Transport North American Express Inc. v. New Solutions
Financial Corp., [2004] 1 S.C.R. 249, 2004 SCC 7
New Solutions Financial Corporation Appellant
v.
Transport North American Express Inc. Respondent
Indexed as: Transport North American Express Inc. v. New
Solutions Financial Corp.
Neutral citation: 2004 SCC 7.
File No.: 29355.
2003: October 16; 2004: February 12.
Present: Iacobucci, Major, Bastarache, Arbour, LeBel, Deschamps and
Fish JJ.
on appeal from the court of appeal for ontario
Contracts — Interest — Criminal rate — Illegality —
Severability — Section 347 of Criminal Code prohibiting effective annual
interest rate in excess of 60 percent — Contract found to contravene
prohibition — Offending interest rate read down so that contract provided for
maximum legal rate of interest — Whether “notional severance” available as
remedy in cases arising under s. 347 — Whether application of notional
severance appropriate in this case — Criminal Code, R.S.C. 1985, c. C‑46,
s. 347 .
The appellant and the respondent entered into a credit
agreement pursuant to which the appellant advanced the respondent the sum of
$500,000. A commitment letter in respect of the proposed credit facility was
signed and provided for the following payments: (a) interest at four percent
per month calculated daily, payable monthly in arrears; (b) a monthly
monitoring fee of $750; (c) a one percent standby fee; (d) royalty payments of
$160,000 in eight quarterly installments; (e) payment of legal and other fees;
and (f) a commitment fee of $5,000. In addition to the commitment letter, the
parties executed an accounts receivable factoring agreement, a promissory note,
a general security agreement and personal guarantees of the indebtedness for up
to $500,000. From the outset, the parties had agreed to depart from the terms
of the accounts receivable factoring agreement. The application judge granted
the respondent’s application for a declaration that the agreement contained an
interest component that contravened s. 347 of the Criminal Code and
applied “notional severance” to reduce the effective annual interest rate to
60 percent so the agreement would comply with s. 347 . The majority
of the Court of Appeal allowed the respondent’s appeal; it struck out the clause
providing for interest at a rate of four percent per month, calculated daily
and payable monthly in arrears, and left in place the other payments, which
amounted to an effective annual rate of 30.8 percent when computed as
interest as per s. 347(2).
Held (Bastarache,
Deschamps and Fish JJ. dissenting): The appeal should be allowed.
Per Iacobucci, Major,
Arbour and LeBel JJ.: The various payments made by the respondent, with the
exception of any portion of the payments relating to repayment of principal,
satisfy the definition of “interest” in s. 347(2) and cumulatively amount
to an interest rate in excess of that permitted by the Code. Notional
severance is available as a matter of law as a remedy in cases arising under
s. 347 . The traditional rule that contracts in violation of statutory
enactments are void ab initio is not the approach courts should
necessarily take in cases of statutory illegality involving s. 347 .
Instead, judicial discretion should be employed and a spectrum of remedies is
available. At one end of the spectrum are contracts so objectionable that
their illegality will taint the entire contract — exploitive loan-sharking
arrangements and contracts that have a criminal object should be declared void ab
initio. At the other end of the spectrum are contracts that, although they
do contravene a statutory enactment, are otherwise unobjectionable. Contracts
of this nature will often attract the application of the doctrine of
severance. In each case, the determination of where along the spectrum a given
case lies, and the remedial consequences flowing therefrom, will hinge on a
careful consideration of the specific contractual context and the illegality
involved. If the case is an appropriate one for the court to sever only those
provisions of the loan agreement that put the effective interest rate over
60 percent, and if it is conceded, as it must be, that such rewording
alters the agreement of the parties, the question becomes only a choice of the
appropriate technique of severance. The preferred severance technique is the
one that, in light of the particular contractual context involved, would most
appropriately cure the illegality while remaining otherwise as close as
possible to the intentions of the parties expressed in the agreement. The
“blue-pencil” technique may not necessarily achieve that result. The change
effected by the blue-pencil technique will often fundamentally alter the
consideration associated with the bargain and do violence to the intention of the
parties. Indeed, in many cases, the application of the blue-pencil approach
will provide for an interest-free loan where the parties demonstrated in the
agreement a clear intention to charge and pay considerable interest.
The application of notional severance to the agreement
between the parties in this case was appropriate. Four considerations are
relevant to the determination of whether public policy ought to allow an
otherwise illegal agreement to be partially enforced rather than being declared
void ab initio in the face of illegality in the contract: (1) whether
the purpose or policy of s. 347 would be subverted by severance; (2)
whether the parties entered into the agreement for an illegal purpose or with
an evil intention; (3) the relative bargaining positions of the parties and
their conduct in reaching the agreement; (4) the potential for the debtor to
enjoy an unjustified windfall. Given that the present case involved a
commercial transaction engaged in by experienced and independently advised
commercial parties, it is difficult to see why the choice of a 30.8 percent
rather than 60 percent rate better fosters compliance with s. 347(1)(a)
of the Code. The other considerations also militate in favour of a
flexible remedy. There is no evidence on the record to suggest that the
appellant has been charged with violating s. 347(1)(a). The contract
was entered into for ordinary commercial purposes and there was nothing
inherently illegal or evil about this intention. With respect to the third
factor, each party in this case had independent legal advice, was commercially
experienced and knew what it was getting into. Finally, any potential for an
unjustified windfall in this case arises from the respondent possibly not
having to repay the principal and interest, or from the respondent possibly not
having to pay a commercially appropriate rate of interest on the loan. Given
that each party had independent legal advice and knew precisely the obligations
that it was taking on, the equities of the situation favour the appellant.
Per Deschamps and Fish
JJ. (dissenting): The well-established “blue-pencil” remedy applied in the
Court of Appeal respects the trial judge’s findings of fact, as it must, and
achieves an equitable result consistent with established principle. The trial
judge erred in straining the recognized rules of equity by resorting to what he
described as “notional severance”. Even on the assumption that notional
severance is available as a matter of law as a remedy in cases arising under
s. 347 of the Code, notional severance should be permitted only
where: (1) public policy does not require that the entire agreement be
declared unenforceable; (2) severance is found to be warranted; and (3)
severance simpliciter — or “blue-pencil severance” — is impracticable or
would occasion an unjust result. Here, on the facts as found by the trial
judge, the first two criteria are satisfied but the third is not: blue-pencil
severance is both possible and fair. Unlike notional severance as applied by
the trial judge, blue-pencil severance does not do violence to the policy
purposes of s. 347 of the Code or require a judicial re-writing of
the interest clause agreed to, as such, by the parties. It appears neither “artificial”
nor “arbitrary” to sever the criminal rate of interest agreed to as interest
and to leave intact the distinct and separate charges not agreed to as
interest, and not considered to be interest by either party. This solution
still leaves the appellant with a return of slightly more than 30 percent
per annum. Further, it appears that all four relevant considerations, examined
individually and weighed together, militate here in favour of the remedy
applied by the Court of Appeal and against the remedy adopted by the trial
judge. The effect of the trial judge’s decision was to stretch the principles
of equity in an inappropriate way and to send the wrong message to those who
lend money at a criminally prohibited rate to “willing” borrowers who cannot
otherwise obtain a loan. They should not be encouraged to believe that if their
illegal arrangement is subjected to judicial scrutiny, they will nonetheless
recover the highest rate they could legally have charged — and thus suffer no
pecuniary disadvantage for having violated s. 347 of the Code.
Per Bastarache J.
(dissenting): Severance in the traditional sense, not “notional severance”,
should be the remedy available in these circumstances. There is a fundamental
difference between striking out offending sections of a contract and rewriting
a central provision. Although both approaches interfere in some way with the
intent of the parties, the added flexibility of the rewriting approach comes at
a considerable cost and it is not supported by any principle of contract law.
By contrast, the severance doctrine is a long-standing one. The “blue-pencil”
test has been applied several times in the context of violations of s. 347
of the Code to strike out offending interest provisions. Moreover,
there is no legal or other principled reason to limit the application of the
new approach endorsed by the majority to the criminal rate of interest and
other illegal provisions would be open to judicial redrafting. The
availability of “notional severance” as a remedy creates greater uncertainty in
the law. Under notional severance, courts will be permitted to literally add
new words to the parties’ agreement and by doing so, courts will be
substituting their intentions for those of the parties.
The approach taken by the majority in this case is
also inconsistent with that taken in Garland v. Consumers’ Gas Co.,
[1998] 3 S.C.R. 112, where the Court interpreted the definition of interest
broadly in order to prevent creditors from avoiding the statute by manipulating
the form in which payments were made. Under the majority’s approach, a
creditor would be permitted to escape the consequences of its avoidance
measures by simply reducing the rate applied to the maximum permitted under the
Code and this approach is inconsistent with the general objectives
expressed in the Code and incompatible with the notion of deterrence.
In addition, there do not appear to be compelling reasons to depart from
well-established precedent in this case.
Lastly, clause 9.1 of the accounts receivable
factoring agreement reflects the parties’ own intentions as to remedy. It
cannot be said that the wording of the clause anticipates — still less,
provides for — notional severance. In view of the plain meaning of clause 9.1,
counsel’s concession as to the intention of the parties, and the letter sent by
the appellant’s solicitor to the respondent three weeks after the commitment
letter was signed, the blue-pencil approach adopted by the Court of Appeal is
entirely consistent with the parties’ own intentions and notional severance is
not.
Cases Cited
By Arbour J.
