This is the first decision of the Supreme Court of Canada to assess whether "incentive rates" (i.e., where the interest rate secured by a mortgage is reduced if the mortgagor does not default) violate section 8 of the Interest Act, R.S.C. 1985, c.I - 15 (the "Act").
Section 8 of the Act precludes a mortgagee from imposing terms that have the effect of charging a higher rate of interest on money in arrears than that charged on the principal money not in arrears. The specific issue considered by the Court was whether Section 8 of the Act is offended by the terms of a mortgage imposing a higher "interest rate" that takes effect only where the mortgagor falls into default by failing to make the prescribed payments at a lower "pay rate" or by failing to pay out the loan on maturity.
No fine, etc., allowed on payments in arrears
- 8 (1) 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 Court concluded, in the majority reasons, as follows:
- an interest rate increase triggered by the passage of time alone does not, in and of itself, infringe Section 8 of the Act; and
- a rate increase triggered by default does infringe Section 8 of the Act, whether the increase is framed as imposing a higher rate as a result of default (i.e., framed as a penalty) or as allowing a lower rate by way of reward for the absence of default (i.e., framed as an incentive).
The facts of the case are as follows:
- On November 8, 2006, the mortgagor, Lougheed Block Inc. ("Lougheed"), granted a mortgage to the mortgagee, Equitable Trust Company (through its agent Trans Capital Corporation) ("Equitable") to secure a loan of $27 million. The interest rate on the original mortgage was set at the prime rate plus 2.875 percent per annum.
- Lougheed was unable to repay Equitable when the mortgage matured. Pursuant to a renewal agreement (the "First Renewal Agreement"), the mortgage was extended for seven months from August 1, 2008 with a per annum interest rate of prime plus 3.125 percent for the first six months and then 25 percent for the seventh month.
- The subsequent mortgagees agreed to postpone their mortgages to the First Renewal Agreement.
- At the maturity of the First Renewal Agreement on March 1, 2009, Lougheed again was unable to repay Equitable and, on April 28, 2009, entered into a second renewal agreement that was made effective February 1, 2009 (the "Second Renewal Agreement") that included a per annum interest rate of 25 percent. However, Lougheed was not required to make monthly payments at the 25 percent per annum rate, but only at a lower "pay rate" of the greater of (i) 7.5 percent, and (ii) prime plus 5.25 percent per annum. The difference between the 25% rate and the "pay rate" was accrued to the loan, but, if there was no default by Lougheed, the accrued interest was forgiven. In other words, if Lougheed did not default on its obligation to make full payment on time and to pay out the loan on the maturity date, then Lougheed was excused from paying the accrued interest.
- Lougheed defaulted on the first payment under the Second Renewal Agreement.
- Equitable demanded payment of the loan at the stated rate of 25 percent per annum.
At first instance, the Master concluded that the stated rate of 25 percent per annum offended Section 8 of the Act and the "pay rate" was substituted as the applicable rate of interest.
On appeal, the presiding Justice reversed the decision of the Master and upheld the interest rate as not offending Section 8 of the Act. The Justice noted that, being an exception to the general rule of freedom of contract expressed in Section 2 of the Act, Section 8 ought to be strictly and narrowly construed so long as such interpretation does not frustrate or impair the Act's purpose of curtailing predatory lending. The Court concluded that the effect of the interest provisions of the Second Renewal Agreement was merely to allow Equitable to give a benefit to Lougheed in the event of debt repayment in accordance with the terms of the Agreement and not to penalize Lougheed in such a manner as to trigger the application of Section 8.
On further appeal, the Court of Appeal unanimously held that the First Renewal Agreement did not offend Section 8, but diverged on the treatment of the Second Renewal Agreement. The majority of the Court of Appeal held that Section 8 is directed at penalties for non-performance, not at incentives for punctual payment. An agreement to reduce the amount owing by the difference between the stated per annum interest rate of 25 percent and the stated "pay rate" was a permissible incentive and did not offend Section 8. The dissenting opinion concluded that the interest provisions had the "effect" of increasing the charge on principal money in arrears beyond the rate of interest otherwise payable and therefore violated Section 8 of the Act.
On final appeal to the Supreme Court of Canada, Justice Brown, for the majority, reviewed the development of Section 8 and the case authority interpreting it in order to address the specific issue of whether Section 8 applies to penalties (i.e. an increased rate of interest in the event of a default), incentives (i.e. a reduced interest rate payable in the event of compliance), or both. Justice Brown adopts, as the guiding principle for Section 8, that the section is intended to protect land owners from charges that would make it impossible for them to redeem or protect their equity. Considering its purpose and interpreting the statutory provisions in the Act, Justice Brown concludes as follows:
"In sum, the ordinary sense of the words that Parliament chose to include in s. 8 read together with s. 2 and considered in light of the Act's objects, support the conclusion that s. 8 applies both to discounts (incentives for performance) as well as penalties for non-performance whenever their effect is to increase the charge on the arrears beyond the rate of interest payable on principal money not in arrears. To that extent, I find myself in respectful disagreement with the majority of the Court of Appeal and with the chambers judge."
