Transport North American Express Inc. v. New Solutions Financial Corporation [Indexed as: Transport North American Express Inc. v. New Solutions Financial Corp.]
60 O.R. (3d) 97
[2002] O.J. No. 2335
Docket No. C36517
Court of Appeal for Ontario
Rosenberg, Feldman and Sharpe JJ.A.
June 17, 2002
*Application for extension of time to file the application to cross-appeal granted, and application for leave to cross-appeal dismissed with costs September 25, 2003 (Gonthier, Major and Arbour JJ.).
Contracts -- Illegality -- Severability -- Loan at criminal rate of interest -- Severability of illegal portion of loan -- Court should not make notional severance to enforce loan -- Criminal Code, R.S.C. 1985, c. C-46, s. 347(1)(a).
Interest -- Criminal rate -- Severability -- Loan at criminal rate of interest -- Severability of illegal portion of loan -- Court should not make notional severance to enforce loan -- Criminal Code, R.S.C. 1985, c. C-46, s. 347(1)(a).
Transport North American Express Inc. ("TNAE") borrowed $500,000 from the respondent New Solutions Financial Corp. ("NSF"), each party having received legal advice during the negotiations for the loan. Their agreement provided for the following payments by TNAE: (a) interest at 4 per cent per month calculated daily and payable monthly in arrears; (b) a monthly monitoring fee of $750; (c) a 1 per cent standby fee; (d) royalty payments of $160,000 in eight quarterly instalments; (e) legal and other fees; and (f) a commitment fee of $5,000. The commitment letter contemplated a factoring agreement, but the parties treated the financing as a term loan. This arrangement was confirmed in a letter that stated that the interest rate was 48 per cent per annum.
After the funds were advanced and after some payments, TNAE applied to the court, amongst other things, for a declaration that the agreement contravened the criminal interest rate provisions of the Criminal Code. Cullity J. found that neither party intended to breach s. 347 of the Criminal Code and neither party was advised by its solicitors of the existence of s. 347; however, he concluded that the loan agreement provided for the payment of a criminal interest rate in violation of s. 347. Further, he decided that rather than severing the interest provisions, there should be a notional severance to reduce the interest rate to 60 per cent so that the interest would not be at a criminal rate. TNAE appealed.
Held, the appeal should be allowed.
Per Rosenberg J.A. (Feldman J.A. concurring): A court is not bound to hold an agreement invalid and unenforceable simply because it violates a statute. The court may sever the offending part of the agreement. Where an agreement contains a normal interest provision and a provision calling for payments of some kind of bonus or collateral advantage, the court may sever the bonus but require the borrower to pay the principal with interest as otherwise provided for in the agreement. The rationale for ordering a severance of this sort is that it is the bonus that makes the agreement illegal. The court, however, is not obliged to sever in this way, and it is a matter of discretion. Where the loan transaction resembles a loan sharking arrangement, the court may refuse to sever and hold the entire loan agreement unenforceable. At the other end of the spectrum of remedies, is the case of a good faith commercial transaction in which the equities favour the lender and severance does not undermine the policy of the legislation; in that situation, the court may sever only those provisions of the loan agreement [page98] that put the effective rate of interest over 60 per cent, leaving intact the borrower's obligation to repay the principal and some interest. In the middle is the remedy of severing all the interest provisions while upholding the debtor's obligation to repay the principal. However, to permit a notional severance of the kind ordered by Cullity J. gives virtually no weight to the policy behind criminal prohibition and is in effect a substantial innovation in the common law doctrine of severance. To make such a major innovation at the behest of those who prima facie have violated the criminal law would be inconsistent with the aims of deterrence. In the immediate case, the 4 per cent per month interest provision must be severed because it violates s. 347 and there was no justification for trying to save it simply because it barely exceeded the criminal rate. The other fees and charges were not shown to be part of the interest rate payment and should not be severed. With the illegal interest rate covenant removed, the balance of the agreement was valid. Accordingly, the appeal should be allowed and the judgment below varied.
Per Sharpe J.A. (dissenting): This is an evolving area of the law in which flexibility is desirable. Cullity J.'s approach was permissible under the current state of the law and was sound in policy. The court is not precluded from "reading down" the agreement to bring the effective annual rate of interest within the limit permitted under s. 347 of the Criminal Code. This approach avoids the arbitrariness and formalism of other potential solutions. The parties bargained from relatively equal positions and had legal advice. In the circumstances of this case, the notional severance approach best avoids any element of unjust enrichment.
APPEAL from a judgment of Cullity J. (2001), 2001 28232 (ON SC), 54 O.R. (3d) 144, 200 D.L.R. (4th) 560 (S.C.J.) on an application for a declaration that an agreement contravened s. 347(1)(a) of the Criminal Code, R.S.C. 1985, c. C-46.
