Written by Denise D. Bright, Preet K. Gill, Elizabeth K. Dylke and Justin Duguay
Private equity and alternate lenders often take a basket of rights when investing in an entity. The basket may include equity, options, warrants and/or debt. In the case of debt financing, lenders often negotiate equity sweeteners/kickers in the form of options or warrants to increase their possible return, in addition to receiving interest on a loan. Lenders should be aware that in such cases there is a risk that the gains with respect to such equity received could be considered "interest" and trigger a criminal interest rate. Recent cases have materially reduced that risk, however, courts have been careful to characterize the decisions as fact-specific, leaving the door open for such sweeteners/kickers to fall within the criminal interest rate provisions.
Section 347 of the Criminal Code (Canada) defines a criminal rate as an effective annual rate of interest exceeding 60 percent. Interest by definition 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 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." Put simply, a criminal interest rate can be triggered in two ways. First, by entering into an arrangement or agreement to receive interest at a criminal rate. Second, by receiving payment of interest at a criminal rate. The latter creates a “wait and see” approach. In other words, the concern is that if equity sweeteners granted by the borrower in a loan transaction are considered to be "interest", the transaction could run afoul of the 60 percent criminal interest rate at a later date, when the sweeteners become more valuable. Canadian courts have rarely addressed the question of whether shares, warrants, options or other equity issued by a borrower in support of a loan can constitute 'interest' within the meaning of section 347 of the Criminal Code (Canada).
In May 2017, Bennett Jones published a blog on the decision in Bimman v Neiman, 2015 ONSC 2313 [Bimman] where the Ontario Superior Court considered the ancillary issue of equity sweeteners granted by a company to its shareholders. In that case, a company could not secure third- party financing, therefore it issued shares to its shareholders in response to two cash calls. The plaintiff was a shareholder who had not participated in the cash calls and who argued that the issuance of shares by the company in response to cash calls engaged the section 347 criminal interest provision. The argument was rejected by the trial judge and was not pursued on appeal.
On October 26, 2018, the Supreme Court of British Columbia released its decision in Cirius Messaging Inc. v Epstein Enterprises Inc, 2018 BCSC 1859 [Cirius]. In this case, the Court found that the criminal interest rate did not extend to equity (in the form of shares or warrants) granted by borrowers in connection with an arm's length loan transaction. The trial judge in Cirius acknowledged the judgment in Bimman as helpful for his application of section 347, though not binding. As opposed to Bimman where the lenders were shareholders of the borrowing company, in Cirius, equity sweeteners were granted in the context of an arm's length loan transaction where the borrower later challenged the legality of the transaction.
The Supreme Court of British Columbia: Issuance of Shares and Warrants in Support of a Loan
In Cirius, the borrower was a start-up technology company that entered into a convertible loan agreement with the lender which provided that, under certain conditions, the principal amount of the loan may be converted into shares of the borrower. The borrower and the lender also entered into an ancillary services agreement (ASA) under which warrants to purchase shares at $0.01 per share were granted to the lender.
The borrower argued that the ASA was a sham and the warrants were issued on account of the loans made by the lender. In addition, the borrower argued that if the ASA was a sham, the warrants and/or conversion rights under the loan constituted a "charge or expense" that was "paid or payable" by or on behalf of the borrower, bringing them within the definition of interest in section 347 of the Criminal Code. The trial judge found that the ASA did not represent the parties' true intentions and as such was a "sham or fiction" and was actually an inducement for the loan. However, the trial judge concluded that the converted shares and warrants granted under the loan agreement did not constitute "interest" under section 347.
In reaching his conclusion, the judge focused on the definition of "interest" in section 347 which provides that "interest" means all charges and expenses paid or payable, by or on behalf of a borrower, for the advancing of credit.
A. Charges and Expenses
As the terms "charges" and "expenses" are not defined in the Criminal Code, the judge considered dictionary definitions and concluded that "charges and expenses" imply an obligation to repay a debt. The judge further considered the term "debt" to mean "an obligation to pay a sum certain or a sum readily reducible to a certainty" (i.e., a fixed or specific payment). This level of certainty and precision required in the calculation under section 347 was found to be inconsistent with the valuation of shares or warrants, which remains inherently uncertain. Given that the equity interests in the form of shares and warrants cannot be calculated or determined with precision, the judge determined they could not amount to "interest" in the criminal context.
B. By or on Behalf of the Borrower
The converted shares and warrants were also found not to be an expense that was paid or payable by or on behalf of the borrower, on the basis that the issuance of shares was found not to be an expense of the company; therefore, it was not paid by the borrower. Rather, it was characterized as affecting the capital investment of shareholders in the corporation. Further, the shareholders did not incur an expense on behalf of the corporation because they "are not personally liable for the ensuing financial obligations of a company."
Implications for Corporate Lenders
The decisions in Bimman and Cirius should provide comfort for arm's length lenders who are receiving equity interests related to the advance of loans. Lenders should, however, remain cautious. While the decisions in Bimman and Cirius provide useful precedents, both decisions are fact dependent. It was noted by the trial judge in that valuation was difficult due to the fact that the loan had been repaid and the warrants were still outstanding, which may not always be the case. In fact, the trial judge specifically noted that the door was still open for equity to be considered as "interest" in other circumstances: "it may be, for example, [...] that the payment of a specified number of shares in a publicly traded company, in exchange for a lender advancing credit, constitutes 'interest' under s. 347."
The full implications of section 347 remain to be determined. However, a pending legislative amendment to the Criminal Code, if passed, will change the landscape. Bill S-237, currently at third reading in the Senate, will provide an exemption to the criminal rate of interest for loans for commercial or business purposes in excess of $1,000,000. While business and commercial loans under that amount would still be captured, if the amendment is passed, it would provide comfort for lenders of larger business and commercial loans. In addition, the Bill also provides for an additional criminal interest rate for credit advanced in other cases. The Bill has been slow moving (it was first put forth in 2017) so it is unknown when, or if, this amendment will be passed by the Senate at which time it will also need to be passed by Parliament.