Drafting Interest Rate Calculation Provisions In Corporate Finance Transactions

I. How to Comply with Section 4 of the Interest Act: Settled law and practice?

On financing transactions that involve the calculation of interest, lenders and bondholders have typically included a provision (or, more usually, a formula) for calculating a "nominal" annual rate of interest in order to comply with section 4 of the Interest Act (Canada).1 If a loan document does not comply with this provision, then the interest rate is capped at 5% per annum. Commercial practice and appellate jurisprudence had confirmed that such provisions complied with section 4. Section 4 states:

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.2

However, the Interest Act does not explicitly state what constitutes "an express statement of the yearly rate", disclosure of the "nominal" rate of interest or of the "effective" rate of interest. This is an important distinction. If a monthly rate of interest is 2%, the "nominal" interest rate would be 24% per annum but the "effective" rate would be 26.8% per annum, after taking into account the reinvestment of each monthly payment or the effect of compounding.

This issue has previously been narrowly interpreted by judicial authority. For example, in the 1994 Supreme Court of Canada decision of Dunphy (which affirmed an Alberta Court of Appeal decision), the Court clarified that parties need not disclose the "effective" rate of interest in the relevant agreement in order to comply with section 4, but rather disclosure of the "nominal" rate is sufficient.3 Similarly, the Ontario Court of Appeal came to the same conclusion in McHugh v. Forbes.4 For over 25 years many courts, commentators and legal practitioners considered this issue to be settled law on the basis of these appellate authorities.5

II. New Uncertainty Arising from an Judgment of the Ontario Superior Court of Justice

On January 10, 2018 a trial decision of the Ontario Superior Court of Justice was rendered that potentially questions these appellate level judicial authorities...