Interest Rates and Employment Law
Author: Chris Forguson
The maximum allowable annual rate of interest recoverable in Canada is 60% per annum. Annual interest above 60% contravenes s. 347 of the Criminal Code, R.S.C. 1985, c. C-46 (the "Code"). You may wonder what this has to do with employment law. In February 2004, the Supreme Court of Canada released its decision in Transport North America Express Incorporated v. New Solutions Financial Corporation, [2004] 1S.C.R. 249 (" TNA"). In this decision, the Supreme Court addressed the remedies available to a judge when faced with a loan agreement that contravenes s. 347 of the Code. The ramification of this decision and the way it has been received and applied by appeal courts in the employment law context causes concern that some of the basic principles affecting the enforceability of terms of written employment contracts could be shifting.
The TNA Decision
In March 2000, New Solutions Financial Corp. loaned Transport North American Express Inc. $500,000. The loan agreement contained various fees, charges and interest provisions. The definition of "Interest" in the Code is expansive and included all of the charges and fees as a cost of borrowing. The cumulative annual interest rate in the subject loan agreement was found to be 90.9% with true "interest" of 60.1% and other fees and charges (deemed to be interest pursuant to the Code) of 30.8%.
The application judge, Cullity J., ruled that he was not confined to the so-called "blue-pencil" approach to severance in dealing with the criminal interest rate and instead relied on a "notional severance" to read down the offending interest rate so the contract provided for the maximum legal rate of interest ((2001), 54 O.R. (3d) 144). The Ontario Court of Appeal reversed the decision in a 2-1 decision and ruled that the application judge was bound by the "blue pencil" approach and it was not open to him to read down a criminal rate of interest. Sharpe J.A. dissented, preferring the reasons of Cullity J. On Appeal to the Supreme Court, Justice Arbour for the majority (4-3) reversed the Appeal Court decision and made notional severance the law of Canada.
What is "Notional Severance"?
Notional severance is the re-writing of a contract by the court. As stated succinctly by Justice Bastarache in his dissent at 278-79:
First, like Rosenberg J.A. of the Ontario Court of Appeal, I think there is a fundamental difference between striking out offending sections of a contract and rewriting a central provision of a contract. Although both approaches admittedly interfere in some way with the intent of the parties, the added flexibility of the rewriting approach comes at a considerable cost.
In his dissent, Justice Bastarache cites the familiar restrictive covenant case of Canadian American Financial Corp. (Canada) Ltd. v. King (1989), 60 D.L.R. (4th) 293 (B.C.C.A.) as an example of how the notional severance approach differs from the traditional blue-pencil approach (at 283):
In Canadian Amerian Financial Corp. (Canada) Ltd. v. King, supra, Hinkson, Lambert and Southin JJ.A. wrote three sets of concurring reasons refusing to grant an interlocutory injunction to enforce a covenant in restraint of trade. The provision of the contract in question was a non-competition clause that restrained competition in Canada and Bermuda. All three judges held that the covenant was overly broad.
They refused to substitute a covenant with reasonable terms for the unreasonable provision. Lambert J.A. concluded that the authorities were clear that courts may not make contracts for parties that they have not made themselves. In his opinion, substituting the words 'British Columbia and Alberta' for 'Canada and Bermuda' would have rendered the term enforceable (p. 307), but that was something for the parties, not the court, to do. Under the new approach, would judges be permitted to make such substitutions in order to render the contract enforceable?
The majority in TNA quite correctly point out that the application of the blue pencil test is a form of judicial intervention that changes the bargain agreed to by the parties (at 267):
The use of the blue-pencil approach to sever one or more provisions from a contract alters the terms of the agreement between the parties. The only agreement that one can say with certainty the parties would have agreed to is the one that they actually entered into. The insistence in the case law that the blue-pencil test derives its validity from refusing to change or add words or provisions to the contract is unconvincing. It is doubtful, for example, that the lenders in cases such as Thomson, supra, or Mira Design, supra, would have entered into the agreements at issue had they been aware ex ante that they would only be entitled to the return of the principal advanced. The change effected by the blue-pencil technique will often fundamentally alter the consideration associated with the bargain and do violence to the intention of the parties. Indeed, in many cases, the application of the blue-pencil approach will provide for an interest-free loan where the parties demonstrated in the agreement a clear intention to charge and pay considerable interest.
Justice Arbour's solution (for the majority) to the inherent problems of the blue pencil test was to add the doctrine of notional severance to the remedial tools available to judges faced with criminal interest loans. As usual, where the Supreme Court provides a new judicial remedy, it also provides a guideline for the application of the new remedy. Here, the four pronged test as to whether to apply notional severance is the same test used by the Ontario Court of Appeal in William E. Thomson Associates Inc. v. Carpenter {1989), 61 D.L.R. (4th) 1to determine whether to use the blue pencil test to sever interest repayments from the obligation to repay principle.
The implication from the majority decision is that the more usurious the interest rate, the more ham fisted the appropriate severance tool. An interest rate just over 60% may be a good candidate for notional severance. A higher interest rate may be a candidate for the less precise methodology of the blue-pencil test which could save some component of interest but likely not 60%. Even higher contractual interest may result in a declaration that the loan agreement is completely void thus allowing the borrower to pay no interest and keep the principle.
