COURT FILE NO.: CV-21-00655791-0000
DATE: 20220414
ONTARIO
SUPERIOR COURT OF JUSTICE
BETWEEN:
HYBRID FINANCIAL LTD.
Applicant
– and –
FLOW CAPITAL CORP.
Respondent
Kevin Sherkin and Eric Sherkin, for the Applicant
James Renihan and Fabian Suárez-Amaya, for the Respondent
HEARD: JULY 6, 2021
VELLA J.
AMENDED REASONS FOR DECISION
[1] This is an application by Hybrid Financial Ltd. (“Hybrid”) seeking an order, inter alia, that the financial formula stipulated by the Amended and Restated Royalty Purchase Agreement dated August 10, 2017 (the “Royalty Agreement”) relating to the buyout of two royalties purchased by the Respondent exceeds the criminal rate of interest under s. 347 of the Criminal Code, R.S.C. 1985, c. C-46 (the “Code”).
[2] The Respondent, Flow Capital Corp. (“Flow”), seeks an order requiring Hybrid to pay the amount stipulated by the buyout clause in the Royalty Agreement and triggered by Hybrid’s notice to repurchase the royalties secured under that agreement. It submits that this financial transaction is not captured by s. 347 of the Code.
[3] For reasons that follow, I find that the financial transaction reflected by the terms of the Royalty Agreement is not captured by s. 347 of the Code as it is a hybrid transaction that is predominantly more akin to an equity transaction than a debt or credit transaction.
[4] The application is accordingly dismissed, and the relief sought by Flow is granted.
BACKGROUND
The Royalty Agreement
[5] By way of brief background, Hybrid is an Ontario corporation that carries on business as a sales and distribution company involved in the provision of capital market services, investor relations, asset management and shareholder services.
[6] Hybrid’s Chief Executive Officer, President, and owner is Steven Marshall. Prior to joining Hybrid, Mr. Marshall was CEO of a successful venture capital firm.
[7] Flow provides growth capital for companies across North America and the United Kingdom. It was previously known as Grenville Strategic Royalty Corp.
[8] In 2017, Hybrid was indebted to the Bank of Montreal. The debt was secured by Mr. Marshall’s personal guarantee. Mr. Marshall did not want to carry a personal guarantee and therefore Hybrid searched for an alternative form of financing.
[9] Mr. Marshall approached Flow’s predecessor, Grenville Strategic Royalty Corp. (“Grenville” or “Flow”) on behalf of Hybrid, with a view to securing financing that would allow Hybrid to pay off the bank loan and not require Mr. Marshall to provide a personal guarantee.
[10] Flow and Hybrid jointly prepared an “Investment Memorandum” dated June 23, 2017 which Flow presented to its Investment Committee. Flow’s Investment Committee approved the proposal.
[11] Through negotiations, aided by lawyers representing each party, Flow agreed to provide $750,000 in capital to Hybrid. In exchange, Flow acquired two royalties which are essentially revenue generating assets, subject to a buyout option exercisable by Hybrid. The terms of the transaction are fully reflected in the Royalty Agreement.
[12] Under the Royalty Agreement, Flow was obliged make a monthly royalty payment at a minimum of $15,625 per month for the first two years of the term commencing in 2017. As of January 1, 2019, the monthly royalty payment was to be the greater of $15,625 or an amount tied to Hybrid’s revenues based on a trailing 12-month revenue figure.
[13] Under this financial arrangement, Flow did not acquire any shares in Hybrid, nor did it have a right to a seat on the board of directors or to play any role in the governance of Hybrid. Flow did not have an ownership stake or option in Hybrid.
[14] On the other hand, the monthly payments under the Royalty Agreement were, from January 2019, tied to Hybrid’s monthly revenues such that if the resulting amount was greater than $15,625, the greater amount prevailed. In this way, the royalties secured Flow’s participation in the success of Hybrid while capping its exposure to a minimum monthly payment. The practical ability of Flow to collect revenues from the royalties, however, was subject to Hybrid being solvent and carrying on an active business. If Hybrid were to become insolvent or cease operating, then Flow would be at risk of owning a valueless asset in the form of the royalties without recourse to a personal guarantee or any other form of security.
[15] As well, under the Royalty Agreement, there was no obligation on Hybrid to repay the $750,000 provided by Flow. Rather, s. 2.9 gives Hybrid the right to repurchase the royalties once Hybrid had made royalty payments totalling at least $750,000 (the “buyout clause” or “buyout option”). Under s. 2.9, Hybrid must pay the greater of $1,500,000 or 5% of Hybrid’s net equity value. However, subject to the buyout clause, Hybrid was to make the stipulated royalty payments in perpetuity.
[16] Also relevant to this analysis is the fact that the Royalty Agreement required Hybrid to provide Flow with certain financial disclosure on a monthly basis in order to ascertain both the monthly royalty payments as of 2019 and the buyout purchase price.
[17] The parties accept that in June 2020, Hybrid gave notice of its right to exercise the buyout option. By that time Hybrid has paid an aggregate of $828,205.34 in monthly royalty payments, thus satisfying the condition precedent to the exercise of that option.
Events Following Hybrid’s Notice To Repurchase The Royalties
[18] Initially, Hybrid offered to buy out the royalties by paying $1,500,000 over three years. Flow rejected this offer stating that it was to be paid as a lump sum.
[19] Flow suggested that the parties mutually engage an independent valuator to determine Hybrid’s net equity value pursuant to the terms of the Royalty Agreement.
[20] On July 16, 2020, Hybrid notified Flow that there was now a dispute, within the meaning of section 2.8 of the Royalty Agreement. Under section 2.8, the parties remain bound to the terms of the Royalty Agreement during the course of a dispute.
[21] On July 30, 2020, the parties jointly retained KPMG to conduct a valuation of Hybrid’s net equity pursuant to s. 2.8 of the Royalty Agreement.
