Mortgagors Beware – Inflated Interest on Default May Offend the Interest Act

INTRODUCTION

Can a mortgagee stipulate an inflated interest rate that only applies in case of default? The Supreme Court of Canada says “no”.

BACKGROUND

In Krayzel Corp. v. Equitable Trust Co.,[1] the appellant, Lougheed Block Inc. (“Lougheed”) owned a Calgary office building against which it had registered various mortgages, including mortgages granted to the appellant Krayzel Corporation and Heritage Capital Corporation. On November 8, 2006, Lougheed granted a mortgage to the respondent, Equitable Trust Company, to secure a $27 million loan with an agreed upon interest rate of prime plus 2.875 per cent per annum. On the maturity date, June 30, 2008, Lougheed was unable to discharge the mortgage and Equitable agreed to extend the mortgage term another seven months. This agreement (the “First Renewal Agreement”), effective August 1, 2008, carried a per annum interest rate of prime plus 3.125 per cent for the first six months and 25 per cent in the seventh month.

Lougheed was again unable to discharge when the First Renewal Agreement matured. On April 28, 2009, it entered a second amending agreement with Equitable (the “Second Renewal Agreement”) effective retroactively to February 1, 2009. The Second Renewal Agreement provided that:

1. The per annum interest rate would be 25 per cent;
2. Lougheed would make monthly interest payments at a “pay rate” of either 7.5 per cent or prime plus 5.25 per cent, whichever was greater;
3. The difference between the amount payable (25 per cent) and the amount payable by Lougheed at the “pay rate” would accrue to the loan; and
4. If Lougheed did not default the accrued interest would be forgiven. Essentially, if Lougheed made all payments on time and in full to pay out the loan when due it would be excused from paying the recapitalized interest.

Lougheed defaulted on the first payment due under the Second Renewal Agreement on May 15, 2009, and Equitable demanded repayment of the loan at 25 per cent.

ISSUE

Section 8 of the Interest Act, R.S.C. 1985, c. I-15 precludes a mortgagee from imposing terms that have the effect of charging a higher rate of interest on money in arrears than that charged on the principal money not in arrears.

The relevant provisions read as follows:

Section 2

Except as otherwise provided by this Act or any other Act of Parliament, any person may stipulate for, allow and exact, on any contract or agreement whatever, any rate of interest or discount that is agreed on.

Section 8

(1) 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 immovable that has the effect of increasing the charge on the arrears beyond the rate of interest payable on principal money not in arrears.

(2) Nothing in this section has the effect of prohibiting a contract for the payment of interest on arrears of interest or principal at any rate not greater than the rate payable on principal money not in arrears.

The Court considered the significance, for the purposes of section 8, of the putative distinction between (1) terms imposing, as a penalty, a higher rate on default, and (2) terms reserving, as a discount or reward, a lower rate where there is no default. The Court also considered, briefly, whether mortgage terms providing for a higher interest rate triggered solely by the mere passage of time could offend section 8 (the Court’s answer to that question was “no”).

LOWER COURTS

Master Hanebury of the Court of Queen’s Bench of Alberta found that both renewal agreements offended section 8. Only where a bona fide business reason was demonstrated could such agreements be saved. The Master found that although Lougheed was a sophisticated borrower, it sat in a vulnerable position that was exacerbated by the two renewal agreements.

Romaine J. in the Court of Queen’s Bench of Alberta reviewed the decision of Master Hanebury and reversed it. In her view, section 8 was an exception to the general rule of freedom of contract as preserved by section 2 of the Interest Act, and as such it should be “strict[ly] or narrow[ly]” construed, so long as the Act’s purpose would not be impaired by such an interpretation. In this instance, she found that there was no vulnerability present but rather a sophisticated buyer who chose to take a chance, and thus the freedom of contract protected by section 2 should be preserved.

The Alberta Court of Appeal unanimously agreed that the First Renewal Agreement did not offend section 8 and agreed with the chambers judge that underlying commercial purposes and the vulnerability or sophistication of the parties are irrelevant for the consideration of section 8. However, the Court diverged in its opinion of the Second Renewal Agreement. Hunt J.A., for the majority, agreed with the chambers judge that the agreement complied with section 8. The majority considered itself bound by the decision in Dillingham Construction Ltd. v. Patrician Land Corp.[2] – reading the decision as a confirmation that section 8 is directed at penalties for non-performance only, not at incentives for punctual payment, and found that the agreement to reduce the amount owing by the difference between the stated 25 per cent per annum interest rate and the stated “pay rate” was an incentive to pay on time, not a penalty for late payment.

