AN ACTUARY S PERSPECTIVE ON CRIMINAL RATE OF INTEREST CALCULATIONS

Transcription

1 AN ACTUARY S PERSPECTIVE ON CRIMINAL RATE OF INTEREST CALCULATIONS Prepared By Ian M. Karp, Fellow, Canadian Institute Of Actuaries October 14, 2003 An earlier version of this paper was presented Friday, September 5, 2003 to the Canadian Institute Of Actuaries Actuarial Evidence Seminar, held in Mississauga, Ontario. I wish to acknowledge the very helpful comments on this paper provided by Paul Bennett (Vancouver lawyer), Brian Burnell (Halifax actuary), and Harry Satanove (Vancouver actuary). Of course, any errors, omissions, or other shortcomings in this paper are my sole responsibility. I am an actuary, not a legal expert. Lawyers should regard the legal analysis herein as a supplement to, not a substitute for, their own legal research. Further, I have focused on issues which arise in preparation of actuarial reports. There are other important legal issues which arise in such cases (e.g. severance ) but a detailed discussion of these issues is beyond the scope of this paper. INTRODUCTION AND SUMMARY This paper aims at giving those actuaries and lawyers who are unfamiliar with criminal rate of interest calculations an introduction to the topic, and sources for further reading. I hope experienced actuaries will also find the paper useful, and that it will encourage discussion and debate of these issues within the Canadian actuarial profession. Lawyers experienced in the area will hopefully find that the paper provides a useful review. This paper contains numerous quotes and paraphrases from: i. An excellent 1994 article by Vancouver lawyer Stephen Antle. For further particulars re this article, and also re the court decisions referred to herein, see the list of references (Appendix A) and case citations (Appendix B) at the end of this paper. (For a more recent article, though perhaps of more interest to lawyers than actuaries, see the article by Prof. Christopher Nicholls, published in the edition of Banking and Finance Law Review). The earlier September 5, 2003 version of this paper was prepared before I became aware of the articles by Prof. Mary Anne Waldron and Prof. Jacob Ziegel published in the July, 2003 edition of the Canadian Business Law Journal. Prof. Waldron s article serves to

2 -2- bring the analysis in the Antle article up to ii. The 1998 Supreme Court of Canada ( SCC ) judgments in the Degelder and Garland cases, which review the law in this area in detail. In the rest of this paper, I first describe the legal context in which an actuary s criminal rate of interest calculations are required. Then, I discuss at length an important set of issues in preparing an actuarial report, relating to ensuring that the cash flows defining the transaction are fully specified. I first provide an overview of these issues, then deal with the following particular issues in turn: - Aside from repayment of principal, what payments from the borrower to the lender will be included in the transaction; i.e. which payments fall under s. 347's definition of interest? - Which payments are considered part of credit advanced? - Are calculations needed under s. 347(1)(a), s. 347(1)(b), or both? - For each of the above two possibilities, on what date should repayment of principal be assumed to occur? I then discuss other practical issues facing the actuary in connection with criminal interest calculations. While these issues include some fairly technical points, my discussion does not contain any advanced actuarial mathematics. A 1985 paper by a Halifax actuary, Mr. Brian Burnell, written primarily for other actuaries, contains a very good discussion of the mathematical fundamentals applicable in carrying out such calculations. I think that the actuarial profession would benefit from a reexamination of certain fundamental mathematical issues, but such a reexamination is beyond the scope of this paper. This paper focuses solely on criminal rate of interest calculations, but lawyers sometimes ask actuaries to undertake interest calculations in other contexts; for example: - Situations where the lawyer argues that the lending rate, while not criminal, is unconscionable under consumer protection legislation. - Disputes re how certain features of a lending contract (e.g. mortgage pre - payment penalty) have been interpreted.

3 -3- The following legal text contains a broad discussion of interest topics: The Law of Interest in Canada, Mary Anne Waldron, Carswell LEGAL CONTEXT IN WHICH AN ACTUARY S CRIMINAL RATE OF INTEREST CALCULATIONS ARE REQUIRED Criminal Offences Created By Section 347, Which Was Enacted In 1980 Mr. Antle states at p. 323 of his article: [Section 347 of the Criminal Code] creates two criminal offences....section 347 (1) (a) makes it an offence to enter into an agreement or arrangement to receive interest at a criminal rate. Section 347 (1) (b) makes it an offence to receive a payment or partial payment of interest at a criminal rate. A criminal rate of interest is defined as an effective annual rate of interest, calculated in accordance with generally accepted actuarial practices and principles, that exceeds 60% of the credit advanced. Interest is defined to include all charges and expenses paid or payable for the advancing of credit under an agreement or arrangement by or on behalf of the borrower, regardless of to whom such charges and expenses are to be paid or are payable. There are specific exceptions to this inclusive definition. See the 1998 Degelder decision, paragraphs 17-20, for further discussion of the above points. Historical Background Re Enactment Of S. 347 In 1980 Mr. Antle (at p. 324) gives the following interesting historical background: The offences created by s. 347 are separate from the interest rate disclosure provisions in the Canada Interest Act and the Bank Act and in provincial consumer protection legislation. Parliament enacted s. 347 in 1980 as part of [a larger legislative package which]...[t]he House of Commons passed... unanimously without debate...parliament had enacted the Small Loans Act in Its object was to protect borrowers seeking small loans, not then normally made by financial institutions, from usurious loan charges....parliament repealed the Act in 1980 because, with changes in the Canadian economy, small loans were more widely available. Parliament believed market forces would more effectively protect borrowers. However, it still wished to control the perceived problem of loan - sharking. Parliament enacted s. 347 for that purpose. Section 347 Commonly Applied To Wide Range Of Civil Cases The Supreme Court of Canada states at paragraph 25 of its 1998 (majority) judgment in the Garland case: The ostensible purpose of s. 347 was to aid in the prosecution of loan sharks....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