The purpose of this paper is to trace the implications of this new approach to severance on employment law.
Notional Severance of Restrictive Covenants
Canadian American, supra is one of the most frequently cited cases involving severance of restrictive covenants. This case is difficult to understand and apply in that it has two substantive concurring judgments that are difficult to reconcile. One thing we can generally take from this decision is that the restrictive covenant was unenforceable and not amenable to severance using the blue pencil test because the geographic limit of the restriction was overbroad and could not be fixed without changing the words the parties had agreed on. In that case, the parties had agreed on the geographic limitation of Canada and Bermuda but the evidence indicated that the applicable business was only carried on in Alberta and B.C.
In Canadian American, supra, both Hinkson J.A. and Lambert J.A. agreed that absent legislation that would specifically allow the Court to modify the terms of a covenant to make it reasonable, the Court had no power to do so.
Notional severance would change this. If the Court were faced with a restrictive covenant like that in Canadian American, supra, it could make the substitution that Hinkson J.A. and Lambert J.A. refused to make using notional severance.
Is notional severance available in considering the enforceability of restrictive covenants? Justice Arbour's majority decision in TNA attempts to draw a distinction between those contracts that are illegal due to legislated "bright line" distinctions as compared to the more subjective considerations in a restraint of trade case (at 270):
Section 347 of the Codeinvites difficulties with arbitrariness by imposing a bright line of 60 percent as demarcating legal interest from illegal interest. This legislatively mandated bright line distinguishes s. 347 cases from those involving provisions, for example, in restraint of trade, where there is no bright line.
However, Bastarache J.J. raises this concern in his dissent (at 282):
Second, there is no legal or other principled reason to limit the application of the new approach endorsed by my colleague, that is notional severance, to the application of the criminal rate of interest. This means that other illegal provisions would be open to judicial redrafting.
Since TNA, two appellate courts have considered the application of notional severance in the context of restrictive covenants. In Globex Foreign Exchange Corp. v. Keleher, [2005] A.J. No. 1654 (C.A.), the Alberta Court of Appeal allowed an appeal of in interlocutory injunction enforcing a notionally severed post employment restrictive covenant. The aspect of the case dealing with notional severance is technically obiter dicta because the injunction enforcing the restrictive covenant was set aside on another ground. However, there is a useful analysis of this issue which may signal the Alberta Appeal Court's approach to notional severance in this context (at paras. 44-49):
The chambers judge, however, relying on a recent decision of the Supreme Court of Canada, Transport North American, supra, applied the doctrine of notional severance to re-write the unreasonable portion of the clause. The appellants argue this doctrine does not apply to contracts in restraint of trade, that it is restricted to cases of statutory illegality as was the case in Transport North American itself. We agree the doctrine must be so limited, based on a reading of the Supreme Court's reasons in Transport North American and considering the rationale behind the courts' traditionally close examination of restrictive covenants.
Transport North Americandealt with a loan agreement, the effective interest rate of which contravened s. 347 of the Criminal Code. The case involved a commercial transaction between experienced and independently advised commercial parties. There was no evidence that the parties intended to contravene the interest provisions of the Code. Faced with the choice of striking certain clauses to provide for an effective annual rate of 30.8 percent or applying the concept of notional severance to rewrite the clause and reduce the effective interest rate to 60 percent (the statutory maximum), the majority decided on the latter approach.
Justice Arbour, for the majority of the court, found that notional severance is available as a matter of law as a remedy in cases arising under s. 347: para. 5. In such cases, there is a clear statutory 'bright line' differentiating legal contractual provisions from illegal. It can be a straightforward matter, in cases where the evidence shows the parties did not intend to breach the statute, to reduce the interest provisions to the statutory maximum. A difficulty with attempting to apply the doctrine to restrictive covenants is that there is no clearly discernible legal standard for the courts to apply. H such covenants could be re-written to meet a standard of 'reasonableness' as determined by the court, there would be no certainty of contract until the matter was decided at trial.
Arbour J. recognized this distinction. At para. 34 she referred to contracts in restraint of trade as an example of a provision that does not involve the application of a 'bright line' test:
Section 347 of the Code invites difficulties with arbitrariness by imposing a bright line of 60 percent as demarcating legal interest from illegal interest. This legislatively mandated bright line distinguishes s. 347 cases from those involving provisions, for example, in restraint of trade, where there is no bright line. The interaction of the blue-pencil test with the bright line separating illegal interest from legal interest leads to erratic results.
Further, notional severance was available in Transport North American in part because the parties were independently advised commercial entities of equal bargaining power. The same considerations do not often arise in cases of restrictive covenants between employer and employee. The inequality of bargaining power in employment relationships recognized in Eisley lies at the heart of the conservative approach to severance of restrictive covenants in employment agreements that is exemplified by the blue pencil rule. In the House of Lords decision in Mason v. Provident Clothing and Supply Company, Limited, [1913] A.C. 724, Lord Moulton stated at 745:
It would in my opinion be pessimi exempli if, when an employer had exacted a covenant deliberately framed in unreasonably wide terms, the Courts were to come to his assistance and, by applying their ingenuity and knowledge of the law, carve out of this void covenant the maximum of what he might validly have required.
