Jul 16, 2018

The Principle About Interest: The Ontario Superior Court of Justice on Section 4 of the Interest Act and the Need to Disclose Interest Rates in Commercial Contracts

Solar Power Network Inc. v. ClearFlow Energy Finance Corp., 2018 ONSC 7286 (CanLII)

Overview

The January 2018 Ontario Superior Court of Justice decision of Solar Power Network Inc. v. ClearFlow Energy Finance Corp.[1] is a wake-up call to anyone dealing with a contract under which interest is payable: ignore s.4 of the Interest Act[2] at your peril.

In Solar Power, the application judge, Justice McEwen, found charges in loan documents between the parties to be interest as opposed to fees, and in violation of s.4 of the Act.

As a result, His Honour held that all the interest charges in all the loan documents had to be reduced so that the total annual rate of interest was just 5%, even those that didn't offend the Act.

While ClearFlow has obtained leave to appeal Justice McEwen's decision, the effect of this decision could impact almost all non-consumer loan, credit agreements and other documents where interest is payable.

The Dispute

Beginning in 2015, Solar Power Networks Inc. ("SPN") and ClearFlow Energy Finance Corp. ("ClearFlow") entered into series of loan documents that defined the lending relationship between the parties.

Each of the loan documents contained these elements:

(a) a base interest rate of 12%, which would increase to 24% on default;

(b) an Administration Fee that was charged when the loan was first advanced. If the Fee was not paid when the term of the loan expired, it would be rolled-over into a new loan and a new Fee would be charged; and

(c) a Discount Fee of 0.003% of the outstanding principal of the applicable loan. If the Fee was not paid when the term of the loan expired, the outstanding balance of the Fee would be rolled-over into a new loan, with the Fee continuing to be calculated on a daily basis.[3]

SPN claimed that the Administration Fee and the Discount Fee were interest charges, not fees. SPN also claimed that because those fees were not expressed as a per annum rate of interest in the loan documents, they violated s.4 of the Interest Act. That section states:

When per annum rate not stipulated

4. 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.

The Decision

Justice McEwen found the Administration Fees not to be interest for the following reasons:

(a) ClearFlow's "sensible evidence" that the Administration Fee was compensation for its work in setting up and administering the loans to SPN.[4]

(b) ClearFlow's "common sense" explanation that the higher rates were directly linked to the greater amount of administrative work required for the risker loans advanced under the Promissory Notes. The court rejected SPN's argument that the Administration Fee was more consistent with interest because the Promissory Notes charged a higher Administration Fee than the parties' main loan agreement.[5]

(c) the Administration Fee was charged on a one-time basis and only if a loan was not repaid on time. The Administration Fee did not necessarily accrue over time, which one would expect if it were actually interest.[6]

However, the court found that the Discount Fee did constitute interest. The court reasoned as follows:

(a) the Discount Fee was not linked to the creation of a new Loan Document or a renewal;

(b) it was the same for all types of Loan Documents. Unlike the Administration Fee, which would vary depending on the risk and work undertaken by Clear Flow;

(c) it was calculated daily on a fixed rate; and

(d) the Discount Fee's day-to-day accrual was more suggestive of interest than of a fee. It was not tied to a specific event.[7]

Did the Discount Fee Violate s.4 of the Interest Act?

ClearFlow argued that even if the Discount Fee was interest, it did not violate s.4 of the Act. It pointed to, among other things, a formula in the loan documents for calculating the effective annual rate of interest for both the Administration Fee and the Discount Fee.[8] This, argued ClearFlow's, allowed SPN to determine the Discount Fee on an annualized basis by multiplying 0.003 by 365 (or 366) days.[9]

The court disagreed with ClearFlow's argument. It stated that the actual rate of interest under the Discount Fee could have depended on a number of compound periods of interest, since interest on the Discount Fee compounded each time the applicable loan rolled-over.[10] The court wrote:

...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 Act. Further explanatory language ought to have been used by ClearFlow.[11]

