Some alert readers of my column on payday lending wrote to raise concerns faced by commercial lenders who enter into lending transactions with borrowers who would not otherwise be able to obtain conventional lending.
Under these conditions, the consideration normally has a variable component based upon the success of the business. For example, a lender may require a convertible debenture or a warrant, coupled with a put to the borrower as a “sweetener” in higher-risk lending transactions.
Here the dynamics are very different from those in payday lending. Both the borrower and the lender are relatively sophisticated and retain legal and financial advice to structure the transaction. The borrower is often not able to obtain financing by way of conventional debt because its business is too precarious.
The lender is willing to lend on a secured basis because it feels its likelihood of getting repaid in whole or in part in the worst case is enhanced by using this method. However, the lender would not even consider making a loan without having the ability to participate in the potential success of the business. The convertible debenture or the warrant gives the lender that potential return.
Generally speaking, the public and the courts have not had much sympathy for borrowers who complain about paying lenders the amount they agreed to pay them in circumstances where their businesses have been very successful. However, sympathetic or not, s. 347 of the Criminal Code provides that any person who receives a payment or partial payment of interest at a criminal rate - 60 per cent per annum - is guilty of an indictable offence. Interest is broadly defined to include all charges and expenses paid or payable for the advancing of credit.
The worst case for a lender in these circumstances is that the act of receiving criminal interest could result in criminal charges. However, provincial attorneys general have been reluctant to pursue this route in what are obviously commercial transactions. There have not been many criminal prosecutions of investment bankers under s. 347.
The more common approach is for a borrower to contest the right of the lender to receive interest at a criminal rate contrary to the Criminal Code. Those actions are often successful but the devil is in the detail. There is a line of cases in this area often referred to as the “blue pencil” cases in which the courts take varying views of their ability to rewrite the underlying documents to preserve as much as possible of the intention of the parties when entering into the transaction.
Some of these cases suggest a reading down of the agreement is appropriate such that the lender receives the full 60-per-cent return on everything it loaned but no more.
Others take a more restrained view and suggest that all a court can do is entirely strike out the offending provisions. Using the second, more traditional approach, a lender might well end up with no return at all or with interest only and no return from the equity portion of its compensation.
There are several ways in which lenders try to address this problem. One approach is to attempt to value the equity component of the transaction at closing and actually advance a portion of the money for the equity component.
If it is clear that the intention is to properly assess the value of the equity portion of the transaction at the time, and if a reasonable payment is actually made for that portion, there is no reason for a court to characterize the equity part of a transaction as “interest.” However, the definition of “interest” is very broad and there is no certainty on this point.
In addition, it may be difficult to properly assess the value of the equity component and lenders are often reluctant to advance any portion of the money involved in this kind of transaction in a manner that requires success in order to achieve repayment.
Another approach is to use fulsome severability language, which confers upon the courts the ability to reinterpret the agreement between the parties to limit the compensation received by the lender overall to 60 per cent over the life of the transaction. These kinds of severability/criminal interest provisions are becoming more common and may be the most commercially reasonable approach to the problem.
The interesting aspect of this approach is that it directly addresses the courts’ concerns in the blue pencil cases because it lets courts make needed revisions to get the best result for the lender in the legislative circumstances. However, it would not permit the lender to experience the kind of windfall that a lender in this marketplace dreams of: the $100,000 loan to the next software giant with a 10-per-cent equity sweetener.
While it might be argued that the Criminal Code was intended to protect unsophisticated borrowers who use payday loans, there is no public policy reason for the protection to extend to sophisticated business people acquiring funding in circumstances where the risks make conventional lending unavailable.
It’s unclear what effect this legislation has had on the availability of higher risk financing in Canada. Exempting larger commercial financings from the Criminal Code is a sound idea and would be very helpful to the mezzanine lending/private equity sector in Canada if this quirk of Canadian legislation were eliminated.
Sam Billard is a partner at Aird & Berlis LLP practising primarily in the debt finance area.