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Rate hike on mortgage in arrears slapped down by Supreme Court

Thursday, May 19, 2016 @ 8:00 PM | By Cristin Schmitz

The Supreme Court has put teeth into the federal Interest Act’s s. 8 prohibition against hiking mortgage interest when borrowers fall into arrears.

On May 6 the top court split 6-3 to declare void a 25 per cent interest rate charged by respondent Equitable Trust Co. (now Equitable Bank) on the arrears of a $27 million mortgage on a Calgary office building whose owner, Lougheed Block Inc., defaulted in 2009: Krayzel Corp. v. Equitable Trust Co. 2016 SCC 18.

The majority allowed the appeal of two individuals and two companies who gave loan guarantees under which the guarantors would otherwise have been required to pay several million dollars to respondent Equitable, as well as the appeal of Krayzel Corporation, the holder of a second mortgage. That company now anticipates getting more than $1 million from the proceeds of sale from the property (instead of getting nothing had the Supreme Court upheld the Alberta Court of Appeal below).

Appellants’ counsel, G. Scott Watson of Calgary’s Parlee McLaws, said Justice Russell Brown’s judgment — the former Alberta Court of Appeal judge’s first written majority opinion since joining the top court last August — is of particular note to the commercial real estate and insolvency bars.

Watson said the majority adopted a liberal, flexible and purposive interpretation of s. 8 of the federal Interest Act — which precludes a mortgagee from imposing terms that have the effect of charging a higher rate of interest on money in arrears than that charged on principal money that is not in arrears.

“Section 8 has had some new life breathed into it, or has been rejuvenated in its application,” Watson told The Lawyers Weekly.

He advised lenders, borrowers and receivers to examine the interest rate terms in their mortgage security “with some care” — focusing on the terms’ substance and effects, not their labels.

“Call it a ‘bonus.’ Call it a ‘discount.’ It doesn’t make any difference if it has an effect…that offends s. 8,” he stressed. He predicted “a resurgence of focus” on the section, which applies to both commercial and residential mortgages.

Watson said the court has made it clear that in mortgage agreements, or mortgage renewals, interest rate increases triggered solely by the passage of time (rather than default) can survive s. 8 scrutiny, while those triggered by non-payment won’t.

“A proper interpretation of s.8 requires a purposive and substantive interpretation of the potentially offending interest provision and in a case where it’s a discount or a penalty…if the interest charged on arrears is greater than interest charged on principal not in arrears, it offends s. 8,” Watson explained.

Justice Brown stipulated that the purpose of the somewhat murky provision first enacted in 1880 is to protect landowners from interest or other charges that would make it impossible for them to redeem, or protect, their equity in the property.

The case required the court to decide, for the first time, whether s. 8 is offended by mortgage terms imposing a higher “interest rate” that takes effect only where the mortgagor falls into default by failing to make prescribed payments at a lower “pay rate” of interest, or by failing to pay out the loan upon maturity.

Under the terms of a second mortgage renewal, the defaulting building owner, Lougheed, which had borrowed $27 million, and its loan guarantors, were faced with paying a 25 per cent interest rate when the mortgage went into arrears, as compared to the interest the mortgage renewal imposed on the principal money when it was not in arrears (the greater of 7.5 per cent or the prime interest rate plus 5.25 per cent).

Equitable argued that that its mortgage simply gave the borrower — for paying punctually — a “discount” from the higher interest rate that otherwise applied. This did not amount to a penalty or otherwise offend s. 8.

But the Supreme Court’s majority accepted the appellants’ argument that what counts for s. 8 purposes is not how a mortgage provision is labelled — but how it operates and its consequences.

“Substance, not form, is to prevail,” Justice Brown emphasized. “If its effect is to impose a higher rate on arrears than on money not in arrears, then s. 8 is offended,” he held for the majority. “A rate increase triggered by default does infringe s. 8, irrespective of whether the impugned term is cast as imposing a higher rate penalizing default, or as allowing a lower rate by way of a reward for the absence of default.”

On the other disputed point of law in the appeal, the court ruled 9-0 that s. 8 is not infringed by a rate increase that is triggered by the passage of time only (as opposed to by default).

Therefore the first mortgage renewal agreed to by Lougheed — which charged the prime interest rate plus 3.125 per cent over the first six months and then 25 per cent in the seventh month, did not offend s. 8.

However, Justice Brown held that the 25 per cent annual interest rate set under the second mortgage renewal was void and that the applicable rate under the agreement should be set at the higher of 7.5 per cent or the prime interest rate as of Feb. 1, 2009, plus 5.25 per cent.

“Had Parliament intended to prohibit only penalties (and not discounts), it would not have included a ‘fine’ or a ‘rate of interest,’ in addition to a ‘penalty,’ as a type of charge that might also be prohibited” by s. 8, Justice Brown reasoned. “Further, by directing the inquiry to the effect of the impugned mortgage term, Parliament clearly intended that mortgage terms guised as a ‘bonus,’ ‘discount’ or ‘benefit’ would not as such comply with s. 8…. What counts is how the impugned term operates, and the consequences it produces, irrespective of the label used. If its effect is to impose a higher rate on arrears than on money not in arrears, then s. 8 is offended.”

Dissenting Justices Rosalie Abella, Michael Moldaver and Suzanne Côté said s. 8, as an exception from the foundational general rule of freedom to contract, should be construed narrowly. They viewed the “rate of interest payable on principal money not in arrears” under Lougheed’s second mortgage renewal agreement to actually be 25 per cent — which meant that the second renewal did not have the “effect” of increasing the charge on arrears, which means that s. 8 is not engaged. Moreover, s. 8 does not prohibit a “forgiving discount” — that is, a discount which provides the borrower with some relief from a rate of interest that is chargeable under an agreement, they said.

Counsel for Equitable Bank, Francis Price of Edmonton’s Reynolds Mirth Richards & Farmer, could not be reached for comment at press time.