Cases referred to
677950 Ontario Ltd. v. Artell Developments Ltd., 1993 94 (SCC), [1993] 2 S.C.R. 443, 153 N.R. 238, 82 C.C.C. (3d) 192, 32 R.P.R. (2d) 286, affg (1992), 1992 8646 (ON CA), 93 D.L.R. (4th) 334, 75 C.C.C. (3d) 343, 24 R.P.R. (2d) 113 (Ont. C.A.) (sub nom. Horvat v. Artell Developments Ltd.); Attwood v. Lamont, [1920] 3 K.B. 571, [1920] All E.R. Rep. 55, 90 L.J.K.B. 121, 124 L.T. 108, 36 T.L.R. 895, 65 Sol. Jo. 25 (C.A.); C.A.P.S. International Inc. v. Kotello, 2002 MBQB 142, [2002] M.J. No. 205 (Q.B.); Canadian American Financial Corp. (Canada) Ltd. v. King (1989), 1989 252 (BC CA), 36 B.C.L.R. (2d) 257, 60 D.L.R. (4th) 293, 25 C.P.R. (3d) 315 (C.A.); Garland v. Consumers' Gas Co., 1998 766 (SCC), [1998] 3 S.C.R. 112, 40 O.R. (3d) 479n, 165 D.L.R. (4th) 385, 231 N.R. 1, 129 C.C.C. (3d) 97, 49 M.P.L.R. (2d) 77, 20 C.R. (5th) 44; Milani v. Banks (1997), 1997 1765 (ON CA), 32 O.R. (3d) 557, 145 D.L.R. (4th) 55, 33 B.L.R. (2d) 298 (C.A.); Pacific National Developments Ltd. v. Standard Trust Co. (1991), 53 B.C.L.R. (2d) 158 (S.C.); Terracan Capital Corp. v. Pine Projects Ltd. (1993), 1993 2655 (BC CA), 75 B.C.L.R. (2d) 256, 100 D.L.R. (4th) 431, [1993] 3 W.W.R. 724, 18 C.B.R. (3d) 54, 30 R.P.R. (2d) 119 (C.A.), affg (1991), 1991 11794 (BC SC), 60 B.C.L.R. (2d) 384, [1992] 1 W.W.R. 772, 10 C.B.R. (3d) 223, 20 R.P.R. (2d) 187 (S.C.), supp. reasons (1991), 62 B.C.L.R. (2d) 368, 10 C.B.R. (3d) 223 (S.C.); Trillium Computer Resources Inc. v. Taiwan Connection Inc. (1994), 11 B.L.R. (2d) 1 (Ont. Div. Ct.); William E. Thomson Associates Inc. v. Carpenter (1989), 1989 185 (ON CA), 69 O.R. (2d) 545, 34 O.A.C. 365, 61 D.L.R. (4th) 1, 44 B.L.R. 125 (C.A.) (sub nom. William E. Thomson & Assoc. v. Martin)
Statutes referred to
Criminal Code, R.S.C. 1985, c. C-46, s. 347
Authorities referred to
Fridman, G.H.L., The Law of Contract in Canada, 4th ed. (Toronto: Carswell, 1999) Waddams, S.M., The Law of Contracts, 4th ed. (Toronto: Canada Law Book, 1999) Ziegel, J.S., "The Usury Provisions in the Criminal Code: The Chickens Come Home to Roost" (1986) 11 Can. Bus. L.J. 233 [page99]
Steven L. Graff, for appellant. Milton M. Chambers, for respondent.
[1] ROSENBERG J.A. (FELDMAN J.A. concurring): -- This appeal concerns the application of the doctrine of severability to a contract that provided for the payment of a criminal interest rate in violation of s. 347(1)(a) of the Criminal Code, R.S.C. 1985, c. C-46. Cullity J. adopted an unusual solution to the problem. He did not simply sever the interest provisions, leaving the appellant to repay only the principal. Neither did he apply the so-called "blue pencil" rule, under which certain provisions of the written agreement would be excised. Instead, he opted to perform what he termed a "notional severance" to reduce the annual interest rate to 60 per cent so that the agreement would comply with s. 347(1)(a). While the application judge has provided policy reasons for taking this approach, in my view the authorities indicate that this remedy was not available. Accordingly, I would allow the appeal.
The Facts
[2] The appellant Transport North American Express Ltd. was founded in 1994 by Ken Dragosits. His wife Karen works in the business. Originally, the business consisted of one truck driven by Mr. Dragosits. Over the next few years, the business grew considerably and by 1999 there were other shareholders who owned 50 per cent of the business. The company also had a large debt with its main secured creditor in the amount of $400,000. Towards the end of 1999, the Dragosits negotiated a buyout of their co-shareholders and satisfaction of the indebtedness to the secured lender, who had made a demand for repayment. The transaction was to close in January 2000. In order to finance the transaction, the Dragosits were put in touch with BDO Capital, now the respondent New Solutions Financial Corporation.
[3] The original agreement negotiated by the parties was in the nature of a factoring agreement under which the respondent would finance the appellant's accounts receivable. Both parties had their own lawyers. On March 6, 2000, the appellant executed a commitment letter in respect of the proposed credit facility that provided for the following payments by the appellant to the respondent: [page100]
(a) interest at 4 per cent per month calculated daily, payable monthly in arrears;
(b) a monthly monitoring fee of $750;
(c) a 1 per cent standby fee;
(d) royalty payments of $160,000 in eight quarterly instalments;
(e) payment of legal and other fees; and
(f) a commitment fee of $5,000.
[4] On March 30, 2000, the parties executed an Accounts Receivable Factoring Agreement to govern their relationship. The Agreement provided, inter alia, that the respondent would purchase up to $500,000 of the appellant's accounts receivable. The agreement contained a severability clause. The appellant also executed a General Security Agreement in favour of the respondent and the Dragosits provided personal guarantees to a maximum of $500,000 plus interest at the rate of 30 per cent per annum.
