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Future Interest on Closed Mortgage Not a "Penalty"

In a recent ruling, the Ontario courts held that the future interest due on a closed mortgage is not considered a "penalty" for the purposes of s. 8 of the Interest Act.

The lender had first mortgages on two properties to secure loans of about $10.5 million. The mortgages were granted in 2007 and 2009, each with a term of 20 years. Importantly, they were closed mortgages offering no right of prepayment unless: (1) the mortgagor was not in default; and (2) there was a bona fide arm's-length sale of the property.

The mortgages went into default in 2017, when there was about 8 years left on their terms. In 2019 the properties were ordered sold by a court-appointed receiver. In light of that sale, the lender asked the court to declare it was entitled to be paid $1.5 million from the sale proceeds, as a pre-payment of future interest. The lender argued it was entitled to this amount – over and above the principal owing under the mortgage, plus arrears of interest – for the portion of future interest payments that would have been earned over the remaining 8 years on the charges, had they not been prematurely vested off title in the receiver's sale. The lender founded its claims on: (1) the terms of the mortgage itself; (2) the relevant commitment letters (incorporated by reference); and (3) the common law applicable to closed commercial mortgages discharged prior to their full term.

The court granted the lender's request. In light of the buyers' default, these closed commercial mortgages allowed for no prepayment privileges. They had been terminated prematurely and vested off title on the closing of the sale by the court-appointed receiver. The court found the lender's entitlement to future interest was indeed found in the mortgage documents, which called for interest to be paid over the mortgages' terms.

There were common law principles to support the lender's interest entitlement. First, the law is well-settled that a borrower cannot "open up" a closed mortgage by his or her own default, and no equity of redemption is afforded to a borrower in such circumstances. Nor were the mortgages opened up by the lender when it took steps to realize on its security.

Next, when a closed mortgage is redeemed prior to the end of its term, the borrower must pay not only the outstanding principal and accrued interest, but also the future interest to the end of the term. Such interest is payable even on a mortgage with no right of prepayment, if the lender has not resorted to enforcement of its security and has not triggered the borrower's right to redeem.

Finally, when a mortgage is vested off title, the lender will be entitled to amounts due under the mortgage – and in the case of a closed mortgage this will include future interest accrued to the end of the term. This arises from an implied contractual term, and need not be expressly set out in the mortgage terms.

In this scenario, the court concluded the future interest had not been forfeited; to the contrary, it became due. This was not a violation of public policy and it did not create an unfair preference in the lender's favour over the other creditors of the now-insolvent borrowers.

The court also rejected the argument that the payment of the future interest to the lender would offend s. 8 of the federal Interest Act, R.S.C. 1985, c. I-15. The lender was not seeking to add a penalty to the arrears of interest. Rather, it was seeking payment of capitalized future interest, calculated at the same rate that had been provided for in the mortgage, for the amounts not in arrears. There was no tenable general proposition that any future interest entitlement, the quantum of which exceeds arrears of interest, contravenes s. 8(1) of the Interest Act.

In the end, the court ordered that since the lender's mortgages were fully closed on the receivership sale date, the lender was entitled to nearly $1.5 million as a prepayment of future interest under them. The funds were paid out from those held in trust after the sale. See: First National Financial GP Corp. v. Golden Dragon HO 10 Inc., 2020 ONSC 6994.