Court File and Parties

COURT FILE NO.: 676/15 DATE: 2016/08/31 SUPERIOR COURT OF JUSTICE – ONTARIO

RE: PHOENIX INTERACTIVE DESIGN INC., and 1932780 ONTARIO INC. (Applicants) - and - ALTERINVEST II FUND L.P. BY ITS GENERAL PARTNER, BUSINESS DEVELOPMENT BANK OF CANADA (Respondent)

BEFORE: Justice J. N. Morissette

COUNSEL: Raymond F. Leach and Michael A. Polvere, for the Applicants George Benchetrit and Michael Kril-Mascarin, for the Respondent

HEARD: August 5, 2016

AMENDED ENDORSEMENT

[1] The applicant seeks a declaratory order that the “bonus” payment required under a 2011 loan agreement contravenes section 347 of the Criminal Code of Canada. In the alternative, the applicants’ position is that the provisions for the payment of the bonus sought by the Business Development Bank of Canada (“BDC”), a Crown corporation, is unconscionable and/or ultra vires to the BDC.

Background facts:

[2] Phoenix Interactive Design (“Phoenix”) founded by Kyle MacDonald in 1987, developed, distributed and supported multi-vendor automated teller machine (ATM) software and self-service branch automation software solutions for retail banks and other financial institutions. As the business grew over the years Phoenix’s clients included financial institutions across North America, Europe, the United Kingdom, Australia and New Zealand, from regional credit unions to retail banks.

[3] The initial financing of Phoenix with BDC was in 2000, when Phoenix borrowed $500,000.00 and paid that loan off on its maturity date. Subsequently, in 2006, 2009 and 2011, further loans were made to Phoenix by BDC in the amounts of $1,000,000.00, $1,250,000.00 and $2,250,000.00 respectively with each loan being used to repay any balance on the preceding loan and provide some additional funds for working capital.

Issue:

[4] At issue is the loan advanced in 2011 which contained a clause concerning a bonus, the applicant seeks a declaration that it is either contrary to the Criminal Code, or unconscionable and/or ultra vires to the objects of the lender’s statutory obligations.

The loan:

[5] The provisions in the letter of offer of November 25, 2010 from BDC were amended by Ms. MacDonald as follows:

“… a bonus of 1% of the value of the borrowing companies determined as at the closing date of such transaction becomes due and payable.”

To

“a bonus of 1% of the value of the borrowing companies net proceeds received by the shareholder, after transaction costs determined as at the closing date of such transaction becomes due and payable.”

[6] Ms. MacDonald’s evidence as to her intention when amending this provision was to ensure “to capture what would be the end result of the amount that I would end up with. So anything that I had to pay – for accounting fees, legal fees, taxes, anything that would affect what I ended up with myself, is what I was trying to capture here.”

[7] BDC accepted her amendment without change and that language was incorporated into the loan agreement. As a result section 4.6 (a) of the Loan agreement provides:

“If any of the following events occur: if 50% or more of any Borrower (consolidates assets or shares) is sold or merged with an unrelated company; if there is a change of control of any Borrower; or if any Borrower goes public prior to the Maturity Date or extended maturity date of the Credit Facilities this investment; then a bonus of 1% of the net proceeds received by the shareholder, after transaction costs, determined as of the closing date of such transaction becomes due and payable. Notwithstanding any repayment of the Credit Facilities, the bonus referred to herein will remain in full force and effect until the Maturity Date (or any amended maturity date agreed by the Bank) so that in the event of sale, IPO, or similar transaction the Borrower’s obligation to pay the bonus will survive prepayment.”

The litigation:

[8] On April 10, 2015, BDC commenced an application against Phoenix, 1932780 Ontario Inc. and MacDonald seeking information of the sale price in order to calculate the bonus owed to BDC.

[9] On the same day, the applicants commenced this application seeking a declaration that the bonus is unenforceable at law and an interim order vacating the bank’s security against the assets of the applicants upon payment of $262,178.00 into court.

[10] After hearing arguments, the Honourable Mr. Justice Raikes ordered the applicants to pay into court the amount of $975,000.00 as security for the applicants’ obligations with respect to the bonus, interest and costs in order to discharge the bank’s security pending the final determination of their application.

The sale of the business:

[11] In the fall of 2014, Phoenix was approached by Diebold, a public company headquartered in Ohio – regarding a possible purchase by it of Phoenix. As part of the transaction, Diebold required, as a condition to its purchase, that any outstanding loans be repaid.

[12] Knowing that there would be a bonus owing upon the sale of the business, Ms. MacDonald met with Jeff Hill, the managing director of Growth and Transition Capital at BDC on February 9, 2015. Ms. MacDonald did not want to pay the bonus because she believed it to be too generous given the amount of credit advanced. BDC did not agree to change the calculation of the bonus agreed upon in 2011.