[5] Notwithstanding the Factoring Agreement, the parties treated the financing arrangement from its inception as a term loan rather than a factoring arrangement. This was confirmed in writing in a letter from the respondent's counsel to the appellant's counsel, which included the following statement:
It is anticipated that your client will draw the full amount of the facility and pay interest, fees and royalties as they are set out in the commitment letter. Please note that the interest rate is 48 per cent per annum.
(Emphasis added)
[6] On March 30, 2000, the respondent advanced the principal sum of $500,000. The appellant continued to pay interest to the respondent at the rate of 48 per cent per annum, calculated daily and payable monthly, in accordance with the commitment letter. As of March 26, 2001, in addition to legal fees and the $5,000 commitment fee, the appellant had paid the following amounts:
(a) $8,250 for monthly fees;
(b) $3,116.53 in late payment fees;
(c) $40,000 royalty payments (two quarterly payments for June and September, 2000);
(d) $220,931.51 in interest.
[7] The appellant did not pay the December royalty payment and it was the evidence of the respondent that it deferred the [page101] royalty payments in an effort to assist the appellant. Because the various payments were becoming onerous, the appellant sought legal advice and obtained an opinion that the agreement provided for the payment of a criminal interest rate. As a result, the appellant brought an application heard by Cullity J. in May 2001 for a declaration that the agreement contains an interest component that contravenes s. 347(1)(a) of the Criminal Code. It also sought an order that interest paid by it to the respondent be returned. The respondent originally denied that the agreement violated the Criminal Code but sought severance and rectification if it did.
The Statute
[8] Section 347(1) of the Criminal Code creates the criminal interest rate offence. This case concerns para. (1)(a):
347(1) Notwithstanding any Act of Parliament, every one who
(a) enters into an agreement or arrangement to receive interest at a criminal rate, or
(b) receives a payment or partial payment of interest at a criminal rate,
is guilty of
(c) an indictable offence and is liable to imprisonment for a term not exceeding five years, or
(d) an offence punishable on summary conviction and is liable to a fine not exceeding twenty-five thousand dollars or to imprisonment for a term not exceeding six months or to both.
(Emphasis added)
[9] The term "criminal rate" is defined [in s. 347(2)] in these terms:
"criminal rate" means an effective annual rate of interest calculated in accordance with generally accepted actuarial practices and principles that exceeds sixty per cent on the credit advanced under an agreement or arrangement[.]
[10] The section sweeps a large number of charges and expenses into the term interest and includes, in part, all charges and expenses "whether in the form of a fee, fine, penalty, commission or other similar charge or expense or in any other form, paid or payable for the advancing of credit under an agreement". It is unnecessary to set out the full text of the section because, in my view, the application judge has correctly calculated the rate of interest for the purpose of s. 347.
The Findings of the Application Judge
[11] The application judge found that the following charges and expenses were to be included in the calculation of the annual rate of interest: [page102]
(a) the $750 monthly monitoring fee;
(b) the $3,190.63 in legal and administrative fees;
(c) the $5,000 commitment fee;
(d) the royalty payments.
[12] In addition, the judge found that interest payable at 4 per cent per month at the end of each month represents an effective annual rate, on its own and without consideration of the other fees, of 60.10 per cent, contrary to the statement in counsel's letter that the rate was 48 per cent per annum.
[13] The respondent initially wanted a 30 per cent equity interest in the appellant company. The Dragosits were opposed to this. The royalty payments were intended to reflect an estimate of the value of 30 per cent of the company. Nevertheless, in view of the application judge's finding that the parties intended and agreed to create a debtor and creditor relationship, I agree with his conclusion that the royalty payments constitute interest for the purpose of s. 347. The respondent does not now contest the application judge's refusal to rectify the agreement by converting the royalty payments to a 30 per cent equity interest.
[14] The application judge found that neither of the parties intended to breach s. 347 and neither party was advised by its solicitors of the existence of s. 347. There was no suggestion that the respondent deliberately misled the appellant or that the Dragosits did not fully understand the terms of the agreement and the extent and costs of the obligations the appellant company accepted.
The Issues
[15] This is not a case of "loan sharking", the type of activity at which the criminal interest rate provisions are principally directed. But s. 347 applies equally and arises more frequently in the commercial context, where debtors rely upon it to be relieved of onerous interest obligations. See Garland v. Consumers' Gas Co., 1998 766 (SCC), [1998] 3 S.C.R. 112 at p. 129, 165 D.L.R. (4th) 385. In the typical case, as here, the parties do not intend to violate the criminal law and occupy relatively equal bargaining positions. While the provision has been repeatedly criticized by some commercial lawyers and by academics, as Major J. pointed out in Garland at p. 130 S.C.R., "it is now well settled that s. 347 applies to a very broad range of commercial and consumer transactions involving the advancement of credit, including secured and unsecured loans, mortgages and commercial financing agreements." [page103]
[16] The parties do not dispute that, where an agreement violates s. 347(1)(a) of the Criminal Code, it is open to the court in a proper case to sever the part of the agreement that requires the payment of the criminal interest rate. In the result, the debtor is still required to repay the principal amount.
[17] In this case, the application judge went several steps further. As a result, the appeal involves two issues as follows:
Where a loan agreement violates s. 347(1)(a) of the Criminal Code, is it open to the court to require the debtor to comply with certain provisions of the agreement, although this would require the payment of interest?