Applied: William E. Thomson
Associates Inc. v. Carpenter (1989), 61 D.L.R. (4th) 1; referred to:
Garland v. Consumers’ Gas Co., [1998] 3 S.C.R. 112; Still
v. M.N.R., [1998] 1 F.C. 549; Cope v. Rowlands (1836), 2 M. & W.
149, 150 E.R. 707; Kocotis v. D’Angelo (1957), 13 D.L.R. (2d) 69; Bank
of Toronto v. Perkins (1883), 8 S.C.R. 603; Neider v. Carda of
Peace River District Ltd., [1972] S.C.R. 678; Mira Design Co. v.
Seascape Holdings Ltd., [1982] 4 W.W.R. 97; Trillium Computer
Resources Inc. v. Taiwan Connection Inc. (1993), 11 B.L.R. (2d)
1, aff’d (1994), 11 B.L.R. (2d) 1; Milani v. Banks (1997),
145 D.L.R. (4th) 55.
By Fish J. (dissenting)
William E. Thomson Associates Inc. v.
Carpenter (1989), 61 D.L.R. (4th) 1.
By Bastarache J. (dissenting)
Still v. M.N.R., [1998]
1 F.C. 549; Cope v. Rowlands (1836), 2 M. & W. 149, 150 E.R. 707; Bank
of Toronto v. Perkins (1883), 8 S.C.R. 603; Steinberg v. Cohen,
[1930] 2 D.L.R. 916; Hasiuk v. Oshanek, [1936] 1 D.L.R. 232; Carney
v. Herbert, [1985] 1 All E.R. 438; McFarlane v. Daniell (1938),
38 S.R. 337; Attwood v. Lamont, [1920] 3 K.B. 571; Canadian American
Financial Corp. (Canada) Ltd. v. King (1989), 60 D.L.R. (4th) 293; Mira
Design Co. v. Seascape Holdings Ltd., [1982] 4 W.W.R. 97; Garland
v. Consumers’ Gas Co., [1998] 3 S.C.R. 112; Friedmann Equity
Developments Inc. v. Final Note Ltd., [2000] 1 S.C.R. 842,
2000 SCC 34.
Statutes and Regulations Cited
Criminal Code, R.S.C. 1985, c. C‑46, s. 347 .
Authors Cited
Fridman, G. H. L. The Law
of Contract in Canada, 4th ed. Scarborough, Ont.: Carswell, 1999.
Marsh, Norman S. “The
Severance of Illegality in Contract” (1948), 64 L.Q.R. 230 and 347.
Waddams, S. M. The Law of
Contracts, 4th ed. Toronto: Canada Law Book, 1999.
Ziegel, Jacob S. “Bill C‑44:
Repeal of the Small Loans Act and Enactment of a New Usury Law” (1981), 59 Can.
Bar Rev. 188.
Ziegel, Jacob S. “The Usury
Provisions in the Criminal Code : The Chickens Come Home to Roost” (1986), 11 Can.
Bus. L.J. 233.
APPEAL from a judgment of the Ontario Court of Appeal
(2002), 60 O.R. (3d) 97, 214 D.L.R. (4th) 44, 160 O.A.C. 381, 27 B.L.R. (3d) 163,
6 R.P.R. (4th) 1, [2002] O.J. No. 2335 (QL), reversing a judgment of the
Superior Court of Justice (2001), 54 O.R. (3d) 144, 200 D.L.R. (4th) 560, 16
B.L.R. (3d) 148, [2001] O.J. No. 1948 (QL). Appeal allowed, Bastarache,
Deschamps and Fish JJ. dissenting.
Peter J. Cavanagh and Eric N. Hoffstein, for the appellant.
Robert G. Ackerman, for the respondent.
The judgment of Iacobucci, Major, Arbour and LeBel JJ.
was delivered by
Arbour J. —
I. Overview
1
In March 2000, the appellant, New Solutions Financial Corp. (“New
Solutions”), and the respondent, Transport North American Express Inc.
(“TNAE”), entered into a credit agreement pursuant to which New Solutions
advanced TNAE the sum of $500,000. In addition to various other fees and
charges, the agreement provided for interest to be paid at the rate of four
percent per month, calculated daily and payable monthly in arrears. By all
accounts, the various payments called for by the agreement constituted a “criminal
rate” of interest as defined in s. 347 of the Criminal Code, R.S.C.
1985, c. C‑46 (the “Code ”). The payments soon became too onerous
for TNAE to meet, and the company applied to the Ontario Superior Court of
Justice for a declaration that the agreement contained an illegally high rate
of interest and should not be enforced.
2
The application judge, Cullity J., ruled that he was not confined to the
so-called “blue-pencil” approach to severance in dealing with the statutory
illegality of the contract, whereby only discrete illegal promises could be
excised. Using “notional severance”, he read down the offending interest rate
so the contract provided for the maximum legal rate of interest: (2001), 54
O.R. (3d) 144.
3
Upon appeal to the Court of Appeal for Ontario, Rosenberg J.A., for the
majority, concluded that the doctrine of severance only permits the striking of
distinct promises from a contract: (2002), 60 O.R. (3d) 97. He reversed the
application judge’s finding that notional severance was an available remedial
instrument. Rosenberg J.A. found that it was appropriate to strike out or
blue-pencil the provision calling for interest at four percent per month,
calculated daily and payable monthly in arrears, leaving the balance of the agreement
to be enforced in accordance with its terms. Sharpe J.A., agreeing with the
reasons of Cullity J., dissented.
4
There is broad consensus that the traditional rule that contracts in
violation of statutory enactments are void ab initio is not the approach
courts should necessarily take in cases of statutory illegality involving s.
347 of the Code . Instead, judicial discretion should be employed in
cases in which s. 347 has been violated in order to provide remedies that are
tailored to the contractual context involved. The primary issue in this appeal
by New Solutions is whether notional severance, as formulated and applied by
Cullity J., is valid in Canadian law and applicable here.
5
Given the desirability of remedial flexibility in cases of statutory
illegality arising in connection with s. 347 of the Code , the evolving
nature of the law regarding statutory illegality generally and the sound policy
basis in which the concept is rooted, I find that notional severance is
available as a matter of law as a remedy in cases arising under s. 347 .
6
A spectrum of remedies is available to judges in dealing with contracts
that violate s. 347 of the Code . The remedial discretion this spectrum
affords is necessary to cope with the various contexts in which s. 347
illegality can arise. At one end of the spectrum are contracts so
objectionable that their illegality will taint the entire contract. For example,
exploitive loan-sharking arrangements and contracts that have a criminal object
should be declared void ab initio. At the other end of the spectrum are
contracts that, although they do contravene a statutory enactment, are
otherwise unobjectionable. Contracts of this nature will often attract the
application of the doctrine of severance. The agreement in this case is an
example of such a contract. In each case, the determination of where along the
spectrum a given case lies, and the remedial consequences flowing therefrom,
will hinge on a careful consideration of the specific contractual context and
the illegality involved.
7
The application judge in this case found that (i) the agreement between
New Solutions and TNAE only inadvertently violated s. 347 ; (ii) the parties
were experienced in commercial matters and negotiated at arm’s length; (iii)
there was no evidence that they did not have equal bargaining power; and (iv)
they each had the benefit of independent legal advice in the course of the negotiations
leading to the agreement. Consequently, the application of notional severance
to the agreement between New Solutions and TNAE in this case by Cullity J. was
appropriate. I would allow the appeal.
II. Facts
8
For the relevant time period, TNAE was in the business of expedited
freight trucking. Ken and Karen Dragosits were shareholders in TNAE and
actively involved in the operation of its business. Prior to the end of 1999,
other shareholders held a 50 percent interest in TNAE. A corporation connected
to these other shareholders provided TNAE the funds needed for the firm’s
working capital. A demand was made by this other corporation for the repayment
of the funds owed to it by TNAE. The Dragosits and TNAE decided to search out
a source for the means to repay the indebtedness.
9
The Dragosits sought financing from BDO Capital, now the appellant, New
Solutions, to enable TNAE to repay its indebtedness and for the other
shareholders in TNAE to be bought out. The parties eventually entered into an
agreement that contained a high rate of interest and also significant other
fees and charges. The costly nature of the loan for TNAE no doubt reflected
the high risk New Solutions was taking on in making the funds available.
10
Before arriving at their agreement, New Solutions expressed interest in
acquiring a 30 percent equity interest in TNAE in conjunction with the
contemplated credit facility. The Dragosits resisted this as they wished to be
the sole shareholders of TNAE. In lieu of surrendering an equity interest,
they agreed that New Solutions would receive a “royalty payment” of $160,000,
payable in eight quarterly installments, to reflect the approximate value of a
30 percent equity interest in TNAE.
11
In the negotiations leading up to the agreement, each party had the
benefit of independent legal advice. On March 6, 2000, a commitment letter in
respect of the proposed credit facility was signed by the Dragosits and
provided for the following payments:
(a) interest at four percent per month calculated daily, payable
monthly in arrears;
(b) a monthly monitoring fee of $750;
(c) a one percent standby fee;
(d) royalty payments of $160,000 in eight quarterly installments;
(e) payment of legal and other fees; and
(f) a commitment fee of $5,000.
With the
exception of the standby fee, all these payments were found by Cullity J. and
by Rosenberg J.A. to constitute “interest” under s. 347(2) of the Code .
Presumably, the standby fee was not included in the calculation of the
effective interest rate because no standby fees were charged since the full
credit facility of $500,000 was drawn upon.