Further, the court noted that the formula did not assist ClearFlow in any event with respect to the Discount Fee under the Promissory Notes. The Notes did not contain any formula at all.[12]

The Remedy

SPN argued that all the interest under the Loan Documents, even the annualized base interest, had to be reduced to 5% under the plain wording of s.4 of the Act.[13]

Not surprisingly, ClearFlow disagreed. It argued that if the Discount Fee violated s.4 of the Interest Act, the court should reduce it to the effective annual rate of 5%, and not interfere with the other non-offending interest rates in the loan documents.[14]

Looking at both the wording of s.4 and the policy considerations behind it, the court agreed with SPN. The purpose of s.4 could only be achieved if the total interest payable in the loan documents were reduced to 5%. ClearFlow's interpretation of s.4 would only encourage the type of misleading lending behaviour from which Parliament intended to protect consumers in drafting s.4.[15]

The court acknowledged that the result of its decision was particularly harsh for ClearFlow. However, it justified the result in part as follows:

[93] As draconian as it may seem to limit all of the interest to 5% where the offending Discount Fee is only a small portion of the overall interest obligation, the result is in keeping with the consumer protection purpose of this legislation. It precludes lenders from arguing that only the offending rates should be capped while the other non-offending interest rates should remain...My conclusion, overall, prevents the type of mischief that can occur when multiple loans are taken out, some with annualized rates and some without. To accept ClearFlow's position would allow, and perhaps encourage, lenders to benefit from such complicated and potentially deceitful or misleading business practices.[16]

Conclusions

Until now, s. 4 of the Act was of little concern to parties and their counsel. Existing case law had affirmed that lenders may express annual rates as nominal rates instead of effective rates or provide a formula that may be used to ascertain nominal annual rates.[17] However, Solar Power has created an element of uncertainty for parties to commercial agreements where interest is payable. The decision raises some important issues:

(a) if lenders have provided a formula to determine an effective annual interest rate, they may be left wondering whether their formula has enough information to satisfy s.4;

(b) compliance with the court's decision may prove impossible. Floating interest rates are a commercial reality in Canada. They inherently involve several variables. A formula that allows a borrower to accurately calculate an effective annual interest rate would be impossible.

As noted above, ClearFlow has obtained leave to appeal Justice McEwen's decision. If the decision stands, the nature of the interest provisions in commercial lending relationships in Canada may undergo fundamental change. Until we have further clarity from the appeal, it is recommended that lenders consider the following in any document where interest is payable:

1. include an acknowledgement from borrowers, other obligors or issuers that they fully understand and are able to calculate the yearly rate or percentage of interest payable thereunder based on the methodology for calculating the per annum rates provided for in the agreement; and/or

2. include examples of how the interest calculations would be calculated based on interest calculation provisions in the agreement. If there are floating rates of interest in effect on the closing date of the financing, use those in the example for disclosure purposes.

We also note that real property mortgages are exempt from s. 4 of the Act and consumer loans have additional disclosure requirements set out in the Consumer Protection Act, 2002.[18]

For now, it pays to pay attention to s. 4 of the Interest Act.



[1] 2018 ONSC 7286

[2] R.S.C. 1985, c I-15

[3] Solar Power Network Inc. v. ClearFlow Energy Finance Corp., 2018 ONSC 7286, para. 11

[4] paras. 32 - 34

[5] Ibid, para. 35

[6] Ibid, para. 36

[7] Ibid, para. 42

[8] Ibid, para. 46

[9] Ibid, para. 49

[10] Ibid, para. 62

[11] Ibid, para. 63

[12] Ibid, para. 64

[13] Ibid, para. 75

[14] Ibid, paras. 76 – 77

[15] Ibid, paras. 81 - 85

[16] Ibid, para. 93

[17] See Bank of Nova Scotia v. Dunphy Leasing Enterprises Ltd., 1991 ABCA 351

[18] S.O. 2002, c. 30, Sched. A.