We agree with this analysis. Employers should not be permitted to draft unreasonably broad restrictive covenants with the expectation that, should the matter ever come to trial, the court will simply re-write the clause so as to make it enforceable.
In ACS Public Sector Solutions Inc. v. Arntsen, [2005] B.C.J. No. 2656 (C.A.), the B.C. Court of Appeal came to a different conclusion, also in obiter. The A CS decision was an appeal of a declaratory order whereby the chambers judge severed overbroad portions of a restrictive covenant using the blue pencil method. After reviewing the TNA decision, Donald J.A. for the unanimous Court stated that notional severance was available in the circumstances of this case (at para. 59):
In my view, the spectrum theory endorsed by the Supreme Court of Canada applies to any illegal contract provision, whether by common law or statute. The blue-pencil approach finds itself on the spectrum and is an available remedy in appropriate circumstances. So the law has traveled some distance from the all-or-nothing proposition advanced by the appellants. In my judgment, this was an appropriate case for severance and the trial judge applied the blue-pencil remedy appropriately. Contrary to the submission of the appellants, he was not obliged to strike down the whole of the restrictive covenant because of overbreadth in part of it.
“Any Illegal Contract Provision”
Another area of employment law where the TNA decision and the doctrine of notional severance could have an impact is in circumstances where written employment contracts and the Employment Standards Act collide. A typical scenario is an express termination provision that provides for less than the Employment Standards minimum. This is a situation involving what Arbour J.J. called a "bright line" distinction in TNA.
The leading case is Machtinger v. HO] Industries Ltd., [1992] 1S.C.R. 986. Machtinger holds that where an employer attempts to contract for a notice period that is less than the minimum mandated by Employment Standards legislation, the contractual term is null and void and the standard of reasonable notice applies to fill the void. While Machtinger was not framed as a severance case, the issue was stated by the Supreme Court as follows (at 996):
If an employment contract stipulates a period of notice less than that required by the Employment Standards Act, R.S.O. 1980, c. 137, is an employee who is dismissed without cause entitled to reasonable notice of termination, or to the minimum period of notice required by the Act?
In reaching its decision in Machtinger, the Supreme Court, which was unanimous in the result, stated the following policy reasons in support of its decision:
If the only sanction which employers potentially face for failure to comply with the minimum notice periods prescribed by the Act is an order that they minimally comply with the Act, employers will have little incentive to make contracts with their employees that comply with the Act. As Swinton and Etherington suggest, most individual employees are unaware of their legal rights, or unwilling or unable to go to the trouble and expense of having them vindicated. Employers can rely on the fact that many employees will not challenge contractual notice provisions which are in fact contrary to employment standards legislation. Employers such as the present respondent can contract with their employees for notice periods below the statutory minimum, knowing that only those individual employees who take legal action after they are dismissed will in fact receive the protection of the minimum statutory notice provisions.
In my view, an approach more consistent with the objects of the Act is that, if an employment contract fails to comply with the minimum statutory notice provisions of the Act, then the presumption of reasonable notice will not have been rebutted. Employers will have an incentive to comply with the Act to avoid the potentially longer notice periods required by the common law, and in consequence more employees are likely to receive the benefit of the minimum notice requirements. Such an approach is also more consistent with the legislative intention expressed by s. 6 of the Act, which expressly preserves the civil remedies otherwise available to an employee against his or her employer.
This policy of putting the onus of ensuring statutory compliance on the party seeking to benefit from the contractual term with punitive consequences for attempting to circumvent the legislated standard is similar to what Bastarache J.J. said in dissent in TNA (at 284-285):
Under my colleague's approach, a creditor would be permitted to escape the consequences of its avoidance measures by simply reducing the rate to the maximum permitted under the Criminal Code. In my opinion, this approach is inconsistent with the general objectives expressed in the Code and incompatible with the notion of deterrence. It is a criminal offence for any lender, even a commercial creditor, to enter into a loan agreement providing for [page285] an effective interest rate greater than 60 percent per annum. And, as Rosenberg J.A. remarked, at para. 31, of the majority reasons of the Court of Appeal ((2002), 60 0.R. (3d) 97) to permit a notional severance of the kind ordered by the application judge is to effect a substantial innovation in the common law doctrine of severance to the benefit of those who prima facie stand in violation of the criminal law.
Machtinger and the line of cases following it, particularly Shore v. Ladner Downs, [1998] B.C.J. No. 1045 (C.A.) are still good law. However, the development of notional severance and the apparent acceptance of it by our Court of Appeal in A CS could lead to a reconsideration of these principles.
Conclusion: Notional Severance and Employment Law
The doctrine of notional severance has not yet been successfully applied in the employment law context. If extended into this area, it could have a profound impact on restrictive covenants and also statutory illegality situations such as in Shore v. Ladner Downs.
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