An academic version of this article written by Barry was published in Canada’s premier law journal, the Banking & Finance Law Review.
Charging usurious loan interest is a criminal offence under section 347 of the Criminal Code of Canada. There is little chance of a prosecution under this section in a commercial transaction. However, the offence has been used by debtors in civil transactions to reduce their payment obligations.
There have been a number of cases interpreting and applying this section of the Criminal Code. This article examines only one element, namely equity components.
Loan interest at a rate of 60% per annum or more is illegal under section 347. This rate is an actuarial calculation of the annual effective rate, not a nominal rate. A nominal rate of about 48% per annum, payable monthly, is equivalent to an annual effective rate of about 60%.
The definition of interest in section 347 is broad and includes non-periodic payments that would not normally be considered as interest. For example, bonuses and other lump sum payments are included and can readily tip the balance in "high risk" transactions, particularly if paid up front.
If an equity kicker is treated as interest, a high risk transaction could contravene section 347.
If a transaction is found to contravene section 347, a "write-down" of the interest component is the expected result so that the total interest charges comply with section 347. Obviously, this result takes away part of the lender’s return or upside (in the case of an equity component). This element of the return may have been "market" and entirely justifiable in relation to the risk of the lender. (Note that an abusive transaction may be set aside as unconscionable, apart from the application of section 347.)
The courts have not adequately addressed whether an equity kicker in a loan may be considered interest. There are, of course, different forms of equity, such as shares or comparable equity interests, warrants to acquire shares or other equity interests, convertible debentures, profit participation, royalty agreements or joint ventures. The form of equity participation may affect the result under section 347.
If the equity component may be considered interest, there is a troubling question of valuation. Some writers have suggested that an equity component should be valued at its ultimate value, rather than at the outset of the transaction. This writer thinks that the only sensible approach is to value the equity component at the outset of the transaction. In other words, if the borrower issues warrants to the lender for $1 that are worth $100,000, the "interest" component (if any) is $100,000. If the lender ultimately gets $500,000 for the warrants, some writers suggest the interest component is $500,000. The "ultimate value" approach also has timing uncertainties. If, when the loan is repaid, the lender still holds the equity component, should its value be measured when the loan is repaid or at the later date when the interest is disposed of?
Some cases seem to take for granted that some equity interests are not subject to section 347. However, in doing so, the courts have not specified what characteristics of the equity component will achieve that result. A review of the cases suggests various factors that may weigh in favour of or against a determination that the equity component should be treated as interest. An "equity" component may be treated as interest if it constitutes a share of gross revenue or a royalty, or if the ultimate proceeds are capped or the return is guaranteed. The accounting treatment has been considered neutral in this analysis.
While it seems that the strongest case for interest exclusion would be shares or warrants, a conservative approach suggests that the lender should calculate the deemed interest rate (including all components of section 347) and include the "going-in" value of the equity kicker. If the value of the equity kicker pushes the transaction over the line, consideration can then be given to the risk of section 347 inclusion and how to manage that risk, perhaps by modifying the form or characteristics of the equity kicker.
Also to bear in mind is that some structures may be disadvantageous if the debtor becomes subject to insolvency proceedings.
Section 347 is generally viewed as an inappropriate and unnecessary means of controlling interests rates in commercial transactions. Other jurisdictions, such as New York State, have exempted loans to corporations from usury laws.
In 2004, the Uniform Law Conference of Canada submitted a recommendation to the Federal Minister of Justice that the definition of interest should exclude participation in the borrower’s profit, regardless of the form.
Late in 2004, a Bill was introduced in the Senate that would have lowered the criminal rate to around 40% (varying with a specified short-term rate), but the section would only apply to loans under $100,000. The change would, of course, have eliminated the concern about equity in the case of most business transactions. However, the Bill was not passed by the last government. Instead, the current government enacted Bill C.9 in 2007 exempting "pay day loans" from section 347, leaving that business to be regulated provincially.
In result, the lingering uncertainty of equity kickers continues.
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.