Equity Sweeteners Get a Bit Sweeter

A recent Ontario court decision helps insulate lenders from potential attacks that equity sweeteners issued in connection with a loan might result in the lender running afoul of the criminal interest rate.

What You Need To Know

• Higher-risk borrowers often encourage investors to lend money by promising to issue shares at a discount or even just a nominal cost—a so-called “equity sweetener” or “equity kicker.” Under Canadian law, there is a risk that the issuance of those shares could offend the “criminal interest rate” provisions of section 347 of the Criminal Code. 
• As a result, a promise to issue those shares could be unenforceable, and a lender to whom the shares had been issued might be asked to return them for cancellation. 
• A recent Ontario trial court decision reduces—but does not eliminate—that risk.  

Background

Most commercial lenders don’t have the risk of fine or imprisonment on their minds when they extend credit to their borrowers, and might be surprised to learn that it can be a criminal offence to receive or contract for too high a rate of return. And yet, there is, even in commercial loan transactions, a risk of contravening section 347 of the Criminal Code. 

Crafted as a deterrent to loan-sharking, section 347 makes it an offence to receive interest, or enter into an agreement to receive interest, at a criminal rate, which is defined to mean an effective annual rate of interest exceeding 60% per year. While it would be unusual for a commercial loan agreement to expressly provide for a nominal interest rate higher than 60% per annum, the potential trap for the unwary lies in the broad definition of “interest.”

“Interest” is defined to encompass the aggregate of all charges and expenses, of any nature or kind regardless of the form, paid or payable for the advancing of credit under an agreement or arrangement. This expansive formulation potentially sweeps into the “interest” calculus a wide range of charges, including upfront loan fees, royalties, commitment and facility fees, capitalized interest and legal expenses. However, Ontario courts appear to have drawn the line at equity incentives such as warrants or convertible debentures which are a typical feature of subordinated and mezzanine debt offerings, LBOs, equity recapitalizations and similar financings at the riskier end of the credit spectrum.

Recent Developments

In Bimman v. Neiman,¹ Justice Gans held that a promise to issue shares at less than fair market value in connection with shareholder loans made under a shareholders agreement was not “interest” within the meaning of the Criminal Code. Therefore, the “criminal interest rate” provisions of section 347 did not apply to that promise.

While courts have interpreted the definition of “interest” broadly, there is very little case law addressing whether the issuance of shares to a lender ought to be characterized as interest. A British Columbia trial-level decision in Boyd v. International Utility Structures Inc.² found that the issuance of shares at a discount to a lender by a company related to the borrower was a collateral advantage connected to the loan and therefore was “interest” within the meaning of section 347. The Court of Appeal in that case did not address this issue.

In his recent decision in Bimman, Justice Gans suggested that the issuance of shares will not necessarily be characterized as “interest.” He found that the shares to be issued in that case were not a “charge or expense” to the borrower and did not constitute a charge that was “paid or payable” by the borrower. In particular, the Court held the following.

• A shareholder loan coupled with the issuance of shares did not seem to be the type of transaction Parliament intended to prohibit under section 347.
• While there may be a cost associated with issuing shares at less than fair market value, that cost was borne by the shareholders of the company, not by the company itself (by reason of the company receiving less for the shares than it should otherwise have received, thereby diluting the value of the shareholders’ shares). Therefore, the company per se did not incur a “charge or expense” in connection with the issuance of the shares.
• The issuance of the shares was not a charge that was “paid or payable” by the company, and as such was not “interest” within the meaning of section 347 on that ground as well. That was the case because the shares were not redeemable, the company was under no obligation to re-purchase them at a future date, and the shares did not guarantee any right to future payment.

Recognizing that this decision addresses the issuance of shares in connection with shareholder loans—not loans provided by an arm’s-length lender—the court’s views about who is bearing the cost to issue shares at less than market prices and the absence of any payment obligation on the part of the borrower should apply equally to arm’s-length lending. Therefore, while the criminal rate risk still exists, it would appear that, as a result of this decision, the risk is diminishing.

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¹ 2015 ONSC 2313 (S.C.J.)

² 2001 BCSC 559, aff’d on other grounds 2002 BCCA 438