If so, is it open to the court to, in effect, rewrite the agreement to reduce the effective annual interest rate to 60 per cent or must the court adopt the "blue pencil" approach?
Analysis
[18] It is now recognized that a court is not bound to hold an entire agreement invalid and unenforceable simply because it violates a statute. In a proper case, the court will sever the offending part of the agreement. In William E. Thomson Associates Inc. v. Carpenter (1989), 1989 185 (ON CA), 69 O.R. (2d) 545, 61 D.L.R. (4th) 1 (C.A.) at p. 552 O.R., p. 8 D.L.R., Blair J.A. identified the two broad questions that the court must consider in the context of severing the part of an agreement that violates s. 347(1)(a). First, the agreement must be capable of severance in the sense that the clauses providing for payment of interest must be capable of being excised "without affecting the substance of the obligation to repay the principal of the loan and without making a new agreement for the parties". Second, the court must determine whether public policy prevents severance of the agreement because the agreement is tainted by illegality. Blair J.A. identified four considerations relevant to this policy question, including the purpose and policy of the legislation and the relative bargaining positions of the parties. I need not review these four considerations in full. The application judge resolved all of them in favour of the respondent and I see no reason for interfering with his conclusion. In other words, policy considerations do not stand in the way of severance. This case really turns on the manner in which the severance is to be performed.
[19] In this court's first opportunity to consider severance, William E. Thomson, supra, the court severed a loan agreement between two companies from the personal guarantees of two directors of the debtor company. The court therefore held all of [page104] the debtor's interest obligations unenforceable, including a "facility fee" and a provision calling for interest payable monthly at a variable rate per annum of 2 per cent above the U.S. base rate. In the result, the court only required that the directors honour their guarantees on the principal.
[20] In subsequent cases, including decisions from this court, the courts have been prepared to sever some of the provisions of an agreement calling for payment of interest while leaving others intact. This remedy is most commonly applied where the agreement contains both what I would term a normal interest provision and a provision calling for payment of some kind of bonus or collateral advantage. In 677950 Ontario Ltd. v. Artell Developments Ltd. (1992), 1992 8646 (ON CA), 93 D.L.R. (4th) 334, 75 C.C.C. (3d) 343 (Ont. C.A.), the lender agreed to fund a purchase of property on the security of a second mortgage. The mortgagee advanced $375,000. Interest on this sum was payable at the prime lending rate plus 5 per cent. However, the principal amount of the mortgage was $1,675,000, which included a share of the estimated profit that the owner would receive when the property was resold. Blair J.A. held that this $1,300,000 constituted interest within the meaning of s. 347 and thus the agreement violated the provision. However, he did not sever all of the provisions calling for the payment of interest. Rather, he made a declaration that the mortgage had been satisfied by the payment of the sum of $375,000 together with interest thereon and that the additional $1,300,000 together with accrued interest was to be returned to the mortgagor. His reasons at p. 345 D.L.R. on this aspect of the case are brief:
Since the agreement to pay the sum of $1,300,000 provides for a "criminal rate" of interest in contravention of s. 347, it cannot, for reasons of public policy, as the Thomson case, supra, held, be enforced by a civil action.
[21] An appeal by the lender was dismissed by the Supreme Court, 1993 94 (SCC), [1993] 2 S.C.R. 443, 82 C.C.C. (3d) 192. From the very brief reasons it appears that the main issue on that appeal was whether the $1,300,000 attributed to a profit-sharing scheme fell within the term "interest" in s. 347.
[22] It is, then, open to a court faced with a loan agreement providing for an illegal interest rate to sever what is often referred to in the agreements as a "bonus" but require the borrower to repay the principal with interest as otherwise provided for in the agreement. The rationale for ordering severance of this sort is that it is the bonus that renders the agreement illegal. See Pacific National Developments Ltd. v. Standard Trust Co. (1991), 53 B.C.L.R. (2d) 158 (S.C.); 677950 Ontario Ltd. v. Artell, supra. [page105]
[23] However, severance of the bonus only is not the inevitable result. In Terracan Capital Corp. v. Pine Projects Ltd. (1991), 1991 11794 (BC SC), 10 C.B.R. (3d) 223, 60 B.C.L.R. (2d) 384 (S.C.), Spencer J. considered Pacific National Developments but severed all of the provisions calling for the payment of interest. He reasoned, at p. 232 C.B.R.:
. . . I do not think the court should become involved in choosing which of the several clauses which provide for a return on the amount lent should be invalidated and which should be preserved. It is not for the court to recalculate an acceptable commercial return by choosing from the interest, fees and bonus terms any combination that will fit within 60 per cent.
[24] Spencer J.'s decision was upheld by the British Columbia Court of Appeal at (1993), 1993 2655 (BC CA), 100 D.L.R. (4th) 431, 75 B.C.L.R. (2d) 256 (C.A.). Prowse J.A., speaking for the court, treated the question of whether or not to sever only some of the provisions requiring payment of interest as a matter of discretion. After rejecting the proposition that Spencer J. had failed to consider the severance provision of the loan agreement, Prowse J.A. held, at p. 447 D.L.R., as follows:
Nor am I satisfied that he erred in the exercise of his discretion in refusing to enforce any of the provisions with respect to interest. He was aware that there was precedent for severing interest provisions from other interest provisions in order to lower the effective rate of interest, but he declined to adopt that approach on the facts before him. In my view, the courts should not be too quick to rewrite agreements by picking and choosing from alternative provisions which would result in a legal rate of interest. Otherwise, there will be little incentive for lenders to ensure that their agreements provide for interest at legal rates. I refrain from suggesting that it is never appropriate to do so.
