The Ontario Superior Court of Justice (the “Court”) recently handed down the only Canadian decision to date considering nominal annual rate conversion formulas in Solar Power Network Inc. v. ClearFlow Energy Finance Corp., 2018 ONSC 7286 (“Solar Power”). Solar Power Network Inc. and its affiliated companies (collectively, “SPN”) are renewable energy companies that specialize in installing solar panels on commercial, institutional and industrial rooftops. ClearFlow Energy Finance Corp. (“ClearFlow”), a project finance company that provides financing to the solar energy and clean technology sector, became SPN’s major lender in mid-2015. SPN and ClearFlow entered into a number of loan agreements (the collectively, the “Loan Documents”), the primary of which was a lending agreement that provided for construction loans and warehouse loans from ClearFlow to SPN (the “Loan Agreement”).
Each of the Loan Documents contained three key features: (1) a base interest rate typically at the rate of 12% per annum compounded and calculated monthly (the “Base Interest Rate”); (2) an administration fee that was charged when the loan was initially advanced, and if it was not paid off, again each time it renewed (the “Administration Fee”); and (3) a discount fee of 0.003% of the outstanding principal of the loan, calculated on a daily basis for every day that the loan was outstanding (the “Discount Fee”). The Loan Agreement also contained a “formula” for converting non-annualized fees, interest rates, and other amounts in the Loan Documents into annualized terms.
Shortly after the commencement of their relationship, SPN began to default on its payments to ClearFlow. SPN argued that this was a result of an inability on its part to adequately calculate the amounts owing to ClearFlow, whereas ClearFlow maintained that SPN’s payment delinquencies were simply a result of poor business planning. SPN applied to the Ontario courts for a declaration that the fees were in fact interest rates, the fees were not stated in annualized terms, and ClearFlow was therefore limited under Section 4 of the federal Interest Act, RSC 1985, c I-15 (the Act) to collecting no more than 5% off the outstanding principal sum under the Loan Documents.
Issues before the Court
The issues to be decided were the following:
- Are the Administration Fees and Discount Fees really fees, or are they properly characterized as interest within the meaning of the Act?
- If both or either of these fees are considered interest, should any or all of the interest be reduced to 5% in accordance with Section 4 of the Act?
The Court held that the Administration Fee was a fee, but the Discount Fee was in fact an interest rate. Further, not only was the Discount Fee made payable at a rate less than a year, but also the “formula” provided in the Loan Agreement did not contain an express statement of the yearly rate or percentage of interest to which the Discount Fee was equivalent. As a result, Section 4 of the Act was contravened and therefore the total interest that ClearFlow could legally collect on all the Loan Documents was 5%.
1 Are the Administration Fees and Discount Fees fees or interest rates within the meaning of the Act?
The Court accepted SPN’s submission that there are three essential elements to an interest rate:
- Interest is the return or consideration or compensation for the use or retention of money that is owed to another person;
- Interest must relate to a principal amount or an obligation to pay money; and
- Interest must accrue over time: Saskatchewan.
It was clear to the Court that the Base Interest Rate was both an interest rate and in compliance with the Act, as it was expressed on an annualized basis. However, there was some uncertainty regarding the Administration Fee and the Discount Fee.
The Court found that the Administration Fee was not an interest rate as it clearly accounted for specific administrative tasks for the creditor and it was a one-time charge that did not necessarily accrue over time. However, the Court held that Discount Fee did meet the criteria for an interest rate listed above. The Discount Fee (a) was consideration or compensation for the use or retention of money owed to ClearFlow, (b) related to the principal amount, and (c) accrued over time (literally day-to-day). The Court also distinguished the Discount Fee from the Administrative Fee on the following grounds:
- Unlike the Administration Fee, the Discount Fee was not linked to the creation of a new Loan Document or a renewal.
- Unlike the Administration Fee, which would vary depending on the risk and resulting work undertaken by ClearFlow, the Discount Fee was the same for all types of Loan Documents.
- Unlike the Administration Fee, which was charged at the outset or upon renewal, the Discount Fee was calculated daily on a fixed rate.
- The day-to-day accrual of the Discount Fee was more suggestive of interest than that of a fee. It was not tied to a specific event. It simply flowed, day-to-day, seemingly unrelated to any ongoing, specific events.
2 Legal effect of finding that the Discount Fee constitutes interest
(a) Does the Act apply?