[22] Beginning in July 2020, Hybrid ceased to provide the required financial disclosure under the Royalty Agreement to Flow. This meant that Flow could not calculate the amount of monthly royalty payments due as that amount was dependent on Hybrid’s 12 month trailing revenue. In response, Flow reverted to sending invoices for the fall back minimum monthly amounts of $15,625 to Hybrid, without prejudice to its right to claim any outstanding balance that might be due under the Agreement’s net equity valuation formula.
[23] Hybrid made the minimum monthly royalty payments (albeit late) from June to October 2020 and ceased paying anything at all as of November 2020.
[24] KPMG delivered a draft valuation report dated November 16, 2020. It estimated Hybrid’s net equity value to be approximately $75,500,000. Using this 5% net equity valuation stipulated in the Royalty Agreement, the purchase price of the royalties under the buyout clause would be $3,775,000.
[25] Hybrid disputed this valuation and claimed that the net equity value of the company was under $30,000,000 thereby justifying its offer of $1,500,000 under the buyout clause.
[26] On November 26, 2020, for the first time, Hybrid asserted its claim that the Royalty Agreement is in violation of section 347 of the Code. In addition, it, unlike Flow, refused to provide the requested comments to KPMG on its draft report, and then instructed KPMG not to complete the net equity valuation report. KPMG also stated that it could not finalize its valuation without Hybrid’s comments.
[27] The parties have been at a standstill ever since.
ISSUES
[28] The main issue to be determined is whether the capital payment secured by the Royalty Agreement is predominantly a “credit advanced” attracting “interest” within the meaning of s. 347 of the Criminal Code. If so, does the s. 2.9 of the Royalty Agreement violate s. 347 of the Code?
[29] In the event that the financial transaction as reflected by the terms of the Royalty Agreement is not captured by s. 347 of the Code, then what steps under the must be taken in order to complete the buyout of the royalties?
ANALYSIS
[30] At the heart of this proceeding is a determination of the nature of the financial transaction represented by the Royalty Agreement. It is apparent that the Royalty Agreement features characteristics of both a traditional loan/credit transaction and an equity investment, thus appropriately characterized by both parties as a hybrid agreement. However, the task for this court is whether this financial transaction is of the type that is captured by s. 347 of the Criminal Code.
[31] Hybrid focused its argument on the issue of whether the amounts due under the Royalty Agreement constitute “interest” within the meaning of s. 347. However, in my view, it makes sense to consider whether the advance of $750,000 can be properly characterized as a “credit advanced” alongside whether the payments by Hybrid collectively comprise “interest” under s. 347. As will become apparent, the analysis of these two determinations are inextricably intertwined.
[32] If the advance of $750,000 by Flow is properly characterized as predominantly a debt transaction, or as suggested by Hybrid, a revolving line of credit, and if the buyout payment constitutes “interest” and exceeds the maximum percentage interest rate of 60% stipulated by s. 347 of the Criminal Code, then by virtue of s. 6.13 (Maximum Rate Permitted) the applicable interest rate defaults to 59%.
Relevant Contractual Provisions
[33] I will focus my analysis first on an interpretation of the relevant provisions under the Royalty Agreement to determine whether the Royalty Agreement, as a hybrid agreement, is more appropriately characterized as predominantly an “equity” arrangement or, alternatively, a credit arrangement.
[34] In Canada Deposit Insurance Corp. v. Canadian Commercial Bank, 1992 CanLII 49 (SCC), [1992] 3 S.C.R. 558 (CDIC), the Court considered whether a financial transaction was a loan or a capital investment within the context of the winding up of a chartered bank. At p. 588, Iacobucci J. described the approach to this analysis as follows:
As in any case involving contractual interpretation, the characterization issue facing this Court must be decided by determining the intention of the parties to the support agreements. This task, perplexing as it sometimes proves to be, depends primarily on the meaning of the words chosen by the parties to reflect their intention. When the words alone are insufficient to reach a conclusion as to the true nature of the agreement, or when outside support for a particular characterization is required, a consideration of admissible surrounding circumstances may be appropriate.
In this case, the Court found that while the transaction had an equity component (warrants to buy shares), that component was only incidental to what was in substance a debt transaction based on the wording of the underlying agreement.
[35] Therefore, this exercise requires the court to carefully examine the wording of the Royalty Agreement as the first step in determining the intention of the parties with respect to the type of financing arrangement reflected in it (Millson v. 1156653 Ontario Limited (2007), 2007 CanLII 21591 (ON SC), 38 B.L.R. (4th) 69 (Ont. S.C.), at paras. 240-41). The material clauses are set out next.
[36] Section 2.2 of the Royalty Agreement sets out the formula for the revenue stream of monthly payments accruing to Flow from the purchase of the two royalties:
As consideration for, and conditional on, the payment by the Purchasers of the Initial Installment and (if applicable) any Subsequent Installment, and subject to the terms hereof, the Company [Hybrid] covenants and agrees to pay to Grenville, at such times and in such manner as required by Sections 2.4 and 2.5, subject to termination or reduction as set forth in this Agreement, a royalty (each, a “Royalty Payment”) determined in accordance with the following (the “Gross Sales Royalty”):
(a) for and in respect of the period commencing on the Effective Date and ending on (and including) December 31, 2018, the Company shall pay to Grenville the sum of $15,625 (the “Minimum Monthly Amount”) on a monthly basis pro-rated for any partial month (it being understood that the final payment to be made under this Section 2.2 (a) shall be made on December 31, 2018, which amount shall represent the Royalty Payment attributable to the month of December, 2018); and
(b) effective as of and including January 1, 2019, the Company shall pay to Grenville a monthly Royalty Payment equal to the greater of (x) the Minimum Monthly Amount, and (y) the amount determined in accordance with the following (it being understood that the first payment to be made under this Section 2.2(b) shall be made by the Company on January 31, 2019, which amount shall represent the Royalty Payment attributable to the month of January, 2019):
(i) if Trailing 12 Month Revenue is equal to or less than $6,500,000, 2.4% of monthly Revenue of the Hybrid Group during each calendar month, in perpetuity (unless terminated in accordance with this Agreement), and pro-rated for any partial month, which percentage shall be effective from and including, and following, January 1, 2019;
(ii) if Trailing 12 Month Revenue is equal to or greater than $10,000,000, 1.62% of monthly Revenue of the Hybrid Group during each calendar month, in perpetuity (unless terminated in accordance with this Agreement), and pro-rated for any partial month, which percentage shall be effective from and including and following, January 1, 2019; or
(iii) if Trailing 12 Month Revenue is greater than $6,500,000 but less than $10,000,000, such percentage of monthly Revenue of the Hybrid Group determined by dividing the applicable Royalty Numerator with respect to the Aggregate Instalment Amount from Table 1 below, by the amount of the Trailing 12 Month Revenue, and multiplying the result by 100. The resulting percentage shall be effective from and including, January 1, 2019. For illustrative purposes only, if Trailing 12 Month Revenue is $8,000,000 and the then applicable Aggregate Installment amount is $750,000, the Gross Sales Royalty effective from and including, in perpetuity following, January 1, 2019 will be 1.99% (being 159,429/8,000,000 times 100).