(Emphasis added)
[25] Most recently, in Milani v. Banks (1997), 1997 1765 (ON CA), 32 O.R. (3d) 557, 145 D.L.R. (4th) 55 (C.A.), this court considered several of the authorities and concluded that only the part of the agreement calling for payment of a bonus should be severed. Speaking for the court, McKinlay J.A. considered that several factors favoured this solution, including the nature of the risk, that none of the parties intended to breach s. 347, that the lender had herself borrowed money from her bank to make the loan, and that the borrowers were seeking only short-term financing to prevent sale of their home by existing mortgagees. At p. 562 O.R., McKinlay J.A. held as follows:
It is clear that in a prosecution under s. 347 it is irrelevant whether the accused is aware that the effective interest rate charged is illegal. However, in a civil action to enforce a loan of moneys actually advanced, the knowledge of the parties and all of the facts surrounding the transaction must be relevant to determining what is just between the parties. [page106]
I consider this case to be one strongly favouring the position of the appellant. She is clearly not entitled to the $3,000 fee, but I would strike only that provision, and leave the loan otherwise intact as a $32,000 loan with interest at 18 per cent per annum for a 30-day term.
[26] That brings me to the solution adopted by the application judge in this case. As indicated, rather than severing all of the parts of the agreement calling for the payment of interest or severing certain parts of the agreement to bring the effective rate of interest below 60 per cent, he performed a notional severance. The application judge held that the respondent was entitled to enforce as written all parts of the agreement except one: the monthly interest rate, which was to be changed to reduce the effective interest rate, inclusive of royalty payments and other fees, to 60 per cent per annum. It would seem that he adopted this solution because the normal severance option of severing the royalties or the various other fees would not reduce the interest rate to 60 per cent. As I have indicated, the interest rate of 4 per cent calculated daily, payable monthly in arrears produces an effective interest rate of 60.10 per cent per annum. If that part of the agreement were severed, leaving only the royalties and other fees, the effective annual rate would be under 31 per cent. The application judge was of the view that some of the same considerations that determine whether to enforce the agreement at all should also govern the extent to which the contract is enforced. He considered the blue pencil test to be artificial. In his view, that traditional approach to severance placed form over substance and had no necessary connection with the intention of the parties, often producing results that reflect nothing more than accidents of drafting.
[27] A very helpful discussion of the principles of severance and the blue pencil rule in particular is found in the reasons of Hinkson J.A. and Lambert J.A. in Canadian American Financial Corp. (Canada) Ltd. v. King (1989), 1989 252 (BC CA), 60 D.L.R. (4th) 293, 36 B.C.L.R. (2d) 257 (C.A.). At pp. 299-300 D.L.R., Hinkson J.A. referred to the decision of the English Court of Appeal Attwood v. Lamont, [1920] 3 K.B. 571, [1920] All E.R. Rep. 55 (C.A.), in which Lord Sterndale M.R. captured the applicable principle at pp. 577-78 K.B.:
I think, therefore, that it is still the law that a contract can be severed if the severed parts are independent of one another and can be severed without the severance affecting the meaning of the part remaining.
This is sometimes expressed, as in this case by the Divisional Court, by saying that the severance can be effected when the part severed can be removed by running a blue pencil through it. This is a figurative way of expressing the principle, and like most figurative expressions may quite possibly lead to [page107] misunderstanding. I prefer the statement of principle of Sargant J. in Nevanas & Co. v. Walker, where he thus expresses it. He refers to the remarks of Lord Moulton in the case to which I have referred of Mason v. Provident Clothing and Supply Co. and says [[1914] 1 Ch. at p. 423]: "I do not think that those remarks were intended to be applicable to cases where the two parts of a covenant are expressed in such a way as to amount to a clear severance by the parties themselves, and as to be substantially equivalent to two separate covenants."
(Emphasis added)
[28] In another judgment in Attwood also cited in Canadian American Financial, Younger L.J., with whom Atkin L.J. concurred, pointed out at p. 593 K.B. that severance might not be appropriate in every case where it could be accomplished by excising words with a blue pencil. Rather, Younger L.J. held that:
The doctrine of severance has not, I think, gone further than to make it permissible in a case where the covenant is not really a single covenant but is in effect a combination of several distinct covenants. In that case and where the severance can be carried out without the addition or alteration of a word, it is permissible.
[29] G.H.L. Fridman in The Law of Contract in Canada, 4th ed. (Toronto: Carswell, 1999) at pp. 441-45 summarizes the principles of severance. He points out at p. 443 that the blue pencil rule is nothing more than a rule of thumb and the true test is "whether the subtraction of the void part of a contract affects the meaning of the remainder, or merely the extent. It is not permitted to change radically the purport and substance of the original contract." He also makes the point that severance is the act of the parties: "The issue is whether the parties have by their language identified separate promises. The promise must appear severable." Understood in this way, I do not think that the existing test for severance is so artificial that it cannot be applied in a way that will produce principled, understandable and predictable results. The solution adopted by the application judge is not consistent with these principles. He recognized this, of course, and referred to his remedy as a "notional severance".
