Back to 'Commercial' Reality: Decision on Interest Disclosure under Section 4 of Interest Act is Successfully Appealed to the Relief of Lenders

In Solar Power Network Inc. v. ClearFlow Energy Finance Corp.,^[1] the Court of Appeal for Ontario recently held that the use of formulas to express annual interest rates satisfies the interest disclosure requirements under section 4 of the Interest Act (Canada).^[2] This decision reflects common commercial practice in an environment that had been temporarily tainted with uncertainty following the unexpected (and now, successfully appealed) decision of the lower court.

Background: Section 4 of the Interest Act

Section 4 of the Interest Act requires that any written agreement for the payment of interest "at a rate or percentage per day, week, month, or […] any period less than [one] year" contain "an express statement of the yearly rate or percentage of interest to which the other rate or percentage is equivalent."

If an agreement fails to satisfy this requirement, section 4 of the Interest Act provides "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."

Annualizing Formula: 'Confusing and even misleading'^[3]

The decision of the Superior Court of Justice,^[4] made earlier this year, applied section 4 of the Interest Act to 'cap' all of the interest payable under a number loans to just 5% per annum despite the parties contractually agreeing to base interest rates of 12% and 24%. This remedy was made available to the court after finding that the annualizing formula contained in a loan agreement made between the borrower, Solar Power Network Inc. ("Solar") and the lender, ClearFlow Energy Finance Corp. ("ClearFlow") failed to satisfy the requirement under section 4 of the Interest Act.

Provisions in the loan agreement requiring the borrower to pay "administration fees" and "discount fees" attracted the section 4 analysis. These particular fees, the borrower argued, were not truly fees but rather charges that should be characterized as interest. After distinguishing between the two types of fees, the court held that only the daily discount fee of 0.003% on the outstanding principal constituted interest within the meaning of the Interest Act which in turn, invoked the application of section 4.

Annualizing Formula: 'Common sense, commercial reality'^[5]

On appeal, ClearFlow argued that the "discount fee" was not interest and in any event, the loan agreement contained an annualizing formula that satisfied section 4 of the Interest Act. Furthermore, ClearFlow reasoned that Solar entered forbearance agreements acknowledging its indebtedness to ClearFlow, and therefore could not now dispute the interest owing. In the alternative, ClearFlow argued the appropriate remedy was to limit the application of section 4 to the discount fee rather than reduce the interest payable on all of the outstanding loans to 5%.^[6]

The Court of Appeal, in reasons written by Justice Sharpe, held that the application judge did not err in characterization of the fees, but did err by (1) finding that the discount fee contravened the Interest Act and (2) holding that all interest payable under the loan agreement should be limited to 5%.^[7]

In finding that the discount fee did not contravene the Interest Act, Justice Sharpe held that "s. 4 must be interpreted in the light of modern commercial reality."^[8] In support of this notion, the court contended that both the case law and commercial practice affirmed the validity of using an annualizing formula as a means for complying with section 4. To hold otherwise, Justice Sharpe argued, "could cause significant mischief in international commercial arrangements."^[9]

The analysis also considered the language of section 4 which requires "an equivalent "rate or percentage" (emphasis added) instead of just employing the word "percentage."^[10] The binary nature of the phrase, Justice Sharpe reasoned, suggested that Parliament used language to indicate that the effective annual interest was not required to be expressed as a numerical percentage for the purposes of section 4 but could instead be expressed in an alternate manner (e.g. by way of a formula).

Further, and in contrast to the conclusion of the application judge, Justice Sharpe held that for the case at bar, an equivalent "nominal" rate provided through the annualizing formula "was sufficient for the purposes of s. 4."^[11] Unlike an "effective" equivalent rate, a "nominal" rate does not take compounding into account. Indeed, the fact that the discount fee would be added to the principal on the due date and compound only if the loan were unpaid at that time made it impossible for the parties to determine if the discount fee would ever be compounded.

The Court of Appeal adopted an interpretive approach "more in line with modern commercial reality and the expectations of the parties" in departing from the application judge's use of the section 4 remedy to limit interest to 5% per annum. The issue of that remedy arose in relation to promissory notes that contained discount fee provisions much like those contained in the loan agreement, except that the promissory notes did not include the annualizing formula and they therefore, failed to satisfy the requirement under section 4. In using the section 4 remedy, Justice Sharpe agreed that the limitation of interest to 5% per annum should be restricted to the discount fee on the promissory note loans (e.g. the non-compliant interest provision) as opposed to reducing the interest payable on all loans advanced by ClearFlow.

Conclusion

ClearFlow's successful appeal should be a welcome relief to lenders following the uncertainty that resulted from the earlier decision of the Superior Court of Justice. Going forward, lenders should continue to exercise caution by ensuring that the formulas used to express annual interest rates are clearly set out in the underlying loan agreements and furthermore, that the borrower has a clear understanding of the interest payable under those  agreements.