I. How to Comply with Section 4 of the Interest Act: Settled law and practice?
On financing transactions that involve the calculation of interest, lenders and bondholders have typically included a provision (or, more usually, a formula) for calculating a "nominal" annual rate of interest in order to comply with section 4 of the Interest Act (Canada).1 If a loan document does not comply with this provision, then the interest rate is capped at 5% per annum. Commercial practice and appellate jurisprudence had confirmed that such provisions complied with section 4. Section 4 states:
Except as to mortgages on real property or hypothecs on immovables, whenever any interest is, by the terms of any written or printed contract, whether under seal or not, made payable at a rate or percentage per day, week, month, or at any rate or percentage for any period less than a year, no interest exceeding the rate or percentage of five per cent per annum shall be chargeable, payable or recoverable on any part of the principal money unless the contract contains an express statement of the yearly rate or percentage of interest to which the other rate or percentage is equivalent.2
However, the Interest Act does not explicitly state what constitutes "an express statement of the yearly rate", disclosure of the "nominal" rate of interest or of the "effective" rate of interest. This is an important distinction. If a monthly rate of interest is 2%, the "nominal" interest rate would be 24% per annum but the "effective" rate would be 26.8% per annum, after taking into account the reinvestment of each monthly payment or the effect of compounding.
This issue has previously been narrowly interpreted by judicial authority. For example, in the 1994 Supreme Court of Canada decision of Dunphy (which affirmed an Alberta Court of Appeal decision), the Court clarified that parties need not disclose the "effective" rate of interest in the relevant agreement in order to comply with section 4, but rather disclosure of the "nominal" rate is sufficient.3 Similarly, the Ontario Court of Appeal came to the same conclusion in McHugh v. Forbes.4 For over 25 years many courts, commentators and legal practitioners considered this issue to be settled law on the basis of these appellate authorities.5
II. New Uncertainty Arising from an Judgment of the Ontario Superior Court of Justice
On January 10, 2018 a trial decision of the Ontario Superior Court of Justice was rendered that potentially questions these appellate level judicial authorities and multiple years of commercial practice. This judgment should cause some lenders and their counsel to pause and consider whether their loan documentation requires any modifications to comply with section 4. Solar Power Network Inc. v. ClearFlow Energy Finance Corp.6 holds that the absence of an explicit, unambiguous statement of the annual rate of interest in loan documentation can cause such documentation to be non-compliant with section 4 and thus interest payable could be capped at 5%.
In Solar Power Network, the lender ClearFlow Energy Finance Corp. ("ClearFlow") had provided short-term financing to the borrower, Solar Power Network Inc. ("SPN").7 The loans carried interest payable at 12% per annum, compounded and calculated monthly, with a step-up to 24% per annum on default. The loan documents also provided for two "fees": an "administration fee" and a "discount fee". The court agreed that the "administration fee" was properly characterized as a fee and not interest for the purpose of section 4. However, the court held that the "discount fee" was actually interest because it accrued on a daily basis.8 The loan agreement described the "discount fee" as follows, providing that SPN would pay ClearFlow:
on the date of repayment of such Loan [...] a discount fee of 0.003% of the outstanding balance of such Loan for every day such Loan remains outstanding until such Loan is repaid in full.9
As is customary commercial practice, the loan documents also included a "conversion provision" which set out a formula to convert any interest rate that was not expressed as an annual rate in the agreement into a nominal annual rate, so that the interest calculated on a period shorter than a calendar year could be converted into a nominal rate and therefore comply with section 4. The "conversion provision" stated:
Unless otherwise stated, in this Agreement if reference is made to a rate of interest, discount rate, fee or other amount "per annum" or a similar expression is used, such interest, fee or other amount shall be calculated on the basis of a year of 365 or 366 days, as the case may be. If the amount of any interest, fee or other amount is determined or expressed on the basis of a period of less than one year of 365 or 366 days, as the case may be, the equivalent yearly rate is equal to the rate so determined or expressed, divided by the number of days in the said period, and multiplied by the actual number of days in that calendar year.10
The court held that the formula provided in the "conversion provision" in the loan documentation was not an "express statement" of the annual interest rate as required by section 4. Justice McEwen reasoned that:
In my view, the statutory requirement for an express statement is designed to avoid the exact type of mischief that can occur when rates are not annualized and the borrower, therefore, does not have a clear understanding of its obligation to pay interest. A formula does not necessarily allow for this clear understanding to occur. Formulas can be confusing and even misleading. The requirement for an express statement of the annual interest rate, to my mind, is designed to avoid exactly the type of situation that has arisen in this case. SPN is claiming that it cannot understand its interest obligations, while ClearFlow is claiming that the obligations are well set out and SPN could simply do the interest calculation. The requirement of an express statement does away with this type of dispute and uncertainty, particularly where in this case there are multiple loans, which may roll-over.11
