Mar 18, 2020

Interest Rate Penalty Clause: Response to Shahzad Siddiqui's critique

Forest Hill Homes v Ou, 2019 ONSC 4332 (CanLII)

On March 16th 2020, in his ‘Rebuttal by Counsel Shahzad Siddiqui, the lawyer who represented the defaulting buyer, took issue with my critique of Morgan’s handling of the interest rate penalty clause in this residential real estate transaction.

In paragraph 1 sentence 1 Siddiqui explains that the buyer backed out of the deal after a precipitous decline in the real estate market. Apparently the buyer could not get financing. The buyer said this at trial, without providing any evidence of it. (Morgan para 5)

(Note: Having represented many defaulting buyers who could not get financing after signing an APS, it is of course, strongly recommended that counsel lead such evidence to establish either the financing condition defence in the agreement of purchase and sale, or at worst, mitigation.)

The point is, of course, as every lawyer knows, once the finance condition passes, the risk of the contract passes to the buyer. In other words, it was perfectly correct for Morgan J. to deem the buyers in breach of the contract for not closing. Contracts are creatures of risk allocation.

So we are left with a buyer of a $1.6M Toronto house, whom Siddiqui admits to being involved in the ‘real estate frenzy’

As I stated in my initial commentary, there is a difference between a consumer rushing through an airport and renting a car for $50 or $100 per day and Siddiqui’s client who sought to buy a $1.6M house and then backed out because the market fell. The ticket cases should not be extended to $1.6M multi-stage contracts. At some point between the ticket-situation and a $1.6M purchase, the old-fashioned English law idea that the parties are deemed to have read and understood the contract, must apply.

Siddiqui says they didn’t have a lawyer. Well, why not? We don’t rush through airports signing $1.6M contracts at Tilden. What are the consequences for large-tranche contracts if a $1.6M contract can fall victim to the ‘I didn’t know what I was signing and I didn’t get a lawyer’ theory. I would like Siddiqui to publish the entire contract to see if the standard ‘go get a lawyer’ clause was in there.

Because Siddiqui led no evidence of frustration (i.e. that the buyer could not actually obtain finance) this situation is observationally equivalent to an options contract: a buyer buys an option on the expectation of increasing price. When the price instead falls, the options buyer does not get to complain that they didn’t really know what they were signing.

Siddiqui nevertheless states that the buyers were ‘completely unaware of the high interest penalty clause hidden on page 7 paragraph 34.’

According to the Siddiqui theory of contract a contract which states:

[34]…Any monies owing by the Purchaser not paid when due shall accrue interest at a rate of 20% per annum.

is ‘hidden’ and the reader is ‘completely unaware’ of it.

No contract clause of any kind would survive Siddiqui’s critique.

Siddiqui’s theory of efficiency.

In his efficiency paragraph 1: Siddiqui says that builders and bankers must prove they are entitled to an interest component.

1. How is a builder to prove entitlement to an interest component other than by putting it in the contract in plain language?

2. Siddiqui’s critique goes too far as Morgan did not prohibit interest per se, He reduced it to the courts of justice amount.

3. Siddiqui did not confront the fact that the prevailing case law repeatedly upholds interest penalty clauses below 60%.

A teachable moment

Siddiqui’s critique did do one constructive thing: From now on, builders seeking the interest component will need to lead damage evidence of the debt burden the builder carries between breach and judgment collection. In other words, prove damages rather than assume that the words of the contract are going to be upheld.

Once this evidential base is led by the builder, all of the moralism against the interest rate penalty clause will be properly put back in the Aristotle box where we keep unreasonable economic thought.

Siddiqui cites no less than Aristotle, Justinian, and the bible as his authority for the attack on usury. Well let’s just take Justinian out of the equation right away. You think Gladiator was bad for the way the emperor treated Russell Crowe? Any emperor (Justinian) who would pluck the eyes out of Belisarius and leave him a beggar in the streets is not an emperor I’m going to listen to on the niceties of contract interest penalties.

I agree that the bible discouraged interest. As I said in my initial commentary, it is because we abandoned biblical interest as legal authority that material progress in the west has occurred. So don't call on the bible for theoretical support of striking down interest penalty clauses.

Aristotle's theory of interest

Siddiqui’s calling on Aristotle means that we have to confront Aristotle. I could make equal ridicule of Aristotle, (whose defence of private property was in essence a defence of slavery (see Schumpeter p.56)), but Aristotle’s rank inadequacy on the question of interest payments, is emblematic of a great part of humanity, lately speaking through Siddiqui.

So let’s confront Aristotle

Schumpeter (History of Economic Analysis p.62) is a better confronter than me so I will call on him:

For Aristotle, interest was no such chip. He accepted the empirical fact of interest on money loans and saw no problem in it. He did not even classify loans according to the various purposes they are capable of serving and does not seem to have noticed that a loan that financed consumption is something very different from a loan that financed maritime trade (foenus nauticum). He condemned interest—which he equated to ‘usury’ in all cases—on the ground that there was no justification for money, a mere medium of exchange, to increase in going from hand to hand (which of course it does not do). But he never asked the question why interest was being paid all the same. This question was first asked by the scholastic doctors. It is to them that the credit belongs of having been the first both to collect facts about interest and to develop the outlines of a theory of it. Aristotle himself had no theory of interest.

What is important to see in this is not Aristotle’s moralism against interest. Rather that Aristotle did not explain why interest is ever paid. Siddiqui and Morgan likewise fail to ask the analytical question (why is there any interest component in this contract), before dismissing the interest component as an aberration of greed which can be dispensed with.

Marx, (p.649) who took precisely the same moralistic outrage position against interest, at least was such a superior theorist as to accept that interest plays an important part in the economic machine and it cannot be dispensed with, without consequences.

It must be understood that Siddiqui’s interest rate critique is a manifestation of a long-standing failure, by a large part of society, to appreciate the role interest plays in economic activity.

What is a house-builder?

Siddiqui calls the moving party in his case a house-builder. I would rather see him as a time-manager of money flows. The builder arranges, but does not take, finance to build. The builder finds a buyer (who will buy the house once built). Armed with the buyer’s promise, the builder borrows (and builds). The interest rate clock is ticking on the builder’s borrowed monies. The builder’s borrowing-time was supposed to be from buyer’s signature to buyer-closing. That is the interest component the builder expected to pay, relying upon the buyer’s promise.

Siddiqui’s buyer breaches. The builder cannot repay his own finance on time.The builder now blows past his own re-payment date and incurs more unexpected lender-interest, perhaps even his own interest penalty, because the builder’s borrower himself borrowed and had his own banker repayment schedule. Not to worry, clause 34 will protect the builder and allow the builder to pay the builder’s-lender for the extended period from closing to actual cash recovery (practically two years or more).

Along comes Morgan and smashes the time-interest architecture that may involve multiple levels of lenders. The builder now has to pay his own interest penalty (for passing his own repayment date). But this second level of analysis is never done by interest rate moralists.

take-away: a contract breach plaintiff should lead interest damage evidence to keep your interest penalty clause in place.

Usurers:1 Aristotle: 0