4 -4- 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 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...[i]t 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. Commercial lawyers and academics have criticized the application of s. 347 to commercial cases as unfair to lenders; see articles cited in the Garland judgment, paragraph 25. Thus Prof. Ziegel wrote in a 1981 article (quoted in the 1984 B.C. Nelson judgment, pp ): Any public discussion of the merits of the Bill was effectively forestalled by the haste with which it was rushed through the House....Loansharking is said to be rampant in Montreal and other major Canadian cities and the usury provision was apparently requested by the Montreal police to assist them in their fight against the underworld...implicit in the [eventual new Section 347] is the assumption that any rate exceeding sixty per cent is extortionate and indelibly stamped with a criminal intent, including presumably the willingness to use violent collection methods to ensure repayment of the loan. These assumptions are demonstrably unsound. Assume an employee requests a loan of $10.00 from another employee and promises to repay $11 a week later. The one dollar charge if interpreted as interest, corresponds to an annual interest rate of approximately 520 per cent, which sounds extortionate. In fact it is not because the time spent by the fellow employee in making and collecting the loan would alone be worth a dollar. In any event it is economically unsound to stigmatize any cost of credit as extortionate if the borrower was a free agent and was not coerced into borrowing the money. Prof. Ziegel s opposition to s. 347 is undiminished over 20 years later. He states in his 2003 article: There are no reported cases I know of where acknowledged criminals have been successfully prosecuted under s [W]e now have the worst of all possible worlds: no successful prosecution of loan sharks...but major headaches for commercial lenders in legitimate loan transactions. (pp ) The Court expresses similar views in the 2001 Boyd B.C. Supreme Court decision; upheld on appeal 2002: This [case] presents another instance of a sophisticated, corporate borrower which, having negotiated a loan in circumstances free of coercion or power imbalance, seeks to escape the consequences of its bargain by calling in aid the criminal interest rate provisions... (paragraph 1) The criminal interest rate provisions of the Criminal Code were enacted to combat loan sharking, an activity often associated with organized crime. The section has been used

5 -5- only rarely for that purpose. It has, however, been relied upon frequently by borrowers seeking to escape the rigor of otherwise unremarkable commercial loan transactions. (paragraph 15) The Court clearly disagrees with the application of the law in this manner, but must follow previously decided cases, in particular the 1998 SCC decisions in Degelder and Garland. An actuary may be retained occasionally by law enforcement authorities to carry out calculations in connection with possible criminal prosecutions. However, more commonly, in line with the above comments, actuarial calculations are requested in connection with commercial transactions. Recently, some cases have involved payday loans. Prof. Waldron states in her July, 2003 article:...[s]everal recent cases suggest that the payday lending industry may be at significant risk of being obliterated by the civil consequences of the section. (p. 369) Prof. Nicholls more recent article, referred to earlier, also expresses strong concerns about the practical effects of the application of s Prof. Waldron s 2003 article acknowledges arguments such as those made by Profs. Ziegel and Nicholls, but she disagrees that s. 347 should be repealed: It is not possible to conclude, however strong the commercial argument for repeal may be, that it necessarily must outweigh the protective purposes of the law. On what basis are the two very different aims to be balanced against each other? (p. 378) Prof. Waldron then proceeds to examine various options for law reform. Law Clarified By 1998 Supreme Court Of Canada ( SCC ) Decisions As discussed in detail later, the 1998 SCC decisions in the Degelder (B.C.) and Garland (Ontario) cases clarify many points of law. Certificate Signed By Qualified Actuary Required To Establish Breach Of S. 347 As noted above, a criminal rate of interest is defined as an effective annual rate of interest, exceeding 60%, calculated in accordance with generally accepted actuarial principles. Mr. Antle elaborates at pp : Subsection 347 (4) provides that the certificate of a Fellow of the Canadian Institute of Actuaries is, unless there is evidence to the contrary, proof of the effective annual rate of interest. The courts have held this is not the only acceptable mode of proof. For