Importantly, Justice Brown rejects the "legitimate commercial purpose" test that had been utilized in some of the existing jurisprudence. The legitimate commercial purpose test would, in effect, save an offending interest rate if such rate met or was based on a legitimate commercial purpose. In rejecting the test, Justice Brown notes:
". . . Part of the difficulty with the legitimate commercial purpose test is that, as Finch C.J.B.C. observed in Reliant Capital (at para. 87), it leads to commercial uncertainty as to s. 8's arbitrary application. More fundamentally, inquiring into the "legitimacy" of the purpose underlying an arrangement that offends s.8 not by its purpose but by its effect undermines Parliament's clearly expressed intent. The same objection also applies to any attempt, whether achieved by "strict" construction or by focussing on other irrelevant considerations under s.8 such as the relative degree of sophistication or bargaining power between the parties, to derogate from the purely results-oriented focus that s.8 expressly requires. The Court has recently observed that it cannot "do by 'interpretation' what Parliament chose not to do by enactment" ... but the converse is also true: courts may not undo by "interpretation" what Parliament chose to do by enactment. If s.8 reflects bad or outdated public policy, then the remedy lies with Parliament, not with the courts." [Emphasis added.]
Returning to the facts of the case, the majority decision analyzed the First Renewal Agreement. The Court concluded that an interest rate increase triggered by the mere passage of time (and not by default), such as that imposed under the First Renewal Agreement, does not offend Section 8. Looking to the Second Renewal Agreement, Justice Brown, on behalf of the majority, notes that the effect of the interest rate scheme is to reserve a higher charge on arrears (25 percent), than that imposed on principal money not in arrears (the greater of 7.5 percent or prime plus 5.25 percent). The labelling of one charge as an "interest rate" and the other as a "pay rate" did not impact the analysis as the Court focused on substance over form. In the circumstances, the Court concluded that the appeal should be allowed noting the following:
- Section 8 of the Act applies with equal force to a mortgage term imposing by way of a penalty a higher rate in the event of default and reserving, by way of a discount, a lower rate in the event of no default.
- The 25 percent interest rate set by the Second Renewal Agreement is void.
- The interest rate in force under the Second Renewal Agreement was the higher of 7.5 percent per annum or prime plus 5.25 percent per annum.
In the dissenting opinion, Justice Côté disagreed that the interest rate payable under the Second Renewal Agreement could be interpreted to be anything other than 25 percent, such that there was no actual increase of interest rate on the amounts in arrears. Moreover, Justice Côté was of the view that Section 8 does not prohibit a forgiving discount. Justice Côté was of the view that Section 8 should be read narrowly, and its application limited, so as to fulfill its purpose of protecting struggling mortgage debtors. In this case, Justice Côté felt that the Second Renewal Agreement provided Lougheed with a less onerous path to fulfill its payment obligations and protect its equity. Justice Côté felt, as a result, that the Second Renewal Agreement did not offend Section 8.
Justice Côté was also of the view that Section 8 did not have the effect of increasing the charge on arrears. Specifically, Justice Côté argued that the rate of interest payable on the purchased money not in arrears was set at 25 percent throughout the entire term of the agreement and was to be applied consistently to both principal money not in arrears and principal money or interest in arrears. According to the wording of the Second Renewal Agreement "interest was to be charged each month on the entire principal of the loan, which included amounts added to the principal as interim financing to cover the difference between the aggregate interest rate of 25 percent and the pay rate".
Justice Côté disagreed with the conclusion that the effect of the renewal agreement is to reserve an interest charge on arrears at a higher rate than one imposed not on arrears. Justice Côté noted that "the possibility of having a portion of these interest payments forgiven does not have the "effect" of reducing the interest that was to be paid monthly in principal amounts, not in arrears. Consequently, Section 8 is not engaged. I would dismiss the appeal on the basis of this ground alone".
Justice Côté went on to note that Section 8 does not prohibit all forms of discounts. Focusing on the fact that Lougheed was already in default under the First Renewal Agreement (with a valid 25% per annum interest rate), Justice Côté argued that Section 8 does not prohibit discounts designed to provide relief from a higher rate of interest payable, as is the case for the Second Renewal Agreement.
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