After establishing that the Discount Fee was in fact an interest rate, the Court then asked whether the Act applied to this interest rate, which the Court answered in the affirmative. ClearFlow made three arguments to the contrary, each of which the Court dismissed. Firstly, SPN obtained two legal opinions which favoured ClearFlow’s position. Secondly, ClearFlow argued that the formula provided in the Loan Agreement allowed for SPN to calculate the annual rate of interest for both the Discount Fee and the Administration Fee, thus satisfying Section 4 of the Act. Thirdly, ClearFlow and SPN entered into several forbearance agreements that, ClearFlow argued, precluded SPN from relying on Section 4 of the Act.
The Court quickly dismissed ClearFlow’s first argument that its position was supported by two legal opinions obtained by SPN from its legal counsel confirming the enforceability of the Loan Documents, as each opinion included a qualification stating that the enforceability of the Loan Documents may be limited by laws affecting creditors’ right generally. ClearFlow argued that the two legal opinions demonstrated that SPN knew the fees were in fact fees and not interest rates. However, the Court found that Section 4 of the Act was included under the umbrella of “laws affecting creditors’ rights generally”, and thus formed part of the qualification.
The Court also rejected ClearFlow’s second argument that the formula in the Loan Agreement allowed for the calculation of an annual interest rate, holding that the formula in the Loan Agreement did not comply with Section 4 of the Act by providing an “equivalent” annual rate of interest.
Section 4 of the Act essentially provides that, if any interest rate is payable at a rate for any period less than one year, the maximum rate payable on the principle sum is 5% unless the agreement provides an express statement of the annual rate to which the other rate is equivalent. The full text of the provision is as follows:
When per annum rate not stipulated
4 Except as to mortgages on real property or hypothecs on immovables, whenever any interest is, by the terms of any written or printed contract, whether under seal or not, made payable at a rate or percentage per day, week, month, or at any rate or percentage for any period less than a year, 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 unless the contract contains an express statement of the yearly rate or percentage of interest to which the other rate or percentage is equivalent. [Emphasis added.]
ClearFlow submitted that the requirement to provide an “express statement of the yearly rate or percentage of interest to which the other rate or percentage is equivalent” was satisfied by the following formula in the Loan Agreement:
1.2 Interest and Fee Calculations, Maximum Interest Rate
a) Unless otherwise stated, in this Agreement if reference is made to a rate of interest, discount rate, fee or other amount “per annum” or a similar expression is used, such interest, fee or other amount shall be calculated on the basis of a year of 365 or 366 days, as the case may be. If the amount of any interest, fee or other amount is determined or expressed on the basis of a period of less than one year of 365 or 366 days, as the case may be, the equivalent yearly rate is equal to the rate so determined or expressed, divided by the number of days in the said period, and multiplied by the actual number of days in that calendar year.
ClearFlow argued that, given this formula, SPN simply had to multiply 0.003% by 365 or 366 days in order to obtain the annualized rate for the Discount Fee (i.e., 1.095%).
The Court disagreed and found that the formula did not satisfy Section 4 of the Act because it did not provide an equivalent annual interest rate. Canadian case law accepts that there are two methods of expressing an equivalent annual interest rate of the type referenced in Section 4 of the Act: the “nominal interest rate” and the “effective annual interest rate”. A nominal interest rate is expressed simply by multiplying a monthly interest rate by the number of compounding periods (e.g., 2% per month multiplied by 12 months is the “equivalent” to 24% per annum). An effective annual interest rate, on the other hand, factors in the effect that compounding has on the overall interest rate (e.g., 2% per month, when factoring in yearly compounding, is “equivalent” to 26.8% per annum). The Court stated that the nature of the Discount Fee, which was understood by both SNP and ClearFlow, required that an effective annual rate be disclosed. The Court held that, despite ClearFlow’s objections, the Discount Fee was not easily calculable simply by multiplying 0.003% into an annualized rate, as “[t]he actual interest rate pursuant to the Discount Fee could be dependent on a number of compounding periods of interest since interest on the Discount Fee is compounded each time the loan rolled-over”. Moreover, the “statutory requirement for an express statement is designed to avoid the exact type of mischief that can occur when rates are not annualized and the borrower, therefore, does not have a clear understanding of its obligation to pay interest. A formula does not necessarily allow for this clear understanding to occur”. In essence, the Court based its determination that the formula failed to disclose an equivalent annual rate of the Discount Fee not on the structure of the formula itself but rather SPN’s level of confusion in using it. The Court cited the fact that SPN claimed it could not understand its interest obligations and that confusion over interest calculations arose in coming to its conclusion. The Court also did not hold SPN to any explicit standard of reasonableness in its use of the formula.