6 -6- example, the courts have also accepted actuaries affidavits and actuaries reports attached as exhibits to affidavits of non - actuaries. My approach is to provide a report, with a certificate appended to the report. A sample report in a very simple (hypothetical) case is attached, as Appendix C. While redundant from a substantive point of view, attaching a certificate appears to meet the concerns of lawyers regarding form. Further, I use the same form of report whether or not the final result of my calculations exceeds 60%. I refrain from commenting in my reports as to whether or not the result is a criminal rate of interest, since I regard that as a legal issue. IMPORTANT SET OF ISSUES IN PREPARING AN ACTUARIAL REPORT; ENSURING CASH FLOWS DEFINING TRANSACTION ARE FULLY SPECIFIED; OVERVIEW Before preparing a report, the actuary should work with the lawyer - client to ensure that all bases have been covered. The actuary is asked to determine the effective annual rate of interest inherent in a financial transaction. The cash flows defining that transaction need to be specified. The issues surrounding this specification are ultimately legal rather than actuarial, and therefore properly the subject of instructions from the lawyer to the actuary. However, the actuary can assist the lawyer in arriving at appropriate instructions. The transaction will consist of certain payments from the lender to the borrower, and certain payments from the borrower to the lender. The actuary will generally need instructions on the following: i. What payments from the borrower to the lender will be included in the transaction? Such payments will include the repayment of principal, and all those payments falling under s. 347's definition of interest. ii. What payments from the lender to the borrower will be included in the transaction? Such payments will be those falling under s. 347's definition of credit advanced. iii. Are calculations needed under 347(1)(a) (provisions of contract), 347 (1) (b) (what actually occurred between the parties), or both? iv. For each relevant possibility per iii. above, on what date should repayment of principal be assumed to occur? I now discuss in detail legal considerations, including case law, governing i. through iv.

7 -7- above. I intend this discussion to be of interest to both lawyers and actuaries. I then discuss various other detailed issues affecting actuarial work; that portion of the paper will probably be of more interest to actuaries than lawyers. ASIDE FROM REPAYMENT OF PRINCIPAL, WHAT PAYMENTS FROM THE BORROWER TO THE LENDER WILL BE INCLUDED IN THE TRANSACTION; I.E. WHICH PAYMENTS FALL UNDER S. 347'S DEFINITION OF INTEREST? Statutory Definition Of Interest Section 347 (2) of the Criminal Code defines interest as:...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... As explained in detail below, and with the exceptions listed below, case law has established a very broad interpretation of interest. Amounts Which Statute Specifically Excludes From Definition Of Interest At p. 328, Mr. Antle lists, and explains further, the resulting six statutory exceptions, as follows: 1. repayments of principal; 2. insurance charges (the cost of insuring the lender s risk, so long as the face amount of the insurance does not exceed the credit advanced); 3. official fees (fees the borrower must pay to government authorities to perfect security); 4. overdraft charges (charges of up to $5 for the creation of or increase in an overdraft); 5. required deposit balances (amounts advanced under the loan agreement required to be deposited or invested by or for the borrower which may be available to the lender on default); and 6. in mortgage transactions, amounts the borrower must pay for property taxes. Profit - Sharing Payments ; Possible Exclusion From Definition Of Interest According to Mr. Antle (p.330) additional exceptions could relate to profit - sharing, albeit that the courts would apply a strict definition of profit - sharing. Thus, in the 2001 Boyd

8 -8- decision, the borrower s repayments included royalties. The lender claimed that the royalty payments were, in substance, meant to embody a profit sharing arrangement. (paragraph 22). However, the Court (paragraphs 23, 24) rejected this argument: The royalty payable to [the lender] is not based upon the amount of profit or income earned by the borrower....the royalty payments are, in substance if not in form, charges paid or payable for the advancing of the loan. Prof. Waldron is sharply critical of this decision in her July, 2003 article. The determination of the [B.C. ] Court of Appeal to find and apply a single characterization [i.e. a loan] to a complex transaction...must further heighten the concerns of the commercial lending community...why is it not reasonable...to divide the transaction between its debt and equity roots? (pp ). Further Payments Apparently Excluded From Definition Of Interest ; Payments By The Borrower Re Separate Debts Owed To The Lender; Payments By The Borrower To Its Own Advisors, Or To Advisors Unrelated To The Lender Obviously, only payments relating to the transaction in question should be considered. But in practice, confusion can easily arise where a particular borrower has a number of transactions with the same lender. (A related legal question is whether to treat a number of related transactions as separate, or parts of a single transaction). Thus, in the 1996 B.C. case Falcon Pacific v. Kerkhoff a $250,000 guarantee fee was not included as interest because the borrower was already liable to pay it to the lender, whether or not the further transaction under consideration had taken place; see paragraphs of the judgment. Payments To Borrower s Own Advisor Similarly, the borrower cannot reasonably claim for inclusion payment of its own advisors, but payment of the lender s advisors (e.g. legal fees) normally is included. Payments To A Mortgage Broker A more difficult example involves payments made by the borrower to a mortgage broker. The B.C. Court of Appeal s 1993 decision in the Helo Enterprises case was upheld by the Supreme Court of Canada in It excluded a mortgage broker s fee from the definition of interest. The circumstances were as follows: The [borrower] approached an investment services company to find a lender who would provide 100 per cent financing for a condominium project. The broker presented a loan brief proposal to the [lender], which issued a loan commitment acceptable to the [borrower]. The broker invoiced the [borrower]...the lender paid [the broker s invoice] but charged [the amount of the invoice] to the [borrower s] account. (Headnote).