12
By March 30, 2000, the parties had, in addition to the commitment letter,
executed an accounts receivable factoring agreement, a promissory note and a
general security agreement. The Dragosits also each executed personal
guarantees of the indebtedness for up to $500,000 plus interest at the rate of
30 percent per annum. From the outset, the parties had agreed to depart from
the terms of the accounts receivable factoring agreement. On March 28, 2000,
the solicitor for New Solutions wrote to the solicitor for TNAE and the
Dragosits, confirming that the parties had agreed on March 27 that they would
not strictly follow the terms of the accounts receivable factoring agreement
unless New Solutions elected to exercise its rights under it. Instead, the
understanding was that TNAE would borrow the full $500,000 from New Solutions
and pay the interest, fees and royalties as set out in the commitment letter.
According to Cullity J., “the concept of a factoring of receivables was put
aside and replaced by a revolving credit facility” (para. 5).
13
The principal amount of $500,000 was advanced by New Solutions. At
the outset, TNAE paid interest at the rate of four percent per month,
calculated daily and payable monthly in arrears, as well as the other fees and
charges, in general accordance with the terms of the commitment letter.
14
The various payments eventually became onerous, and TNAE sought legal
advice regarding the repayment of the borrowed funds. TNAE then applied to
the Ontario Superior Court of Justice for a declaration that the agreement
contained an interest component that contravened s. 347 of the Code . It
also sought an order that interest previously paid be returned.
15
On the basis of actuarial evidence, Cullity J. found that the effective
interest rate on the loan, if it was repaid in full within two years, was 90.9
percent per annum. In itself, the promise to pay interest at four percent per
month calculated daily, payable monthly in arrears, amounted to an effective
annual interest rate of 60.1 percent. The remaining payments amounted to an
effective annual interest rate of 30.8 percent.
16
New Solutions originally denied that the agreement violated the Code
but sought severance and rectification if it did. Cullity J. found that the
agreement was in contravention of s. 347(1) (a) and applied “notional severance”
to reduce the effective annual interest rate to 60 percent so the agreement
would comply with s. 347 . The Court of Appeal allowed TNAE’s appeal; it struck
out the clause providing for interest at a rate of four percent per month
calculated daily and payable monthly in arrears, and left in place the other
payments, which amounted to an effective annual rate of 30.8 percent when
computed as interest as per s. 347(2) . New Solutions seeks the
restoration of the decision of the application judge.
III. Relevant
Statutory Provisions
17
The pertinent text of the relevant provision of the Criminal Code
is:
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.
(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 sixty per cent 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 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;
.
. .
(3) Where a person receives a payment or partial
payment of interest at a criminal rate, he shall, in the absence of evidence to
the contrary, be deemed to have knowledge of the nature of the payment and that
it was received at a criminal rate.
.
. .
(7) No proceedings shall be commenced under this
section without the consent of the Attorney General.
IV. Issue
18
Are judges in Canada 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?
V. Analysis
A. Illegality
of the Contract
19
The definition of “interest” in s. 347(2) is broad: see Garland v.
Consumers’ Gas Co., [1998] 3 S.C.R. 112, at para. 28. 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 in s.
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 .
B. The
Doctrine of Illegality
20
The Federal Court of Appeal’s decision in Still v. M.N.R., [1998]
1 F.C. 549, provides a useful summary of the development of the doctrine of
illegality, including a discussion of the development and evolution of the
doctrine’s common law and statutory branches. In addressing the current state
of the doctrine of illegality, Robertson J.A. remarked, at para. 12:
Law reform agencies have been quick to conclude
that the law of illegality is in an unsatisfactory state . . . . There is
a plethora of conflicting decisions and great uncertainty as to the principles
which should be guiding the courts. Arguably, so many exceptions have been
grafted on to the common law rule that illegal contracts are void ab initio
that the validity of the rule itself is brought into question.
In light of
the excellent treatment of the doctrine’s history by Robertson J.A. in Still
v. M.N.R., there would be little benefit to fully retracing the doctrine’s
history here. Instead, given the evolving nature of this area of law, a very
brief survey of some of the existing case law on the application of the
doctrine of illegality will provide sufficient context for the finding in this
case that notional severance is available as a discretionary remedy in cases
where s. 347 has been violated.
21
The historical common law approach to contractual illegality is
reflected in the following passage of Parke B. in Cope v. Rowlands
(1836), 2 M. & W. 149, 150 E.R. 707 (Ex. Ct.), at p. 710:
[W]here the contract which the plaintiff seeks to enforce, be it
express or implied, is expressly or by implication forbidden by the common or
statute law, no court will lend its assistance to give it effect. It is
equally clear that a contract is void if prohibited by a statute, though the
statute inflicts a penalty only, because such a penalty implies a prohibition.
In Cope v.
Rowlands, the question surrounded whether an unlicensed broker could
recover for the work that he had done for the defendant. The court concluded
that the legal requirement (under threat of penalty) that brokers be licensed
by the city of London implied a prohibition on work being done by unlicenced
brokers. As a consequence, the contract was held to be void ab initio
and the unlicensed broker was unable to enforce his claim for payment for the
work that had been done. The Court of Appeal for Ontario denied recovery in a
similar case involving an electrician seeking to recover for work done without
possessing the appropriate class of licence: see Kocotis v. D’Angelo
(1957), 13 D.L.R. (2d) 69.
22
The historical common law approach that contracts illegal under statute
are void ab initio has been applied by this Court: see, e.g., Bank of
Toronto v. Perkins (1883), 8 S.C.R. 603, and more recently, Neider v.
Carda of Peace River District Ltd., [1972] S.C.R. 678. However, some time
ago Canadian courts began to develop a more flexible approach to
statutory illegality in contract, often severing the illegal provisions and
enforcing the remainder. For example, in one of the earliest cases dealing
with the application of s. 347 of the Code , Mira Design Co. v.
Seascape Holdings Ltd., [1982] 4 W.W.R. 97 (B.C.S.C.), Huddart L.J.S.C.
held that although the interest provisions of a mortgage were unenforceable,
exceeding as they did the maximum effective interest rate permitted under s.
305.1 of the Code (the predecessor to s. 347 ), the contract as a whole
should not be held to be void ab initio. Her reasoning, at p. 104, was
that although the section makes it an offence to receive interest at an illegal
rate, the section did not seek to make associated collateral agreements (such
as for the transfer of the real estate or the payment of the principal amount
owing on the mortgage) void ab initio:
Most Canadians would agree that the purpose of the
Criminal Code is to protect the public by providing for the punishment of
behaviour that Parliament considers to be against the public interest. The
purpose of s. 305.1 [now s. 347 ] is to punish everyone who enters into an
agreement or arrangement to receive interest at a criminal rate. It does not
expressly prohibit such behaviour, nor does it declare such an agreement or
arrangement to be void. The penalty is severe, and designed to deter persons
from making such agreements. It replaces the Small Loans Act, which included a
prohibition of such agreements and gave the court the power to reconstruct them.
It is designed to protect borrowers. There is no penalty imposed on a person
who makes an agreement to pay, or pays, interest at a criminal rate. It is not
designed to prevent persons from entering into lending transactions per se.
23
The same approach was taken by the Court of Appeal for Ontario in William
E. Thomson Associates Inc. v. Carpenter (1989), 61 D.L.R. (4th) 1. Having
considered s. 347 of the Code , the court in that case concluded that
where an interest rate provided for in an agreement exceeds the 60 percent
statutory maximum, the interest rate provision of the contract may be severed
without declaring the whole contract void.
24
In Thomson, at p. 8, Blair J.A. considered the following four
factors in deciding between partial enforcement and declaring a contract void ab
initio: (i) whether the purpose or the policy of s. 347 would be subverted
by severance; (ii) whether the parties entered into the agreement for an
illegal purpose or with an evil intention; (iii) the relative bargaining
positions of the parties and their conduct in reaching the agreement; and (iv)
whether the debtor would be given an unjustified windfall. He did not
foreclose the possibility of applying other considerations in other cases,
however, and remarked (at p. 12) that whether “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”.
25
In Trillium Computer Resources Inc. v. Taiwan Connection Inc.
(1993), 11 B.L.R. (2d) 1 (Ont. Ct. (Gen. Div.)), aff’d (1994), 11 B.L.R. (2d) 1
(Ont. Div. Ct.), Conant J. entered summary judgment in favour of the plaintiff
who had paid $8,000 interest in consideration of credit extended by the
defendant for eight days. In a brief judgment and without addressing the
authorities on this point, Conant J. stated, at p. 2:
I am satisfied that an interest rate of over 3,000
% per annum, whether it be for credit and/or compensation for damages and other
matters suffered by the Defendant, is a flagrant breach of s. 347 of the Criminal
Code of Canada. This, in my view, is illegal and shall be returned to
the Plaintiff less the maximum rate of 60% per annum allowed under the Code .
[Emphasis added.]
This approach
is similar to the one applied by Cullity J. and endorsed by Sharpe J.A. (in
dissent at the Court of Appeal) in the present case.
26
In Milani v. Banks (1997), 145 D.L.R. (4th) 55, the Court of
Appeal for Ontario applied the contextual approach endorsed by Blair J.A. in Thomson,
supra. This case involved a $32,000 loan with a term of 30 days. The
contract provided for $3,000 to be kept by the creditor in respect of the costs
associated with the loan, and an 18 percent annualized interest rate to be paid
on the full principal amount. McKinlay J.A. for the court held, at pp. 59‑60
that:
In this case, the appellant takes the position that
the only offensive part of the loan was the $3,000 charge for “fees”, and that
if the agreement were left intact apart from that provision, the result would
be a fair one in the circumstances. I am inclined to agree with that position
. . . .