[37] The Royalty Agreement sets out a contractual formula relative to the buyout clause:
2.9 Buyout Option
(a) Subject to Section 2.9(b), at any time following the date on which the Purchasers have received Royalty Payments that are, in the aggregate, equal to the then applicable Aggregate Installment Amount, the Company may by delivery of notice in writing to Grenville (an “Buyout Notice”) purchase and extinguish all (but not less than all) of the amounts owing or to become owing to the Purchasers hereunder (but excluding any amounts which are or may be, owing under Section 2.12(c)), including the Aggregate Installment Amount and the Gross Sales Royalty applicable thereto (the “Buyout Option”), upon payment to Grenville by wire transfer of immediate available funds on the date that is no later than the third Business Day following the date of the Buyout Notice of an amount equal to the greater of the following:
(i) an amount equal to two times the Aggregate Installment Amount as at the date of the Buyout Notice; and
(ii) an amount equal to A multiplied by B multiplied by C, where:
(A) A is equal to the Aggregate Installment Amount as at the date of the Buyout Notice divided by $12,000,000;
(B) B is equal to 0.8; and
(C) C is equal to the net equity value of the Hybrid Group as determined by a third party valuator mutually agreed upon by Grenville and the Company (or, if the Buyout Option is being exercised in connection with a Change of Control, the net equity value of the Hybrid Group based on the terms of the proposed Change of Control transaction).
[38] The Royalty Agreement also has an entire agreement clause.
[39] Hybrid placed considerable reliance on the following clause:
6.13 Maximum Permitted Rate
Under no circumstances shall a Purchaser be entitled to receive nor shall it in fact receive a payment or partial payment (whether in the form of Royalty Payments, Buyout Payments or otherwise) under or in relation to this Agreement at a rate that is prohibited under Laws. Accordingly, notwithstanding anything herein or elsewhere contained, if and to the extent that under any circumstances the amounts received or to be received by a Purchaser pursuant to this Agreement or any agreement or arrangement collateral hereto entered into in consequence or implementation hereof would, but for this Section 6.13, be a rate that is prohibited under Laws, then the effective annual rate, as so determined, received or to be received by a Purchaser shall be and be deemed to be adjusted to a rate that is one whole percentage point less then the lowest effective annual rate that is so prohibited (the “Adjusted Rate”); and, if such Purchaser has received a payment or partial payment which would, but for this Section 6.13, be so prohibited then and the amount or amounts so received by such Purchaser in excess of the lowest effective annual rate that is so prohibited shall and shall be deemed to have comprised a credit to be applied to subsequent payments on account of other amounts due to such Purchaser at the Adjusted Rate.
[40] Laws are defined to mean “applicable laws (including common law), statutes, codes, bylaws, rules, regulations, orders, ordinances, protocols, codes, guidelines, treaties, policies, notices, directions, decrees, judgements, awards or requirements, in each case of any Governmental Authority.
[41] Also notable in this Royalty Agreement is the fact that nowhere in the document is there a reference to a “loan”, “debt” or “credit facility” or “credit”. The term used by these sophisticated parties to describe the asset secured by Flow is a “royalty”, and valuation of the buyout option is premised on the “net equity” of Hybrid.
[42] The term “indebtedness” only appears in Section 3.11 by way of a representation by Hybrid that it has no material indebtedness other than as set out in its disclosure letter. A specific reference to “interest” is made any Section 2.4(b)(f) of the Royalty Agreement but only as chargeable on late payments at the rate of 1% per month, compounded monthly.
[43] The Royalty Agreement does not require Hybrid to repay a debt obligation to Flow. Rather, as stated, Hybrid is obliged to make monthly payments to Flow called royalty payments.
[44] Finally, the advancement of $750,000 is clearly set out as consideration for the purchase of two royalties by Flow which, in turn, is called a purchaser throughout the Royalty Agreement. The advancement of each amount (of $425,000 and $325,000 respectively) is called an “installment”, with the opportunity for more such installments to be made by Flow to purchase additional royalties.
[45] These are features of an equity investment and are supported the plain language of the Royalty Agreement.
[46] On the other hand, the fact that Flow was guaranteed of minimum monthly royalty payments (subject to the upside of increased revenues) is a feature that is more akin to a debt transaction since pure equity arrangements do not provide any guarantee of recovery of the capital investment and are entirely dependent on the success of the business. Furthermore, Flow was not granted any ownership stake in Hybrid.
[47] There is no doubt that the Royalty Agreement is a hybrid agreement.
Section 347 of the Criminal Code
[48] This part of the analysis focuses on a statutory interpretation of subsections 347(1) and 347(2) of the Criminal Code. Section 347(1) of the Code makes it illegal for a lender enter into an agreement or arrangement to receive interest at a criminal rate. Section 347(2) provides the relevant statutory definitions:
(2) In this section,
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;
criminal rate means an effective annual rate of interest calculated in accordance with generally accepted actuarial practices and principles that exceeds 60% on the credit advanced under an agreement or arrangement;
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 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 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 should fee, overdraft charge, required deposit balance or, in the case of a mortgage transaction, and the amount required to be paid on account of property taxes;
[49] There is considerable jurisprudence providing guidance on the interpretation of these definitions and their application to hybrid financial transactions. Critical to this court’s analysis of the gravamen of the Royalty Agreement are the meanings of the terms “credit advanced” and “interest” and whether the advance of $750,000 and the money payable under the buyout clause are captured by those statutory definitions.