9 -9- The rationale for the Court s decision was as follows: The brokerage fee was an expense incurred by the [borrower] for professional assistance in finding someone to lend the money it sought. It was not a charge or expense paid or payable for the advancing of credit. The [borrower] retained the broker to act for it; the broker was not the agent of the lender. The fee was not one payable under the contract between the lender and borrower. Such a fee is the only one caught by the statutory definition of interest. The fact that the fee was paid out of the mortgage proceeds did not change its character. (Headnote) Mr. Antle (pp ) cites a 1992 Ontario case coming to a similar conclusion, and states that it is wrongly decided. Mr. Antle notes that 347(2) provides that interest includes all charges paid by the borrower for the advancing of credit regardless of whether the charges are paid to the lender or to another person. However, he does not opine specifically on the Helo Enterprises decision. The 2002 B.C. decision in the Huston case is also in the lender s favour, excluding from interest a broker s fee, and certain other expenses incurred by the borrower. It relies on Helo Enterprises, although the facts differ. A comprehensive legal analysis of the conditions under which a payment by the borrower to a broker (and perhaps to certain other parties other than the lender) is interest would be welcome, but is beyond the scope of this paper. With Above Exceptions, Case Law Has Established A Broad Definition Of Interest Excerpts From Boyd Decision As described in detail in the 2001 Boyd decision (B.C.S.C. paragraphs 16-21), the 1998 SCC decisions in Degelder and Garland create a very broad definition as to what is interest. The Supreme Court of Canada has emphasized, in its twin decisions in [Degelder and Garland], that the definition of "interest" in s. 347(2) is an extremely comprehensive one and includes many types of payments which would not be considered interest at all at common law or under generally accepted accounting principles: Garland, para. 27. One must look to the substance, and not merely the form, of a charge or expense to determine whether it is caught by the definition: Garland, paras. 28 and 32. 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: Garland, para. 25. It is unnecessary to show that a lender intended to receive interest at a criminal rate: TerraCan Capital Corp. v. Pine Projects Ltd. (1993), 75 B.C.L.R. (2d) 256 (B.C.C.A.). (Underlining per original source).

10 -10- Decided cases illustrate the very broad reach of the section. In Garland, a late payment penalty imposed by Consumers'Gas on its customers for tardy payment of invoices was found to offend the provision. In Ontario Ltd. v. Artell Developments Ltd. (1992), 93 D.L.R. (4th) 334 (Ont. C.A.), affirmed [1993] 2 S.C.R. 443 (S.C.C.), the lender received a second mortgage in the amount of $1,675,000 to secure a $375,000 loan and the further sum of $1,300,000, which represented 50% of the estimated profits to be earned on the eventual development and resale of the land in question. The trial judge found there was no violation of the criminal interest rate provision because the $1,300,000 obligation was a "collateral arrangement for profit sharing". The Ontario Court of Appeal disagreed. After noting that the definition of interest is "all inclusive and covers charges of any kind or in any form paid or payable under an agreement or arrangement for the advancing of credit", the court had no difficulty including this sum within the definition of interest. In a brief oral judgment affirming this decision, the Supreme Court of Canada said the $1,300,000 amount fell "clearly" within the provisions of s In J.D.M. Capital Ltd. v. Smith (1998), 58 B.C.L.R. (3d) 272 (B.C.C.A.), a loan in the amount of $2,280,000 was given to assist in the acquisition of shares in a company. In addition to agreeing to repay the loan with interest, the borrower agreed that it would use its best efforts, when it became a controlling shareholder of the company to be acquired, to enable a company related to the lender to acquire $5,000,000 worth of treasury shares in a company controlled by the subject corporation. The result of this share acquisition, if it came to fruition, would have been the acquisition of shares with a book value of $6,660,000 for the price of $5,000,000, resulting in a tax-free "lift" of $1,660,000. The trial judge held that this tax-free lift was a collateral advantage connected with the loan and was caught by the definition of "interest" in s. 347(2). In the Court of Appeal this analysis was accepted, although the appeal was allowed for other reasons. In Georgia 50.4 Syndicate v. Butler (1990), [1991] 1 W.W.R. 185 (B.C.S.C.) ; affirmed (1995), 9 B.C.L.R. (3d) 328 (B.C. C.A.), a loan of $150,000 was advanced for the purchase of real property. The loan agreement called for repayment of the principal and an additional $82,500 "surplus", which was said to represent the lender's"portion of the monies earned arising from the financing arrangement herein contemplated". The Court of Appeal agreed that this provision offended s. 347 of the Criminal Code. In the Boyd case itself, the Court found that royalty payments qualified as interest : The fact that the royalty payments became due only after the loan principal had been repaid entirely does not prevent the royalties from being treated as "interest"...the fact that the Royalty Agreement might be viewed as a collateral agreement is not fatal either; the definition of "credit advanced" in s. 347(2) illustrates that consideration specified in an agreement collateral to the Loan Agreement may be treated as "interest". I find that the form of the Loan Agreement and the Royalty Agreement, both of which state that the royalties are granted as "further consideration" for the loan, are in harmony with the substance of the transaction. The royalty payments are "interest" within the meaning of s. 347(2) of the Criminal Code. (paragraphs 25,26)