Regarding ClearFlow’s final argument that SPN was precluded from challenging the rates and fees under the Loan Documents due to several forbearance agreements between the parties, the Court held that this interpretation of the agreements could not withstand scrutiny. Shortly after entering into the Loan Documents, ClearFlow and SPN entered into several forbearance agreements, one of which stated the following:
The Indebtedness, together with interest accrued and accuring thereon, and fees, costs, expenses and other charges now or hereafter payable by [SPN] to [ClearFlow] are unconditionally owing by [SPN] to [ClearFlow], without offset, defence or counterclaim of any kind, nature or description whatsoever. [Emphasis added.]
A subsequent forbearance agreement, which replaced the earlier versions of this agreement, included an almost identical clause, but added the words “except as may otherwise be required by law” to the end. In the Court’s view, this “exception” language was sufficient to allow SPN to challenge the interest amounts in the Loan Documents. Interestingly, the Court seemed to imply with this conclusion that parties may contract out of application of the Act.
(b) Are all interest charges reduced to 5%?
The Court held that the plain language of Section 4 of the Act mandates that if any interest rate in a contract contravenes Section 4 of the Act, then all of the interest payable must be capped at 5%. The Court stated that if the 5% limit was only applied to offending interest rates, it would have no practical application in situations where the offending rate is already less than 5%. Further, it would allow the lender to easily include a series of non-annualized rates in a loan arrangement to obscure the total annual interest rate.
Despite ClearFlow’s protests, the Court also held that borrower sophistication would not act to uphold the parties’ bargain in this case. The Court stated that Canadian case law has repeatedly recognized that Section 4 of the Act should be applied equally to sophisticated and unsophisticated parties.
Finally, the Court acknowledged the “draconian” result of its decision but emphasized that the strict enforcement of the Act is in keeping with its consumer protection purpose. The Act, the Court said, is designed to preclude lenders from arguing that only the offending rates should be capped while other non-offending rates remain. The result would also prevent the types of mischief that can occur when multiple loans are taken out, some with annualized rates and some without, leading at times to complicated and potentially deceitful or misleading business practices.
Takeaways and Reactions
Solar Power provides several clarifying points. Referring to some type of charge in a contract as a fee will not preclude a court from finding that it is in fact an interest rate, and thus possibly subject to the Act. The Court also suggested that parties may opt out of application of the Act to their contracts. Perhaps most importantly, Solar Power makes it clear that if any interest rate – whether or not referred to as such in the agreement – is payable at rate of less than one year and no equivalent rate is provided, the maximum interest the lender will be able to collect on the loan is 5%.
The case also leaves several questions open. Firstly, while the Court indicates that borrower sophistication plays no part in determining whether the Act applies to a borrower’s loan, other cases have implied the opposite. For example, in Strother v. Darc, 2016 BCCA 297, two parties entered into a promissory note which called for a rate of 5.5% interest, without stating the period over which this rate would apply. The British Columbia Court of Appeal (BCCA) held that the trial judge was entitled to find that it was the lender’s intention for the rate to be 5.5% per annum in light of the circumstances of the case, which included the commercial sophistication of the parties. As a result, the BCCA upheld the trial court’s decision that Section 4 of the Act did not apply. The Court in Solar Power also failed to delineate exactly why the formula provided in the Loan Agreement was insufficient to provide an express statement of the equivalent annual rate of the Discount Fee such that lenders could know what features of this formula to avoid using in the future. The Court seemed to base its decision simply on the borrower’s confusion in using the formula, without scrutinizing the features of the formula itself or SPN’s reasonableness when using it. Further, the Court provides no indication that any formula would satisfy Section 4 of the Act in lieu of providing an express statement of the annual rate of interest, simply stating that a formula does not necessarily allow a borrower to have a clear understanding of its obligation to pay interest. This is obviously a problem for loan agreements that involve variable or floating interest rates and may even result in a chilling effect between lenders and borrowers.
Since the decision in Solar Power was handed down, legal publications have suggested many approaches to dealing with the uncertainty it has caused. Some suggest that, while Section 4 refers to the disclosure being “contained” in the loan agreement, disclosure incorporated by reference may be acceptable. For example, Section 4 of the Act could perhaps be satisfied if a borrower were able to consult a website where the lender posts updates of the current effective rates payable by the borrower, or if the lender were to provide such updates on request from the borrower. Another suggestion is for a lender to obtain a representation and warranty from the debtor, if a conversion formula is the only feasible option for disclosing the equivalent annual rate, that (a) the borrower is a sophisticated commercial entity that understands and is comfortable using the conversion formula contained in the documentation and (b) the conversion formula satisfies the disclosure requirements stipulated in Section 4 of the Act.
The most definite takeaway from Solar Power is that the decision has resulted in significant confusion among the legal and business communities and will continue to do so until the issues in the case are ultimately resolved on appeal.