[50] In making this determination, the court is concerned with the substance of the underlying Royalty Agreement. The court must determine the nature of the underlying financial transaction by examining the words of the Royalty Agreement as a whole so as to ascertain the intentions of the parties at the time they entered into this transaction. Did they intend the financial arrangement to be, in essence, a conventional debt/credit transaction or a creative commercial investment transaction that avoided some of the more restrictive features of a debt transaction?
[51] In Cirius Messaging Inc. v. Epstein Enterprises Inc., 2018 BCSC 1859, 16 B.C.L.R. (6th) 380, the court considered the application of s. 347 to a hybrid agreement that featured both debt and equity components. The BC Supreme Court observed, at para. 74, that the line between debt and equity, from a commercial perspective, has become “blurred”, and that there are now “many financings that are hybrid in nature”.
"Credit Advanced"
[52] In examining the financial components of the Royalty Agreement through the lens of s. 347, the court must determine whether the $750,000 provided by Flow to Hybrid falls within the meaning of “credit advanced”. In other words, was the provision by Flow of the sum of $750,000 by way of a loan or credit facility, or rather by way of a capital investment in Hybrid.
[53] Hybrid submits that the financial arrangement was in effect a revolving line of credit, while Flow takes the position that it was a capital investment in the business in return for a stream of revenues tied to the success of Hybrid and secured through its purchase of the royalties.
[54] Both parties rely on the Supreme Court of Canada’s decision rendered in Garland v. Consumers’ Gas Co., 1998 CanLII 766 (SCC), [1998] 3 S.C.R. 112. In that decision, the Supreme Court considered whether an interest rate of 5% on unpaid monthly utility bills charged as a late payment penalty on consumers by a utility company was captured by s. 347 of the Criminal Code.
[55] In considering the scope and ambit of the phrase “credit advanced”, the Supreme Court, at para. 33, observed that while s. 347 is not confined to “loan-sharking” situations, it does require:
[T]ransactions which involve an advance of money in some form, whether in a conventional loan, a mortgage, a commercial financing agreement or otherwise.
[56] Furthermore, at paras. 34, 35 and 37 of that decision, the Supreme Court added:
[34] Notably, this definition encompasses not only “the money” advanced under an agreement or arrangement, but also “the monetary value of any goods, services or benefits” which may be so advanced. The scope of s. 347 therefore is not confined exclusively to loans of money….
[35] The most plausible interpretation of s. 347(2) is that an “advance” of “the monetary value of any goods, services or benefits” means a deferral of payment for such items. A debt is deferred – and credit extended – when an agreement or arrangement permits a debtor to pay later than the time at which payment would otherwise have been due…. The substance of such “credit” is a determined amount of money which is payable over time. Unlike the principal of the loan, however, such credit is not initially paid out to the debtor in the form of money, but arises when a debt is incurred for goods, services or benefits, and that debt is then deferred in full or in part by agreement of the parties.
[37] It is crucial to bear in mind that the “credit advanced” in such situations consists of “monetary value” – a specific amount of money that is owed for goods, services or benefits pursuant to an agreement or arrangement – and not the goods, services or benefits themselves. If every sale, performance of services or conveyance of benefits were understood to be an advance of “credit”, there would be virtually no limit to the application of s. 347. That section, despite its broad scope, is essentially concerned with regulating the relationship between creditors and debtors, not the relationship between commercial actors in the ordinary course of business.
[57] The Supreme Court also cautioned, at para. 39, that Parliament did not intend to capture “absurd” results such as, for example, triggering the Criminal Code interest rate as to capture leasing agreements. The Court gives the example of renting a car for a day where the car is the “credit advanced” but the payment is due the same day could give rise to an “astronomical interest rate” based on the value of the car rental to illustrate the point. In other words, not all commercial financing arrangements are intended to be captured by s. 347 of the Code.
[58] At para. 39, the Supreme Court also stated that in order for a deferral of a debt to be considered a “credit advanced” under s. 347, “there must be a specified amount owing, and that amount must actually be due in the absence of an arrangement permitting later payment.”
[59] In CDIC, at pp. 590-91, the Supreme Court of Canada recognized that contemporary commercial reality calls for creative commercial financing arrangements resulting in hybrid agreements featuring a mix of debt and equity components. The Court reminds us, at p. 588, that in order to determine the true nature of a financial agreement, the court must determine the intention of the parties. Only if the words in the document are ambiguous or gives rise to uncertainty, should the court look to surrounding circumstances as may be appropriate and admissible.
[60] The Court, in CDIC, found that the substance of the hybrid financial transaction at issue was really a loan when considered as a whole because there were several components requiring payment of money by the borrower to the lender including a specific interest component. The transaction as a whole had all of the features of a debt transaction. The fact the transaction included warrants to purchase shares giving rise to an equity component did not transform it into an equity transaction because the warrants were merely “sweeteners” to the otherwise conventional $255 million loan transaction; i.e., an upside to induce the lenders to enter into the transaction. In that case, the loan agreement described the advance of $255,000,000 as a “debt” that had to be repaid by a certain date. The warrants to purchase shares (embodied in a separate “equity agreement’) were found to be insufficient to “tip the scales when faced with the strong indicia of debt present here” (p. 592) when the words of the agreements were examined.
[61] This is not the situation reflected in the Royalty Agreement based on a plain reading of that agreement as a whole.
[62] As indicated earlier, the royalties, while not giving rise to an ownership/equity interest in Hybrid, do give rise to a right to participate in the revenues to Hybrid, and the buyout option is tied to the net equity value of Hybrid. Flow purchased two royalties for fixed amounts of capital. The royalties are in effect revenue generating assets. In the first two years, the revenue stream was a fixed monthly sum. However, in the following years, the royalty payments were tied to the revenues of Hybrid in perpetuity, subject to a guaranteed minimum monthly amount. The royalties could be repurchased by Hybrid, at its option, once it made at least $750,000 in royalty payments (the equivalent of the capital advanced) by paying the greater of $1,500,000 or 5% of Hybrid’s net equity value under s. 2.9 of the Royalty Agreement.