. . .
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 annum for a thirty day term.
The approach
taken by McKinlay J.A. in Milani is reflected in the path taken by
Rosenberg J.A. at the Court of Appeal for Ontario in the case at bar. McKinlay
J.A. severed one of the “interest” terms (actually attributable to “costs”)
from the loan so that the interest rate would be legal, just as Rosenberg J.A.
in this case severed the promise to pay interest at four percent per month,
calculated daily, payable monthly in arrears, thereby leaving the other charges
to amount, cumulatively, to a permissible rate of interest under s. 347 .
C. The Problematic Nature of the Blue-Pencil
Test
27
The blue-pencil approach is understood both as a test of the
availability of severance to remedy contractual illegality and also as a
technique for effecting severance. The blue-pencil approach as a test
of the appropriateness of severance requires a consideration of whether an
illegal contract can be rendered legal by striking out (i.e., by drawing a line
through) the illegal promises in the agreement. The resulting set of legal
terms should retain the core of the agreement. If the nature or core of the
agreement is disturbed, then on this test the illegal clause in the contract
is not a candidate for severance and the entire contract is void. The
blue-pencil approach as a technique of effecting severance involves the
actual excision of the provisions leading to the illegality, leaving those
promises untainted by the illegality to be enforced.
28
The use of the blue-pencil approach to sever one or more provisions from
a contract alters the terms of the agreement between the parties. The only
agreement that one can say with certainty the parties would have agreed to is
the one that they actually entered into. The insistence in the case law that
the blue-pencil test derives its validity from refusing to change or add words
or provisions to the contract is unconvincing. It is doubtful, for example,
that the lenders in cases such as Thomson, supra, or Mira
Design, supra, would have entered into the agreements at issue had
they been aware ex ante that they would only be entitled to the return
of the principal advanced. The change effected by the blue-pencil technique
will often fundamentally alter the consideration associated with the bargain
and do violence to the intention of the parties. Indeed, in many cases, the
application of the blue-pencil approach will provide for an interest-free loan
where the parties demonstrated in the agreement a clear intention to charge and
pay considerable interest.
29
The blue-pencil test was developed in cases where the courts were
considering instruments under seal, where the form of the deed governed and
where the intention of the parties was irrelevant. It was therefore important
that what remained after severance would be a valid deed:
In the deed form was everything; the actual intention of the parties
was immaterial. It was, therefore, natural that in considering the possibility
of severance of promises in a deed, the court should be concerned to see that
what was left remained a valid deed; there could be no question of implying a
promise to take effect if part of the original bargain was illegal. This is
the historical origin of what was later called the ‘blue-pencil test’.
(N. S. Marsh, “The Severance of Illegality in Contract” (1948), 64 L.Q.R.
230 and 347, at pp. 351‑52)
Historically,
courts were not concerned with the intention of the parties. The artificiality
of the blue-pencil test arises from the common law constraints imposed on
courts unaided by principles of equity.
30
Courts inescapably make a new bargain for the parties when they use the
blue-pencil approach. As Cullity J. remarked, at paras. 35‑36:
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.
Despite repeated statements in the cases that
the court will not make a new agreement for the parties, that is, of course,
exactly what it does whenever severance is permitted in cases like William
E. Thomson and Milani. [Emphasis added.]
I am in
complete agreement with the conclusion that when a court employs the
blue-pencil test, it is making a new agreement for the parties. Indeed, all
forms of severance alter the terms of the original agreement.
31
I also agree with the view of Rosenberg J.A. at the Court of Appeal in
the present case, at para. 33, that severance lies along a spectrum of
available remedies. Depending on the circumstances, the court may exercise its
discretion to find the whole agreement unenforceable or sever only the
provision(s) that put the effective interest rate over 60 percent:
[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] M.J. No. 205 [(QL)] (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 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 [Capital Corp. v. Pine
Projects Ltd. (1993), 100 D.L.R. (4th) 431(B.C.C.A.)], where the court
severed all the interest provisions but upheld the debtor’s obligation to repay
the principal. [Emphasis added.]
This statement
of the remedial discretion of a judge in a case involving a violation of s. 347
of the Code takes into account the seriousness of the illegality
involved in any given case, the identity and nature of the parties and the
broader contractual context.
32
If the case is an appropriate one for the court to sever only those
provisions of the loan agreement that put the effective interest rate over 60
percent, and if it is conceded, as it must be, that such a rewording alters the
agreement of the parties, the question becomes only a choice of the appropriate
technique of severance. The preferred severance technique is the one that, in
light of the particular contractual context involved, would most appropriately
cure the illegality while remaining otherwise as close as possible to the
intentions of the parties expressed in the agreement. The blue-pencil
technique may not necessarily achieve that result.
33
The blue-pencil test is imperfect because it involves mechanically
removing illegal provisions from a contract, the effects of which are apt to be
somewhat arbitrary. The results may be arbitrary in the sense that they will
be dependent upon accidents of drafting and the form of expression of the
agreement, rather than the substance of the bargain or consideration involved.
For example, if the effective interest rate of the total interest obligation
(as defined in s. 347(2) ) in the agreement between New Solutions and TNAE were
only 0.1 percent lower, then the excision of the various charges, fees and
royalty payment provisions using the blue-pencil technique would have resulted
in a legally valid agreement bearing an effective annual rate of interest of 60
percent. Although the results obtained from the blue-pencil approach will in
many cases be sensible and may often be desirable, due to its artificiality,
the application of the blue-pencil approach will sometimes be inappropriate.
34
Section 347 of the Code invites difficulties with arbitrariness
by imposing a bright line of 60 percent as demarcating legal interest from
illegal interest. This legislatively mandated bright line distinguishes s. 347
cases from those involving provisions, for example, in restraint of trade,
where there is no bright line. The interaction of the blue-pencil test with
the bright line separating illegal interest from legal interest leads to
erratic results. Consider the following three substantively equivalent
contracts. Assume for each contract that each party was commercially
sophisticated, of equivalent bargaining power and in receipt of independent
legal advice. Assume also that neither party was aware the interest payable
was prohibited by the Code . The three contracts lead to dramatically
different results when the blue-pencil test is applied.
35
First, consider the result obtained using the blue-pencil approach in
the case at bar. Accepted actuarial evidence showed that the contract between
TNAE and New Solutions providing for interest at four percent per month,
calculated daily, payable monthly in arrears, represented an effective interest
rate of 60.1 percent per annum; other fees and charges reflected a further 30.8
percent interest per annum, resulting in a total rate of 90.9 percent. The
application of the blue-pencil test required that, at the very least, the 60.1
percent interest provision be struck from the contract since, standing alone,
it violated s. 347 . After considering the equities of the contractual context,
Rosenberg J.A. concluded that TNAE should have to repay the principal and at
least some interest. Consequently, the provision calling for 60.1 percent
effective annual interest was struck from the contract, and TNAE was held
accountable for repaying the principal plus the other fees and charges,
amounting to an effective annual interest rate of 30.8 percent.
36
Second, consider a contract that provides for 60.0 percent interest in
one provision and 30.9 percent interest in the remaining provisions. This
contract would result in the same 90.9 percent per annum rate of interest payable
overall. Given the equities of the contractual context as found in the courts
below, the application of the blue-pencil test would result in the other fees
and charges being struck from the contract and the 60.0 percent interest
payment obligation surviving.
37
Finally, consider what the result would be under the blue-pencil
approach if there were only one interest provision, and that this provision
called for an effective annual interest rate of 90.9 percent, which would also
involve exactly the same amount of consideration passing from borrower to the
lender as under the previous two contracts. The blue-pencil test would require
that the entire interest obligation be severed from the contract, since it
alone would violate s. 347 . This would result in no interest being payable
under the contract. It is possible, in this last example, that the illegality
of the rate would be so apparent that courts would be justified in reducing to
zero such a blatantly illegal rate. On the other hand, if the criminal rate
was arrived at inadvertently — or under a misapprehension of the law — as
assumed for the comparison of these three contracts, the obligation to repay at
least some interest should be upheld. In that case, the maximum permissible rate
would best reflect the intention of the parties, while curing the illegality.
38
This demonstrates that, at least in the case of contracts in violation
of s. 347 of the Code , the results associated with the application of
the blue-pencil approach are overly dependent upon the form of the contract,
rather than its substance. In these three similar contracts, the borrower must
pay 30.8 percent interest, 60.0 percent interest, or no interest, depending on
otherwise insignificant differences in drafting. Results this erratic and
sensitive to the form of contractual expression are undesirable, and can be
avoided through the use of notional severance in cases where considerations
flowing from the broad contractual context favour the lender.
39
There is little danger that abuses of this remedial flexibility would
surreptitiously creep past trial judges. On the contrary, judges are apt to be
quite suspicious, and rightly so, of credit arrangements which provide for
effective annual rates of interest in excess of 60 percent per annum. Using
notional severance to read down interest provisions to be just within the legal
limit would not find application in traditional loan-sharking transactions. It
would be available as a remedy where a court recognizes the commercial
sophistication and professional advice received by both parties, concludes that
the violation of s. 347 by the parties was unintentional, and considers it
equitable to give effect to the highest legal interest obligation available. In
such cases, there is no reason, in my view, to prefer the blue-pencil approach
as more likely to deter criminal interest rates. I will return to this point
below.
