On November 25, 2022, Ontario’s Court of Appeal released a notable decision relating to the criminal interest provisions of the Criminal Code that may have caught lawyers and business people by surprise. It deals with two very important aspects of the criminal interest prohibition:
- The substance over form approach courts are to take in determining whether an agreement is caught by s. 347 of the Criminal Code which defines and prohibits a criminal rate of interest; and
- The efficacy and import of including a “maximum permitted rate” clause in an agreement.
Hybrid Financial Ltd. v. Flow Capital Corp concerned an agreement between Flow Capital Corp. (“Flow”), which provided growth capital for companies in North America and the United Kingdom, and Hybrid Financial Ltd. (“Hybrid”), which carried on business as a sales and distribution company involved in the provision of capital market services, investor relations, asset management and shareholder services and thereby was in possession of certain royalty streams from some of its investments. Flow agreed to provide financing to Hybrid to assist it in retiring its debt to a bank, and it was the terms of the agreement between the parties, in particular a “buyout” provision, that became the subject matter of proceedings as a result of which application of the provisions of s. 347 of the Criminal Code caused Flow to lose much of the benefit it had hoped to achieve in the transaction.
The financing agreement in issue
Under an Amended and Restated Royalty Purchase Agreement dated August 10, 2017, (the “Agreement”), Flow agreed to provide Hybrid with CA$750,000, payable in two installments. In exchange, Flow acquired the right to receive monthly “royalty” payments in an amount based on Hybrid’s revenues, subject to a buyout exercisable by Hybrid once it had made royalty payments totalling at least CA$750,000 (the “buyout option”). Upon exercise of the buyout option, Hybrid was required to pay the greater of CA$1,500,000 or 5% of its net equity value. Otherwise, Hybrid was to make the stipulated royalty payments in perpetuity. There was no fixed dated for repayment by Hybrid of the CA$750,000, but there was an acceleration clause which required Hybrid, at Flow’s option, to repay the amount advanced and any outstanding royalty payments upon the occurrence of an “Event of Default” or “Bankruptcy Occurrence” as defined in the Agreement.
In June 2020, Hybrid gave notice of its exercise of the buyout option. By that time Hybrid had paid an aggregate of CA$828,205.34 in monthly royalty payments, thus satisfying the condition precedent to the exercise of the option. Initially, Hybrid offered to buy out the royalties by paying CA$1,500,000 over three years. Flow rejected this offer, stating that the payment was to be made as a lump sum. The parties could not agree on a means of resolving the dispute, so that, under the terms of the Agreement, it remained in force. Beginning in July 2020, Hybrid ceased to provide the required financial disclosure to Flow with the result that Flow could not calculate the amount of monthly royalty payments due. In response, Flow reverted to sending invoices for the fall back minimum monthly amounts, without prejudice to its right to claim any outstanding balance that might be due under the Agreement’s net equity valuation formula. Hybrid made the minimum monthly royalty payments (albeit late) from June to October 2020, and ceased paying anything at all as of November 2020. The specified accounting firm which had been jointly retained by the parties to conduct a valuation of Hybrid’s net equity delivered a draft valuation report which estimated Hybrid’s net equity value to be approximately CA$75,500,000. Using the 5% figure stipulated in the Agreement, the purchase price of the royalties under the buyout clause would be CA$3,775,000. Hybrid disputed this valuation and claimed that the net equity value of the company was under CA$30,000,000, thereby justifying its offer of CA$1,500,000 under the buyout clause.
Section 347 Criminal Code issues
On November 26, 2020, for the first time, Hybrid asserted that the Agreement violated s. 347 of the Criminal Code. In addition, it refused to provide the requested comments to the accounting firm on its draft report, and then instructed the firm not to complete the net equity valuation report. The accounting firm advised that it could not finalize its valuation without Hybrid’s comments. Thereafter, the parties were at a standstill.
Hybrid then brought an application seeking a declaration that the financial formula stipulated in the Agreement provided for interest which was a criminal rate under s. 347 (i.e., in excess of 60%). Flow brought a cross-application seeking a declaration that Hybrid was in default under the Agreement and requiring Hybrid to pay the buyout amount.
Under the statute, it is an offence to both enter into an agreement or arrangement to receive interest at a criminal rate, and to receive a payment or partial payment of interest at a criminal rate. A “criminal rate” means an effective annual rate of interest which exceeds 60%, and the term “interest” is broadly defined to include all manner of charges and expenses paid or payable for the advancing of “credit” (with some specified exceptions), while “credit advanced” means “the aggregate of the money and the monetary value of any goods, services or benefits actually advanced or to be advanced under an agreement or arrangement minus the aggregate of any required deposit balance and any fee, fine, penalty, commission or other similar charge or expense incurred under the original or any collateral agreement or arrangement.”
Loan agreement or equity investment?
The application judge found that the Agreement was a “hybrid agreement” which lacked most of the benchmarks of a loan and was more akin to an equity investment than a credit arrangement. Accordingly, the CA$750,000 was not “credit advanced” for the purposes of the Criminal Code provisions, and neither were the payments made under the Agreement “interest” because they were not sufficiently fixed or readily calculable.
