for 12 months. Interest is payable at 5% per annum, both before and after default. Part way through the term, "C" sells its debt claim against "D" to "X" on the basis that "X" will "step into the shoes" of "C" and be able to require "D" to pay back the debt (with interest at 5% per annum) by the end of the term. However, "C" agrees with "X" that "C" will only receive (from "X" for the purchase of "D"'s debt) $75.00. Thus, by the end of the term, "X" thus will have collected (assuming "D" pays in full when due) $100.00 plus 5% per annum over the 12-month term. But, "X"'s rate of return will be higher than 5% per annum, because he was able to purchase the right to get $100.00 by paying only $75.00.
- Scenario #7 - "C" extends $108.00 credit to "D" for 12 months. No interest is payable by "D" during the term and no interest is payable beyond the end of the term where "D" does not repay on time. However, if "D" pays in full at the end of the term, "C" will forgive and release its claim of entitlement for $8.00.
Does Section 8 prohibit any - or all - of these arrangements? Recently (judgement rendered May 6, 2016) The Supreme Court of Canada, in the Equitable Trust Company case (hereinafter, the "Equitable Case") considered directly, and probably by implication, all of the above scenarios.
Based on the majority judgement (the majority consisted of 7 of the 10 judges sitting) in the Equitable Case, and considering the reasoning put forward by the majority, this writer believes that Section 8 of the Act would apply to the above-described scenarios as follows:
- Scenario #1 - would prohibit. This is a "black and white" case, and there should be no doubt here.
- Scenario #2 - complies with Section 8. However, where the higher rate of interest becomes payable just before the end of the term (say one or two days before the maturity date), Section 8 may prohibit the arrangement on the basis of "substance over form".
- Scenario #3 - would prohibit. This is a "discount type" arrangement, and the Court emphasized that Section 8 is not restricted to the charging of interest post-default in the usual sense of the word "interest". It also applies to discount incentives.
- Scenario #4 - would prohibit. This too is a "discount type" arrangement, or at least sufficiently analogous to one that it would be prohibited by Section 8.
- Scenario #5 - would prohibit. This contradicts what other Courts have felt to be permitted under the Section 8 restrictions, such arrangements being typically referred to as "zero rate" loans.
- Scenario #6 - complies with Section 8. The writer mentions this example simply to distinguish the discount transaction which exists between the creditor and the creditor's assignee, not between the creditor and the debtor. The arrangement does not in any way change what the debtor is obliged to pay on account of its debt, whether before or after default.
- Scenario #7 - complies with Section 8. In this scenario, not only is the creditor not getting any rate of return, it is (arguably) agreeing, in advance, to take a loss on payment. Commercially and realistically, it is almost impossible to visualize such an arrangement being entered into.
In coming to its conclusion in the Equitable Case, the Court stressed that Section 8 refers to what the effect of an arrangement is. Where the agreement provides an inducement to the debtor to perform on time and where the debtor fails to perform on time, the debtor becomes obligated to pay value - in addition to the principal balance - in excess of what the debtor would have had to have paid if the debtor had performed on time, the arrangement is prohibited by Section 8.
The dissenting judges pointed out that if discount type inducements are not legally permissible, arrangements which may actually benefit debtors will be unavailable to them. This writer agrees with the dissenting minority, but, with respect, it appears that the majority judges correctly interpreted the meaning of Section 8, based in particular on the evidence before them, including, in particular, the principles of statutory interpretation. Accordingly, it is this writer's view that Parliament should amend Section 8 to narrow its application, and in particular, to permit the entering into and the offering of bona fide discount and similar inducements to perform on time.
If and when Parliament does consider this matter, the legislators should keep in mind that the prohibition in Section 8 only applies to real estate secured debt. The Section was based on a pre-statutory equitable principle going back several hundred years to when most wealth was represented by real estate, not - as is the case today - equipment, inventories and investment property, all of which can secure debt which calls for post-default higher interest rates and other "penalties" (subject of course to the "penalties" or higher interest rates not being unconscionable). At the very least, Parliament should consider amending Section 8 so as to remove its application from non-residential property secured loans and/or non-consumer credit transactions.
In attempting to navigate around the dangers which may be imposed - sometimes unexpectedly - by the application of Section 8 to credit transactions, consider the following:
(a) Although unusual, a borrower, a lender (or other credit grantor) and a guarantor (of the borrower's obligation) could enter into an arrangement (with the borrower pledging real estate to secure its direct borrowing obligation) whereby after default by the borrower, and upon the lender making demand of the guarantor, the guarantor's obligation would be to not only pay the principal debt, but also to pay interest at a rate higher than the rate payable by the borrower on its debt obligation. Would this arrangement run afoul of Section 8? It would probably depend on whether or not a Court concluded that the guarantor's obligation was so closely related to (or derived from) the borrower's obligation, that Section 8 must apply both to the borrower and to the guarantor. If the guarantor's obligation was replaced by an indemnification obligation, it appears to this writer that it would be less likely for Section 8 to be held to apply to the indemnifying party.
(b) Where a creditor has obtained a real property mortgage from a debtor which, by its terms, secures all present and future obligations, limited only to the maximum principal or face amount of the mortgage (sometimes called a "multi-purpose mortgage" or a "collateral mortgage"), and one or more of the debts thereby secured contravene Section 8, with one or more of the other debts not being in contravention of Section 8, this can present a problem to the mortgagee. It is the writer's practice to include a provision in this type of mortgage to the effect that where any debt secured by the mortgage by its terms contravenes Section 8, then either the mortgage doesn't secure that debt, or, it secures the debt, but only to the extent of non-contravention. This may well be useful where one or more of the debts secured by the realty mortgage are also substantially secured by personal property security interests. The rule in Section 8 does not apply to debts secured by charges on personalty.