40
Thus, the appropriate approach is to vest the greatest possible amount
of remedial discretion in judges in courts of first instance. The spectrum of
available remedies runs from a court holding contracts in violation of s. 347
void ab initio, in the most egregious and abusive cases, according to
the criteria identified in Thomson, supra, to notional
severance. In the determination of where along the spectrum a particular
contract lies, the considerations identified in Thomson by Blair J.A.
should be referred to and analysed carefully. Although Blair J.A. was
considering the desirability of severing illegal interest from principal, the
same factors are helpful in determining whether to reduce illegal interest to a
legal level.
D. Application of the Revised Approach
41
Finding, as I do, that the maximum level of remedial flexibility should
be vested in judges and available for application by them subject to a careful
analysis of the factors identified in Thomson, I will apply this
approach to the facts of the case at bar.
42
As outlined above, in Thomson, Blair J.A. identified four
considerations relevant to the determination of whether public policy ought to
allow an otherwise illegal agreement to be partially enforced rather than being
declared void ab initio in the face of illegality in the contract:
1. whether the purpose or policy of s. 347 would be subverted by
severance;
2. whether the parties entered into the agreement for an illegal
purpose or with an evil intention;
3. the relative bargaining positions of the parties and their conduct
in reaching the agreement;
4. the potential for the debtor to enjoy an
unjustified windfall.
43
The first factor — whether the policy behind s. 347 would be subverted
here by partial enforcement — is related to the concerns expressed by Rosenberg
J.A. in this case that civil remedies should not frustrate the deterrence
purpose of the criminal prohibition. In this regard, it is important to
identify the policy purpose underlying s. 347 . Ostensibly, it was intended to
curb loan-sharking activity. It is difficult to pinpoint the precise rationale
behind the provision, however, because the legislative record yields few
clues. According to Professor Ziegel:
On July 22nd, 1980, only a day after its first reading, the House of
Commons gave second and third reading to Bill C‑44, “An Act to amend the
Small Loans Act and to provide for its repeal and to amend the Criminal Code ”.
The Bill was not debated and its adoption had the unanimous support of all
three political parties. Any public discussion of the merits of the Bill was
effectively forestalled by the haste with which it was rushed through the
House. This failure to give interested parties an opportunity to study and
comment on the Bill would be serious enough if the Bill only dealt with minor
technical matters. But it does not. The Bill deals with questions of major
social, economic, and legal importance which warranted careful examination.
Even if one accepts the soundness of the objectives of the Bill, it does not
follow that its technical implementation is equally unobjectionable or that the
same goals could not have been realized in a less controversial manner. In the
writer’s view, the Bill is open to objections on both counts and may generate
as many new problems as it was designed to resolve.
(J. S. Ziegel, “Bill C‑44: Repeal of the Small Loans Act and
Enactment of a New Usury Law” (1981), 59 Can. Bar Rev. 188, at p. 188)
As was stated
by this Court in Garland, supra, at para. 25:
The ostensible purpose of s. 347 was to aid in the
prosecution of loan sharks. See House of Commons Debates, 1st Sess.,
32nd Parl., vol. III, July 21, 1980, at p. 3146; Thomson, supra,
at p. 549. However, 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. Although s.
347 is a criminal provision, the great majority of cases in which it arises are
not criminal prosecutions. Rather, like the case at bar, they are civil
actions in which a borrower has asserted the common-law doctrine of illegality
in an effort to avoid or recover an interest payment, or to render an agreement
unenforceable. For this reason, the provision has attracted criticism from
some commercial lawyers and academics, and calls have repeatedly been made for
its amendment or repeal. . . . Nevertheless, 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.
Since it is
very difficult to identify the policy objective behind s. 347 of the Code
beyond the prevention of loan-sharking, violations of the section that clearly
do not involve loan-sharking should be approached cautiously, keeping in mind
that there is no need to deter, through the criminal law, effective interest
rates of up to 60 percent per year. Given that this was a commercial
transaction engaged in by experienced and independently advised commercial
parties, it is difficult to see why the choice of a 30.8 percent rather than 60
percent rate better fosters compliance with s. 347(1) (a) of the Code .
44
The second factor is whether the agreement was entered into for an
illegal purpose or with an evil intention. There is no evidence on the
record to suggest that New Solutions has been charged with violating s. 347(1) (a).
Absent a criminal conviction, New Solutions has the benefit of the presumption
of innocence. Concerns with specific and general deterrence are best
addressed by the criminal law. A prosecution under s. 347 of the Code
cannot be initiated without the consent of the Attorney General. This suggests
that even a criminal remedy is not always appropriate for an infringement of s.
347 , let alone a civil remedy seeking to promote the criminal law objective of
deterrence. Cullity J. found that the parties were unaware that the agreement
contravened s. 347 , their intent being only to provide the means by
which TNAE could buy out its remaining shareholders and acquire commercially
necessary working capital. It was a contract entered into for ordinary
commercial purposes. There was nothing inherently illegal or evil about this
intention. The worst that could be said is that TNAE was a high-risk debtor
for New Solutions to lend to (even with the personal guarantees of the
Dragosits), the corporation’s needs were high relative to its value, and it
needed the money on relatively short notice. This second consideration
militates in favour of a flexible remedy.
45
The third factor concerns the relative bargaining positions of the
parties and their conduct in reaching the agreement. Each party had
independent legal advice. Each party was commercially experienced. The
Dragosits and TNAE knew what they were getting into, as did New Solutions. The
one failing seems to be that neither side realized that their agreement would
contravene s. 347 of the Code . This third consideration, too, favours
a flexible remedy.
46
Finally, any potential for an unjustified windfall in this case arises
from TNAE possibly not having to repay the principal and interest, or from TNAE
possibly not having to pay a commercially appropriate rate of interest on the
loan. Given that each party had independent advice and knew precisely the
obligations that they were taking on, my conclusion is that the equities of the
situation favour New Solutions. This is in accord with the findings by both
the lower courts in this case.
47
New Solutions should be repaid the principal, with the highest amount of
interest legally allowable, namely 60 percent. This represents a reduction
from the interest rate of 90.9 percent that the contract provided for, but,
given s. 347 of the Code , is the most that New Solutions can legally
receive. This no more rewrites the contract than enforcing only the other
obligations, which cumulatively amount to “interest” at 30.8 percent.
48
My colleague, Bastarache J., refers to clause 9.1 of the accounts
receivable factoring agreement (para. 68), arguing it supports the blue-pencil
approach to severance. I agree that by clause 9.1 the parties expressed a
preference for the use of severance to give full effect to the valid provisions
of that agreement. I have two responses to the view, however, that the clause
calls for the use of the blue-pencil approach to severance rather than notional
severance. First, from the outset the parties agreed not to strictly abide by
the terms of the accounts receivable factoring agreement. Therefore, I
question whether it is appropriate to refer to clause 9.1 of this agreement.
Second, accepting for the sake of argument that the factoring agreement is
relevant, the use of notional severance is not foreclosed by the intent underlying
the inclusion of clause 9.1 in the factoring agreement. The genuine intent
underlying clause 9.1 was to preserve as much of the agreement as possible
should any part of it be deemed to be invalid. In light of the analysis above,
the part of the agreement that is invalid is the obligation to pay an effective
interest rate in excess of 60 percent per annum. Therefore, notional
severance is the most appropriate remedy to apply here, since it gives the
greatest possible legal effect to the valid aspects of the agreement, which is
in concert with the intention underlying clause 9.1.
VI. Conclusion
49
For the foregoing reasons I would allow the appeal, set aside the order
of the Court of Appeal and restore the order of Cullity J. I would award costs
to the appellant in this Court and in the Court of Appeal.
The following are the reasons delivered by
50
Bastarache J.
(dissenting) — I have read the reasons of Arbour J. and respectfully
disagree. I would not make available the remedy of “notional severance”,
whereby judges are permitted to rewrite offending provisions in a contract so
as to make them conform with the law. Instead, I would restrict the remedy
available under such circumstances to severance, in the traditional sense,
whereby judges are permitted to strike out offending provisions in a contract
provided they represent separate promises.
51
My dissent is based on three major considerations.
52
First, like Rosenberg J.A. of the Ontario Court of Appeal, I think there
is a fundamental difference between striking out offending sections of a
contract and rewriting a central provision of a contract. Although both
approaches admittedly interfere in some way with the intent of the parties, the
added flexibility of the rewriting approach comes at a considerable cost.
Furthermore, it is not supported by any principle of contract law. On the
contrary, the severance doctrine is a long-standing one. A useful survey of
the history and development of severance for illegality can be found in Still
v. M.N.R., [1998] 1 F.C. 549 (C.A.).
53
Historically, courts held that illegality in contract rendered the
entire agreement unenforceable and refused to order the return of money or
property transferred under the agreement. This classic approach to contractual
illegality was articulated by Parke B. in Cope v. Rowlands (1836), 2 M.
& W. 149, 150 E.R. 707 (Ex. Ct.), at p. 710:
[W]here the contract which the plaintiff seeks to enforce, be it
express or implied, is expressly or by implication forbidden by the common or
statute law, no court will lend its assistance to give it effect. It is
equally clear that a contract is void if prohibited by a statute, though the
statute inflicts a penalty only, because such a penalty implies a prohibition.
54
This Court has also endorsed the traditional doctrine of statutory
illegality. In Bank of Toronto v. Perkins (1883), 8 S.C.R. 603, Ritchie
C.J. stated, at p. 610:
It would be a curious state of the law if, after
the Legislature had prohibited a transaction, parties could enter into it, and,
in defiance of the law, compel courts to enforce and give effect to their
illegal transactions.
