Mar 22, 2020

Interest Penalty Clauses: How does Canadian law actually assess opportunity cost in contract breach?

Bank of America Canada v. Mutual Trust Co., 2002 SCC 43, [2002] 2 SCR 601

[Note: the decision at first instance is reported in Quicklaw but not on CanLii; Farley's judgment is an important summary of Ontario law of judgment interest; some of Farley's cited cases are not reported on Canlii]

Bank of America Canada v. Mutual Trust Co., [1998] O.J.No. 1525

The condo-building game involves a builder gathering a group of individual condo-buyers who put down $1000 before construction, with a further promise to pay the balance of the purchase price upon move-in date.

Armed with a couple of hundred individual purchase and sale agreements, the condo builder goes to a long-term lender (e.g. Mutual Trust) and says: ‘if I get this building built using some other bank’s construction finance loan, will you agree to lend each individual condo-purchaser the necessary closing monies?’

In this case, Mutual said yes we will! (headnote) So the condo-builder signs an agreement with Mutual.

Armed with this long-term mortgagee agreement, the builder goes to Bank of America and says: ‘hey! I got a couple of hundred individual buyers, and I have Mutual Trust as the guaranteed long-term mortgagee once the building is built. Will Bank of America provide the construction finance to actually build the building?

Bank of America says: ‘because you have Mutual to take us out once the building is built, that’s is our insurance, so YES, we will finance your construction’ (which BOA did do). The building was built.

Then the Toronto real estate market went into the 1990’s recession and all those now-built condos have fair market values about 33% lower than the purchase price agreed between buyer and builder years earlier.

Mutual Trust refuses to advance funds to any of the individual buyers

Why did Mutual refuse to extend the mortgages as agreed?

comment: because the result would have been either that the buyers would have immediately refused to close (which would have let Mutual off the hook) or the buyer would have closed and then after a little while realizing that the mortgage payment was much higher than the re-sale value, then the new owner would have defaulted on the mortgage leaving Mutual trying to liquidate a condo building, unit by unit over many years.

So instead Mutual simple refused to extend the mortgage monies they had earlier agreed to extend.

This left Bank of America in the position of being the building mortgagee-in-possession. BOA then sold the building for about $22M, about $15M below its mortgage amount. BOA then sued Mutual for not extending the mortgages.

What interest rate should apply against Mutual?

In making Mutual pay BOA for the loss the important question was what interest rate to apply against Mutual.

Being a bank, BOA could borrow from the central bank at approximately prime. BOA’s true loss (as opposed to Court of Justice Act deemed rate) arising from the date that BOA’s monies should have been paid by Mutual, to the date that BOA actually received judgment was prime plus 1 compounded monthly (para 118)

comment: Newbould was the bank’s lawyer, so he is one judge who would understand this issue. (Although Newbould, as counsel, hadn’t asked for monthly compounding in the statement of claim).

comment: take note that you had better particularize your interest rate demands in the statement of claim.

Does Ontario law appreciate opportunity cost?

Mutual’s lawyer then uses the type non-economic argument often heard from people who do not understand ‘opportunity cost’. The lawyer said there was no lost opportunity from having funds tied down because BOA has unlimited funds from parents. (para 119).

Farley points out that there is no such thing as unlimited free borrowing, every act of borrow carries a burden. Farley was sophisticated enough even to cite the bank borrowing ratio imposed by the central bank. (para 119) (refreshing!)

In other words, Farley is not going to simply pretend that the BOA loss of opportunity to use the tied up monies in some other manner, is simply the Courts of Justice pre-judgment interest rate.

Mutual cites Speed v. Finance America Reality (1971, 11 RPR 161 (NSCA) for the proposition that:

It is proper, as against the mortgagor, to claim interest at the contract rate. As against anyone else, this basis cannot be applied.

Farley answers this by saying that Mutual is in fact a lender so the alleged rule (of only applying the Courts of Justice pre-judgment interest rate) doesn’t apply (para 119).

Farley cited the court of appeal in Claiborne (at pp.107-109):

where there is a wrongful detention of money which ought to have been paid. This is on the theory it is reasonable to assume that the wrongdoer made the most beneficial use of the money and is accountable for the profits. A reasonable use of money implies compounding interest at some appropriate interval. Thus the court in these instances has a general jurisdiction to award compound interest and is not limited by s. 36(5)(b) of the Judicature Act.

Farley then cited the court of appeal in Graham (p.629):

Prejudgment interest cannot, however, become a means of punishing or rewarding a party to the proceedings. Rather prejudgment interest must be viewed as part of the compensatory package provided to the person wronged: Irvington Holdings Ltd. v. Black .. (C.A.).

Farley then cites the court of appeal in Armak (p.4):

... the essence of interest is that it is a payment which becomes due because the creditor has not had his money at the due date. It may be regarded either as representing the profit he might have made if he had had the use of the money, or conversely the loss he suffered because he had not that use. The general idea is that he is entitled to compensation for the deprivation.

Farley then finds High Court of Justice support for compensating the plaintiff at the plaintiff’s true borrowing costs (as opposed to the Courts of Justice rate):

... However, I am also of the view that it was an appropriate case for the referee to award interest at the rate of interest equivalent to the borrowing rate of the plaintiff. The plaintiff is entitled to be adequately compensated for the moneys that the defendant has held over the past 4 years while this litigation has been proceeding. To deny the plaintiff interest at his borrowing rate will result in the plaintiff financing the defendant's involvement in this project. That, in my view, would be clearly unjust.

The Supreme Court of Canada has held the same (Farley para 122):

He went on to follow the Supreme Court of Canada decision in Prince Albert Pulp Co. v. Foundation Co. of Can., [...........and approved a rate of interest equivalent to the borrowing rate of the claimant. I believe that rate of interest applicable in this case.

This is a first instance summary. The Court of Appeal reversed Farley on the issue of compound interest which the SCC restored - upholding compound prejudgment and post-judgment interest.

Comment: The default position (of Courts of Justice Act pre-judgment interest rate) in monetary cases, is wrong in economics, and as it turns out, wrong in law.

Comment: this is the first important stepping stone in the modern Ontario treatment of pre-judgment interest which I will address over several future comments;