A Return to Normalcy: Annualizing Formulas for Interest Rate Disclosure
1. INTRODUCTION AND BACKGROUND
In our prior legal update “Drafting Interest Rate Calculation Provisions in Corporate Finance Transactions”, we discussed the implications of the Ontario Superior Court of Justice decision in Solar Power Network Inc. v. ClearFlow Energy Finance Inc. with respect to provisions for calculating interest rates in finance documents and how to comply with Section 4 of the Interest Act (Canada).
Section 4 states:
The relevant facts in this case were that a lender, ClearFlow Energy Finance Corp. (“ClearFlow”), had provided short-term financing to a borrower, Solar Power Network Inc. (“Solar Power”). 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”. Solar Power brought an application arguing that the loan documents did not comply with Section 4, notwithstanding the inclusion of an annualizing formula in the loan agreement. The annualizing formula set out how to calculate the annual rate for both the administration fee and the discount fee.
The application was heard by Justice McEwen of the Ontario Superior Court of Justice. He held that the “administration fee” was properly characterized as a fee and not interest for the purpose of Section 4 – a finding affirmed by the Ontario Court of Appeal. However, Justice McEwen held that the “discount fee” was actually interest, but failed to comply with Section 4 because the annualizing formula: (1) could not satisfy the purpose of the statutory requirement for an express, annualized statement of interest as “[f]ormulas can be confusing and even misleading” and (2) did not provide the information required by Section 4 as it failed to take into account compounding of interest. As a result of these findings, Justice McEwen found that the appropriate remedy was to reduce pursuant to Section 4 all interest to 5% and ClearFlow was denied approximately $10 million of accrued interest.
As we anticipated, the application decision was appealed and heard on an expedited basis by the Ontario Court of Appeal. The Canadian Bankers’ Association was given leave to intervene and argued that the application judge had misinterpreted Section 4. In reasons released on September 4, 2018, a unanimous panel of the Ontario Court of Appeal (Justice Sharpe, writing for himself, Justice Brown, and Justice Trotter) agreed with the appellant lender and the Canadian Bankers’ Association and allowed the appeal.
2. KEY FINDINGS BY THE COURT OF APPEAL
The Ontario Court of Appeal’s decision in this case is well-reasoned and practical. The key findings made by the Ontario Court of Appeal should provide comfort to creditors in that the Court held that annualizing formulas can satisfy the requirements of Section 4.
(a) A formula can adequately express a yearly interest rate
Justice Sharpe’s reasons take into account the modern commercial reality in interpreting compliance with Section 4 by the use of the annualizing formula, which affirms long standing case law. He rejected Justice McEwen’s reasoning that formulas can be confusing and even misleading, by stating that this statement of the application judge is difficult to reconcile “with the case law accepting the use of formulas, many of which are more complex and yield less certain information than the one at issue in this case”.
Additionally, Justice Sharpe held that the Parliament of Canada used the words “an express statement of the yearly rate or percentage of interest to which the other rate or percentage is equivalent” in Section 4 in order to indicate that the effective annual interest need not necessarily be expressed as a numerical percentage but also can be expressed by a rate – i.e. a formula. The Court of Appeal held that an annualizing formula provides a rate for purposes of satisfying Section 4. He found that formulas are regularly used in complex loan agreements “to determine variable rates of interest based upon some standard external to the agreement such as the prime bank rate.” In analyzing the past case law where formulas tied to variable rates of interest external to the contract satisfy legislative provisions similar to Section 4, the Court of Appeal also found that to “hold otherwise could cause significant mischief in international commercial arrangements.”
It is worth noting that the Ontario Court of Appeal’s decision is consistent with the 1994 Supreme Court of Canada decision of Dunphy. In that decision, the Supreme Court of Canada confirmed that parties need not disclose the “effective” rate of interest in the relevant agreement in order to comply with Section 4 and that disclosure of the “nominal” rate is sufficient. In an earlier decision, the Supreme Court of Canada also held that there is no rule or principle of law that mandates the application of the deemed reinvestment principle; this principle is often invoked in support of the position that true disclosure of an interest rate would require a statement of the “effective” rate where a loan provides for interest payments at regular intervals until the maturity of the loan.
(b) Section 4 cannot be engaged when a lender only fails to provide information that is impossible to provide
The Ontario Court of Appeal rejected the application judge’s reasoning that Section 4 should be engaged since the annualizing formula did not account for the fact that the discount fee would compound if the loan was not paid at term and subsequently renewed. Justice Sharpe reasoned that the loan documents could not have set out an effective rate of interest reflecting the compounding of the discount fee, because the compounding of interest depends entirely on whether the borrower decides to repay or to ask the lender that the due date of the loan be extended. Therefore, it was impossible for the loan agreement to “state an equivalent rate or percentage of interest that took into account compounding of the discount fee” since the precise rate could not have been known. The Ontario Court of Appeal held that “[i]t cannot be the case that s. 4 is engaged when a lender fails to provide information that […] is impossible to provide.”
(c) Commercial reality is a key consideration in interpreting the Interest Act
In reaching its decision, the Ontario Court of Appeal reasoned that the consumer protection purpose of Section 4 must be properly balanced with the countervailing interpretive principles of fairness and the need to accommodate contemporary commercial practices.
The Ontario Court of Appeal held that the application judge’s remedy was not appropriate and would result in a “substantial windfall” to the borrower. The remedy had been to reduce the interest payable for the whole transaction to 5% because the promissory notes granted by Solar Power in connection with certain of its loans did not contain an annualizing formula and therefore did not comply with Section 4. Justice Sharpe acknowledged that ClearFlow and Solar Power were sophisticated parties and referred to Supreme Court of Canada judgments to state that the provisions of the Interest Act (Canada) should be interpreted “in keeping with common commercial practice” and “to-day’s commercial reality” when their language so permits. In doing so, he reasoned that it was appropriate that only the non-compliant rate be reduced to 5% in order to take into account the lender’s legitimate interests and expectations. In this case, since the non-compliant discount fee’s yearly rate of 1.095% was significantly less than 5%, no reduction would be necessary.
3. WHAT’S NEXT?
ClearFlow and Solar Power have until November 3, 2018 (60 days from September 4, 2018, the date of Justice Sharpe’s Ontario Court of Appeal decision) to seek leave to appeal to the Supreme Court of Canada. However, we anticipate it is unlikely that the Supreme Court of Canada will grant leave to appeal.
Until the appeal period has expired or if leave to appeal to the Supreme Court of Canada is granted and the Supreme Court of Canada has rendered a judgment on this case, it would be prudent for lenders to continue to supplement 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.
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