Equity Kickers And The Criminal Rate Of Interest

Entering into a loan transaction that also has an equity component, such as the issuance of shares or warrants, has previously given rise to some concern that the loan could ultimately run afoul of the 60 percent criminal rate of interest. While this has widely been thought to be contrary to the intended purpose of the criminal interest provision (preventing loan-sharking), there has still been a risk that equity could be captured and valued as interest due to the broad definition and judicial interpretation of "interest" in that provision. However, that risk has been diminished by a decision of the Ontario Superior Court that was recently upheld by the Ontario Court of Appeal.1

The Criminal Rate of Interest and Equity

Section 347 of the Criminal Code makes it a criminal offence to enter into an agreement with an effective annual interest rate in excess of 60 percent.2 The provision is triggered in two ways: (1) if the agreement, on its face, has an interest rate above 60 percent; or (2) if, during the term of the loan, the lender ultimately obtained interest in excess of 60 percent. The latter creates a "wait and see" approach, and has sometimes been a source of concern where equity has been offered in connection with a loan transaction (often referred to as an "equity kicker" or "equity sweetener"). The concern often being that at the end of the credit period, the value of that equity, if considered "interest" under section 347, will result in an interest rate above 60 percent. While corporate directors and executives need not be overly concerned with criminal charges, this provision has been used by borrowers to attack a loan agreement (or parts thereof) as unenforceable and has provided a basis for challenging the originally agreed upon transaction.

Despite the original intention of section 347 to avoid loan-sharking, the definition of interest in section 347 is drafted broadly and has generally been interpreted broadly by the courts, resulting in its potential application to otherwise legitimate corporate transactions between sophisticated parties. In determining whether an item is "interest", courts have generally considered whether the item is, in substance, a cost incurred to receive credit.3 There has been fairly limited case law under section 347 considering the use of equity, and similar, instruments in connection with a loan. However, royalty payments, anticipated profits, shares, warrants and even an investment opportunity have...