11 -11- Mr. Antle s Comments Although made in 1994, prior to the 1998 SCC decisions, Mr. Antle s comments agree closely with those made in the Boyd case:...[t]he courts have...taken a broad approach to what is included as interest. They will consider as interest virtually all elements of the cost of borrowing, regardless of how the parties have characterized them... (p.328) Mr. Antle goes on to list the following items which the Courts had deemed to be interest : Commitment fees; initial fees; loan fees; loan advance fees; facility fees; finance charges; bonuses; legal fees; extension fees; capitalized interest; bonus interest; compensation for interest lost on money advanced on short notice; lender s costs; an increase in the outstanding balance of the purchase price if the borrower does not pay the original balance within a set time; amounts the borrower is to pay in addition to repaying principal, for example where the lender advanced US $150,000 and the borrower agreed to repay US $232,500, plus interest and other charges, in 90 days; and the borrower s estimated share of the profit on resale of the property concerned, which the borrower agreed to pay to the lender in addition to repaying the amount advanced. (pp ). WHICH PAYMENTS ARE CONSIDERED PART OF CREDIT ADVANCED? Statutory Definition Of Credit Advanced Section 347 (2) of the Criminal Code defines credit advanced as:...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. Case Law Establishes A Broad Interpretation Again, case law establishes a broad interpretation of credit advanced. In particular, the 1998 Garland case extends the reach of the legislation to cases where a customer is charged a late payment penalty: The scope of s. 347 was very broad. Interest under s. 347 expressly included charges or expenses in the form of a penalty. However, to constitute interest the charge must be paid or payable for the advancing of credit under an agreement or arrangement.... Credit advanced is broadly defined under s. 347(2) and not confined exclusively to loans of money. The first step was to determine whether the relationship involved any advancement of credit within the meaning of s The respondent did not lend any money to its customers. However, credit advanced was broadly defined under s. 347(2) and not confined exclusively to loans of money. An advance of the monetary value of goods and services meant a deferral of payment for such items. A credit arose

12 -12- when debt was incurred for goods, services or benefits and the debt was then deferred by agreement. The credit advanced consisted of the monetary value and not the goods and services themselves. (Headnote) Avoiding Double Counting Of Certain Payments As Both Interest And Deductions From Credit Advanced Mr. Antle explains this point at p. 330: The amounts which the courts will consider interest, and the amounts they will deduct from the benefits advanced to the borrower to arrive at the credit advanced, are similar. The courts could either include [such] charges...as interest, or deduct them from the benefits advanced. The British Columbia court held in BCorp Financial Inc. v. Baseline Resort Developments Inc. that it would be double counting to do both. Such fees should be included only in one of these calculations. The choice of approach here has no effect on the outcome of the actuary s calculation of the effective annual rate of interest. For example, suppose the amount of the loan is $1,000,000 (i.e. the borrower is required to eventually repay $1,000,000, possibly together with other amounts), out of which $300,000 is retained by the lender as a commitment fee, so that the actual cheque written from the lender to the borrower is $700,000. The two possible approaches, assuming all payments are made January 1, 2005, are as follows First approach;$300,000 counts as interest. The transaction involves the following two payments: 1. The lender pays to the borrower $1,000,000 on January 1, The borrower pays to the lender $300,000 on January 1, Second approach;$300,000 counts as a deduction from credit advanced. The transaction involves the following payment: 1. The lender pays to the borrower $700,000 on January 1, The actuarial calculations re effective annual rate of interest depend only on the net cash flow as of January 1, 2005; thus the actuary s result will be the same under both approaches. I prefer the second approach because it is more direct, focusing on the amount actually changing hands. Timing Of Letter Of Credit Mr. Antle states, at p In Kebet Holdings Ltd. v B.C. Ltd. the lender obtained for the borrower a letter of credit payable to the vendor on the date the borrower s promissory note for the balance of

13 -13- the purchase price fell due. The British Columbia Court of Appeal held the letter of credit was part of the credit advanced, but not until it was payable. The lender could not include the value of the letter of credit in the total value of benefits advanced when the loan was made. The court considered the letter of credit to have no value until it was payable. This reduced the credit advanced sufficiently to make the interest rate criminal. This decision illustrates why lawyers should carefully review proposed loan transactions in light of s In this case both lender and borrower...considered the lender to have advanced the letter of credit on the same date as the principal amount. The key point above is that the letter of credit was part of the credit advanced, but not until it was payable. This issue was revisited in the 2002 B.C. Supreme Court decision in 5908 Holdings Ltd. v. Hu Enterprises Ltd., upheld on appeal A letter of credit was never drawn upon, but the letter of credit was irrevocable and could have been drawn on as early as its date of delivery. The borrower, citing Kebet Holdings, argued that no credit whatsoever was advanced. Presumably given that certain payments were nevertheless required of the borrower, the borrower submitted an actuarial report which stated (correctly) that the resulting effective annual rate of interest inherent in the transaction was infinite. However, the Court found for the lender, indicating that, for calculation purposes, the letter of credit should be assumed to have been presented by the borrower on the date of its issuance. The B.C. Supreme Court reasons stated the following: Kebet Holdings dealt with a letter of credit issued on May 2, 1989, but the letter could not be cashed before January 8, The B.C. Court of Appeal concluded...[it] be treated as an irrevocable promise [made on May 2, 1989 to advance funds] on January 8, (paragraph 12)...Kebet Holdings does not suggest that a letter of credit must be drawn upon before it can be found to be credit advanced. In [Kebet Holdings], the letter of credit was not credit advanced when the letter was delivered, but on a date eight months later. A letter of credit may be credit advanced on delivery, if the letter is effective and enforceable on delivery. [In this case], [o]n delivery of the letter of credit,...the holder of the letter, could draw upon or cash the letter. It was therefore credit advanced on the date the letter of credit was issued... (paragraph 14) Amounts May Be Applied To The Borrower s Other Debts, Rather Than Paid Directly To The Lender Rather than being paid to the lender, the lender may apply certain amounts to pay amounts owing under other, separate arrangements between the borrower and the lender. This should not change the amounts considered to form part of credit advanced, or interest.

