Under Interest Act Prohibition, is a Discount the Same as a Penalty?

In a case decided by the Supreme Court of Canada called Krayzel Corp. v. Equitable Trust Co., the issue was whether the provisions of the federal Interest Act were breached by a mortgage agreement that (unlike the usual scenario) did not impose a penalty in the event of a default, but rather allowed for a lower-interest discount if there was no default.

The Court’s ruling turned on the interpretation of section 8 of the Interest Act, which prohibits a lender under a mortgage agreement from imposing a “fine, a penalty or a rate of interest” that has the effect of creating a higher charge on arrears than what has been imposed on principal money not in arrears.

In this case, depending on whether the mortgage was in good standing or not, it was subject to two different rates of interest, which were known as the “interest rate” and the “pay rate”. The higher “interest rate” took effect only if the mortgagor defaulted, either by failing to pay out the loan upon maturity, or else by failing to make the regular set payments, which were calculated at the lower rate of interest, called the “pay rate”. Essentially, the option to pay the lower “pay rate” was a discount available to the borrower only so long as it was not in default, and served as an incentive for punctual payment.

With that conceptual dichotomy in mind, the Court considered the details of the particular transaction in issue. It involved the lender taking a mortgage against the borrower’s office building in exchange for a $27 million loan. The interest rate was agreed to be prime plus 2.875 percent per annum. When the borrower defaulted by failing to pay out the mortgage on maturity, the lender agreed to extend for seven months, but the amending/renewal agreement carried a higher rate of interest, namely prime plus 3.125 percent for the first six months, and 25 percent during the seventh month. Once again, on maturity the borrower went into default by failing to pay out.

The parties then entered into a second renewal/amending agreement. The second amending agreement bumped the interest rate even higher: it provided a per annum “interest rate” on the entire loan of 25 percent, and made that higher rate retroactive to a month before the first renewal agreement expired. Monthly payments were set at the “pay rate” of either 7.5 percent, or else prime plus 5.25 percent, whichever was greater. So the mortgage renewal agreement expressly provided for these two different rates, one being the much higher “interest rate”, and the other being the lower “pay rate” which was in force only if there was no default.

When the borrower defaulted a final time, the lender demanded repayment of the loan balance at the 25 percent “interest rate”. Naturally this prompted a dispute between the parties; after various rulings in the lower courts as to the validity of the renewal agreements in light of section 8 of the Interest Act, the matter came before the Supreme Court of Canada.

Against this background the Supreme Court of Canada therefore had to consider whether, for the specific purposes of interpreting section 8 of the Act, there was a difference between: (1) terms that impose a higher rate of interest after default as a penalty and (2) terms that reserve, by way of discount, a lower rate of interest if there is no default. The Court concluded that there was no distinction; the interest rates established by the mortgage agreements’ discount provisions offended section 8 and could not be insisted upon by the lender.

It was true that the express wording of the Interest Act set out only three different categories of charges: a “fine”, a “penalty”, and a “rate of interest”. Also – and aside from the blanket prohibition in section 8 – the Act’s other provisions allowed the parties a general right of freedom to contract for any rate of interest or discount they wished.

However, when looking at the overall goal of the Act, it was clear that section 8 must reasonably be considered to apply not only to penalties for non-performance, but also to incentives for performance in the form of “discounts.”

Historically, the legislative purpose behind section 8 was to protect landowners from charges that would make it impossible for them to redeem, or to protect their equity. That overarching purpose would not justify creating a distinction between a higher interest rate being imposed as a penalty for default, and a discounted interest rate for punctual payment. Under either scenario the net result would be to make it more difficult for borrowers already in default.

The Court observed that the key to understanding and applying section 8 was to look at the effect of the contentious terminology in any mortgage agreement. Regardless of whether the parties use misleading terms like “bonus”, “discount” or “benefit”, the validity of the provision is determined by its substance, not by its form. What matters is how the impugned mortgage term operates and the consequences that it produces, irrespective of the label or name that is used.

Looking merely at the second renewal agreement in this case, it purported to impose a 25 percent interest rate on arrears, as compared to the 7.5 percent interest on principal money not in arrears. This result fell within the wording of the section 8 prohibition.

That 25 percent rate was therefore void; instead, the Court set the interest as either 7.5 percent, or else prime plus 5.25 percent, whichever is higher.

See Krayzel Corp. v. Equitable Trust Co., 2016 (SCC).