Loss of incentives for performance held to offend section 8 of the Interest Act: Supreme Court of Canada

In two earlier editions of Fully Secured (March 2015 and September 2015; Volume 6, Nos. 1 and 3)¹, we reported on the lower court and Alberta Court of Appeal decisions in the Loughheed Block, Krayzel and Equitable Trust mortgage litigation². Those decisions involved the interpretation of Section 8 of the federal Interest Act³ and its application to the interest terms of two real estate mortgage renewal agreements.

Section 8 is well-known in the lending community for its prohibition on fines, penalties and interest rates being imposed upon any arrears of principal or interest secured by a mortgage on real property that have the effect of increasing the charge on the arrears beyond the rate or interest payable on principal money not in arrears. 

After a split decision at the Alberta Court of Appeal level, Krayzel⁴ made its way to the Supreme Court of Canada.  The Supreme Court focussed its decision on the Second Renewal Agreement which contained provisions that set an initial interest rate of 25%, but only required Lougheed to make monthly interest payments at a lower “pay rate” equal to the greater of either 7.5 % or at the prime rate plus 5.25%.  These provisions also prescribed that the difference between the amount of interest payable at the 25% rate and the lower pay rate would accrue on the loan, but if there were no default by Lougheed, that accrued interest would be forgiven.⁵  Thus the benefit or performance incentive represented by the lower “pay rate of interest” was lost upon a default and the original 25% interest rate would prevail in that instance.  

In another split decision, the Supreme Court of Canada determined that Section 8 of the Interest Act applies equally to mortgage terms imposing by way of penalty a higher interest rate in the event of default, and those mortgage terms reserving by way of discount a lower rate of interest in the event of no default.⁶  In drawing upon the general principles of construction outlined in Section 2 of the Interest Act, the majority of the Supreme Court concluded that even though the word “discount” is not mentioned in Section 8, that section applies both to discounts (incentives for performance) as well as penalties for non-performance whenever their effect is to increase the charge on the arrears beyond the rate of interest payable on principal money not in arrears.⁷  The majority’s interpretation could be seen as the equivalent of applying a “directly or indirectly” construction to the operative words.

Section 8 has always represented a formidable challenge for mortgage lenders looking to craft alternative interest rate terms for specialized commercial transactions.  The Supreme Court of Canada’s decision in Krayzel has now added a new element to keep in mind throughout that process.