[30] Further, it seems to me that the solution adopted by the application judge gives virtually no weight to the policy behind the criminal prohibition. As I observed above, while s. 347 may have been principally directed towards loan sharking, it is not limited to such transactions. As Major J. pointed out in Garland, supra, at p. 129 S.C.R.:
it is clear from the language of the statute -- e.g., its reference to insurance and overdraft charges, official fees, and property taxes in mortgage transactions -- that s. 347 was designed to have a much wider reach, and in fact the section has most often been applied to commercial transactions which bear no relation to traditional loan- sharking arrangements. [page108]
[31] It is a criminal offence for any lender, even a commercial creditor, to enter into a loan agreement providing for an effective interest rate greater than 60 per cent per annum. And to permit a notional severance of the kind ordered by the application judge is to effect a substantial innovation in the common law doctrine of severance. While the common law develops over time, it would be inconsistent with the aims of deterrence for the courts to make such a major innovation at the behest of those who prima facie stand in violation of the criminal law. As Huddart J. said in Pacific National Developments, supra, at p. 163 B.C.L.R.: "It is not for the courts either to strain to find ways in which to avoid the application of the Criminal Code, or to assist those who strain to do so, although it is for the courts to interpret strictly penal provisions of statutes".
[32] Useful in this connection are the comments of Professor Ziegel at (1986) 11 Can. Bus. L.J. 233 at p. 242:
So far as the interest component is concerned, obviously the lender cannot recover that part of it which exceeds 60 [per cent]. But can he recover the first 60 [per cent]? In my view, the answer should be no, and this on two grounds. First, it is unlikely that the contract itself will distinguish between the two interest components. There is therefore no basis on which to apply the doctrine of severance. The second reason is that severance would undermine the policy of s. 305.1 [now s. 347] (even if one believes, as the writer does, that it is a bad policy) and encourage lenders to run calculated risks, secure in the knowledge that they would only lose that part of the interest which exceeds 60 [per cent].
As I have pointed out, there are cases where Professor Ziegel's first reason for refusing to permit recovery of some interest component does not apply because the agreement does distinguish between different interest components.
[33] I agree with the British Columbia Court of Appeal in Terracan, supra, that a judge has discretion to apply the doctrine of severance to an agreement that offends the criminal interest rate provisions of the Code. This discretion gives rise to a spectrum of available remedies. Where the loan transaction resembles a traditional loan sharking arrangement, the court may refuse to apply the doctrine of severance and hold the entire loan agreement unenforceable, including the obligation to repay the principal. While this remedy leaves the borrower with a windfall, this result may be justified in some cases by the need to denounce such usurious practices. See C.A.P.S. International Inc. v. Kotello, 2002 MBQB 142, [2002] M.J. No. 205 (Q.B.). At the other end of the spectrum, in the case of a good faith commercial transaction where the equities favour the lender and severance does not undermine the policy of the legislation, the court may sever only those provisions of [page109] the loan agreement that put the effective interest rate over 60 per cent, leaving intact the borrower's obligation to repay the principal and pay some interest. See e.g., Milani, supra. Closer to the centre of the spectrum lies a case like Terracan, where the court severed all the interest provisions but upheld the debtor's obligation to repay the principal.
[34] Where does the present case fit on the spectrum? The application judge concluded, and I have accepted, that the equities favour the lender. His reasons make it clear that if he had concluded that notional severance was not available, he would have severed the provision calling for payment of an interest rate of 4 per cent per month calculated daily, payable monthly in arrears. I agree that this is the appropriate remedy.
[35] In this case there are at least two distinct covenants that can be traced back to the negotiations leading to the agreement. As indicated, the respondent initially wanted an equity interest in the appellant's business. This is the source of the royalty payments. The other covenant was the more conventional agreement with respect to interest. In my view, it is possible to sever one or both in a manner consistent with the established principles respecting severance. The 4 per cent per month interest provision must be severed because it violates s. 347 of the Criminal Code. I see no justification for trying to save that provision simply because it only barely exceeds 60 per cent. The respondent is an experienced commercial lender. It misled the appellant, albeit unintentionally, when its solicitor referred to the interest rate as merely 48 per cent. The appellant has not shown that the other fees and charges such as the commitment fee and monitoring fee are clearly part of the interest rate payment and accordingly they should not be severed.
[36] With the illegal interest rate covenant removed, the balance of the agreement, reflecting the estimate of the 30 per cent equity interest and related fees, is valid.
Disposition
[37] Accordingly, I would allow the appeal, set aside para. 2 of the judgment of the application judge and order severance of the provision calling for payment of an interest rate of 4 per cent per month calculated daily, payable monthly in arrears. The respondent should repay to the appellant any excess amounts.
[38] In my view, the appellant is entitled to its costs of the appeal. In order to fix costs of the appeal, the appellant will have seven days to submit a bill of costs. The respondent will have seven days to respond. The application judge made no order for costs. I would not interfere with that order. [page110]
[39] SHARPE J.A.: (dissenting): -- I have had the advantage of reading the reasons for judgment of Rosenberg J.A. For the reasons that follow, I respectfully disagree with my colleague that Cullity J. erred in granting "notional severance" to reduce the effective annual interest rate to 60 per cent to comply with s. 347(1)(a) of the Criminal Code. I agree with the application judge that this is an evolving area of the law in which remedial flexibility is desirable. In my view, the solution adopted by the application judge is both permissible under the current state of the law and sound in policy.