[13] On February 25, 2015, Phoenix’s CFO, Hutchinson, requested a payout statement from the bank without any amount owing under the bonus provisions in light of a potential sale of the business to Diebold, stating instead that Ms. MacDonald would deal with the issue of the bonus separately. The bank provided such statement but also reminded the applicants that the bonus would be owing if the business was sold before the maturity date of November 25, 2015.

[14] On March 5, 2015, Phoenix made a prepayment in the amount of $408,944.66 as full and final amount owing under the loan but for the bonus. Between the date of the loan agreement and March 5, 2015, the applicants had made all payments as required under the loan.

[15] On March 13, 2015, Phoenix was sold to Diebold, through a stock purchase agreement for $92,500,000.00 Canadian.

[16] On the advice of Deloitte, a number of transactions were undertaken by Phoenix and its related companies prior to completing the sale of the shares to achieve tax efficiency, and to ensure dividends paid to certain key employees who participated in Phoenix’s success. [emphasis added]

[17] In doing so, a $55,125,000.00 “certified indebtedness” was created as an intellectual property sale between the borrowers’ related companies and the applicants.

[18] The bank argues that the “certified indebtedness” contravened the consent provision in paragraph 8.1 of the loan agreement which the applicant failed to obtain.

[19] The applicants say that the pre-sale transaction to a related company as payment of dividends is contemplated by the loan agreement and is not in contravention of the agreement.

Law and analysis:

Is the bonus contrary to s. 347 of the Criminal Code?

[20] Section 347(1) of the Criminal Code states:

“Despite any other Act of Parliament, everyone who enters into an agreement or arrangement to receive interest at a criminal rate, or receives a payment or partial payment of interest at a criminal rate is:

(a) Guilty of an indictable offence and liable to imprisonment for a term not exceeding five years; or

(b) Guilty of an offence punishable on summary conviction and liable to a fine not exceeding $25,000 or to imprisonment for a term not exceeding six months or to both.”

[21] Section 347(2) of the Criminal Code provides:

“(i) “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 and other similar charge or expense directly or indirectly incurred under the original or any collateral agreement or arrangement;

(ii) “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;

(iii) “interest” means the aggregate of 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 or arrangement, by or on behalf of the person to whom the credit is or is to be advanced, irrespective of the person to whom any such charges and expenses are or are to be paid or payable, but does not include any repayment of credit advanced or any insurance charge, official fee, overdraft charge, required deposit balance or, in the case of a mortgage transaction, any amount required to be paid on account of property taxes.”

[22] It is conceded that the definition of “interest” includes a bonus.

[23] The Bank submits that their expert’s evidence calculates the effective interest rate under the loan including a bonus payment of $925,000.00 to be 26.9 percent.

[24] The applicants submit that once Phoenix paid the loan down to a zero balance on March 5, 2015, any subsequent amount owing, such as a bonus results in an effective annual interest rate that is infinite and therefore exceeds the 60 percent Criminal Code rate.

[25] The applicants’ expert, conceded under cross-examination that he was specifically instructed by the applicants’ lawyers to make his determination of the effective interest rate based on the assumption that zero credit was advanced. However, the loan agreement provided for the requirement for the bonus to be paid regardless of whether any prepayment had been made by the applicants prior to the maturity date.

[26] Accordingly, given the terms of the loan agreement that the bonus is still owing notwithstanding any prepayment before the maturity date, the credit advanced cannot be a zero balance, since the bonus is still owing.

[27] Even if the flawed assumption relied upon by the applicants was sound, the principle that an agreement or arrangement for credit which is legal on its face cannot become illegal under s. 347 through the voluntary act of the debtor.

[28] The Supreme Court of Canada in Garland v Consumers’ Gas Co. [1] and Degelder Construction Co. v. Dancorp Developments Ltd. [2] offers some guidance on the issue of a voluntary prepayment. In essence, where the prepayment is within the control of the borrower and not required by the lender, that prepayment was found to be such a voluntary act by the debtor and therefore could not give rise to illegality under s.347.

[29] I accept the expert evidence of the Bank that the maximum interest rate is 26.9 percent at its worst.

[30] For these reasons, this Court cannot find that the payment of the bonus is contrary to s. 347 of the Criminal Code.

Is the bonus unconscionable?

[31] The applicants argue that the bonus provision in the loan agreement results in an unconscionable windfall for the bank that is contrary to its legislated stated purpose of “support” and “attention to the needs of small and medium-sized enterprises”.

[32] The applicants argue that to pay the amount of bonus sought by the Bank is contrary to public policy because the bonus provision was discretionary both as to whether it is included in any borrower’s loan terms at all, and the percentage amount to be inserted in the bonus template by the loan officer charged with making or overseeing the loan.

