On May 6, 2016, the Supreme Court of Canada (“SCC”) released its much anticipated decision Krayzel Corp v Equitable Trust Co., appealed from the Alberta Court of Appeal. At issue, was whether incentives or discounts for prompt payment in a mortgage, which would be lost on default, offended s. 8 of the Interest Act.
This decision has important ramifications for lenders and provides needed guidance on how to structure mortgage interest provisions so that they do not run afoul of the Interest Act.
Lougheed Block Inc. (“Lougheed”) borrowed $27 million from Equitable Trust Company (“Equitable”) secured by a mortgage on the Lougheed Building in downtown Calgary. The mortgage had an interest rate of prime plus 2.875%. When the mortgage matured on June 30, 2008, Lougheed could not obtain funds to pay out the mortgage. Lougheed and Equitable agreed to a renewal agreement (“First Renewal Agreement”) to extend the mortgage for seven months with an interest rate of prime plus 3.125% for the first six months and an interest rate of 25% for the seventh month. When the first renewed mortgage matured, Lougheed could not obtain funds to pay it out. It entered into another renewal agreement (“Second Renewal Agreement”) with Equitable, commencing retroactive one month prior to the expiry of the First Renewal Agreement, with an interest rate of 25%, however if Lougheed made prompt monthly payments, the interest rate would decrease to the greater of 7.5% or prime plus 5.25%. Lougheed defaulted on the second renewed mortgage and Equitable claimed 25% interest for each month of default.
The lower courts considered whether the structure of the First and Second Renewal Agreements infringed s. 8 of the Interest Act, which prohibits penalties or rebates on loans that have the effect of increasing the interest charge on arrears greater than the rate of interest payable on principal not in arrears.
The Alberta Court of Appeal unanimously held that the First Renewal Agreement did not offend s. 8 of the Interest Act, but were split on whether the Second Renewal Agreement was in violation of s. 8, with the majority holding that the Second Renewal Agreement’s structure was permissible under the Interest Act. Key to the Alberta Court of Appeal’s decision was the distinction between penalties and incentives and the applicability of s. 8 only to penalties. The Alberta Court of Appeal held that the Second Renewal Agreement was an incentive, rather than a penalty, and as such was allowable under the Interest Act. This reading contrasted sharply with s. 8’s interpretation in Ontario, where the courts drew no distinction on s. 8’s applicability to penalties or incentives. The matter was appealed to the SCC.
For more information on the judicial decision history and the Alberta Court of Appeal’s decision, see our earlier blog post.
The SCC Decision in Krayzel
The SCC unanimously agreed that the First Renewal Agreement was not a violation of s. 8, as interest rate increases triggered by the mere passage of time, and not default, were permissible under the Interest Act.
On the Second Renewal Agreement however, the SCC split 6-3, with the majority holding that the Second Renewal Agreement did infringe s. 8 of the Interest Act. In coming to the decision, the majority considered that the ordinary sense of the words that Parliament chose to include in s. 8, read together with s. 2 (freedom to contract) and the objectives of the Interest Act, supported the conclusion that s. 8 applied to both discounts, incentives and penalties. The majority held that substance of the term, not form, should prevail. What mattered to the SCC was how the impugned term operated, and the consequences it produced, irrespective of the label used. Using this analysis, the majority determined that the effect of the Second Renewal Agreement was to reserve a higher charge on arrears (being the rate of 25%) than that imposed on principal money not in arrears and that the labelling as one rate as the “pay rate” rather than the “interest rate” was of no consequence.
The dissent disagreed, arguing that the rate of interest payable on principal money not in arrears under the Second Renewal Agreement was actually 25% throughout the entire term of the Second Renewal Agreement. Resultantly, the Second Renewal Agreement could not have the effect of increasing the charge on arrears, since the rate remained consistent at 25%, meaning s.8 was not engaged.
The dissent relied heavily on the case of North West Life Assur Co of Ca v Kings Mount Hldg Ltd, (“North West”). In North West, the initial mortgage term was set at a 19% interest rate. The renewal agreement also stipulated a 19% interest rate but provided a discounted 13% rate in the event of timely payment. The dissent held that North West’s facts were indistinguishable from the case at bar, but the majority distinguished it, holding that the structure was permissible under the Interest Act because the initial interest rate was already set at 19%, rather than in this case where the interest rate increased to nearly three times the originally agreed upon rate.
Substance Prevails: Previously, in Alberta, unlike Ontario, s. 8 of the Interest Act only applied to penalties, not discounts or rebates, that had the effect of increasing the interest charge on arrears greater than the rate of interest payable in principal money not in arrears. The SCC has clearly stated in Krayzel that s. 8 applies to both discounts and penalties. The determining factor in an analysis for a s. 8 infringement rests on the effect the impugned term. Therefore, when structuring interest provisions, lenders should be cognizant of the effect of the interest provisions, regardless of whether a provision is considered an incentive, discount or penalty. If a provision in effect reserves a higher charge on arrears than that imposed on principal money not in arrears, s.8 will be infringed.
It is interesting to note, however, that lenders are not precluded from charging an initially high interest rate and forgiving or discounting it upon prompt repayment, such as in the case of North West. Based on the majority’s commentary, it appears that s. 8 of the Interest Act is only infringed if the interest rate increases in renewal agreements from the initial interest rate stipulated.
Interest Increases Due to Passage of Time are Acceptable: The SCC has clearly stated that interest increases due merely to a passage of time are acceptable and do not violate s. 8 of the Interest Act. Lenders are therefore still permitted to structure interest provisions with interest rates that increase on set dates and are not tied to default.