[63] As noted in Bimman v. Neiman, 2015 ONSC 2313, 41 B.L.R. (5th) 95, at para. 205, aff’d 2017 ONCA 264, a fundamental feature of equity investments is the risk that investors take that they may not receive any return on their capital investment and may lose the capital itself. In this way, equity investors share in both the risk and profit of an enterprise. In this case, at para. 205, the court recognized that equity can take the form of a royalty agreement.
[64] In the Royalty Agreement, Flow capped its downside by requiring a monthly minimum payment, where the net revenues of Hybrid would not justify a higher amount, and also required that a minimum of $750,000, its capital payment, be fully repaid before the buyout option could be triggered by Flow. This was counterbalanced by the fact that Mr. Marshall was not required to provide a personal guarantee nor did Hybrid have to pledge any security for the $750,000 purchase price of the royalties.
[65] Most telling of what the intentions of these parties were when they entered into the Royalty Agreement are the words used to describe the advance of funds by Flow, and the corresponding payment obligations of Hybrid. Nowhere in the Royalty Agreement is the advance of the respective sums of $425,000 and $325,000 by Flow characterized as a “loan”, “debt”, “credit” or any type of credit facility or loan arrangement. Rather the consideration for the advance of capital is the “purchase” of royalties. Similarly, the corresponding payment obligations of Hybrid are not characterized as interest payments, nor is there any allocation of these payments as between principal and interest in the Royalty Agreement. Rather, they are called “royalty payments”. Further, there is no requirement of any kind on Hybrid to ever repay the principal sum of $750,000. The Royalty Agreement expressly states that the royalty payments are to be made “in perpetuity”. The sum required for Hybrid to buy back the royalties and end the royalty payments is referred to in the Royalty Agreement as the “buyout payments” (s. 2.5).
[66] In short, the Royalty Agreement read as a whole does not support a characterization as predominantly, or in substance, a loan agreement or credit facility agreement. Rather, this financial transaction centres around the sale of a revenue generating asset by Hybrid to Flow with an ability to buy back that asset under terms specified by the Royalty Agreement. This is not analogous with a loan or credit arrangement which is premised on advancing credit that must be ultimately paid back on terms that include an interest component.
"Interest"
[67] Even if the purchase of the royalties (in the total sum of $750,000) could be seen as a “credit advanced”, within the meaning of s. 347 of the Criminal Code, the repayment mechanism does not have the features of “interest” as defined in the Code and applied in the jurisprudence.
[68] In Garland, at para. 27, Major J. confirmed that the definition of “interest” in s. 347 is “an extremely comprehensive term, encompassing many types of fixed payments which would not be considered interest proper at common law or under general accounting principles.”
[69] In Cirius Messaging Inc., the issuance of warrants to purchase common shares did not constitute interest within the mean of s. 347 in the context of the financing arrangement when considered as a whole. At para. 84, the court defined “interest” as a fixed or specific payment incurred by a borrower for the advancing of credit. At para. 124, the court went on to observe that if the amount payable on the advancement of the funds is dependent on an appraisal of the worth of the enterprise, that cannot constitute “interest” within the meaning of s. 347 of the Criminal Code. Interest must be set out as a fixed rate of percentage or readily calculable as a fixed percentage (like the prime interest rate plus 2 percent). See also 12178711 Canada Inc. v. Wilks Brothers, LLC, 2020 ABCA 430, 17 Alta. L.R. (7th) 228, at para. 58 and In the Matter of the Notice of Intention to Make a Proposal of CIM Bayview Creek Inc., 2021 ONSC 220, 86 C.B.R. (6th) 273, at para. 62.
[70] Hybrid submits that a royalty has been found to be “interest” within the meaning of s. 347. It relies on Transport North American Express Inc. v. New Solutions Financial Corp., 2004 SCC 7, [2004] 1 S.C.R. 249, at paras. 10 and 19, Millson, at para. 244, Fawcett v. Western Canadian Coal Corp, 2010 BCCA 70, 3 B.C.L.R. (5th) 13, at paras. 16, 44-47 and Boyd v. International Utility Structures Inc., 2002 BCCA 438, 216 D.L.R. (4th) 139, at paras. 18-20, 31-33, and 40-41. In each of these cases, the financing arrangement under scrutiny was found to be a debt or “credit advanced” within the meaning of s. 347.
[71] It is true that repayment obligations which have included a royalty or share component have been included in the calculation of the “criminal” interest rate under s. 347 of the Code.
[72] In Transport North American Express Inc., the Supreme Court was dealing with an agreement that described funds advanced as a credit facility. One of the components of the terms of the advancement of the credit in the principal amount of $500,000 was a payment of a royalty in eight quarterly installments totalling $160,000.00. There were other forms of consideration governing repayment including a stipulated interest rate and other fees.
[73] The Supreme Court stated, at para 19:
The definition of “interest” in s. 347(2) is broad… The various payments made by TNAE, with the exception of any portion of the payments relating to the repayment of principal, satisfy the definition of “interest” as defined ins. 347(2). This includes the “royalty payments”. I agree with the courts below that the payments made by TNAE to New Solutions cumulatively amount to an interest rate in excess of that permitted by the Code.
[74] The Supreme Court found, based on the wording of the agreement which included an obligation to repay the principal amount of the credit facility, that the royalty payment was included as consideration for the overall debt transaction and thus subsumed as part of the total interest calculation required under s. 347. In other words, the royalty payments were incidental to the debt transaction.
[75] What was at issue at that case, however, was whether judges in Canada are “permitted by law to exercise remedial discretion to partially enforce a contract contravening s. 347 of the Code by reading down interest rate provisions to avoid what would otherwise be illegality”. In that case the Supreme Court permitted the reading down of the agreement. There was no doubt that the underlying transaction, however, was a “credit advanced” within the meaning of s. 347 based on the plain wording of the agreement.