At p. 613,
Strong J. added:
Whenever the doing of any act is expressly forbidden by statute,
whether on grounds of public policy or otherwise, the English courts hold the
act, if done, to be void, though no express words of avoidance are contained in
the enactment itself.
See also Steinberg
v. Cohen, [1930] 2 D.L.R. 916 (Ont. C.A.); Hasiuk v. Oshanek, [1936]
1 D.L.R. 232 (Man. C.A.).
55
Over time, the lower courts in Canada moved away from this strict
approach because it was viewed as harsh and inequitable in some cases and could
result in a windfall to one party. Courts have come to apply a modern approach
when faced with a contract that contains an illegal provision. Under the
modern approach to illegality, a contract that violates a statute may be
enforceable, but not in its entirety. In Carney v. Herbert, [1985] 1
All E.R. 438, the Privy Council succinctly summarized the principles to be
applied. At p. 443 of the decision, their Lordships quoted with approval the
following statements made in an Australian case, McFarlane v. Daniell
(1938), 38 S.R. 337 (N.S.W. Dist. Ct. App.), at p. 345:
When valid promises supported by legal
consideration are associated with, but separate in form from, invalid promises,
the test of whether they are severable is whether they are in substance so
connected with the others as to form an indivisible whole which cannot be taken
to pieces without altering its nature . . . . If the elimination of the
invalid promises changes the extent only but not the kind of the contract, the
valid promises are severable . . . . If the substantial promises were all
illegal or void, merely ancillary promises would be inseverable.
Accordingly,
the illegal promise may be severed from the rest of the contract, leaving the
remaining promises to be enforced by the court. See G. H. L. Fridman, The
Law of Contract in Canada (4th ed. 1999), at pp. 441‑45; S. M.
Waddams, The Law of Contracts (4th ed. 1999), at p. 421. This has been
referred to as the “blue-pencil” test, a label first used in the case of Attwood
v. Lamont, [1920] 3 K.B. 571 (C.A.).
56
In my opinion, the “blue-pencil” test is nothing more than an expression
to describe the application of the severance principle. In Canadian
American Financial Corp. (Canada) Ltd. v. King (1989), 60 D.L.R. (4th) 293
(B.C.C.A.), at pp. 299‑300, Hinkson J.A. referred to Attwood v. Lamont
in which Lord Sterndale M.R. captured the essence of the applicable principle,
at pp. 577‑78:
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.
57
Under the blue-pencil test, severance is only possible if the judge can
strike out, by drawing a line through, the portion of the contract they want to
remove, leaving the portions that are not tainted by illegality, without
affecting the meaning of the part remaining. In other words, the offending
provision must constitute a separate promise, and one that is not part of the
main purport and substance of the contract. The provision must appear
severable. See Fridman, supra, at p. 443.
58
The blue-pencil test has been applied several times in the context of
violations of s. 347 of the Criminal Code, R.S.C. 1985, c. C‑46 ,
to strike out offending interest provisions. For example, in an earlier
dealing with the application of s. 347 (then s. 305.1 ), Mira Design Co. v.
Seascape Holdings Ltd., [1982] 4 W.W.R. 97 (B.C.S.C.), at p. 105, Huddart
L.J.S.C. held:
In these circumstances, and considering that the
offending provisions can be deleted by striking the first proviso on p. 2 of
the mortgage, the words “in the event it is paid to the Mortgagee”, and
“together with interest at the aforesaid rate on the principal sum of Eighty Thousand ($80,000) Dollars”
from the second proviso, the entire following paragraph and the words “and
interest” from the covenant contained in para. A on the same page, I have
concluded that the offending portions are severable in fact.
At p. 104,
Huddart L.J.S.C. also described the scope and application of s. 305.1 of the Criminal
Code as follows:
Most Canadians would agree that the purpose of the
Criminal Code is to protect the public by providing for the punishment of
behaviour that Parliament considers to be against the public interest. The
purpose of s. 305.1 [now s. 347 ] is to punish everyone who enters into an agreement
or arrangement to receive interest at a criminal rate. It does not expressly
prohibit such behaviour, nor does it declare such an agreement or arrangement
to be void. The penalty is severe, and designed to deter persons from making
such agreements. It replaces the Small Loans Act, which included a prohibition
of such agreements and gave the court the power to reconstruct them. It is
designed to protect borrowers. There is no penalty imposed on a person who
makes an agreement to pay, or pays, interest at a criminal rate. It is not
designed to prevent persons from entering into lending transactions per se. As
regards subject matter, its scope and application are limited to agreements
regarding interest. Moreover, to find that s. 305.1 necessarily prohibits the
entering into of agreements or arrangements to receive interest at a criminal
rate would be to accomplish that which Parliament has chosen not to do, or
cannot do, directly.
59
Second, there is no legal or other principled reason to limit the application
of the new approach endorsed by my colleague, that is notional severance, to
the application of the criminal rate of interest. This means that other
illegal provisions would be open to judicial redrafting. In my opinion, the
availability of “notional severance” as a remedy creates greater uncertainty in
the law. It is clear that both severance and notional severance alter the
parties’ agreement in some way. However, under the traditional severance
approach, courts continue to work with the words of the parties themselves,
removing only those portions of the contract that render it illegal. In stark
contrast, under notional severance, courts will be permitted to literally add
new words to the parties’ agreement. By doing so, courts will be substituting
their intentions for those of the parties. Notional severance would extend the
judicial role in what I consider to be an unfortunate way. One instance, in
particular, comes to mind.
60
In Canadian American Financial Corp. (Canada) Ltd. v. King, supra,
Hinkson, Lambert and Southin JJ.A. wrote three sets of concurring reasons
refusing to grant an interlocutory injunction to enforce a covenant in
restraint of trade. The provision of the contract in question was a
non-competition clause that restrained competition in Canada and Bermuda. All
three judges held that the covenant was overly broad. They refused to
substitute a covenant with reasonable terms for the unreasonable provision.
Lambert J.A. concluded that the authorities were clear that courts may not make
contracts for parties that they have not made themselves. In his opinion,
substituting the words “British Columbia and Alberta” for “Canada and Bermuda”
would have rendered the term enforceable (p. 307), but that was something for
the parties, not the court, to do. Under the new approach, would judges be
permitted to make such substitutions in order to render the contract
enforceable?
61
It is important to note that Lambert J.A. found, at p. 307, that the
blue-pencil rule would have made no difference to his decision as he would not
have been any more willing to sever a portion of the clause had it named all
the provinces and territories of Canada separately, and so been amenable to the
application of the blue-pencil rule. (I am not convinced under traditional
severance that a court would not be permitted to strike out a number of
offending provisions, or a number of provinces within a list, in order to
render the contract compliant with the law. As the majority’s decision
preserves traditional severance as one of the remedies within the trial judge’s
discretion, this issue will likely be considered in a more appropriate case in
the future.)
62
Furthermore, Lambert J.A. held that a clause, where one alternative
encompasses another, would be, in his opinion, void for uncertainty and should
not be made valid by severance. For example, a contract containing a covenant
not to compete: (1) in Ottawa, and (2) in the rest of Ontario, might be valid
as to Ottawa, but overbroad, and therefore wholly invalid, as to Ontario.
Including the two promises within the same contract renders the whole clause
invalid. In Lambert J.A.’s opinion, the only point on which the covenant is
clear is that the covenant is to cover at least Ottawa. But the parties could
have simply stated that. Again, under the approach adopted by my colleague,
could a court rewrite the second clause to read, for example, “in the rest of northeastern
Ontario”, so that it no longer constitutes an illegal restraint of trade?
63
Third, in my view, the approach taken by the majority in this case is
inconsistent with that taken in Garland v. Consumers’ Gas Co., [1998] 3
S.C.R. 112. In Garland, this Court interpreted the definition of
interest broadly in order to prevent creditors from avoiding the statute by
manipulating the form in which payments are to be made. At paras. 27‑28,
Major J. wrote:
It is apparent from this definition that for the purposes of s. 347
“interest” 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. . . .
. . .The broad language of s. 347 was
presumably intended . . . to prevent creditors from avoiding the statute simply
by manipulating the form of payment exacted from their debtors . . . . It is
the substance, and not merely the form, of a charge or expense which determines
whether it is governed by s. 347 .
64
Under my colleague’s approach, a creditor would be permitted to escape
the consequences of its avoidance measures by simply reducing the rate applied
to the maximum permitted under the Criminal Code . In my opinion, this
approach is inconsistent with the general objectives expressed in the Code
and incompatible with the notion of deterrence. 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 percent per annum.
And, as Rosenberg J.A. remarked, at para. 31, of the majority reasons of the
Court of Appeal ((2002), 60 O.R. (3d) 97) 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 to the benefit of those who prima facie stand
in violation of the criminal law.
65
It is also important to note that this Court has developed a method for
determining whether, as a matter of principle, a departure from
well-established precedent is warranted. I canvassed the relevant factors in Friedmann
Equity Developments Inc. v. Final Note Ltd., [2000] 1 S.C.R. 842, 2000 SCC
34, at para. 43, as follows:
In the recent case of Robinson [R. v.
