Copyright 2011, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Real Estate, May 2011
Section 8 of the Interest Act (Canada) prevents a lender from charging a higher rate of interest following a default on a mortgage of real property than that charged during the term of the mortgage. For example, a mortgage that provides for a rate of interest of 5% during its term that is increased to 10% should the borrower fail to pay the amount due at maturity or should the borrower go into default will contravene section 8 of the Act. This section is not limited to interest, but rather it includes fines, lump-sum bonuses and increased rates of compounding interest where the effect is an increased cost of a mortgage loan on default.
Treatment by Canadian Courts
The interpretation of section 8 of the Actin Canadian jurisprudence has been inconsistent and of little assistance in setting out general principles. Indeed, as one British Columbia Court of Appeal judge put it in Reliant Capital Ltd. v. Silverdale Development Corp. (Reliant): "about the only thing on which the courts seem to agree is the difficulty of construing the language of section 8 in the context of the modern commercial world." In Ontario, case law has tended to focus on the substance and effect rather than the semantics of the provision, looking to whether the outcome was a differential rate of interest on arrears over that of principal not in arrears. Therefore, a mortgage agreement entitling the borrower to an interest rebate that effectively rendered the loan interest-free until the maturity date was held to violate section 8 of the Act, as were mortgage agreements permitting increased interest rates on maturity or following default.
In Western Canada, on the other hand, there has been significant appreciation by the courts for the contractual freedom of the parties, with courts looking to whether a borrower requires protection from penal loan provisions or whether a provision that appears on its face to violate section 8 can be saved by virtue of serving a "legitimate commercial purpose." In Alberta, the consideration of whether there is a bona fide business reason for the increase in the interest rate has been held to retain the intent of the legislation while allowing lenders to address the contemporary realities of their business.
The Court of Appeal in Reliant, however, rejected the legitimate commercial purpose test followed in Alberta, on the basis that such a test gives rise to commercial uncertainty and leads to arbitrary application. Instead, the court adopted a strict or narrow interpretation of section 8 of the Act and stated that "the circumstances in which the contract was made must be viewed objectively and the intention of the parties must be determined, as far as may be possible and necessary, from the language used by the parties in their agreement, viewed against objective circumstances in which the agreement was made." In that case, a higher rate of interest applicable one month prior to maturity of the mortgage was construed as compensation for the higher risk of default at a date later in the term of the loan and therefore found not to offend section 8.
Although the commercial purpose test is no longer applicable in B.C., nevertheless, the Court of Appeal in Reliant continued to emphasize that section 8 exists to "protect property owners against abusive lending practices, while recognizing that generally speaking parties are entitled to freedom of contract." On the whole, however, Reliant, along with much of the judicial consideration of section 8, reinforces the conclusion that each case must be assessed on its individual facts.
Application in a Commercial Reality
A prudent lender in structuring a mortgage agreement whereby a default rate of interest is necessary or desirable should ensure that the increased rate is not triggered by a default or a maturity date in order to avoid conflict with the scope of section 8 of the Act. Rather, an increased rate of interest prior to default or maturity will likely be acceptable if the lender is able to demonstrate that the increased rate is caused by some other event, such as a construction schedule date or the attainment of a financial ratio.
Another manner in which a lender can avoid a potential contravention of section 8 of the Act, in particular foreign lenders who are accustomed to extracting default rates of interest in jurisdictions that permit such rates, is to stipulate a default rate of interest in the loan agreement, to the maximum extent permitted by law, thereby rendering the increased interest rate severable in the event it is found unenforceable. For greater certainty, the mortgage that secures the loan should expressly provide that it does not secure the obligation to pay the higher rate of interest on default. In this way, to the extent that a lender has also obtained personal property security, a lender may be able to recoup its default rate of interest from the sale of personal property.
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