[76] In Millson, again, there was no doubt that the underlying financial transaction involved a “credit advanced” within the meaning of s. 347 as it was styled as a loan agreement, the parties were described as the lender and borrower, and the agreement had a fixed debt and repayment obligation payable at a fixed rate of interest. What was at issue was whether a fee for service in a separate consulting agreement was subsumed in the definition of “interest” as being part of the cost of the loan. The court found that the consulting agreement was not linked to the loan. The parties to the consulting agreement were not the same as to the loan agreement, and the consulting agreement fees were linked to the sale of slot machines, not the loan.
[77] In the Boyd and Fawcett cases, royalties were found to fall within the definition of “interest” under s. 347. However, the reason why royalties were found to constitute interest was because they were identified as consideration for what the parties expressly characterized as loans in the underlying agreements.
[78] In Boyd, the borrower agreed to pay a royalty as part of the consideration for a loan. In the underlying financial agreement, the parties expressly characterized the financial transaction as a loan and formally documented it as such. The associated, but separate, royalty agreement was explicitly stated to be consideration for the loan referenced in the loan agreement, and the loan agreement similarly stipulated that the royalty was in consideration for the loan. Under those circumstances, the British Columbia Court of Appeal found that the royalty payments constituted interest under s. 347.
[79] In Fawcett, the British Columbia Court of Appeal found, at para. 45, that the Royalty Sharing Agreement (“RSA”) contained a covenant for the repayment of the advances arising from prior loans and purchase transactions. The Court found with reference to the loan component of the RSA, that certain royalty payments were expressly stipulated as consideration for the loan. Therefore, at paras. 45 and 47, the court found that those royalty payments made in reference to the loan transaction constituted “interest” under s. 347, following Boyd.
[80] Conversely, the Court found, at para. 46, that the RSA was, in substance, a commercial agreement. Certain royalty payments were made in reference to what were “sale purchase transactions”. Those royalty payments did not constitute “interest” within the meaning of s. 347 of the Code.
[81] These cases are of limited assistance to Hybrid in light of the fact that they were premised on the fact that the transactions were expressly characterized by the parties as loans in the underlying agreements and thus “credit advanced”. The mischief that was addressed by the court in these cases was the attempt by lenders to design a loan or credit transaction using a conventional legal rate of interest, and then add on other financial obligations that, if severed from the interest component, would escape s. 347, but if included in the calculation would be in violation of s. 347. The courts will not allow these attempts to subvert the prohibition provided by s. 347 by severing these other financial components from the purely interest-based components of the terms of repayment of what is otherwise acknowledged by the parties to be a loan or credit agreement.
[82] There is no reference in the Royalty Agreement supporting the characterization of the advanced funds as a loan or credit arrangement. There is also no obligation to repay, or pay a rate of interest on the, advance of $750,000. The royalty payments are not identified as consideration for obtaining a loan or credit facility in the sum of $750,000. Subject to my analysis of s. 6.13 of the Royalty Agreement, the language used by the parties in the Royalty Agreement reflects an intention to structure a creative hybrid commercial financing agreement that is not captured by s. 347 of the Code.
What is the effect of the Maximum Rate Clause?
[83] Hybrid submits the purpose of inserting s. 6.13 into the Royalty Agreement was to ensure that the royalty payments and the buyout payment would not exceed the criminal interest rate stipulated by s. 347 of the Code and reflects the common intention of the parties entering into this arrangement. It relies on Mr. Marshall’s evidence that the intention of the parties of inserting this clause was to ensure that the interest rate payable by Hybrid not violate s. 347. Hybrid points out that Flow acquired the Royalty Agreement by assignment. It was not a party to the negotiations and therefore Flow has offered no evidence to contradict Mr. Marshall. Flow’s deponent, Mr. Baluta, testified under cross examination that he did not know of the circumstances surrounding the execution of the Royalty Agreement since he was not employed by Flow at that time.
[84] Hybrid submits that s. 6.13 cannot be reconciled with s. 2.9 except by understanding the transaction to be a revolving line of credit.
[85] Hybrid submits that there would be no meaning given to s. 6.13 if not to incorporate by reference s. 347 of the Code into it as governing the maximum payment terms payable under the Royalty Agreement.
[86] Flow submits that Section 6.13 cannot be used to transform what is otherwise a commercial hybrid financial arrangement that is not on its face a loan or credit facility agreement attracting an interest component by way of royalties into one. It submits that this is a standard clause to save the transaction in the event it should be found to run afoul of any law, not that it was premised on an assumption that s. 2.9 would ultimately violate a law, much less s. 347 of the Code. It points to s. 6.5 of the Royalty Agreement which is a standard severability clause requiring that any part of the agreement found to be illegal or unenforceable be severed from the balance of the agreement and notes that Article 6 (entitled “General”) contains the standard general provisions found in many contracts.
[87] Neither party provided any jurisprudence to support their respective positions. However, it is elemental that specific contractual provisions must be considered in the context of the whole of the contract but will generally trump the general provisions of a contract.
[88] If, as Mr. Marshall deposed, the purpose of s. 6.13 was to incorporate by reference s. 347 of the Criminal Code as governing the payment terms, why not specifically reference that provision or at least specify that the royalty payments and/or buyout amounts constitute “interest”? More telling is the fact that the rest of Royalty Agreement overwhelmingly supports the interpretation that this financial transaction was not, in substance, intended by the parties to be a loan or revolving line of credit. The absence of language in the Royalty Agreement describing this transaction as a debt, loan or credit facility, together with the words used to describe this transaction, is a strong indication that the parties’ respective intention was to create a non-debt financial transaction more akin to an equity transaction, thus falling outside the scope of s. 347.