Robinson, [1996] 1 S.C.R. 683], Lamer C.J., for a majority of the Court,
relied on five factors to justify the reversal of an earlier decision of the
Court in MacAskill v. The King, [1931] S.C.R. 330. These factors were
the existence of previous dissenting opinions in this Court, a trend in the
provincial appellate courts to depart from the principles adopted in the
original decision, criticism of the case or the adoption of a contrary rule in
other jurisdictions, doctrinal criticism of the case and its foundations, and
inconsistency of the case with other decisions. While they are not
prerequisites for a change in the common law, these factors help to identify
compelling reasons for reform. On the other hand, courts will not intervene
where the proposed change will have complex and far-reaching effects, setting
the law on an unknown course whose ramifications cannot be accurately
measured: see Bow Valley [Husky (Bermuda) Ltd. v. Saint John
Shipbuilding Ltd., [1997] 3 S.C.R. 1210], at para. 93.
In my opinion,
there do not appear to be compelling reasons to depart from the lower courts’
and Privy Council’s well-established precedent.
66
My colleague has provided a comprehensive summary of the facts in
issue. In my opinion, the finding by the trial judge that there was no
criminal intent should not cloud our analysis. Knowledge is not a requirement
under the provision. Indeed, as noted by Rosenberg J.A., at para. 15 of the
majority reasons of the Court of Appeal, the typical case is one where the parties
do not intend to violate the criminal law and occupy relatively equal
bargaining positions.
67
Also, while legal advice will almost certainly be helpful, parties
cannot rely on such advice to excuse themselves from non-compliance with the
law. Here, advice was given on the specific interest clause only, that the
interest was 48 percent, and that advice was wrong. Neither party was advised
by its solicitor of the scope of s. 347 of the Criminal Code (see
appellant’s factum, at para. 5; respondent’s factum, at para. 1). Contracting
parties should consider all of the provisions in the agreement when determining
the total interest charged.
68
I would like to conclude by drawing attention to clause 9.1 of the
accounts receivable factoring agreement which reflects the parties’ own
intentions as to remedy (see tab 4 of the respondent’s record). Clause 9.1
reads as follows:
9.1 Severability. If any provision of this Agreement is
deemed by a court having jurisdiction to be wholly or partially invalid, this
Agreement shall be interpreted as if such provision had not been part of this
Agreement, and so that the validity of such provision shall not affect the
validity of the remainder of this Agreement which shall be construed as if this
Agreement had been executed without such provision.
69
At the hearing of the appeal in this Court, counsel for the appellant
submitted that “this severance provision really doesn’t apply to the interest
rate provision that is in effect in this case which is found in a separate
document which was in the commitment letter”. Counsel conceded however that
clause 9.1 “reflects an intention that if, to the extent that a provision is
tainted by illegality, it will not render the contract invalid, and this clause
applies to the extent that notional severance is not effected” (emphasis
added). The underlined caveat is, of course, incompatible with the plain
meaning of clause 9.1 and unsupported by the record.
70
In any event, the commitment letter referred to by counsel is dated March
6, 2000, and the factoring agreement that contains clause 9.1 indicates
that it was executed as of March 30, 2000. And, significantly, the commitment
letter and the factoring agreement provide for the same royalty payment of
$160,000, the same monitoring fee of $750 per month, and the same standby fee
of 1 percent per month.
71
A letter sent from the appellant’s solicitor to the respondent is
instructive in this regard. As the trial judge explains, at paras 4‑5 of
his reasons ((2001), 54 O.R. (3d) 144):
Although a factoring agreement, promissory note and
general security agreement were executed on — or as of — March 30, 2000,
the parties had already agreed to depart from the provisions of the first of
these documents. On March 28, 2000, the respondent’s solicitor wrote to
the solicitor acting for the applicant and the Dragosits:
Further to our conversation of March 27, 2000, I confirm on behalf of
my client that as an economic accommodation to your client, the administration
of the factoring facility will not strictly follow the provisions of the
factoring agreement, unless my client elects to exercise its rights under
that agreement. 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.
In consequence, the concept of a factoring of
receivables was put aside and replaced by a revolving credit facility
secured on the current assets of the applicant including its accounts
receivable. Each of the Dragosits signed a personal guarantee for the entire
$500,000. [Emphasis added.]
72
In these circumstances, I am not persuaded that clause 9.1 of the
factoring agreement was in any way overtaken by the commitment letter dated
earlier. While certain aspects of the financial arrangement were governed by
the commitment letter alone, it is apparent from the letter sent by appellant’s
solicitor that the provisions of the factoring agreement were still very much
alive.
73
A plain reading of the clause indicates that, should a term of the
agreement between the parties be “deemed . . . wholly or partially invalid”,
the parties intended their agreement to be “construed as if this Agreement had
been executed without [the offending] provision”. I cannot see how the wording
of the clause can be said to anticipate — still less, to provide for — notional
severance.
74
Bearing in mind the plain meaning of clause 9.1, counsel’s concession as
to the intention of the parties and the letter sent by the appellant’s
solicitor to the respondent on March 28, 2000 — three weeks after the
commitment letter, on which the appellant relies, was signed, I feel bound to
conclude that the blue-pencil approach adopted by the Court of Appeal is
entirely consistent with the parties’ own intentions and that notional
severance is not.
75
In light of this consideration, I respectfully disagree with my
colleague that reducing, or effectively rewriting, the rate of interest to the
legally prescribed rate of 60 percent would show more respect for the sanctity
of the bargain between the parties. It appears from clause 9.1 that the
parties turned their minds to this very issue and agreed that, in the event of
a court declaring a provision in the contract invalid, the agreement shall be
interpreted, not redrafted, as if that provision was not part of the contract.
76
For these reasons, I would dismiss the appeal with costs.
The reasons of Deschamps and Fish JJ. were delivered by
77
Fish J. (dissenting) —
With respect for the contrary view of Justice Arbour, I would, like Justice
Bastarache and for the reasons that follow, dismiss the appeal with costs.
I
78
We are concerned in this case with the civil consequences of a serious
violation of the criminal law of Canada.
79
Section 347 of the Criminal Code, R.S.C. 1985, c. C‑46 ,
provides that it is a criminal offence to charge or agree to receive “interest
at a criminal rate”, which is defined as interest that exceeds 60 percent per
annum. I consider the violation in this case to be serious because the
appellant charged the respondent an effective interest rate of more than 90
percent.
80
I recognize that the law of equity is not a closed-end list of
off-the-shelf remedies. Like the majority in the Court of Appeal, however, I
do not believe this case required a new and novel prescription to ensure a fair
and reasonable solution. The well-established “blue-pencil” remedy described
by my colleagues and applied in the Court of Appeal respects the trial judge’s
findings of fact, as it must, and achieves an equitable result consistent with
established principle.
81
Finally, I agree with the majority in the Court of Appeal that the trial
judge erred in straining the recognized rules of equity by resorting to what he
described as “notional severance”. In different circumstances, his fresh and
creative approach might well prove appropriate. That would be so where notional
severance is necessary to resolve a private dispute fairly and in a manner that
is not incompatible with the social and legal objectives of the criminal law —
which, in my respectful view, is not the case here.
II
82
The appellant made a commercial loan to the respondent at a “criminal
rate” within the meaning of s. 347 of the Criminal Code . Pursuant to
that provision, as I have mentioned, anything over 60 percent per annum is, as
a matter of law, a “criminal rate”.
83
The loan in this case was made at an effective annual rate of 90.9
percent, or 150 percent of the legal maximum.
84
There were two components to the interest charged.
85
The first provided for interest at four percent per month, calculated
daily, payable monthly in arrears. Appellant’s solicitor, without intending to
mislead, erroneously advised respondent’s solicitor “that the interest rate
[was] 48 (per cent) per annum”. It was in fact 60.1 percent, a criminal rate in
itself.
86
The second component consisted in various charges that, taken together,
increased the effective annual interest rate from 60.1 percent to 90.9 percent.
87
These facts are not in dispute.
88
Moreover, the appellant, though it did so at the outset, no longer
contests: (1) that the rate stipulated as interest was a “criminal rate” within
the meaning of s. 347 of the Criminal Code ; and (2) that the additional
charges I have mentioned fall within the definition of “interest” in s. 347 .
And it is common ground that s. 347 applies to the kind of commercial loan that
concerns us here.
89
Two defining features of the impugned loan agreement must therefore be
borne in mind from the outset. First, that we are not dealing in this case
with a contract that violates civil, commercial or regulatory legislation, but
rather with an agreement that violates the Criminal Code of Canada; and
second, that the effective interest rate under that contract amounts to more
than one-and-a-half times the threshold criminal rate, and does not
exceed it barely, slightly, or by only 0.1 percent.
90
The trial judge found that the appellant did not intend to breach s. 347
of the Criminal Code . This was therefore, in his view, a case
for severance of the illegal provisions in the contract.
91
It is important to remember that only one provision of the contract was illegal
in itself: the provision which charges interest at the criminally
prohibited rate of 60.1 percent. The other charges, included in the definition
of interest set out in s. 347 , were separately set out in the agreement and not
stipulated as interest.
92
Had the trial judge severed the interest clause and left the other
charges intact, his decision would have fallen within the bounds of his
discretion.
93
He declined, however, to do so.
94
Instead, he applied a new and novel remedy that he described as “notional
severance”, rewriting the interest clause so as to yield, when added to the
other charges, a cumulative, effective interest rate of 60 percent — the very
threshold of the criminal rate prohibited by s. 347 of the Code .
95
In the Court of Appeal for Ontario, the majority found that the trial
judge had erred in “straining” the law in this way. The appellant had charged
the respondent a criminal rate of interest far exceeding the limit established
by Parliament, and the Court of Appeal found it inappropriate, as a matter of
legal principle and judicial policy, to bend or extend the equitable remedy of
severance in order to secure for the appellant the maximum rate of interest it
could have recovered had it not violated the law.
