The Crucial Distinction Between Carrots and Sticks: Incentives and Penalties in the Interpretation of the Interest Act
Do incentives for prompt payment in a mortgage, which would be lost on default, run afoul of the prohibition against penalties for non-performance contained in s.8 of the Interest Act? The Alberta Court of Appeal recently split over this question, with the majority saying no. This case could affect the structure of mortgages in Alberta, encouraging the use of "non-penal" devices to ensure performance that may be difficult to distinguish, in operation, from penalties.
This appeal considered whether two mortgage renewal agreements violated s.8 of the Interest Act. Section 8 applies specifically to mortgages on real property and hypothecs on immovables, and prohibits any "fine, penalty or rate of interest... that has the effect of increasing the charge on the arrears beyond the rate of interest payable on principal money not in arrears."
The appeal concerned two renewals of a $27 million mortgage. The first renewal charged interest at a rate of 3.125 per cent per annum, which increased to 25 per cent one month before maturity.
When the mortgagor did not repay, the parties entered into a second renewal. The second renewal provided that interest would be calculated at a rate of 25 per cent, but the difference between that and the "pay rate" of 7.5 per cent or prime plus 5.25 per cent would be added to the principal each month and ultimately forgiven if there was no default before maturity. The mortgagor defaulted before making any payments under the terms of the second renewal.
The Master declared that the first and second renewals violated s.8 of the Interest Act. On the mortgagee’s appeal to the Court of Queen’s Bench, Romaine J. found that the first renewal did not offend s.8 because the interest rate increased due to the passage of time, not on default. She also upheld the 25 per cent rate under the second renewal, because s.8 did not restrict the parties’ freedom to contract for that rate and did not prohibit discounts or incentives. She did find that a $556,000 renewal fee and $10,000 per month default administration fee offended s.8 because they were penalties that were only payable on default.
The mortgagors, guarantors and subsequent encumbrancers appealed.
The majority of the Alberta Court of Appeal agreed with Justice Romaine. Justice Berger, in his dissent, would have allowed the appeal because the "incentive" in the second renewal had the effect of increasing the rate payable on arrears and therefore offended s.8. His dissenting reasons are described further below.
All three justices of the Court of Appeal agreed that the first renewal did not offend the Interest Act, because the higher rate resulted from the passage of time (becoming effective one month before maturity) and not from default. They also agreed that the motives of the lender and the sophistication of the borrower are not relevant, and the Court should not consider whether there is a "legitimate commercial purpose" for the interest provisions.
The majority, Justices Hunt and Nation, held that the essence of the second renewal was an agreement for 25 per cent interest, with a discount to be applied to the principal if there was no default. They found that this arrangement did not come within the "literal prohibition" of s.8, which was "directed at penalties for non-performance, not at incentives for performance".
The majority felt bound by the Alberta Court of Appeal’s earlier decision in Dillingham. Dillingham held that s.8 implemented an earlier equitable rule against penalties for non-performance, rejecting an Ontario decision that held that Parliament intended to prohibit both "penal and non-penal" devices.
Justice Berger would have disallowed the 25 per cent interest on the second renewal, because that rate would only be payable in the event of default. He reasoned that if the mortgage remained in good standing, the interest rate would remain at the lower "pay rate", which would in effect be the "interest rate".
He therefore found that there was no true "incentive" for performance; rather, the effect was to impose a penalty for default. He further distinguished Dillingham on its facts, and concluded that "a forfeited discount that operates as a penalty runs afoul of s.8 of the Interest Act".
This decision is authority for a narrow reading of s.8 of the Interest Act. This suggests that, in Alberta, a carefully drafted mortgage agreement may contain incentives for prompt payment without offending s.8 of the Interest Act, even if the loss of those incentives on default could arguably be characterized as having the effect of increasing the charge on arrears.
Decision Date: July 22, 2014
Alberta Court of Appeal Interest Act mortgage renewal agreements Queen's Bench of Alberta