[89] Hybrid’s argument is premised on the assumption that the Royalty Agreement is in fact a debt transaction. However, this is a circular argument. If this court finds that the Royalty Agreement is predominantly a debt transaction and thus captured by s. 347 of the Code, then s. 6.13 would apply to cure the illegality by replacing the criminal interest rate with the formula of the maximum permitted interest rate of 60% with one percent less, or 59%. Conversely, if this court finds that the Royalty Agreement is predominantly an equity-like transaction, then is not captured by s. 347 and s. 6.13 has no application to the payments and buyout amount.
[90] Does this mean that s. 6.13 has no meaning? In my view, s. 6.13 still has meaning and purpose. For example, s. 6.13 states that it also has application to “any agreement or arrangement collateral hereto”. Section 6.13 is a general provision intended to provide a fallback position in the event that royalty payment, buyout payment or any other payment required under the Royalty Agreement was found to be in violation of any applicable law (as defined). It does not transform an otherwise legal agreement into one that is in violation of the law.
Conclusion
[91] As indicated before, there is no reference to the $750,000 advanced by Flow being some sort of loan, debt or credit facility and also of interest. To the contrary, the words in of the Royalty Agreement, chosen by two sophisticated corporate entities through negotiations aided by lawyers, lacks most of the hallmarks of a loan, debt or credit facility. By way of example, the Royalty Agreement shows that:
a) it is styled as a “Royalty Purchase Agreement” (emphasis added);
b) the subject royalties are described throughout as a “purchase” not a loan;
c) the royalty payments, after the second year of the Royalty Agreement, are tied to Hybrid’s revenues;
d) the buyout amount for the royalties is tied to Hybrid’s net equity value;
e) the advancements of capital to buy the two royalties are termed the “Initial Installment” and “Second Installment” respectively, and the royalties are stated to be “purchased” from Hybrid for the stipulated sums ($425,000 and $325,000) “plus all applicable Taxes”;
f) potential third parties that could contribute to further royalty purchases are described as “investors” and in s. 2.1(c) as “co-investors” with Grenville (now Flow);
g) Flow is provided with an opportunity to purchase more royalties from Hybrid (to a maximum amount) and this opportunity is called a “potential investment” under s.2.1(c);
h) It contains no provision requiring the repayment of any amount of fixed debt; and
i) the only section that expressly references an “interest” rate is s. 2.4(f), and it only It applies to any late payment made under the Royalty Agreement.
[92] Weighed within the context of the language used (and not used) by the parties in the Royalty Agreement is the absence of any personal guarantee from Hybrid’s owners – one of the key motivators behind Hybrid seeking to retire its bank debt and replace it with the financing arrangement negotiated with Grenville and assigned to Flow.
Is the Royalty Agreement’s Financing Arrangement captured by s. 347, Criminal Code?
[93] For the reasons stated, the Royalty Agreement is not predominantly, or in substance, a debt or loan transaction or an agreement for a credit facility (including a revolving credit facility). As stated by the courts, in today’s commercial environment, parties are entering into creative financing agreements to permit the movement of capital to risky ventures beyond the constraints of conventional debt financing. This Royalty Agreement reflects a creative financing hybrid arrangement that features the potential of a high or low return for Flow (or even no return if Hybrid ceases business) depending on the success of Hybrid.
[94] Section 347 of the Code was not intended to capture creative commercial financing arrangements including hybrid agreements in which the true nature of the agreement is more akin to an equity arrangement and not a loan arrangement. Here, the royalties were sold by a sophisticated corporate entity, aided by lawyers, as a revenue generating asset that could be bought back, to allow it to retire a bank debt. The royalty payments are not incidental to a debt repayment scheme. Section 347 of the Criminal Code was not intended to foreclose creative financing commercial arrangements between sophisticated parties negotiating on a level playing field. There is no suggestion that Hybrid was in dire straits and had nowhere to turn for financing other than Flow. Hybrid had secured financing in the form of a traditional debt/loan from a bank. It wanted a different type of financial arrangement and that is what it bargained for. It cannot now resile from that arrangement because it is more successful than it anticipated in would be when it entered into the Royalty Agreement.
Did Hybrid voluntarily trigger an interest rate that exceeds the maximum rate under s. 347 of the Criminal Code?
[95] In the event that I am wrong in my conclusion that the Royalty Agreement is fundamentally akin to an equity arrangement, and is captured by s. 347 of the Criminal Code, Flow submits the rate of interest was triggered by the voluntary act of Hybrid when it exercised its right to buy out the royalties.
[96] As held in Garland, at para. 58 and Nelson at para. 17 (dealing with the predecessor of s. 347), a “criminal” rate of interest cannot be triggered by the voluntary act of the borrower. Rather the legality of the interest rate must be determined as at the date of the transaction, and take into account the intended term of the repayment obligations.
[97] In Delgelder Construction Co. v. Dancorp Developments Ltd., 1998 CanLII 765 (SCC), [1998] 3 S.C.R. 90, at para. 24, the Supreme Court explicitly affirmed Nelson:
The holding of Nelson was that a transaction which was legal when entered into cannot become illegal under s. 347 through a voluntary act of the debtor. That conclusion was affirmed by this Court. (emphasis in original)
[98] More recently, the Court of Appeal in Phoenix Interactive Design Inc. v. Alterinvest II Fund LP, 2018 ONCA 98, 420 D.L.R. (4th) 335, at paras. 35-36, affirmed that borrowers cannot rely on a prepayment clause in a loan transaction to trigger a rate of interest that violates s. 347. The prepayment clause was within the sole control of the borrower and not required by the lender, thus making the prepayment of the loan voluntary.
[99] In this case, there was nothing in the Royalty Agreement that mandated Hybrid to trigger the buyout option. There was certainly incentive in the sense that, barring exercising the buyout option, Hybrid was committed to making royalty payments in perpetuity. However, this was the bargain it struck with open eyes, as a sophisticated entity led by a Chief Executor Officer, President, and owner who was experienced in corporate equity transactions.
[100] As well, as held in Nelson, the rate of return must be calculated with reference to the term of the loan commitment (or in that case the term of the mortgage). That is not possible in this case because the Royalty Agreement sets out royalty payments in perpetuity. There is no fixed term for the repayment of the funds advanced to purchase the royalties and there is no allocation of the royalty payments as between repayment of the advances by Flow and the “interest” component.