Justice McEwen also held that even if a formula could constitute an "express statement," the formula used in the loan documents in question was inadequate because it did not stipulate the "effective" rate of interest. The court held:
It is therefore not accurate to say that by simply multiplying 0.003% x 365 that the Discount Rate could be annualized so that the borrower's obligation could clearly be understood. Confusion over interest calculations did arise. The nature of the Discount Fee, which was understood by both parties, required that an "effective annual rate" be disclosed. I find that the formula provided in the Loan Agreement does not produce a sufficient and equivalent rate for the purposes of satisfying s. 4 of the [Interest] Act. Further explanatory language ought to have been used by ClearFlow.12
As a result, Justice McEwen concluded that the total interest rate payable pursuant to the loan documents must be capped at 5% per annum as required by the Interest Act as it may otherwise allow and even encourage lenders to benefit from inclusion of complicated formulas and interest rate clauses in their loan documents which may undermine the spirit of the consumer protection purposes of this legislation.13
We consider this case to be an outlier from existing binding appellate authority that does not appear to have been considered in the decision (particularly the Dunphy case noted above) and many years of commercial practice. This judgment also is problematic for contracts for loans in foreign currencies where interest may be stated to be calculated on the basis of a 360-day year (such as LIBOR based loans).14 Additionally, the analysis in this decision may prove to make it impossible for certain lenders to comply with section 4 when floating interest rate benchmarks are used.15 Therefore, the potential uncertainty introduced by this case may require action by parties involved in financing transactions that include interest rates calculated for a period less than one year.
III. What to do?
While we understand that this trial decision is under appeal, given the potential uncertainty created by this case, it would be prudent to augment any new credit agreement, loan agreement, trust indenture or other credit document that provides for the payment or calculation of interest for a period of less than one year to include an acknowledgement from the borrower, the guarantors and the issuer, as the case may be, that they fully understand and are able to calculate the interest payable thereunder based on the methodology for calculating the per annum rates provided for in the agreement.16 However, an exception to this, of course, is real property mortgages, which are exempt from the provisions of section 4, but not the credit documents underlying a real property financing, which are not exempt.17 Another method may be to provide disclosure by the lender of examples of how the interest calculations would be calculated based on the methodologies set forth in the agreement and the floating rates of interest in effect on the closing date of the financing. Lastly, we would note that for new bond financings, the introduction of risk factor disclosure concerning the Interest Act compliance uncertainty is advisable.
We anticipate that in the appeal it will be argued that the binding appellate level judgments will be found not to have been adequately considered in Solar Power Network. We will monitor developments relating to this case as the appeal progresses.
Footnotes
1 Interest Act, R.S.C., 1985, c. I-15, s. 4.
2 Ibid., [emphasis added].
3 Bank of Nova Scotia v. Dunphy Leasing Enterprises Ltd., [1994] 1 S.C.R. 552, aff'ing 1991 ABCA 351 (A.B. C.A.) ["Dunphy"]. See also Metropolitan Trust Company v. Morenish Land Development Ltd. [1981] 1 S.C.R. 171, in which the Supreme Court of Canada held at 181 that there is no rule or principle of law that mandates the application of the deemed reinvestment principle.
4 McHugh v. Forbes, (1991) 4 O.R. (3d) 374 (Ont. C.A.).
5 For example, see Wilfred M. Estey, Legal Opinions in Commercial Transactions, 3d ed. (Markham, Ontario: LexisNexis Canada Inc., 2013) at 279-280. See also Stuart H. Cobbett, Loan Agreements, (1981) Meredith Memorial Lectures, 314 at 319.
6 Solar Power Network Inc. v. ClearFlow Energy Finance Corp., 2018 ONSC 7286 ["Solar Power Network"].
7 Ibid.
8 Ibid at paras. 43-45.
9 Ibid at para. 13.
10 Ibid at para. 48.
11 Ibid at para. 53 [emphasis added].
12 Ibid at para. 63 [emphasis added].
13 Ibid at para. 93.
14 For the difficulties that arise if section 4 is applied for LIBOR based loans in a way which requires the disclosure of an effective rate, see Cobbett, supra note 5.
15 See the discussion by Mary Anne Waldron, The Law of Interest in Canada, (Scarborough, Ontario: Carswell, 1992) at 112.
16 To the extent the agreement provides for a methodology that goes beyond the conversion provision cited above.
17 However, in V.K. Mason Construction v. Bank of Nova Scotia, (1985) 1 S.C.C. 271, at 286, the Supreme Court of Canada held that the fact that the mortgage is contained in a document distinct from the loan does not prevent the loan from being exempt from section 4. This would be the case where credit facilities are secured by a collateral mortgage.
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