Lastly, the application judge held that even if the Agreement was captured by the Criminal Code provisions, Hybrid had voluntarily triggered the alleged criminal rate when it sought to exercise the buyout option which, under the case law, meant the payment was outside the scope of s. 347. She dismissed Hybrid’s application and granted the relief sought by Flow.
Court of Appeal reverses – s. 347 is applicable
On appeal, the Court of Appeal reversed the decision of the application judge, holding that she made errors of law in failing to consider the substance of the Agreement, as opposed to its form, and in failing to give effect to the specific contractual provision which dealt with the possibility that the amounts to be paid by Hybrid might result in a rate prohibited by s. 347.
1. Substance of the transaction prevails over form in determining whether there is an advance of credit
As was noted by the Supreme Court of Canada in Garland v. Consumers Gas Co., the interpretation of “interest” mandated by s. 347 “may not follow intuitively from the concepts of ‘credit’ and ‘interest’ as those terms are employed at common law and in everyday life”. The Court of Appeal held that stripped to its essence, the substance of the transaction here was that Flow advanced money to Hybrid and Hybrid was required to pay money in return. The money that Hybrid had to pay was an expense incurred for the advance of credit which was therefore subject to the strictures of s. 347. The application judge erred in limiting her inquiry to whether the Agreement contained provisions with watertight compartments consistent with debt or credit transactions, as opposed to those amounting to equity investments, so that she lost sight of the breadth of the statutory language.
The Court of Appeal further found that the application judge erred when she concluded that the repayment mechanism in the Agreement lacked the features of “interest”. Flow asserted that the buyout payment was not “interest” because only payments of a fixed amount can qualify as interest, so that where quantifying a payment requires a valuation subject to different opinions, that payment cannot be interest. However, the parties had chosen a contractual mechanism (through the accounting firm) to resolve the issue of how much had to be paid, which could be determined with precision applying the method set out in the Agreement. The fact that different valuators might come to different conclusions about value was not a consideration.
2. Maximum Permitted Rate clause is applicable and indicates substance of the transaction
The Court of Appeal also found that the application judge had failed to consider s. 6.13 of the Agreement – the “Maximum Permitted Rate” provision – which stipulated that “under no circumstances” could Flow receive a payment “at a rate that is prohibited under Laws.” The application judge determined that this provision was not relevant because it did not specifically reference s. 347, but as there was no other law that could apply to the transaction that would prohibit a rate, the provision should have been given significance. In particular, it indicated that the parties had contemplated that s. 347 could be applicable, and therefore had contracted for an adjusted rate in the event that the section was triggered.
Finally, the Court of Appeal rejected Flow’s assertion that because the Agreement did not, on its face, require the payment of an illegal interest rate, and that a rate over 60% was only triggered when Hybrid chose to exercise the buyout option, that meant s. 347 did not apply. It was unnecessary, in the circumstances, to consider the voluntary act exception in light of the Maximum Permitted Rate provision, since the parties had provided for a reduced rate in the event the exercise of the buyout provision resulted in a prohibited rate of interest. There was no question of Hybrid’s unilateral act rendering an otherwise legal rate of interest illegal. Rather, by including s. 6.13, the parties had provided a mechanism for achieving a lawful rate of interest if the buyout option was exercised. Both parties were sophisticated and must have recognized that there was a risk that payment under the Agreement could run afoul of s. 347, so there was no reason why they should not be held to their agreement.
As noted, the appeal from the decision of the application judge was allowed. It remained for the Court of Appeal to determine the appropriate remedy. There was no dispute that if the buyout amount would otherwise require interest payments at a criminal rate, the Maximum Permitted Rate provision would govern. The valuation process to determine the amount was not yet complete, and the record did not permit the court to calculate the precise amount owing, particularly given the passage of time. The matter was therefore remitted back to the Superior Court for a determination of the buyout amount pursuant to the Maximum Permitted Rate provision as well as any other amounts owing pursuant to the Agreement.
1. This case is a cautionary tale for any party who seeks to avoid the consequence of s. 347 by attempting to dress up what is, in substance, a loan transaction with provisions designed to obscure that essential purpose. In that regard, the following dictum of the Court of Appeal in this case is worthy of note:
The issues raised in this appeal go beyond the interests of the immediate parties. The form of this agreement may find its way into other contexts where both parties are not as sophisticated, and one party may be vulnerable to exploitation by another. It is important to remain cognizant of the breadth of the statutory language and the dictates in Garland to give effect to the substance of the agreement.
2. This case also indicates that the inclusion of a Maximum Permitted Rate clause in a financing agreement has a double edge. While it may be a significant factor in the court’s characterization of the agreement as one caught by s. 347, it will be given force and effect by the court, and will therefore protect the lender from the potentially much harsher consequences that befall agreements that call for, or result in, payment of a criminal rate of interest.
 2022 ONCA 820.
 Nelson v. C.T.C. Mortgage Corp. (1984), 59 B.C.L.R. 221 (C.A.), , aff’d  1 S.C.R. 749.
  3 SCR 112, at para.51.
 2022 ONCA 820, at para. 45.