Equity Kickers and the Criminal Rate of Interest

Written By Preet K. Bell and David S. Rotchtin

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

The Criminal Rate of Interest and Equity

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

Despite the original intention of section 347 to avoid loan-sharking, the definition of interest in section 347 is drafted broadly and has generally been interpreted broadly by the courts, resulting in its potential application to otherwise legitimate corporate transactions between sophisticated parties. In determining whether an item is "interest", courts have generally considered whether the item is, in substance, a cost incurred to receive credit.³There has been fairly limited case law under section 347 considering the use of equity, and similar, instruments in connection with a loan. However, royalty payments, anticipated profits, shares, warrants and even an investment opportunity have potentially been considered "interest", or potentially included in an interest calculation, for purposes of section 347.⁴ This has led to some uncertainty and concern that the section could be applicable where some form of equity is offered as part of a debt transaction, notwithstanding the fact it does not fit within the original intention of section 347.  However, a decision of Justice Gans of the Ontario Superior Court, which was recently upheld by the Ontario Court of Appeal, provides some comfort to corporate lenders.⁵

Bimman v. Neiman Narrows the Scope

In 2015, Justice Gans of the Ontario Superior Court released his decision in Bimman v. Neiman,⁶ narrowing the application of section 347 to equity kickers.

The case was an oppression application brought by shareholders with respect to actions taken by the defendants (mainly in respect of cash calls and the granting of a mortgage), and also sought repayment of amounts under a shareholders’ agreement. While only an ancillary issue before the court, Justice Gans specifically considered whether shares that the defendant shareholders received as a result of their loans to the company fell within the definition of "interest".  Justice Gans recognized the original intention of section 347 to stop loan-sharking and found that transactions such as the one in this case–shareholder loans in exchange for or coupled with the issuance of shares–were not the type that Parliament intended to prohibit. Justice Gans was not persuaded that the shares constituted a "charge or expense" as those terms are used in the statutory definition of interest. Notably, he found that while there may be a cost associated with issuing shares at sub-market value, that cost is really borne by the shareholders of the company and, additionally, the issuance of shares is not a charge "paid or payable" by the company and therefore does not fall within the definition of "interest"; the shares were not redeemable at the option of the shareholders, the company was not committed to re-purchasing them in the future, and they did not guarantee any right to future payment.

However, Justice Gans was careful to state that he was not determining whether shares were categorically excluded from section 347 and that each case must be decided on its own particular facts. In addition, he noted that neither the shareholders nor the company were attacking the shareholder loans as violating section 347, which may give his finding less weight than a case where the borrower was challenging the legality of the loan transaction. Nevertheless, his finding, which moves the issuance of shares away from the definition of interest in section 347, should still provide some comfort to those providing and receiving equity as part of a loan transaction. Although this specific issue was not at issue before the Court of Appeal, the fact that the substance of Justice Gans' decision was unanimously upheld by the court should give the decision more weight.⁷ While the risk of section 347 for equity kickers and similar transactions is not completely gone, it appears to have diminished.

Notes:

¹ Birman v. Neiman 2017 ONCA 264, appeal and cross-appeal from 2015 ONSC 2313, 2015 ONSC 3076, 2015 ONSC 4144, and 2015 ONSC 4414

² A "payday loan" exception was introduced in 2007: s. 347.1.

³ See Garland v. Consumers' Gas Co., [1998] 3 S.C.R. 112.

⁴ See e.g. Boyd v. International Utility Structures Inc. (2001), 88 B.C.L.R. (3d) 183 (S.C.), aff'd 2002 BCCA 438; 677950 Ontario Ltd. v. Artell Developments Ltd. (1992), 93 D.L.R. (4^th) 334 (Ont. C.A.), aff'd [1993] 2 S.C.R. 443; J.D.M. Capital Ltd. v. Smith, 39 B.C.L.R. (3d) 340 (S.C.), rev'd (1998), 58 B.C.L.R. (3d) 272 (C.A.); Aectra Refining & Marketing Inc. v. Lincoln Capital Funding Corp. (1991), 6 O.R. (3d) 146 (Ct. J. (Gen. Div.)); and Re Bearcat Explorations Ltd. (2004), 3 C.B.R. (5^th) 173 (Alta. Q.B.).

⁵ The issue of section 347 was not pursued on appeal but the Ontario Court of Appeal generally upheld the findings and analysis of Justice Gans, with the exception of his award for punitive damages and a valuation point.

⁶ 2015 ONSC 2313.

⁷ 2017 ONSC 264, dismissing the appeal but reversing findings with respect to punitive damages and the number of shares to be issued.