Canada: Challenge To Priority For Default Interest Fails

Last Updated: August 3 2012

Article by Michael Birch

Section 8 of the Interest Act (Canada) (the Act) was considered by the Ontario Superior Court of Justice in Grant Forest Products Inc. (Re) in the context of an inter-creditor dispute. The facts involved a unique scenario where second lien creditors attempted to block first lien creditors from receiving default interest from the proceeds of sale of the debtor's business in a liquidation proceeding, which were held in trust by the monitor pending a determination of the creditors' respective entitlements to the funds.

Background Facts

Grant Forest Products Inc. (GFP) and its subsidiaries (collectively, the debtors) were the subject of Companies' Creditors Arrangement Act (CCAA) proceedings that had resulted in a liquidation of the debtors' assets. The assets were subject to security interests securing obligations to two groups of creditors: senior lenders (the First Lien Creditors), who had entered into a credit agreement (the First Lien Credit Agreement) with GFP in October, 2005 and had taken and perfected first priority security interests to secure the obligations outstanding under such credit agreement (the First Lien Debt), and second lien lenders (the Second Lien Creditors), who had entered into a credit agreement (the Second Lien Credit Agreement) with GFP in March 2007 and had taken and perfected security interests, subordinate to those of the First Lien Creditors, to secure the obligations outstanding under the Second Lien Credit Agreement (the Second Lien Debt).

The First Lien Credit Agreement had been amended in March 2007 to permit the Second Lien Debt to be advanced to GFP by the Second Lien Creditors. Both groups of creditors had obtained general security agreements in respect of all assets of the debtors, including real property and intangible assets in Canada and the U.S. Both credit agreements provided for 2% per annum to be added to the interest rate otherwise applicable in the event of default, and GFP was in default under both agreements.

In connection with the advance of the Second Lien Debt, the First Lien Creditors and the Second Lien Creditors had entered into an inter-creditor agreement to, among other things, govern the relative priorities of their respective security interests. The agreement dealt with a number of aspects of the relationship between the two groups of creditors. Notably, the inter-creditor agreement permitted the First Lien Creditors to enforce their rights and remedies under their security without consulting the Second Lien Creditors, and included a covenant by the Second Lien Creditors not to oppose, among other things, any claim by the First Lien Creditors for post-petition interest, "including any additional interest payable pursuant to the First Lien Credit Agreement arising from or related to a default...".

The First Lien Creditors, who had already received their outstanding principal and interest, other than default interest, out of the proceeds of liquidation, brought an application to determine their entitlement to default interest out of the remaining sale proceeds. The Second Lien Creditors opposed the application. The issue before the court was whether the Second Lien Creditors could rely on section 8(1) of the Act to prevent the First Lien Creditors from recovering default interest. Section 8(1) provides:

"No fine, penalty or rate of interest shall be stipulated for, taken, reserved or exacted on any arrears of principal or interest secured by mortgage on real property or hypothec on immovables that has the effect of increasing the charge on the arrears beyond the rate of interest payable on principal money not in arrears."

The Second Lien Creditors argued that the First Lien Creditors' claim for default interest should not succeed because such claims were illegal under section 8(1) of the Act and, therefore, (i) amounts in respect of default interest would not be payable by the debtors to the First Lien Creditors and (ii) the Second Lien Creditors' agreement not to challenge the First Lien Creditors' claims in respect of such default interest should not apply. They argued that section 8(1) of the Act clearly applied because the First Lien Debt was secured by a mortgage on real property and a penalty had been charged on the amount in arrears. The First Lien Creditors acknowledged that the First Lien Debt was, in part, secured by a mortgage over Canadian real property, but such mortgage security was merely incidental to the true purpose of the financing, which was, in substance, a business refinancing to finance the building of new oriented strand board mills in the U.S. Accordingly, the transaction was principally a business financing transaction directed mainly at the operations of GFP in the U.S., rather than a mortgage financing of real property in Canada.

Decision

The court ruled that the application of the Act as between a debtor and creditor was not determinative of the Act's application between the two groups of creditors. The inter-creditor agreement and individual credit agreements had been entered into to govern the parties' relationship between themselves and with the debtors, respectively, including with respect to the priority of the security obtained and the rights and remedies of the creditors. Of particular significance to the court was the amendment of the First Lien Credit Agreement to permit the incurrence of the Second Lien Debt and the covenant in the inter-creditor agreement from the Second Lien Creditors not to oppose any claim for post-petition interest, including default interest, by the First Lien Creditors.

In reviewing past cases considering section 8 of the Act, the court noted that, although the results of many cases appear to be in conflict, the prior cases were all contextual and fact-driven, quoting from the Court of Appeal's judgment in 2000 in Langley Lo-Cost Builders Ltd. v. 474835 B.C. Ltd. as follows:

"In summary, these cases, each one decided on his own particular facts are authority for the view that a change in interest rate upon default, or some other arrangement such as a waiver of interest upon due payment may not offend against the Act."

Prior cases had also predominately related to issues directly between a debtor and creditor. There were no known cases where a second lien creditor sought to rely on a debtor's defence to prevent a first lien creditor from realizing on its security. Furthermore, in this case, the Second Lien Creditors were challenging the legality of default interest provisions that also existed in their own credit agreement with GFP.

The court concluded that, in the context of the contractual agreement entered into with the First Lien Creditors, the Second Lien Creditors could not rely on section 8(1) of the Act to defeat the entitlement of the First Lien Creditors to the default interest that the parties had first agreed the First Lien Creditors would be entitled to have. As a result, the First Lien Creditors were entitled to recover their principal, interest and default interest, while the Second Lien Creditors recovered nothing, because that was the bargain the parties made.

Conclusion and Analysis

Whatever the state of play may be as between debtors and creditors under section 8 of the Act, the section is not intended to govern relationships among creditors. Furthermore, an agreement by a creditor not to challenge another creditor's security, would appear to be enforceable, notwithstanding that a debtor may have grounds to make such a challenge. The court's remarks also support the view that sophisticated commercial parties should be permitted to agree to the application of default interest, and the courts will not allow one of the parties to use section 8 of the Act to avoid honouring its 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.

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