In a 6-3 majority decision, the Supreme Court of Canada confirmed Friday that the provisions of a mortgage loan affording the mortgagor a discount of interest for prompt payment has the effect of imposing a higher charge on arrears than on principal money not in arrears, and as such offends Section 8 of the Interest Act (R.S.C. 1985, c. I-15).
This is the first decision of the country’s highest court considering whether an interest rate that takes effect only if a mortgagor falls into default by failing to make payments at a lower rate of interest breaches Section 8.
In Krayzel Corp. v. Equitable Trust Co., 2016 SCC 18 (Krayzel), the borrower under a mortgage loan found itself unable to repay the loan at maturity. The lender agreed to a first seven months extension at an increased interest rate for the first six months and a further increased interest rate of 25% for the seventh month. The lender then agreed to a second extension, made retroactive to one month prior to the expiry of the first extension. This second extension provided for a rate of interest of 25%, but for a “pay rate” of the greater of 7.5% or prime plus 5.25%, with the difference accruing to the loan. The second extension further provided that if the borrower did not default, the accrued interest would be forgiven.
Section 8 of the Interest Act
Section 8 (1) of the Interest Act provides that:
“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.” (our emphasis)
Justice Brown, writing for McLachlin C.J. and Cromwell, Karakatsanis, Wagner, Gascon JJ. and himself, concluded that in order to apply Section 8, one must look “at the effect of the impugned mortgage terms”. (par. 25) Couching a provision as a discount rather than an increase in a rate of interest is irrelevant. Justice Brown writes that “substance, not form, is to prevail. … If [the impugned provision’s] effect is to impose a higher rate on arrears, than on money not in arrears, then s. 8 is offended.” (par. 25).
The majority then went on to conclude that the arrangement stipulated in the mortgage at issue, in effect a discount on a rate of interest stipulated, offended Section 8 of the Interest Act, such that the interest rate in force was the higher of 7.5% or prime plus 5.25%.
Although little discussed, the automatic forgiveness of the accrued interest for the difference between the stipulated rate of 25% and the lower “pay rate” is clearly a deciding factor in the court’s decision. One can imagine that if the said difference had merely accrued to the loan and become payable at maturity, the court’s decision may have been different.
In its majority reasons, the court also confirms that “an interest rate increase triggered by the mere passage of time (and not by default) … clearly does not offend s. 8.” (par. 33).
Minority (Dissenting) Decision
Justice Côté, writing for the dissenting minority composed of Abella and Moldaver JJ. and herself, would have upheld the impugned provision, finding that the rate of interest stipulated in the mortgage at issue was 25%, and that such rate was the same before and after default.
According to Justice Côté’s reading of the mortgage, the terms were crystal clear as to the rate of interest that was applicable, namely a rate of 25%, and those terms did not offend Section 8. The difference between the stipulated rate and the “pay rate” was added each month to the principal of the loan, essentially as additional interim financing. Because the interest charges calculated on the basis of 25% were actually paid monthly (whether paid or accrued to the loan) and not simply “taken, reserved or exacted” in the event of default, Justice Côté concludes that the interest payable on arrears is the same as that payable on principal not in arrears. She goes on to write that “The possibility of having a portion of these interest payments forgiven does not have the “effect” of reducing the interest rate that was to be paid monthly on principal money not in arrears.” (par. 45).
Alternatively, Justice Côté also concludes that a discount (which is specifically mentioned in Section 2 of the Interest Act as permitted subject to the provisions of the Act or other Acts of Parliament and is not mentioned in Section 8), when it is a “forgiving discount”, is not prohibited by Section 8.
In her reasons, Justice Côté laments that the majority decision may have an effect counter to the intent of Parliament by dissuading lenders to agree to terms which may provide relief to struggling debtors where such relief is conditional upon prompt payment, and may constitute a pure windfall for the borrower.
The Krayzel decision provides useful guidance for practitioners in the application of Section 8 of the Interest Act, by confirming that discounted rates of interest will fall within the ambit of fines, penalties or rates of interest which may trigger the application of the said Section 8. The decision also confirms that increases of interest rate triggered by the mere passage of time (and not by default) are permissible.
In its majority decision, the court is mindful of preserving certainty for co-contracting parties, by applying a test focusing on the effect of impugned provisions rather than on their intent. However, this decision may have the effect of dissuading lenders from working out relief or extensions of time predicated upon prompt payment. Lenders will be reluctant to agree to longer term extensions or to agree in advance to forgiveness of interest if they cannot be assured of the benefit of prompt payment during an extended term while the distressed borrower attempts to refinance its loan.
It is useful to underscore that the rules of Section 8 of the Interest Act are only applicable to loans secured by mortgages on real estate (or hypothecs on immovable property).