In a recent decision of the Alberta Court of Appeal in Lougheed Block1, the Court considered the question of whether incentives for prompt payment in a mortgage agreement, which would be lost upon default, offend the prohibition on penalties for non-performance contained in section 8 of the federal Interest Act.2
Section 8 codifies a long-standing equitable principle and prohibits a fine, penalty or rate of interest “on any arrears of principal or 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 provision prohibits penalties for non-performance on loans secured by mortgages of real property.
The case involved two agreements for the renewal of a $27 million mortgage. The mortgage originally had an interest rate of prime plus 2.875% and provided for a monthly $10,000 administration fee if the borrower defaulted. The parties entered into the first renewal agreement, which specified an interest rate of prime plus 3.125%, with the interest rate to increase to 25% one month before maturity. It also included the same monthly $10,000 administration fee if the mortgage went into default. When the borrower defaulted, the parties entered into a second renewal agreement. The second renewal specified an interest rate of 25%, but the difference between that rate and the “pay rate” of the greater of (i) 7.5%, and (ii) prime plus 5.25%, would be added to the principal each month and ultimately forgiven if there was no default before maturity. The borrower defaulted again before making any payments under the terms of the second renewal.
Master Hanebury found that both the first and second renewals and the monthly $10,000 administration fee breached section 8 of the Interest Act. On appeal by the lender, Justice Romaine of the Court of Queen’s Bench found that the first renewal did not offend section 8 because the increased interest rate was triggered by the passage of time, rather than upon default. She also upheld the second renewal agreement, finding that the parties were free to contract for the 25% interest rate and the Interest Act did not prohibit incentives or discounts for performance. She agreed, however, with the Master’s earlier determination that the administration fee was a penalty and was unenforceable.
On appeal by the borrower, the guarantors and the subsequent encumbrancers, the three-member panel of the Alberta Court of Appeal concurred that the first mortgage renewal did not offend the Interest Act. They unanimously agreed with Justice Romaine that the higher rate of interest took effect due to the passage of time, not upon default. They also all noted that the motives of the lender and the sophistication of the borrower are not relevant considerations. In their view, the “legitimate commercial purpose test” applied in previous decisions was unhelpful because it could give rise to commercial uncertainty and lead to arbitrary application. In relation to the second mortgage renewal, the Court was split: Justices Hunt and Nation found that it was essentially an agreement for 25% interest, with a discount to be applied to the principal if there was no default. This did not fall within the literal and narrow meaning of s. 8, which prohibits “penalties for non-performance”, not incentives for performance. In dissent, Justice Berger noted that if the mortgage remained in good standing, the “pay rate” and the “interest rate” were effectively the same. Therefore, in his view the effect of the agreement was not a true incentive but rather “has all the earmarks of a penalty”.
The Lougheed Block decision appears to diverge somewhat from authorities in British Columbia and Ontario which suggest section 8 prohibits both penal and non-penal incentives. However, the decision suggests that, at least for the time being in Alberta, mortgage agreements may contain provisions for increased interest rates triggered by the passage of time or incentives for prompt payment without offending section 8 of the Interest Act, even if the effect is to increase the charge on arrears.
Each of the subsequent encumbrancers recently filed applications for leave to appeal the Lougheed Block decision to the Supreme Court of Canada, so there may be a further chapter in this dispute and a resolution of the provincial differences.
1 Equitable Trust Co. v. Lougheed Block Inc., 2014 ABCA 234. [Lougheed Block]