[101] Hybrid relied on the expert evidence of Andrew Kulyk, an actuary, to calculate what the maximum buyout amount under s. 6.13 of the Royalty Agreement would be (assuming this was a debt transaction captured by s. 347 of the Code). Mr. Kulyk’s expert report is very brief and attaches the schedule of royalty payments made by Hybrid to Flow from the advance of the two royalty purchase prices in August 2017 to the date of Hybrid’s notice to buyout the royalties of June 30, 2020.
[102] Mr. Kulyk appears to have made no distinction between the principal and interest allocated to the royalty payments. In his report he states he assumed that the royalty payments were “legally classified as principal and/or interest only” without providing any allocation. According to his calculations, the maximum buyout amount under s. 2.9, restricted to an interest rate of 59% (consistent with s. 6.13), is $1,374,769.93 as at June 30, 2020.
[103] The difficulty with this calculation is that it does not seem to account for the payment of the principal sum advanced of $750,000. Rather, $1,374,769.93 seems to be presented as purely interest with no allocation attributed to the $828,205.34 actually paid. One might infer that of the $828,205.34 made by Hybrid as royalty payments, that Mr. Kulyk allocated $750,000 to principal and the balance as interest in his calculations. However, his report does not state that and indeed does not reveal the mechanics of his calculations. This is perhaps not surprising, since the Royalty Agreement does not make any such allocation reinforcing the notion that the royalty payments were neither intended to be interest nor paydown of a principle debt.
[104] Accordingly, Mr. Kulyk’s expert evidence is of little assistance to the court.
[105] While Flow adduced expert evidence of its own (Thomas Liston, a Chartered Financial Analysis and founder of Water Street Capital) it was not on this issue but rather on the issue of the characterization of the royalty agreement as a hybrid equity form of investment and the frequency by which businesses are necessarily resorting to this type of creative financing. Mr. Liston opines that the type of financial arrangement evidenced by the Royalty Agreement is similar to other structures commonly used in the venture capital industry. While Mr. Liston’s expert opinion was useful as a general context for hybrid equity financial transactions, it did not (appropriately) address whether the Royalty Agreement itself was one such structure.
[106] Neither expert was cross examined.
Is Hybrid in breach of the Royalty Agreement?
[107] As indicated, once Hybrid notified Flow that there was a dispute under the Royalty Agreement, s. 2.8 provided what steps were to be taken by the parties. This section specifically provides that “until such time as such Dispute is finally resolved in accordance with the terms of this s. 2.8, the Parties shall continue to be bound by all of the provisions of this Agreement in accordance with their terms (including the Gross Sales Royalty and Minimum Monthly Amount then in effect) notwithstanding the subject-matter of the Dispute.” This means that Hybrid (and Flow) were bound to abide by the covenants in the Royalty Agreement including making ongoing monthly royalty payments and ongoing monthly financial disclosure.
[108] Since June 2020, Hybrid has not made any financial disclosure to Flow, contrary to its covenant at ss. 2.10(e)-(i) of the Royalty Agreement.
[109] Furthermore, since November 2020, Hybrid has failed to make any of the royalty payments required by s. 2.2. In addition, for the period from June to October 2020, Hybrid only made the “minimum” monthly payments. It may be, after a review of the required monthly financial disclosure requirements that more than the minimum was required for that time period.
[110] Finally, s. 2.8 requires both parties to provide their “final figures in respect of the disputed amounts along with supporting documentation to substantiate their positions” to KPMG to enable that firm to finalize the net equity valuation report. By instructing KPMG not to finalize its report and failing to provide its feedback to the draft report, Hybrid is in violation of that covenant. Of note, KPMG (as the “Independent Accountant”) was designated by both parties to act as an expert and its determination of the net equity is stated in the Royalty Agreement to be “final and binding upon the Parties, absent manifest error”.
[111] Notwithstanding Hybrid’s decision to challenge the legality of the buyout amount as violating s. 347 of the Code and to advocate for a different rate of interest pursuant to s. 6.13 of the Royalty Agreement, it was contractually obliged to follow the dispute mechanism provided in the Royalty Agreement once it notified Flow of the dispute. It was also obliged to continue discharging its contractual obligations during the course of the Dispute.
DISPOSITION
[112] The application is dismissed.
[113] Flow has asked that this court make certain declarations in the event that the application is dismissed. The declarations requested are consistent with the provisions of the Royalty Agreement. It is noted that Hybrid already jointly appointed, with Flow, KPMG undertake the requisite valuation of its net equity worth. There is no reason why KPMG should not be permitted to complete its valuation. Hybrid still has an opportunity to provide its input provided it is done in an expeditious manner.
[114] Accordingly, this court declares
a) Hybrid shall instruct KPMG to complete its valuation report and provide its feedback as requested by KPMG; and
b) Hybrid is in breach of its obligations under sections 2.2, 2.4(f), 2.8 and 2.10(e)-(i) of the Royalty Agreement.
[115] Hybrid and Flow have uploaded their respective Cost Outlines.
[116] In the event that the parties cannot agree on costs, then Flow shall have 20 days from the date of the release of these reasons to provide written submissions. Hybrid will then have 10 days to provide its responding written submissions. Each set of submissions will not exceed 3 pages in length and will be provided to my judicial assistant.
Justice S. Vella
Released: April 14, 2022
CORRECTION NOTICE
Corrected decision: the text of the original judgment was corrected on April 14, 2022, and the description of the correction is appended:
On paragraph 11, first line, the word “Hybrid” is replaced with “Flow” and second line, the word “Flow” is replaced with “Hybrid” to read “Flow agreed to provide $750,000 in capital to Hybrid”.
COURT FILE NO.: CV-21-00655791-0000
DATE: 20220414
ONTARIO
SUPERIOR COURT OF JUSTICE
BETWEEN:
HYBRID FINANCIAL LTD.
Applicant
– and –
FLOW CAPITAL CORP.
Respondent
AMENDED REASONS FOR JUDGMENT
Vella J.
Released: April 14, 2022