96
Bearing in mind the trial judge’s findings of fact and applying the
recognized blue-pencil approach, the Court of Appeal instead severed the
criminal rate agreed to by the parties as interest and permitted
the appellant to recover the separately stipulated charges, which left in place
an effective interest rate of just over 30 percent.
97
The decisive question in this Court is whether the Court of Appeal erred
in law in concluding as it did.
98
I would answer that question in the negative.
III
99
Without so deciding, I am prepared for present purposes to agree with
Arbour J., at para. 5, that “notional severance is available as a matter of law
as a remedy in cases arising under s. 347 ” of the Criminal Code .
100
Even on that assumption, however, I would permit notional severance only
where: (1) public policy does not require that the entire agreement be declared
unenforceable; (2) severance is found to be warranted; and (3) severance simpliciter —
or “blue-pencil severance” — is impracticable or would occasion an unjust
result.
101
Here, on the facts as found by the trial judge, the first two criteria
are satisfied but the third is not: blue-pencil severance is both possible and
fair. And, unlike notional severance as applied by the trial judge,
blue-pencil severance does not do violence to the policy purposes of s. 347 of
the Criminal Code or require a judicial rewriting of the interest clause
agreed to, as such, by the parties.
102
Section 347(1) of the Code provides that everyone 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.
103
And s. 347(2) provides:
(2) In this section,
. . .
“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;
104
As consideration for its loan to the respondent, in addition to the
interest stipulated as interest, the appellant, as already mentioned, charged
various other amounts that constituted interest called by another name. As
noted by Arbour J., it is undisputed that those charges fall squarely with the
definition of “interest” set out in s. 347(2) of the Criminal Code .
Together, they added 30.8 percent to the 60.1 percent expressly contemplated by
the agreement.
105
The trial judge found as a fact that the appellant, in charging the
respondent an effective interest rate of 90.9 percent per annum, did not intend
to breach the provisions of s. 347 . His conclusion in this regard should not
be misunderstood: an intent to breach the section is not an essential element
of the offence.
106
There is no doubt, moreover, that the appellant was perfectly aware of
the stipulated rate of interest (though perhaps not of its actuarial
quantification) and was aware of all the other charges that, as a matter of
law, constitute interest as well.
107
As I said earlier, I am prepared to assume for present purposes that
notional severance is a remedy known to law, but would permit its application
in cases involving a breach of the criminal law only where severance is
nonetheless warranted as a matter of equity and severance simpliciter is
impracticable or would create an unjust result.
108
The question, then, is whether this is such a case.
109
With the greatest of respect, I am persuaded that it is not, essentially
for the reasons set out by Rosenberg J.A., speaking for the majority in the
Ontario Court of Appeal ((2002), 60 O.R. (3d) 97, at paras. 31‑35):
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. [now J.A.] said in Pacific National Developments [Ltd. v.
Standard Trust Co. (1991), 53 B.C.L.R. (2d) 158 (S.C.),] at p.
163 . . . : “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”.
.
. .
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] M.J. No.
205 [(QL)] (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 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.
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.
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.
110
I agree with Rosenberg J.A.’s analysis and would add these additional
considerations.
111
The first relates to the appellant’s purported good faith. As I
understand it, this refers to:
(1) the trial judge’s finding that the appellant
did not intend to breach s. 347 , in the sense that the appellant appears
not to have realized that its otherwise well-understood charges violated the Criminal
Code ; and
(2) the fact that the separate and distinct
charges which added just over 30 percent per annum to the stipulated rate of
interest were not known by the appellant to constitute interest within the
meaning of s. 347(2) of the Code .
112
I accept that neither the appellant nor the respondent thought of the
added charges as interest.
113
On this assumption, it appears to me neither “artificial” nor
“arbitrary” to sever the criminal rate of interest agreed to as interest
and to leave intact the distinct and separate charges not agreed to as
interest, and not considered to be interest by either party.
114
This solution responds adequately to the policy concerns expressed by
the majority in the Court of Appeal. Unlike notional severance, it requires no
judicial rewriting of the interest clause agreed to as such by the parties.
And it still leaves the appellant with a return of slightly more than 30
percent per annum.
IV
115
Arbour J. concludes that the four factors set out by Blair J.A. in William
E. Thomson Associates Inc. v. Carpenter (1989), 61 D.L.R. (4th) 1 (Ont.
C.A.), favour severance in this case. I agree. That is why I would affirm the
judgment of the Court of Appeal.
116
But the more difficult question is whether these four factors favour
notional severance as opposed to the established blue-pencil form of
severance contemplated by Blair J.A. in Thomson. In my respectful view,
they do not.
117
The first consideration or factor is whether the purpose and policy of
s. 347 of the Criminal Code would be better served by severance simpliciter
or by notional severance.
118
In support of her conclusion, on this branch of the matter, Arbour J.
cites at para. 43, an article in which Professor Ziegel explains his objections
to s. 347 (J. S. Ziegel, “Bill C‑44: Repeal of the Small Loans Act and
Enactment of a New Usury Law” (1981), 59 Can. Bar Rev. 188). On the
issue that concerns us here, however, Professor Ziegel elsewhere states:
So far as the interest component is concerned,
obviously the lender cannot recover that part of it which exceeds 60%. But can
he recover the first 60%? 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%. [Emphasis added.]
(J. S. Ziegel, “The Usury Provisions in the Criminal Code : The Chickens
Come Home to Roost” (1986), 11 Can. Bus. L.J. 233, at p. 242)
119
Professor Ziegel’s first reason is of limited application here, since
the parties did distinguish between the two components of the illegal
interest rate. Moreover, there is a sound basis for distinguishing between
them: the first, agreed to by the parties as interest, itself exceeds the
limit, albeit narrowly, while the second was not considered by the parties to
be part of the interest rate, though s. 347 gives it that effect.
120
Professor Ziegel’s second reason, which I share, clearly militates in
favour of blue-pencil severance, the solution adopted by the majority in
the Court of Appeal, and against “notional severance”, which the trial
judge applied in awarding the appellant interest at the threshold of the
criminal rate.
121
I agree with Arbour J. that the second consideration — whether the
parties entered into the agreement for an illegal purpose or with an evil
intention — in this case favours a flexible remedy. That objective, however,
is satisfied by severing the interest clause and leaving the other charges
intact, since this requires the respondent to pay, and allows the appellant to
receive, an effective interest rate of more than 30 percent on the commercial
loan that was the object of their agreement.
122
This remedy certainly differs from — but is no less “flexible” — than
the remedy conceived by the trial judge.
123
Had there been only an effective interest rate of 60.1 percent — and not
a cumulative effective rate of 90.9 percent — it might have been desirable, I
concede, not to sever the interest clause entirely. But that was not the case
here.
124
The third consideration relates to the relative bargaining positions of
the parties and their conduct in reaching the agreement.
125
In this regard, it is true that the respondent had the advice of a
solicitor and does not appear to have been a naive or inexperienced victim of
misunderstanding. But a commercial borrower who agrees, for lack of an
alternative source of financing, to pay an effective interest rate of 90.9
percent per annum — many times the normal commercial rate — and to provide
personal guarantees for the loan, can hardly be said to have bargaining power
equal to that of the lender.
126
I turn now to the fourth consideration, relating to the potential for
unjust enrichment or, in the words of Arbour J., an “unjustified windfall”
(para. 42).
127
Unlike Arbour J., I do not consider that the respondent can be said to
be unjustly enriched if it is relieved by a court of law of its contractual
undertaking to pay a criminal rate of interest where, as here, it is required
at the same time to pay an effective annual rate of more than 30 percent and to
repay the principal as well — in full.
128
In short, it appears to me that all four considerations identified by
Blair J.A. in Thomson, supra, examined individually and weighed
together, militate here in favour of the remedy applied by the Court of Appeal
and against the remedy adopted by the trial judge.
129
Accordingly, I agree with the Court of Appeal that the trial judge erred
in substituting for the criminal rate of interest charged by the appellant to
the respondent the highest rate the appellant could otherwise have charged.
130
And, like the Court of Appeal, I see no basis in the established rules
of equity that would permit the trial judge to rewrite the illegal interest
clause agreed to by the parties in this way. It should simply have been struck
out on the accepted blue-pencil approach.
131
The effect of the trial judge’s decision was to stretch the principles
of equity in an inappropriate way and to send the wrong message to those who
lend money at a criminally prohibited rate to “willing” borrowers who cannot
otherwise obtain a loan.
132
They should not be encouraged to believe that if their illegal
arrangement is subjected to judicial scrutiny, they will nonetheless recover
the highest rate they could legally have charged — and thus suffer no pecuniary
disadvantage for having violated s. 347 of the Criminal Code .
V
133
As mentioned at the outset, I have assumed for the purposes of this
appeal the correctness of Arbour J.’s premise that “notional severance is
available as a matter of law as a remedy in cases arising under s. 347 ” of the Criminal
Code .
134
On this assumption, I would apply notional severance to cases involving
a breach of the Criminal Code only where severance does no violence to
public policy interests, is found to be warranted as a matter of equity, and
severance simpliciter is impracticable or, though possible, would create
an unjust result.
135
For all of these reasons and, to the extent that they are not
incompatible, the reasons of Bastarache J., I would dismiss the appeal with
costs.
Appeal allowed with costs, Bastarache,
Deschamps and Fish JJ. dissenting.
Solicitors for the appellant: Fraser Milner Casgrain,
Toronto.
Solicitors for the respondent: Ackerman Law Office, Toronto.