Where loan agreements are governed by Canadian law, borrowers and lenders should remain alert to the range of rules contained in Canadian legislation and jurisprudence that govern the payment of interest. The following is a summary of key Canadian interest rate rules and their practical implications.
(1) criminal rate of interest
Under section 347 of the Criminal Code (Canada), interest rates exceeding 60% per annum are "criminal rates of interest". Section 347 contains two separate offenses. The first applies to those who enter into an agreement to receive interest at a criminal rate and the second to those who actually receive interest payments at a criminal rate. If an agreement permits, but does not require, the payment of interest at a criminal rate, there is no automatic violation. Instead, a ‘wait-and-see' approach has been adopted by the courts and, in these circumstances, a violation will only occur where a criminal rate of interest is actually received.
While it would be rare for an ordinary commercial transaction to explicitly provide for interest at a rate over 60%, loan agreements often include up-front arrangement, commitment and other fees. The broad definition of "interest" in the Criminal Code captures ordinary commercial interest as well as a broad range of fees, fines and expenses (including legal expenses). Other examples include consideration payable to a lender in the form of "equity kickers" such as shares, rights or warrants, which may also be regarded as "interest". In 2010, the British Columbia Court of Appeal considered the appropriate treatment of a royalty payable as consideration for a loan to enable a mining development company to acquire licences for a group of properties. The Court held that the royalty came within the extended definition of "interest" in the Criminal Code and constituted illegal interest to the extent that it exceeded 60% per annum.
Where the terms of a loan have been agreed upon in good faith by experienced and independently advised commercial parties, the doctrine of notional severance may apply to reduce a criminal rate of interest to the statutory maximum of 60%. The doctrine remains in the discretion of the court but can helpful for lenders since it minimizes the potential for courts to drastically reduce interest rates by severing the entire offending payment provision. A provision in a loan agreement whereby the parties agree to reduce the rate of interest to a legal rate without making a new agreement can be particularly influential in helping a court allow a lender to receive the maximum legal rate of interest.
(2) statement of annual rate of interest
If a loan agreement provides that interest is payable at a rate or percentage per day, week, month or any period less than a year, section 4 of the Interest Act (Canada) requires the agreement to also contain an express statement of the yearly rate or percentage of interest to which the other rate or percentage is equivalent, except in real estate mortgages. LIBOR and the US Base Rate, for instance, are calculated on the basis of a 360-day year. Under the Interest Act, failure to include this statement may prevent the lender from charging any interest over 5% per annum.
(3) higher interest rate after default for loans secured by a mortgage on real property
Section 8 of the Interest Act prohibits fines or penalties or interest rates that increase the charge on arrears of principal or interest secured by a mortgage of real property beyond the interest rate payable on principal money not in arrears. In other words, a lender cannot charge a higher rate of interest on monies owing after default. Prompt payment provisions in real property mortgages, which reduce the rate of interest at maturity if all payments had been timely, may also run afoul of section 8.
(4) non-corporate borrower prepayment rights
Section 10 of the Interest Act provides natural persons and certain other types of non-corporate borrowers with an automatic right of pre-payment in certain circumstances where principal or interest under a closed mortgage loan are payable more than five years after the date of the loan. Where section 10 applies, the mortgage can be pre-paid in full any time after the five-year period together with a payment of three months worth of interest.
Mortgages given by corporations and joint-stock companies are expressly excluded from this prepayment right. Until recently, other entities that existed for business or commercial purposes were not necessarily captured by the exclusion. New regulations that came into force in January 2012, however, expanded the range of entities carved out from the application of section 10. Now mortgages or hypothecs granted by partnerships, trusts settled for business or commercial purposes and unlimited liability corporations will not attract these automatic prepayment rights.
(5) failure to include interest rate may be binding on the lender
In a recent case from the Québec Court, the Court dismissed a claim by a financial institution seeking to rectify a loan agreement that mistakenly failed to state an interest rate. The parties were told to live with the mistake and the financial institution was not permitted to unilaterally amend the loan agreement to include the 6.95% rate that had been stipulated in the loan application. The financial institution was also ordered to pay damages for having registered a notice of default, thereby negatively affecting the credit rating and financial reputation of one of the debtors. Notably, the financial institution did not request the annulment of the contract, which the court concluded would have been the only possible remedy.
As these provisions demonstrate, lenders and borrowers should remain alert to the range of rules contained in Canadian legislation and case law that govern the rate of interest payable. We would be pleased to assist lenders and borrowers with these matters.