Berger J.A, in dissent, found that when Lougheed defaulted and Equitable called the loan, it relied on a term of the Second Renewal Agreement, the effect of which was precisely what section 8 serves to prohibit.

REASONING OF SUPREME COURT

The Supreme Court of Canada granted Lougheed, Heritage Capital and Krayzel leave to appeal.  In a six to two decision, Brown J., writing for the majority, reversed the lower court’s decision.

The appellants’ position was that, by enacting the predecessor provision to section 8 in 1880 (An Act relating to Interest on moneys secured by Mortgage of Real Estate, S.C. 1880, c. 42, section 3) Parliament intended to abolish the old equitable rule that allowed for discounts in the form of reduced interest rates for timely payments and prohibited penalties in the form of increased interest rates on default. The appellants argued that because Parliament intended to abolish the old rule, section 8 prohibits both discounts and penalties that lead to the prohibited effects.

The respondent took the position that such an argument would run counter to the presumption that Parliament does not intend to depart from established principles, policies or practices, unless the statutory language is of “irresistible clearness”.

Section 8(1) identifies three classes of charges (fines, penalties, and rates of interest) that shall not be “stipulated for, taken, reserved or exacted” if the effect of doing so would be to impose a higher charge on arrears than imposed on principal money not in arrears. The Court held that had Parliament’s intention been to prohibit only penalties, it would not have included fines and rates of interest in addition to penalties as forms of prohibited charges. By directing the inquiry to the effect of the impugned term, Parliament clearly intended that mortgage terms masquerading as “bonuses”, “discounts” or “benefits” would not comply with section 8. All that matters for the purposes of section 8’s prohibitions is how the impugned term operates, and the consequences it produces, regardless of how it may be labelled. In essence: if the effect is to impose a higher rate on money in arrears than money not in arrears, section 8 is offended.

The Court did not agree with the special distinction the lower courts afforded to section 2. The Court found that while section 2 operates to preserve a general right of freedom of contract, it still operates with the caveat that such freedom is subject to what is “otherwise provided by this Act, or any other Act of Parliament”.

The Court distinguished Dillingham from the case at hand, stating that the arrangement in that case was in conformity with section 8 – not because it took the form of a discount, but rather because the parties were taken to have agreed to fold the cost of borrowing into a single rate of interest to be applied upon default or maturity. The term was not “penal” because its effect was not to impose a higher charge on arrears than it imposed on principal money not in arrears.

The Court disposed of the appeal by consideration of the Second Renewal Agreement only. The First Renewal Agreement imposed an increase based on the mere passage of time, which the Court found clearly did not offend section 8. The terms of the Second Renewal Agreement, however, operated to reserve a higher charge on arrears (25 per cent) than was to be imposed on principal money not in arrears (7.5 per cent or prime plus 5.25 per cent). The fact that the impugned agreement labelled one charge as an “interest rate” and the other as a “pay rate” is of no consequence because section 8 is explicitly concerned with substance and effect rather than form.

CONCLUSION / RECOMMENDATIONS TO LENDERS

Ultimately, the Court has now clarified that section 8 applies both to discounts as well as penalties whenever their effect is to increase the charge on the arrears beyond the rate of interest payable on principal money not in arrears. No matter how an agreement is framed, phrased or intended, if the effect is to increase the charge on arrears beyond that of the interest payable on money not in arrears, section 8 will be offended. Whether or not an impugned arrangement has an underlying “legitimate commercial purpose” is wholly irrelevant to its effect and therefore to whether it offends section 8. To consider such underlying purposes would be to undermine Parliament’s clearly expressed intentions. The same applies to other considerations such as the degrees of sophistication or bargaining powers between the parties. Section 8 is purely results-oriented.

What advice should lenders take from this decision? Provisions in a loan agreement having the effect of increasing the charge on arrears beyond the rate payable on principal money not in arrears, by any other name, are prohibited and will still offend section 8. Thus, an attempt to write a term into a mortgage that has the effect of increasing the interest rate on default will in all likelihood be found void if challenged by a mortgagor.

[1] 2016 SCC 18. The author extends thanks to Katherine Baker for her research and initial drafts of this article.

[2] (1985), 37 Alta. L.R. (2d) 193 (C.A.).