[40] William E. Thomson Associates Inc. v. Carpenter (1989), 1989 185 (ON CA), 69 O.R. (2d) 545, 61 D.L.R. (4th) 1 (C.A.) is the modern starting point in Ontario for analysis of the enforceability of agreements that contravene s. 347. In Thomson, two guarantors argued that the guarantees they had given were void and unenforceable because the loan agreement provided for an effective annual rate of interest that violated s. 347. This court held that while the guarantors' interest obligation was unenforceable, the guarantors were liable for the principal amount of the loan.
[41] At p. 552 O.R., p. 8 D.L.R. and pp. 553-56 O.R., pp. 10-12 D.L.R., Blair J.A. identified four considerations that are relevant in determining whether public policy prevents the severance and partial enforcement of an agreement that provides for an illegal rate of interest. The first consideration is "whether the purpose and policy of s. 347 would be subverted by severance". The second consideration is "whether the parties entered into the agreement for an illegal purpose or with an evil intention". Where the party seeking enforcement has an illegal purpose or an evil intention, the law does not favour severance. However, where a violation of s. 347 is inadvertent or unintended, severance is possible. The third consideration is "the relative bargaining position of the parties and their conduct in reaching the agreement". A party who takes advantage of another to procure an illegal gain cannot expect to have the contract enforced. On the other hand, where, as in Thomson, the parties bargain from a position of equality and act on the advice of their lawyers, the law may favour severance. The fourth consideration, which is related to the third, is unjust enrichment. A blanket refusal to enforce a tainted agreement may result in unjust enrichment in the absence of an illegal purpose, evil intention or unfair advantage. Although this is particularly true where, as in Thomson, the debtor seeks to avoid repayment of the principal amount of the loan, unjust enrichment may also result where the debtor seeks to avoid payment of an appropriate rate of interest for the loan. [page111]
[42] In Thomson, this court enforced the obligation to pay the principal amount of the loan but severed the obligation to pay interest. In subsequent cases, the law has evolved to permit partial enforcement of the obligation to pay interest. In Milani v. Banks (1997), 1997 1765 (ON CA), 32 O.R. (3d) 557, 145 D.L.R. (4th) 55 (C.A.), the parties' agreement provided for a rate of interest and for a fee that, together, exceeded the effective annual rate of interest permitted under s. 347. This court held that the appropriate remedy was to sever the fee and enforce the balance of the agreement, including the obligation to pay interest. Similarly, in 677950 Ontario Ltd. v. Artell Developments Ltd. (1992), 1992 8646 (ON CA), 93 D.L.R. (4th) 334, 75 C.C.C. (3d) 343 (Ont. C.A.), affd, 1993 94 (SCC), [1993] 2 S.C.R. 443, 82 C.C.C. (3d) 192, this court held that a share of the estimated profit on the resale of a property constituted interest within the meaning of s. 347 and that the share of estimated profit, in and of itself and together with interest otherwise payable, exceeded the effective annual rate of interest under s. 347. This court held that the appropriate remedy was to sever the share of estimated profit and enforce the balance of the agreement, including the interest obligation.
[43] The issue raised in this appeal is whether the considerations identified in Thomson may be applied to reduce the amount of interest payable to the legally permissible rate where that result cannot be accomplished by simply striking out one or more terms of the contract. The issue turns on whether it is necessary to apply the "blue pencil" test, usually traced to Attwood v. Lamont, [1920] 3 K.B. 571, [1920] All E.R. Rep. 55 (C.A.), under which severance is only possible if the severance does not effect a revision of the remaining words in the agreement.
[44] The application judge held that he was not bound to apply the blue pencil test in the circumstances of this case. At p. 157 O.R., he found:
The blue-pencil test is, I believe, a relic of a bygone era when the attitude of courts of common law -- unassisted by principles of equity -- towards the interpretation and enforcement of contracts was more rigid than is the case at the present time. At an early stage in the development of the law relating to illegal promises, severance was held to be justified on the basis of the blue-pencil test alone. As the reasoning in Milani and William E. Thomson demonstrates, we have moved a long way beyond that mechanical approach. Enforcement may be refused in the exercise of the kind of discretionary judgment I have mentioned even where blue- pencil severance is possible.
[45] The application judge further held that he was not precluded from "reading down" the agreement to bring the effective annual rate of interest within the limit permitted under s. 347. In his view, the considerations that are relevant in determining whether public policy prevents the severance and partial [page112] enforcement of an agreement are also relevant in determining the extent of the severance. At p. 158 O.R., he held:
In William E. Thomson, Blair J.A. stated at p. 556 O.R.:
Whether or not a contract tainted by illegality is completely unenforceable depends upon all the circumstances surrounding the contract and the balancing of the considerations discussed above and, in appropriate cases, other considerations. This careful case by case approach was anticipated more than half a century ago by Masten J.A. in Steinberg v. Cohen . . . where he said . . . :
It is possible that each case should depend upon its own facts, and upon a balancing by the Court of the public interest on the one hand and of the private injustice on the other.
There is, I believe, force in an argument that the same principles should govern the extent to which a contract is unenforceable without regard to an artificial test that depends on the form, and not the substance, of an agreement, that has no necessary connection with the intention of the parties and that may apply, or not apply, as a result of mere accidents of drafting.
