When lending to borrowers poised for growth, it is not uncommon for lenders to include mechanisms for them to capitalize on the future growth of the borrower, be it through warrants or other equity sweeteners (often known as participatory loan arrangements). In these circumstances, heed must be paid to section 347 of the Criminal Code's definition of "interest" and its application. Lenders are often surprised to learn that warrants and other equity sweeteners may be subject to Canadian usury laws, and that they may quickly run up against a maximum rate.

Section 347 of the Criminal Code (Canada)

Section 347 of the Criminal Code makes it an offence to enter into an agreement for, or to receive, interest at a rate exceeding 60 percent per year. Section 347 applies to a very broad range of commercial transactions involving the advancement of credit, including secured and unsecured loans and commercial financing agreements. Section 347 has been employed where a borrower asserts the common-law doctrine of illegality to avoid or recover an interest payment.

Does Section 347 Apply? - An Advance of Credit

In determining whether section 347 applies, a preliminary issue arises: characterization of the agreement. The agreement must involve the advance of credit. To characterize an agreement, courts look to the intention of the parties as evidenced by their agreement; in other words, it is an exercise in contractual interpretation. Where an agreement has features of both debt and equity, courts look to the substance of the agreement; courts focus on the main thrust of the agreement and not on aspects which are only incidental or secondary in nature. The more contingent the equity aspects of the agreement, the more likely an agreement will be characterized as an advance of credit.

"Interest" Under Section 347

Assuming an agreement is characterized as an advance of credit, the prohibition contained in section 347 becomes an issue. Though it is unlikely that a sophisticated lender would enter an agreement which, on its face, provided for interest at greater than 60 percent, the definition of "interest" in the Criminal Code and its application may present issues when the total return to the lender includes warrants or other equity sweeteners.

Section 347 uses an extremely broad definition of interest. Interest is defined as the aggregate of all charges and expenses, in any form, that are paid or payable for the advancing of credit. This definition is extremely comprehensive, encompassing many types of fixed payments which would not be considered interest proper at common law or under general accounting principles. In determining what constitutes interest for the purposes of section 347, courts look to the substance, and not merely the form, of the transaction to determine whether the return the lender has received constitutes a cost incurred by the borrower to receive credit from the lender and is therefore, "interest". For example, royalty payments on items manufactured by a borrower have been included in the calculation of interest for the purposes of section 347. Thus, warrants or other equity sweeteners may similarly be captured by the definition of "interest".

The next issue is the time period for calculating the interest rate. In determining the amount of interest received by a lender, courts calculate interest over the period in which credit is actually available. Accordingly, if warrants or other equity sweeteners are captured by the definition of "interest", they may be valued at the time of exercise rather than at the time when the agreement is entered into.

Remedies

Finally, if courts find that an agreement has breached section 347 they are free to employ judicial discretion to provide flexible remedies that are tailored to the contractual context before them. Where the arrangement contravenes section 347 and is otherwise unobjectionable, (e.g. it is not a loan-sharking arrangement), courts will typically employ the remedy of notional severance. Notional severance involves courts reading down the interest rate provisions of the agreement to avoid the illegality and thus partially enforce the agreement. Factors that have been cited as supporting the remedy of notional severance include:

  1. whether the agreement inadvertently contravenes section 347;
  2. whether the parties are experienced in commercial matters and negotiated at arm's length;
  3. whether the parties were of relatively equal bargaining power; and
  4. whether the parties had the benefit of legal advice in the course of negotiations leading to the agreement.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.