[33] The main argument made by the applicants appears to be premised on the fact that the bonus is being […]. They further argue that the bonus is not necessary for the bank to achieve what it considers to be a commercially reasonable return on its loan investment. Further the employee that had the discretionary power to negotiate the terms for the bonus is […], which the applicants say is in conflict with the objects and aims of the banks statutory obligations. That information of self-interest was not disclosed to Ms. MacDonald when she entered into the terms of the loan.

[34] Finally the applicants argue that the bonus is not based on any risk assumed nor is it tied to the amount of the loan advanced. In fact, the evidence demonstrates that the initial loans made had no bonus provisions at a time when they arguably posed the highest degree of credit risk to then seek a bonus provision years later when the applicants had prospered.

[35] At issue for this Court is whether it has the authority to set aside the bonus provisions based on the very able and compelling arguments made by the applicant, without regards to the law of unconscionability as set out in the case law.

[36] The leading authority on unconscionable transactions remains Morrison v. Coast Finance Ltd., (1965) , 54 WWR 257 , 55 DLR (2d) 710 , which provided for four essential elements necessary for a finding that a bargain is unconscionable. In 2007, the Ontario Court of Appeal adopted these four elements in Titus v. William F. Cooke Enterprises Inc. [3] as follows:

(a) A grossly unfair and improvident transaction; and

(b) Victim’s lack of independent legal advice or other suitable advice; and

(c) Overwhelming imbalance in bargaining power caused by victim’s ignorance of business, illiteracy, ignorance of the language of the bargain, blindness, deafness, illness, senility, or similar disability; and

(d) The other party’s knowingly taking advantage of this vulnerability. [4]

[37] Interestingly, the applicants do not address in any way in their factum nor in argument the four elements of unconscionable transactions. Their silence must mean that they have to concede that there is no evidence to suggest that they meet any single one of the elements necessary for a finding that the bonus is unconscionable.

[38] Instead, the applicants rely on Smyth v. Szep where the British Columbia Court of Appeal found, in respect of a Provincial Insurance Corporation, that:

“The community should, in my view, be taken to expect adherence to a high standard of commercial morality of a Crown corporation exercising a monopoly function of this sort in settling claims with members of the public which it serves. While efficiency is, of course, properly expected of such a government enterprise, it would in my view be wrong to assume that the insurance corporation is expected to take unfair advantage of inexperience and unadvised claimants. They are, after all, persons for whose benefit the scheme exists.” [5]

[39] The facts in Smyth are distinguishable from the case at bar. The terms of the loan agreement were not imposed by BDC on the applicants, and BDC does not operate a monopoly in the marketplace. The applicants were free to negotiate more favourable terms with any other lender in the competitive lending marketplace.

[40] Ms. MacDonald is a sophisticated businesswomen who had access to the benefit of independent legal advice from Siskinds and she fully understood the nature of the terms and effect of the bonus provisions.

[41] For these reasons, this Court cannot find that the loan agreement or more specifically the terms of the bonus provision to be unconscionable.

Is the bonus provision Ultra Vires of BDC’s objects?

[42] The Business Development Bank of Canada Act [6] states at sections 4(1) and 4(2):

“(1) the purpose of the bank is to support Canadian entrepreneurship by providing financial management services and by issuing securities or otherwise raising funds or capital in support of those services.

(2) In carrying out its activities, the bank must give particular consideration to the needs of small and medium-sized enterprises.”

[43] The applicants argue that to include a bonus provision, which is not based on the risk profile of the borrower or on the quantum of the credit it has provided, but rather on the success of the particular entrepreneur, is ultra vires of BDC’s objects.

[44] However, in the special BDC Act, Parliament expressly granted BDC the following specific powers:

(a) To make loans and investments; [7]

(b) To determine and charge interest and any other form of compensation for services provided by BDC; [8] and

(c) To determine the remuneration, expense and benefits of its employees as it sees fit. [9]

[45] This Court is unable to find a prohibition for a bonus or restrict the return structure of a loan made by BDC in the Act. By extending the loan to the applicants, BDC supported a Canadian entrepreneur by providing her with financial services to assist her to raise working capital which allowed her to ultimately sell her business for over $92 million.

[46] It remains true, that the applicants had already paid $1,210,000.00 in interest, royalties, and fees on the 2011 loan, in excess of the repayment of $2,250,000.00 in principal for a rate of return of 12.8 percent for the bank. Having said that, there is nothing contrary both in the Act and at law that prevents BDC to negotiate a rate of return, as long as it meets the terms of the law.

[47] For these reasons, this Court cannot find the bonus provision to be ultra vires.