(Emphasis in original)
[46] I agree with the application judge that he was not bound to apply the blue pencil test in this case and that he was not precluded from "reading down" the agreement to bring the effective annual rate of interest within the limit permitted under s. 347. While the results in Thomson, Milani and 677950 Ontario Ltd. may be consistent with the blue pencil test, none of these cases explicitly preclude the remedy granted by the application judge. Further, there is authority supporting the application judge's approach. In Trillium Computer Resources Inc. v. Taiwan Connection Inc. (1994), 11 B.L.R (2d) 1 (Ont. Div. Ct.), the Divisional Court implicitly rejected the blue pencil test. The borrower had paid an effective annual rate of interest of over 3,000 per cent. The Divisional Court upheld summary judgment in favour of the borrower for the return of interest already paid, less the maximum rate of 60 per cent per annum allowable under the Criminal Code. In so doing, the court effectively read down the effective annual rate of interest under the agreement to the rate permitted under s. 347.
[47] In his concurring opinion in Canadian American Financial Corp. (Canada) Ltd. v. King (1989), 1989 252 (BC CA), 60 D.L.R. (4th) 293 at p. 306, 36 B.C.L.R. (2d) 257, Lambert J.A. explicitly rejected the blue pencil test:
In my opinion the [blue-pencil] rule is overly artificial and places too much stress on the words chosen to express the intention of the parties and not enough stress on the intention of the parties, themselves. In my opinion, the "blue-pencil" rule in its strict form, as I have stated it, should not be considered as a rule of law and should not be applied as such in British Columbia. It should be regarded only as an aid to determining whether the case is an appropriate one for severance. . . . [page113]
[48] In The Law of Contracts, 4th ed. (Toronto: Canada Law Book, 1999) at p. 421, Professor Waddams argues that "[n]o satisfactory test of severability has evolved". In his view, the blue pencil test is no answer to the reluctance of courts to rewrite agreements:
The courts are naturally reluctant to undertake the rewriting of contracts, for then an employer, for example, would have nothing to lose by extracting from an employee outrageously wide covenants against competition. The worst that could happen would be that the covenants would be cut down by the court to reasonable size. It is no more satisfactory to adopt what has been called the "blue pencil" test, whereby covenants are severable if they can simply be deleted without revision of the remaining words of the document. Plainly such a test invites evasion by careful drafting. A covenant not to compete (1) in Toronto, and (2) in the rest of Ontario, might, on such a test, be valid as to Toronto, whereas a covenant not to compete anywhere in Ontario might be wholly invalid. Such distinctions are anomalous. A more useful test, it is suggested, is whether the legal parts of the transaction are so closely tied in with the illegal parts that enforcement of the former will tend to subvert the policies underlying the rule of illegality.
(Footnotes omitted)
[49] On the basis of these authorities, I conclude that in the circumstances of this case, it was open to the application judge to reject the blue pencil test and to read down the agreement to bring the effective annual rate of interest within the limit prescribed by s. 347. In reaching this conclusion, I recognize that courts must be cautious when ordering the partial enforcement of an agreement. There is a concern for the sanctity of the agreement, as well as a need to avoid subverting the policy of s. 347, which is violated by the agreement. However, in my view, the law has evolved such that these concerns should not preclude the remedy granted by the application judge in this case.
[50] The appellant did not argue that judicial reluctance to alter the written terms of the agreement should allow the appellant to escape all liability under the agreement. The issue is not whether the court should order partial enforcement, but rather what form of partial enforcement the court should order. At the very least, the appellant must repay the principal of the loan. Further, on the present state of the law, the appellant cannot avoid the payment of some interest. The question is how much interest the appellant should be required to pay. In my view, that question cannot be adequately answered by the application of a mechanical rule. Rather, it is necessary to consider and apply the broader principles identified by the application judge.
[51] In my view, the application judge's solution to the problem of illegality in this case best avoids the arbitrariness and formalism of other potential solutions. If the interest provision had [page114] provided for an annual rate of interest of precisely 60 per cent, there is little doubt that the appropriate solution would have been to enforce that provision and sever the provisions for fees and royalties. The appellant submits that this solution is impossible because the interest provision provided for an annual rate of interest of 60.10 per cent. However, I agree with the application judge that it would be unduly artificial and formalistic to refuse the remedy of reading down the effective annual rate of interest to 60 per cent simply because the parties inadvertently exceeded the maximum permissible rate by one tenth of one percent in the interest provision. To allow the appellant to pay a significantly lower rate of interest would show less respect for the sanctity of the bargain between the parties.
[52] Furthermore, it seems to me that the application judge's solution best reconciles the relevant considerations articulated in Thomson. The purpose and policy of s. 347 would not be subverted by notional severance. This case did not involve reprehensible loan sharking but rather a commercial transaction between sophisticated parties who inadvertently ran afoul of the prohibition in s. 347. The application judge made a clear finding, unchallenged on appeal, that the parties had not entered into their agreement with an illegal purpose or an evil intention. Accordingly, reading down the agreement would not aid or encourage a lender's attempt to evade s. 347. The parties bargained from relatively equal positions and had legal advice. In the circumstances of this case, the application judge's solution best avoids any element of unjust enrichment. To secure the funds it required, the appellant needed to pay and agreed to pay a significant premium. It would unjustly enrich the appellant to reduce this premium considerably.
[53] For the foregoing reasons, I would dismiss the appeal.
Appeal allowed.