14 -14- ARE CALCULATIONS NEEDED UNDER S. 347(1)(a), S. 347(1)(b), OR BOTH? As already discussed, there are two possible offences under s. 347: i. Pursuant to s. 347 (1) (a), entering an agreement or arrangement to receive interest at a criminal rate. ii. Pursuant to s. 347 (1) (b), receiving a payment or partial payment of interest at a criminal rate. The Degelder Reasons, paragraph 34, provide legal guidance:...s. 347 should be interpreted according to the following general principles:...section 347(1)(a) should be narrowly construed. Whether an agreement or arrangement for credit violates s. 347(1)(a) is determined as of the time the transaction is entered into. If the agreement or arrangement permits the payment of interest at a criminal rate but does not require it, there is no violation of s. 347(1)(a), although s. 347 (1) (b) might be engaged...whether an interest payment violates s. 347 (1) (b) is determined as of the time the payment is received. For the purposes of s. 347 (1)(b), the effective annual rate of interest arising from a payment is calculated over the period during which credit is actually outstanding...there is no violation of s. 347 (1) (b) where a payment of interest at a criminal rate arises from a voluntary act of the debtor, that is, an act wholly within the control of the debtor and not compelled by the lender or by the occurrence of a determining event set out in the agreement. (underlining in original) The actuary should ensure that the lawyer canvasses both the above possibilities. If only a single scenario is requested, the actuary should ask the lawyer which of the two possibilities is being addressed. (Occasionally, a lender may retain an actuary in advance of entering into a transaction to ensure that the interest rate inherent in the proposed transaction is less than 60%). FOR EACH OF THE ABOVE TWO POSSIBILITIES, ON WHAT DATE SHOULD REPAYMENT OF PRINCIPAL BE ASSUMED TO OCCUR? The above quote from Degelder largely addresses these issues, but I elaborate further below. i. Under s. 347 (1) (a), the term of the loan per the original contract normally governs. Neither prepayment nor delay of repayment should ordinarily be assumed. The Degelder judgment states, at paragraph 19: For the purposes of s. 347 (1) (a), the appropriate time period for calculating an interest rate is the term of repayment set forth in the loan agreement. If that period produces a

15 -15- criminal rate of interest, then the entire agreement is illegal on its face... Mr. Antle states at p. 333: In determining the interest rate, the courts again look at the substance of the transactions. For example, in Pacific National Developments Ltd. v. Standard Trust Co., where a loan agreement contained a meaningless repayment date intended to make it appear that the effective interest rate did not exceed 60%, the Supreme Court of British Columbia calculated the interest rate based on the effective repayment date and term of the agreement. ii. Under s. 347 (1) (b), with the exception of a voluntary early payment by the borrower, the actual events govern. As stated in the above quote from paragraph 34 of the Degelder judgment: 1. The calculation is made over the period during which credit was actually outstanding. 2. A voluntary act of the borrower does not create a criminal rate. This point is elaborated on by the Garland judgment, and by Mr. Antle, as follows: The Garland judgment states, at paragraph 57: The gravamen of [the 1984 decision in the B.C. Nelson case] is that an agreement or arrangement for credit which is legal on its face cannot become illegal under s. 347 through the voluntary act of the debtor. Mr. Antle states at p. 334, citing Nelson, among other cases:...[a] borrower cannot create a criminal rate by its own act of prepaying the loan and shortening its effective term. Nor can the borrower do so by defaulting on its repayments and accelerating the balance outstanding. The issue of whether a particular prepayment was voluntary arose in Garland. Garland dealt with a late payment penalty(lpp) of 5% of the customer s bill, if the bill was unpaid on the due date. The (majority) judgment concluded as follows: The application of 347(1) (a) was not precluded by Nelson...Customers did not voluntarily pay the [5% late payment penalty, or LPP]. A penalty was not voluntary simply because it could have been avoided. Further, while customers could delay payment beyond 37 days, there was no invitation to do so. If bills became long overdue, the customer risked discontinuation of service, reconnection charges and security deposit payment. The LPP...came within the scope of s. 347 of the Criminal Code. (Headnote) (The 5% LPP is equivalent to an effective annual rate of interest over 60% for customers who pay within 37 days after the due date).