Net Proceeds and calculation of the bonus:

[48] The issues between the parties are with respect to the following:

• whether the “certified indebtedness of $55,125,000” is properly proceeds of sale or not;
• whether the taxes payable are properly deductible from the proceeds; and
• whether the accounting fees and advice are properly deductible from the proceeds.

[49] As indicated earlier, the bonus was not to be payable if the borrower undertook reorganizations and transactions with a related company but rather if it sold or merged with an unrelated company. [emphasis added]

[50] If through legal tax provisions, a vendor can transfer to a related company her industrial property in order for her to pay herself dividends for her efforts made as a key employee of the vendor, this Court cannot find that this pre-sale transaction forms part of the proceeds of sale.

[51] I say this because, if the reorganization which resulted in the certified indebtedness arose for example a year prior to the sale, there would have been no complaint from the Bank, to the extent that MacDonald withdrew dividends legally. The provision that Deloitte recommended to her was not for the purpose of denying the Bank a bonus, but rather to legally provide for reduced taxes and legal dividends payable which MacDonald was allowed to benefit.

[52] The issue of consent does not apply to the pre-sale transaction which was for dividend purposes with a related company.

[53] As for the taxes payable, it is relevant to consider the intentions of Ms. MacDonald when she amended the terms for the bonus. As indicated by McLaughlin, J. in Machtinger v. HOJ Industries Ltd. , [1992] 1 S.C.R. 986 when determining whether intention is relevant to interpret the terms of a contract, she said:

“this question cannot be answered without examining the legal principles governing the implication of terms. The intention of the contracting parties is relevant to the determination of some implied terms, but not all. Intention is relevant to terms implied as a matter of fact, where the question is what the parties would have stipulated had their attention been drawn at the time of contracting to the matter at issue. Intention is not, however relevant to terms implied as a matter of law. As to the distinction between types of implied terms see Treitel, of Contract (7 th ed. 1987), at pp. 158-165 (dividing them into three groups: terms implied in fact, terms implied in law; and terms implied as a matter of custom or usage), and Canadian Pacific Hotels Ltd. v. Bank of Montreal , [1987] 1 S.C.R. 711 .”

[54] Ms. MacDonald’s specific intent in amending the Bank’s original provision for the bonus was to capture what she would end up with. Her intention is relevant as a matter of fact since she had wanted to curtail the quantum of the bonus payable. For these reasons, the taxes payable in the sum of $8,862,167.00 is deducted for the purpose of arriving at the “net proceeds”.

[55] With respect to the accounting advice from Deloitte, the account dated June 4, 2015 in the sum of $ 604,063 specifies the work completed as follows:

“For professional services rendered to April 30, 2015 in connection with income tax advice and other related assistance arising from the disposal of the shares of 1433355 Ontario Inc. held by Habour Grace Holdings Inc. More specifically, the foregoing included advising on the computation of capital gains, safe income attributable to the shares of Habour Grace Holdings Inc., distribution of taxable and capital dividends, negotiations on structuring the transaction with the acquirer and other related tax issues as discussed.”

[56] The respondents argue that the advice appears to be primarily connected with the reorganization transaction and not for the sale transaction per se. The evidence suggests that perhaps that is the case, except that there is evidence [10] that suggests that the accounting advice for the restructuring were submitted prior to that account. Therefore I see no reason why the account of $604,063.00 would not be deductible to determine the net proceeds. The advice was provided for the structure of the sale of the business and is perfectly legitimate professional fees that were paid and are deductible to determine the “net proceeds” for the bonus.

[57] Accordingly, the respondents are entitled to the following bonus payable by the applicants as calculated as follows:

Gross Purchase Price $92,500,000.00 Adjustment for Working Capital ($2,800,000.00) Less the certified indebtedness ($ 55,125,000.00) Adjustment for Working Capital Post-Closing ($ 625,000.00) Less Transaction Costs ($ 228,722.00) Less Accounting and Advisory Fees ($ 604,063.00) Less Income Taxes ($8,862,167.00) Net Proceeds: $24,255,279.00

Disposition:

[58] The applicants shall pay a bonus of 1 percent on the net proceeds of $24,255,279.00 to the respondent in the sum of $242,552.79.00.

[59] Should the parties be unable to agree on the issues of interest and costs, a hearing for same before me may be scheduled through the trial coordinator.

Justice J. N. Morissette Date: Redacted version released September 6, 2016

[1] , [1998] 3 SCR112 (Garland) [2] , [1998] 3 SCR 90 (Degelder) [3] 2007 ONCA 573 [4] Ibid at para. 38 [5] , 1992 10 B.C.A.C. 108 at para. 31 (Smyth) [6] S.C. 1995, c. 28 [7] BDC Act , section 14(1)(a). [8] Ibid, section 22(b). [9] Ibid, section 13(4). [10] At tab 25 of the Applicants’ 2 nd supplementary application record.