16 -16- FURTHER PRACTICAL ISSUES FACING THE ACTUARY IN CRIMINAL RATE OF INTEREST MATTERS Exactly How Interest (Payable By The Borrower To The Lender) Is To be Calculated I use interest here to mean one of the amounts which the borrower pays to the lender (e.g. calculated on the amount of the loan at a rate of prime plus 2% ). Usually, such interest is in addition to various other fees. Thus, under this heading, I do NOT use interest to refer to the interest rate inherent in the transaction finally calculated by the actuary. Often (especially in interpreting a contractual arrangement, rather than what actually occurred) it is not clear exactly how interest is to be paid, or calculated. For example, is interest on interest charged? i.e. is interest payable on the date it falls due, and therefore added to the principal outstanding, leading to further interest? Or is interest, although calculated monthly, not expected to be paid until the same time as principal repayment, in which case there is no interest on interest? In most of these instances, the particular interpretation re such interest will not affect whether the final result of the actuary s calculations is above or below 60%. If so, a useful practical approach for the lawyer is to instruct the actuary to adopt the interpretation least favourable to the lawyer s case. This approach was used successfully in the 2003 B.C. case Brehnan v. Outback Products Inc. ; see paragraph 10 of the decision. When Reviewing Documents, Ensure All Payments Relate To The Transaction At Hand As already mentioned, a particular borrower may have many different transactions with a particular lender. Thus, when reviewing detailed documents, it is important for the actuary to be aware of the possibility (perhaps due to administrative error) of certain payments (e.g. a repayment from the borrower to the lender) relating to a transaction other than the one the actuary is examining. Ensure Correct Information Re Currency, For All Payments This is a mundane but potentially important detail. These days, it is increasingly common for transactions in Canada to provide for some payments in U.S. dollars. Of course, if all amounts are in the same currency, the actuarial calculations and results are exactly the same regardless of which currency is involved. But if, say, some payments are in Canadian currency but some in U.S. currency, suitable conversion to a common currency needs to be made.

17 -17- Points Where More Than One Actuarial Assumption Is Possible; Overview Substantial Differences Between Two Actuaries Results Are Almost Always Attributable To Differences In Lawyers Instructions As described below, there are points where more than one actuarial assumption is possible. Therefore two actuaries, even if given exactly the same set of facts (i.e. amounts and dates of cash flow defining the transaction), may get slightly different answers. However, such differences are very likely to be minor. Substantial differences in results as between two actuaries are very likely attributable to differing instructions from the two lawyers re facts ; i.e. the amounts and dates of cash flows. Is Elapsed Time To Be Measured In Days Or Months? Consider the following transaction: 1. The lender pays to the borrower $100,000 on January 1, The borrower pays to the lender $180,000 on December 1, Calculations, If Time Measured In Days The time between January 1, 2002 and December 1, 2002 is 334 days. The ratio of the length of the year 2002 (365 days) to this 334 day period is (Thus each day is 1/365 of a year in 2002, which is not a leap year. In a leap year, each day is 1/366 of a year). The ratio of the amount repaid by the borrower ($180,000) to the amount advanced by the lender ($100,000) is raised to the power is The effective annual rate of interest inherent in the transaction is minus 1, or.9009, or 90.09%. Calculations, If Time Measured In Months Alternatively, if the period January 1, 2002 to December 1, 2002 is interpreted as being 11 months (i.e. exactly 11/12 of a year), calculations proceed as follows. - The ratio of the length of a year (12 months) to the 11 - month period is raised to the power is

18 The effective annual rate of interest inherent in the transaction is minus 1, or.8988, or 89.88%. Further Comments The difference between 90.09% and 89.88% is not material; i.e. it is unimportant to users of the actuary s report. But it is conceivable that this difference could result, in another situation, in one result over 60% and one result under 60%. For example, if $180,000 is replaced by $153,820, the results are 60.09% and 59.96%. The difference in results is now very material. Therefore, I think an actuary should have a procedure for dealing with this issue, so that if and when a close to the line case arises, it can be better dealt with. My views and procedures are as follows: 1. Where the transaction involves payments occurring on different days of the month, time should be measured in days, not months. In a report dealing with such a transaction, I would not mention this days vs. months issue. 2. Regarding a transaction where all payments occur on the same day of the month, either days or months is reasonable. Fundamentally, days more accurately measures actual elapsed time. Therefore, I present the main result in my report based on days, but I would include the following language (re the transaction with 90.09% and 89.88% results) in my Actuarial Certificate: Calculation of the 90.09% effective annual rate of interest involves measuring the elapsed time between January 1, 2002 and December 1, 2002 (in days) as 334 days, or.9151 of a year. An alternative reasonable procedure would be to measure such elapsed time (in months) as exactly 11 months, or.9167 of a year. If this procedure were applied, the 90.09% rate would decrease to 89.88%. Role Reversal Issue, Arising When Borrower Makes First Payment In practice, it is clear which party to the transaction is the lender, and which is the borrower, and calculation of the effective annual rate of interest inherent in the transaction is relatively straightforward from an actuarial point of view. The lender makes smaller, earlier payments to the borrower. The borrower makes larger, later payments to the lender. Most actuaries are familiar with theoretical examples of financial transactions where more than one effective annual rate of interest is mathematically possible. Such transactions involve the roles of lender and borrower changing at least once during the course of the transaction, and thus are in my opinion of little or no importance practically.

19 -19- However, one very limited example of such role reversal which does occur in practice involves the borrower prepaying certain fees, before the lender advances funds. Consider the following transaction: 1. The borrower pays to the lender $1,000 on December 15, The lender pays to the borrower $100,000 on January 1, (January 1, 2002 is 17 days, or years, after December 15, 2001). 3. The borrower pays to the lender $180,000 on January 1, (January 1, 2003 is 1 year, 17 days, or years, after December 15, 2001). The single effective annual rate of interest inherent in the above transaction is 81.87%. The following calculations verify that the 81.87% rate is correct: - The value of payment #1 as of December 15, 2001 is $1, Re payment #2, raised to the power is.97253; $100,000 x = $97,253. Thus the value of payment #2 as of December 15, 2001 is $97, Re payment #3, raised to the power is.53474; $180,000 x = $96,253. Thus the value of payment #3 as of December 15, 2001 is $96,253. Thus the total present value of the borrower s payments (#1 plus #3) is $97,253, the same as the present value of the lender s payment, #2. However, for the first 17 days of the transaction, it is the borrower, not the lender, who has advanced more funds than it has received. There is a role reversal ; the borrower has the role normally associated with the lender. Thus 81.87% is not only the lender s rate of return in the period January 1, 2002 to January 1, 2003, but also the borrower s rate of return in the period December 17, 2001 to January 1, Mathematically, the transaction can be viewed as having the following two components, each with an inherent effective annual rate of interest of 81.87%: First component; borrower and lender reverse roles. 1. The borrower pays to the lender $1,000 on December 15, A. The lender pays to the borrower $1, on January 1, 2002.

20 -20- Second component; borrower and lender resume normal roles. 2B. The lender pays to the borrower $100,000 - $1,028.25, equals $98, on January 1, The borrower pays to the lender $180,000 on January 1, While the foregoing analysis is correct mathematically, it is artificial. The above $1, figure plays no practical role in the transaction. The lender and borrower do not view the transaction as involving any role reversal. The timing of the borrower s $1,000 initial payment is likely of little importance to the parties, so long as it is received before the lender advances funds. Thus the 81.87% figure overstates both the lender s rate of return and the borrower s cost of borrowing. A possible alternative method is to assign a risk - free rate of return to the role reversal period. Thus the parties are assumed to be indifferent between the borrower actually paying the lender $1,000 on December 17, 2001, or alternatively having the $1,000 placed in a money - market fund December 17, 2001, held in that fund until January 1, 2002, and then paid to the lender on January 1, The resulting payment on January 1, 2002 (based on an assumed risk - free rate of return of about 2.75% per annum) would be about $1,001. The transaction is now viewed as being equivalent to the following: 1. The lender pays to the borrower $100,000 - $1,001, equals $98,999 on January 1, The borrower pays to the lender $180,000 on January 1, Role reversal has now been eliminated, and the effective annual rate of interest inherent in the transaction is 81.82%, rather than 81.87%. Again, the difference between the two rates is not material but could become so if a close to the line case is involved. In , while a member of the Canadian Institute Of Actuaries Actuarial Evidence Committee, I had occasion to review various actuaries correspondence regarding this topic, including that of Prof. Harry Panjer. Much of the above discussion of role reversal is based on my interpretation of ideas originally put forward by Prof. Panjer, including use of the term risk - free rate of return. However, I have not discussed this recently with Prof. Panjer, and thus I do not imply that he is necessarily in agreement with the above.

21 -21- Dealing With Cases Which Are Close To The Line By close to the line I mean transactions where the effective annual rate of interest is very close to 60%. I have seen several such transactions in practice. This may reflect approximate calculations made before the transaction by a non - actuary which (in some cases erroneously) indicate a rate just under 60%. Thus, lenders lawyers should consider having an actuary do some calculations in advance of an agreement being entered into, to ensure that the resulting effective annual rate of interest is indeed less than 60%. I discussed above two issues where more than one actuarial assumption is possible; days vs. months issue, and role reversal issue. As already mentioned, these issues can be very important in close to the line cases. Also, rounding should be scrutinized carefully. For example, for transactions with payments on different days of a month, the actuary should NOT round payment times off to the nearest month (rather than using the exact number of days). If a one day shift in the repayment date would cause the result to move to the other side of 60%, I think that the actuary s report or certificate should disclose this. Actuaries would normally NOT consider the time of day on which a payment occurs; i.e. an implicit assumption is made that all payments are made at more or less the same time on each date. Again, this is a point which is immaterial, except in close to the line cases, and in particular cases where a shift of one day will affect whether the result is over or under 60%. Regarding rounding of the final result, my own practice is to round to two decimals; e.g %. A criminal rate is one which is above 60%. Thus reporting a result of 60.00%, without further comment, could result in uncertainty as to whether the rate is above 60%, below 60%, or exactly 60%. Thus consider the following transaction: 1. The lender pays to the borrower $100,000 on January 1, The borrower pays to the lender $160,001 on January 1, The resulting effective annual rate of interest is exactly %. Rounded to two decimals, this is 60.00%. Thus rounding of results to two decimals is not necessarily sufficient in close to the line cases.